The Nature of Money
The creation of our economic systems is political. Our present banking system, the power given to those that create and control money, is a result of political decisions. Our present economic system is not a natural system: it is a system that was created to serve those that created it. The lifeline of our financial system is money, and in order to fully understand economics, we must first understand the nature of money, how it is created or destroyed, the effects that this process has on the economy and the benefits accruing to those that partake in this process.
What must be made clear, is that before an economist can provide an
analysis of an economy, this person must first understand the financial
system. Otherwise, all analysis becomes meaningless, because different
financial systems affect the economy in different ways. Moreover, if we
do not understand the basics of our financial system, then this leads us
only into logical contradictions and errors. While economists have several
definitions of what money is, we will consider money to consist of deposit
accounts in banks or similar institutions, and government bank notes. Of
these two, deposit accounts make up almost 99% of all money. As such, we
will begin our analysis by examining deposit accounts, how they are created
or destroyed, and the effects this process will have on an economy. Today's
financial system consists of a fractional reserve banking system. In such
a system, deposit accounts, being a liability of the bank, are offset by
loans, which are the assets of the bank. By contrast, in a 100% reserve
banking system, deposit accounts (liabilities of the bank) would be offset
by government notes, which would be the assets of the bank. In a fractional
reserve banking system, money is created when a new loan is given. The
borrower has increased the amount of money he has, while the money held
by all other persons has remained the same. An economist must understand
this before anything else, and failure to understand this will only lead
to an illusion of reality. Next, an economist must understand how the creation
of a loan affects the economy. When a loan is created, this allows the
borrower to increase expenditure, which will affect GDP (Gross Domestic
Product), since expenditures make up GDP. Secondly, the creation of a loan
also results in the borrower having to make payments of interest and principle,
which causes expenditures to be reduced, which again affects GDP. The payment
of either principle or interest will reduce the amount of money held by
the borrower, and since the amount of money held by all other people has
not changed, this must reduce the amount of money. In addition, money is
also created whenever a bank purchases an asset, or is destroyed whenever
a bank sells an asset. To confirm and clarify these points, we will examine
the effect of these transactions on the banks balance sheet.
For simplicity, we assume that there is only one bank, which is the
same as considering the banking system as a whole
Consider a cash-less society in which all financial transactions are handled by cheque, and assume the initial bank balance sheet.
Assets Liabilities
Loans
30
Deposits
30
Buildings
1
Equity
1
Total
31
31
Assume that a person borrows $3, which the bank deposits into his account. In the bank, the loan clerk completes two bookkeeping entries. The loan clerk credits the borrows account by $3 and debits the banks general ledger loan account by $3.
Assets Liabilities
Loans
33
Deposits
33
Buildings
1
Equity
1
Total 34 34
Total loans and total deposits have again increased by $3. The borrower,
now having an extra $3, can write a cheque against his account. However,
this will have no net affect on the banks balance sheet, as another depositors
account is increased by an equal amount. Since we are dealing with bookkeeping
entries with no physical limit, it then follows that there is no limit
to the amount of loans and deposits that can be created. Now governments
can place artificial limits to loan growth, such as restricting total loans
to a total dollar figure, restricting total loans to a certain multiple
of total Gov. Notes, restricting total loans to a certain multiple of owner
equity, or some other factor. However, this not change the fact (and I
stress the word fact), that in a fractional reserve banking system, deposits
and loans are created through simple accounting entries (hence the concept
of money out of nothing), that in the absence of artificial restraints
can increase without limit, so long as banks are willing to lend, and people
are willing to borrow. In many countries, loans are no longer restricted
to a multiple of Gov. Notes. While loans may be restricted to a percentage
of owner's equity, in reality this has little effect. Banks can always
increase their equity through the issuance of new shares, even if a small
percentage of newly created money must be allotted to purchase these shares.
In the absence of artificial restraints, the increase of both
loans and deposits can grow without limit, as they only represent bookkeeping
entries.
Similarly, consider the effects of the purchase of an asset by the bank, in this case being a government bond.
Assets Liabilities
Loans
33
Deposits
33
Buildings
1
Equity
1
Total 34 34
Now, the bank will purchase a government bond for $5. The initial transactions are for the bank to issue a bank cheque to the government for $5. The balance sheet adjusts as follows:
Assets Liabilities
Loans
33
Deposits
33
Suspense Account 5
Bank cheque account
5
Buildings
1
Equity
1
Total 39 39
The bank now purchases the $5 government bond, with the government depositing the cheque in its bank account.
Assets Liabilities
Loans
33
Deposits
38
Government bonds 5
Buildings
1
Equity
1
Total
39
39
Again, these transactions involve only simple bookkeeping entries, and
in the absence of artificial restraints, can be created in unlimited amounts.
Bank deposits are destroyed whenever a loan payment is made, an interest
payment is made, or a bank sells an asset, as shown by the effect that
these transactions have on the bank's balance sheet.
In the above example, let us consider what happens to the banks balance sheet when a $2 principle loan payment is made. In the bank, the loan clerk again completes two bookkeeping entries. The loan clerk debits the depositors account by $2 and credits the bank's general ledger loan account by $2.
Assets Liabilities
Loans
31
Deposits
36
Government bonds 5
Buildings
1
Equity
1
Total 37 37
Loans and deposits have both decreased by $2. Now, consider the effect of a $1 interest payment. The bank completes two bookkeeping entries, a depositors account is debited by $1, with the banks equity account being credited by $1. The balance sheet adjusts as follows.
Assets Liabilities
Loans
31
Deposits
35
Government bonds 5
Buildings
1
Equity
2
Total 37 37
Loans and assets have remained constant, while deposits have decreased and the bank's equity has increased. Thus, the payment of interest has decreased total money supply by the interest paid. I should stress here, that it is because the payment of interest destroys money, that a fractional reserve banking system is an unstable financial pyramid. This will be expanded upon shortly. Now, consider the effect of the bank selling $3 in government bonds. The purchaser of the bonds will have its account debited to purchase the bonds, with the net affect as follows.
Assets Liabilities
Loans
31
Deposits
32
Government bonds 2
Buildings
1
Equity
2
Total 34 34
It is useful to reflect on how the banks equity position affects the banks ability to make loans or purchase assets. Does the increase in equity through profits or share offerings affect the banks ability to create loans or purchase assets? While it may be useful that a banks equity be at a certain level to satisfy some outside financial regulator, technically, it has no bearing on the creation of loans or the purchase of assets. Since each time a bank purchases an asset or creates a loan, an equal and offsetting deposit is created, these transactions can continue to occur regardless of the equity level of the bank. In the granting of a loan, it is also wrong to think of a bank re-lending money (as some conventional economic theory teaches), for this is not what happens. In the process of giving a loan, the bank both creates the loan and the deposit, both being balancing entries on it's balance sheet. This really has nothing to do with the existing assets or liabilities of the bank. In a fractional reserve banking system, debt is first created, and then used to create money. We must contrast these loans with loans where money first exists, and then it's ownership is transferred by a loan contract. These are very different contracts, with totally different effects on the economy.
Before proceeding, I believe that it is important to consider the legality
of these transactions. While this ultimately will be decided in the courts,
I raise the following questions.
It is my contention that bank loans do not constitute a legal
contract, that they represent an attempt to defraud, and that they represent
part of a large pyramid scheme, which by their very nature are illegal.
My rational is as follows. In a borrowing contract, the borrowers account
is credited with the amount of the loan, for which the borrower agrees
to repay the amount borrowed plus interest. In examining the legality of
this contract, we must first examine the source of the borrowed money.
It is commonly believed that the borrower is borrowing money that the owners
of the bank have invested in the bank, or from a pool of funds that depositors
have entrusted to the bank. However, it is not, and herein lies the
deceit and fraud of the bank. When a bank gives a loan, the bank completes
two bookkeeping entries. The bank credits the borrowers account with the
amount of the loan and debits a general ledger loan account by an equal
amount. The banks deposits (liabilities) and loans (assets) have increased
by an equal amount. What has happened is that the bank has created money
out of nothing, and this money, created out of nothing is what they lend
the borrower. The creation of the loan must proceed the creation of the
deposit, and is the very instrument that creates the deposit.
Questions to be asked, are first, can banks legally create money out
of nothing? Secondly, in contract law, is something created out of nothing
valid consideration for a contract?
Thirdly, we must examine the legality of interest charged on the loan.
Is not interest charged on something created out of nothing an attempt
to defraud the borrower? What legal right does the bank have to receive
interest on something created out of nothing? What consideration has it
given to deserve this interest?
Fourthly, we must examine the fractional reserve banking system as
being a large pyramid scheme, which by their very nature are illegal. In
a fractional reserve banking system, money is created when loans are created,
and money is destroyed with the payment of principle or interest. Since
loans are repaid with money, and the amount of money created (through loans)
is always less than the amount of money required to repay the loans (principle
plus interest), it then follows that it is impossible to repay the loans.
By the simple fact that money is destroyed by both interest payments and
principle payments, there can never be enough money created by the banking
system to repay all the loans created by the banking system. Moreover,
should the creation of new loans stop, even if no loan payments were made,
the entire money supply would soon disappear. At a 10% interest rate, this
would happen in less than 10 years.
By a further example, should we wish to keep the money supply constant,
then loans must grow by the amount of interest paid. Over time this leads
to a continual increase in loans for the same money supply, also demonstrating
that loans can never be repaid.
Bankers attempt to maintain their pyramid scheme by ever increasing
amounts of loans. However, these loans are neither self-sustaining nor
repayable, and the system must eventually collapse. This is part of the
deceit of fractional reserve banking, the granting of loans that can never
be repaid.
Separately, but with keeping with the same ideas, we must examine the
legality of government income taxes, and ask if these taxes are not an
attempt to defraud taxpayers.
The main issue centers around government debt, and the collection of
taxes to pay either interest or principle on this debt. The financing of
government deficits could be accomplished with either the printing of new
government notes (in a simple case, the government would print up bank
notes, deposit these notes to their bank account, and write cheques on
the amount deposited), or by borrowing money created out of nothing by
the banks (either by direct loans or by the purchase of government bonds
by the banks). In both cases, the government is spending money that did
not exist before. However, by borrowing from the banks, the government
is deliberately creating a future tax liability when it was not necessary
to do so. These loans then become a fraudulent transfer of wealth from
taxpayers to bankers. Moreover, as we will examine, governments can immediately
repay all loans at no cost to the taxpayers, and at the same time improve
the stability of the financial system. That they fail to do so, clearly
shows their intention to continue to defraud taxpayers.
This is the first problem with letting banks create money, the fraudulent
transfer of wealth. The second problem is the amount of money that is created,
and how this money is used, both of which fall under the control of bankers.
This allows them to control or fuel economic expansions, and create financial
bubbles in specific areas. This gives them the knowledge to speculate at
the right time in the right investments. We must remember that the key
to controlling the world is the creation and control of economic contractions.
It is here that the majority of wealth is transferred to the money people.
Moreover, it is at these times that these same people bring about political
change. As bad as the banks ability to create money is, it is their ability
to destroy money that is even more frightening. We will now consider how
a fractional reserve banking system affects the economy.
When we discuss money, it is important to remember that money is used
both as a store of value as well as a medium of exchange. That is, some
people hold money as a preference to holding some tangible asset such as
real estate. Money is also used as a medium of exchange; it is used as
a means of payment for goods or services. The total amount of money therefore
consists of the total amount of money used as a store of value plus the
total amount of money used as a medium of exchange.
When we discuss economic growth, we must distinguish between the nominal
or dollar valuation of an economy, and the real number of goods or services
produced. This is governed by the equation;
GDP = (# units produced) * (price/unit)
where GDP is the Gross Domestic Product of an economy.
Thus, it is possible that GDP could remain the same when the number
of units produced increases, if the price/unit decreases. What is important
to remember is that two factors determine nominal GDP, both the number
of units produced and the price/unit.
The other equation that must be considered is;
GDP = (amount of money) * (velocity of money)
Here, when we talk of "amount of money", we are referring to the amount
of money used as a medium of exchange. Some may prefer to consider the
"amount of money" as the total combined amount of money, and so a smaller
velocity of money would be shown. I have chosen to separate the amount
of money as to it's uses, as this is more precise, as well as to show the
effects of the changes between the different uses of money. Put Mathematically,
to consider the relationship between these velocities;
MT = Total money supply
ME = money supply circulating in the business economy
MI = money held as an alternative to existing assets
V = velocity of money where VME would be the velocity of money circulating
in the business economy
ME*VME =GDP
MT*VMT =GDP
ME*VME = MT*VMT
ME*VME = ME*VMT + MI*VMT
VME = VMT(1+MV/ME)
In most of our discussion, we will assume that the velocity of money
remains constant in order to consider the relationship between the other
variables. Moreover, unless we can show that the velocity of money is affected
by either the amount of money, or the number of units produced, or the
price/unit, it is the only logical assumption that we can make. This is
further supported by the restraint placed on the spending of money, in
that economic units are generally restricted to spending what they earn
or borrow. This thus gives us the equation;
(amount of money) * (velocity of money) = ( # units produced) * (price/unit)
This represents the Quantity Theory of money, which basically says that economic activity is an exchange of money for goods and services and that the two sides of the equation must at all times be equal.
With the amount of money remaining constant, an increase in the number
of units produced will not effect nominal GDP; it will only decrease the
price per unit. This follows with conventional economic thought that says
when supply increases, prices will fall. An increase in production will
lead to a fall in price/unit, and with costs remaining constant, will see
profit margins decrease. Since the greater the increase in production,
the greater the fall in price, an economy that continually increases production
will eventually see the price/unit fall to or below the cost/unit, making
production uneconomic and leading to production shut downs. If however,
the money supply was increased at the same rate as the increase in production,
the price/unit would remain constant and the profit margins would not be
affected. This clearly points how the manipulation of the money supply
will affect profitability and ultimately production.
The above analysis is true of all financial systems, though effects
will be very different in different systems.
In discussing the effects of loans on GDP, I will consider three types of loan growth, for they all impact the economy in different ways. Specifically, we will consider loans that increase expenditures, loans that increase production capacity, and loans that are used to purchase existing assets.
First, let us consider a fractional reserve banking system when loans are used to finance expenditures. This new debt is spent and increases GDP by the amount of the increase in debt multiplied by the velocity of money. The next year, new loans must increase by interest costs plus principle loan payments just to maintain GDP at last years levels (this maintains a constant money supply). Put mathematically;
If "new loans" = NL; "interest payments" = IP; "principle payments"
=
PP;and "r" = interest rate; MS= "amount of money"; and VL= "velocity
of money", then we have the following nominal values for
GDP (Again, we will assume that the velocity of money remains constant)
GDPy1= MSy1 * VLy1
GDPy2= MSy2 * VLy2
GDPy2= (Msy1+NLy2-Ipy2-PPY2) * Vly2
GDPy2= (MSY1*VLY2) + ((NLY2-IPY2-PPY2)*VLY2)
GDPY2= GDPY1 + ((NLY2-IPY2-PPY2)*VLY2)
If we consider a financial system where loans are first introduced in Year 2, then we have the following;
GDPy2 = GDPy1 + (NLy2*VL)
GDPy3 = GDPY2 + ((NLy3 -(r*NLy2) -PPy3)*VL)
GDPy4 = GDPY3 + ((NLy4 -(r*(NLy3+NLy2-PPy3)-PPy4)*VL)
GDPyn = GDPym + ((NLyn -(r*(sum(NLYm:NLy2)-sum(PPym:PPy3))-Ppyn)*VL)
For simplicity, if we assume that no
principle payments are ever made, then;
GDPyn = GDPym+ (NLyn -(r*(sum(NLym:NLy2))))*VL
Thus, for GDP to remain constant, loan growth in Yn must equal the
total amount of interest paid. For GDP to increase, loan growth must increase
at an even faster rate.
If NL is constant for all years, once NLyn = r*(sum(NLym:NLy2))
then economic growth will stop, and in subsequent years will decrease
at an
accelerating rate. At this point GDP is contracting, even as loans
continue to grow. Thus, for GDP to continue to grow, loan growth must exceed
interest payments(assuming no principle payments).
These relationships are also shown in the equation;
GDP = (amount of money) * (velocity of money) = (# units produced)
* (price/unit)
Where (amount of money )yn = (amount of money)ym +NLyn – IPyn -PPyn
An increase in the amount of money will increase nominal GDP, which
will increase the number of units produced or the price/unit or both. Should
an economy be operating below its productive capacity, then it is likely
that most of the increase in the amount of money will result in higher
production. If the economy is operating near it's productive capacity,
then most of the increase in money will result in higher unit costs.
Considering the above analysis, it might be useful to reflect on the
thoughts of C.H. Douglas and his views on monetary reform.
Douglas thought in terms of "lack of purchasing power", that because
industry incurred debt in any expansion, and had to include the expense
of
repaying this debt in the pricing of it's products, that the wages
generated
in actually producing the products would not be sufficient to actually
buy
all the products produced because of this additional expense (hence
lack of
purchasing power).
Due to this lack of purchasing power, unless new firms were expanding,
and
thus increasing purchasing power prior to actual production, the economy
would slump, with the business cycle attributed to these timing differences.
In order to address the problem of always needing new investment to
keep
adding purchasing power, Douglas proposed that the government issue
to each
person, sufficient debt free money to cover the "lack of purchasing
power".
In a classical sense, Douglas was wrong in his concept of "lack of
purchasing power", and those that concur with "Say's Law", which states
that
the process of producing goods automatically distributes sufficient
purchasing power to buy all the goods produced are correct. In the
context
of Douglas's example, it is true that wages alone would be insuffient
to
purchase all the goods produced because of the need to increase prices
to
cover debt repayments. However, the interest and principle payments
distributed by industry also become purchasing power, and would equal
any
funding gap. In this sense, it would not be possible to develop a
mathematical model to show such a funding gap.
Having said this, I would have to agree with Douglas in a certain sense,
that is, while no funding gap would be created in a 100% reserve banking
system, in a fractional reserve banking system, it would be created
(though
not for the reasons given by Douglas). This is because in a fractional
reserve banking system, payments of principle and interest are not
distributed to anyone (they provide no purchasing power), but simply
cause
money (and hence purchasing power) to disappear. (In making a loan
payment, the borrowers purchasing power is reduced by the amount of the
payment, and since no one else's purchasing power is increased by the payment,
this brings about a reduction in total purchasing power.) This can be compared
to a
100% reserve banking system where payments of principle or interest
are
distributed, can be used as purchasing power, with no money being destroyed.
In this regard, Douglas's proposal to distribute debt free money must
be
seen in a positive light, for it would have replaced the money lost
due to
principle and interest payments, and thus helped maintain the stability
of
the system.
While Douglas appeared to intuitively know that there was something
wrong
with the financial system , and attempted an explanation of what it
was, it
appears that he did not fully understand the consequences of allowing
banks
to create money. More importantly, it appears that he totally failed
to
understand the ability of banks to destroy money. It is this ability
to
destroy money a creates economic contractions, and not some "timing
differences".
Now, let us consider a fractional reserve banking system when loans are given to increase production capacity. This will increase the number of units produced (which will act to lower the price/unit) as well as increase the amount of money (which will act to increase both price/unit, and the number of units produced). The change in the price/unit will be dependent on relative change in these variables. In subsequent years, the amount of increase in the amount of money will be the difference between new loans to increase production less any payments on principle and interest on previous loans. Even if initially, the percentage increase in the price level is greater than the percentage increase in the amount of production, in subsequent years, the increase in the amount of money must continually fall, even as the increase in the amount of production continues at a set rate, by virtue of ever increasing principle and interest payments acting to decrease the amount of money. Thus, over time, the price/unit must fall and will eventually fall below costs, which will lead to closing of production. Should no new loans be given, this process will only accelerate, as the continual decrease in the amount of money due to principle and interest payments, will decrease the price level below cost at an even faster rate. Put mathematically, we have the following equations;
Let Z be the increase in production for every $1 increase in new loans
(NL)
Let UP be the number of units produced
Let P/U be the price per unit
GDPyn =GDPym +(NLyn –PPyn- Ipyn)*VL
UPyn*P/Uyn = UPym*P/Uym +( NLyn- PPyn- Ipyn)*VL
Since UPyn = UPym+(NLyn*Z)
P/Uyn = P/Uym(UPym/(UPym+NLyn*Z) + (NLyn-PPyn-IPyn)*VL/(UPym+NLyn*Z)
The price level (P/Uyn<P/Uym) will turn negative prior to the money
supply turning negative (NLyn<PPyn+IPyn). As we have already described,
for any constant NL, PP+IP will eventually exceed NL even if PP=0.
In an economy operating below it's productive capacity, it should be
expected that the initial loan will result in more production, and will
have only a limited effect on the price level. Once the new capacity is
in operation, this will lower the price level. Thus, we would expect these
loans to have only a minimal initial increase on the price level, soon
to be reversed by a downward trend. Are there negative effects to a fall
in prices? As a society, are we not more concerned about the number of
units produced, and not the relative level of the price level? This question
can only be answered by examining how rigid costs are compared to prices.
If in response to falling prices, costs, at least in the short term do
not fall, then prices will eventually fall below costs resulting in business
closures. More importantly, payments of principle and interest are in nominal
terms and can not fall. Thus, even if all other costs freely fall with
prices, a falling price level will severely impact the financial viability
of a business. This may also be a factor in the ability of different costs
to fall in response to a fall in prices. Rent costs may not be able to
be lowered due to the level of mortgage payments on the building. Workers
may not survive a fall in wages due to high personal loan payments.
A point should also be made that the effects of technological growth
or inflation will have no effect on this financial model.
This analysis is purely numerical; it deals strictly with dollar flows
and says nothing of the quantity of units produced.
If Dollars Spent = (quantity of items) x (price per item), then this
analysis is only looking at the Dollars Spent. When loans are created
and new money spent either the price per item will remain constant and
the quantity of items will increase, or the quantity will remain constant
and the price will increase, or some combination of the two will occur.
The reverse holds true when loans or interest are repaid. In this
world where we have not reached our limit about how many cars or computers
can be produced. I am inclined to believe that some of this new credit
created will result in increased quantity produced. Moreover, if
technological improvements allow quantities to increase while prices fall,
this too has no effect. Money is created or destroyed through loan
growth or repayment regardless of technological advancement. . Perhaps
it is important to touch on a point not well understood. People believe
that there must be economic growth to earn money to repay loans. This is
the same as saying that we get money from economic activity, which can
then be used to repay loans. These statements are false. No economic activity
has ever created any money. Money is only created by within the banking
system by a new loan. Thus to generate money to repay loans, a new loan
must be created creating a circular impossibility. Moreover, since the
payment of interest reduces the amount of money without reducing loans,
this only adds to the problem. By way of comparison, consider the
following statement by Irving Fisher:
"For, under the 10% system it is true, as we have seen, that an increase in business, by increasing commercial bank loans, and so increasing the circulating medium, tends to raise the price level. And, as soon as the price level rises, profits are increased and so business is expanded further. Thus comes a vicious circle in which business expansion and price expansion act each to boost the other- making a "boom". Reversly if business recedes, loans and prices also recede, which reduces profits and so reduces business volume- again causing a vicious circle, making a "depression". But take away the 10% system and you take away these unfortunate associations between business and the price level." (p.164 100% Money)
Irving Fisher felt that the expansion of bank lending would lead to
booms, and the contraction of bank lending lead to depressions, mainly
due to the change of the price level as a result of lending activities.
He thus desired to move away from a financial system where the level of
money was determined by the amount of bank loans which he saw as being
unstable (though he felt that the 10% system combined with a stabilization
plan would work better than an unmanaged 100% system).
Strictly speaking, the above statement by Irving Fisher, while containing
elements of truth is incorrect. It does not consider that the economy may
be operating below capacity, with some expansion possible without affecting
the price level. It does not consider what affect that the extra production
will have on the price level (lowering it), and it does not consider the
effects of interest payments on the price level (through the reduction
in the money supply). If we consider the equation:
(amount of money)*(velocity of money) = (# units produced)*(price/unit)
it is only considering how the (amount of money) is influenced by changes
in commercial loans, and not by the payment of interest. It does not consider
that an increase in (amount of money) may lead only to an increase in (#
units produced), nor does it consider how an increase in ( # units produced)
due to an increase in productive capacity will affect the price level for
any given money supply. This shows the error of those that take the view
that price fluctuations are the cause of the business cycle.
As I have shown, over time, loans that increase productive capacity
must eventually be deflationary as the inflationary effects of creating
money through new loans are counterbalanced by the deflationary effects
of the destruction of money through increasing interest payments as well
as increases in the (# units produced). Continual business expansion will
lead to eventual bankruptcy as business incomes fall below costs. Should
business stop expanding, then new loans stop, and with interest payments
continuing, money supply will continue to contract, with the same result,
a continual drop in the price level, and income falling below costs. Due
to interest destroying money, such a system is not self-sustaining.
A financial system with money based on debt will be unstable and eventually implode, regardless of how efficient or technologically advanced an economy is.
Let us now consider the effects on both GDP and the financial system
as a result of this investment or speculative debt.
To begin with, let us consider a closed system consisting of 10 units
of money, 10 units of loans, and 10 units of land. An equilibrium
exists where people are equally happy to hold either 1 unit of land or
1 unit of money, and thus the value of one unit of land is one unit of
money. Some people wish to purchase some of the land, and through
the banking system, 10 units of money and 10 units of loans are created.
We now have a closed system of 10 units of land, 20 units of money,
and 20 units of loans. The equilibrium value of 1 unit of land would be
2 units of money. Assume now that the creation of new loans stop and repayments
begin to repay loans over a 5 year period or 4 units per year plus interest.
Assuming a 10% interest rate, we have the following table.
Money (start) Loans(start) Money(end) Loans(end) Land value(start) Land value(end)
Year 1 10.00
10
10.00
10
1/unit
1/unit
Year 2 20.00
20
14.00
16
2/unit
1.40/unit
Year 3 14.00
16
8.40
12
1.40unit
.84/unit
Year 4 8.40
12
3.20
8
.84/unit
.32/unit
After reaching a high of 20, the money supply has fallen to 3.20, which has reduced the price of land from 2/unit to .32/unit
The next points to consider the effects of these loans within
an
open economy. In our previous examples, we have assumed that money was
either only used as a medium of exchange in economic production or consumption,
or as a medium of exchange in purchasing existing assets. Since money is
used for both of these, we will show the interaction between both of these
systems.
Consider an open economy that has 10 units of land, 50 units of money,
50 units of loans, and an equilibrium price of land at 1 unit of land =
1 unit of money. Here it is assumed that people are equally happy owning
1 unit of money or 1 unit of land, and that 40 units of money circulate
within the economy. Again, assume that 10 units of money and 10 units
of loans are created in which to purchase land. What is the
effect on the economy and land prices? The answer is that it all
depends. Should people decide that they wish to maintain the same
number of units of land that they own, the price of land will rise to $2
per unit. Should the people who sell land decide not to own land
at all, the price will not change. Generally, the net result will
be somewhere between these extremes. What is the effect on the economy?
Again, if the price of land rose to $2/unit, there would be no immediate
effect on the economy. However, if the price of land did not increase,
an extra 10 units of money would be spent on the economy. People
who sell land have an option of using the money to finance expenditures
(increase GDP) or holding on to the money. Should they decide not
to spend this money, then as in the first example, the amount of money
relative to the units of land will increase and the price of land will
increase. Should this money be spent, the GDP will increase by the
amount of money spent. If the price of land increased to $1.50/unit, an
extra 5 units of money would be spent in the economy. We thus see
that the results of investment borrowing will increase GDP by the difference
between loans created and the increased value of land.
While this may be a theoretical truism, in a world that is constantly
changing, with peoples perceptions of value subject to change and manipulation,
over a certain period of time what we can observe is something quite different.
Price changes occur at the margin, generally representing a small percentage
of the whole yet affecting the perceived value of the whole.
In our above example, should only 4 units (of the 10) of land be available
for sale, and the holders of the new 10 units of money wish to exchange
this for land, the value of the land would need to increase to more than
1 unit of land = 2` units of money. Carrying on with this example,
over the short term, expectations of price movements tend to be based more
on historical trends than on economic fundamentals. Perhaps this
is based on the human tendency to view what is observable and not search
for the forces and actions creating our perceived reality.
In any case, in most cases, the following generalities will be observed.
When new loans (and money) are created to purchase existing assets
- prices of the asset class will increase
- some of the newly created money will be spent in the general economy,
thus increasing GDP
- there is an equilibrium price between money and the asset class,
though in the short term, these may be a substantial distortion between
the market price and equilibrium price.
Mathematically, we are again seeing the following equation
GDP = (amount of money)*(velocity of money) = (# units produced)*(price
per unit)
When the amount of money is increased to purchase existing assets,
if the velocity of money decreases (people decide to hold on to the money
from the sale of their asset), then GDP will remain constant. However,
if people decide to spend the money from the sale of assets (velocity of
money remains constant), then GDP will increase. It is important to reflect
on factors that effect the velocity of money and the effect on GDP. When
earnings are spent to purchase existing assets, and not expenditures, then
GDP will fall which is reflected in a decline in the velocity of money.
When people receive money from the sale of assets, if they spend this money
on expenditures, then GDP will increase which is reflected in an increase
in the velocity of money. If people receiving money from the sale of assets
decide also to purchase assets with this money, then GDP is unaffected.
Put differently, it is best to think of MT=ME+MI, where;
MT= total money supply
ME = money used in business economy
MI = money held as an alternative to existing assets
And GDP= ME*VME
Should people or firms spend less than they earn, then there is a transfer
of the use of money from ME to MI, thus reducing GDP and increasing asset
prices. Conversely, if people or firms spend the money that they were holding
as an investment, ME increases, MI decreases, with GDP increasing and asset
prices falling. A shift to ME to MI will raise income while lowering asset
prices. The combination of a lower price and greater income will increase
investment returns, and encourage money to flow back from ME to MI, and
so we see a natural equiibrium between these two supplies of money. Similarily,
a movement to MI from ME will lower GDP while raising asset prices, thus
reducing investment returns. This will encourage money to flow back to
ME, thus maintaining a natural equilibrium.
If we consider an increase in MI,(say from loans to purchase real estate),
this will increase the price of assets while leaving GDP unchanged, thus
reducing investment returns. This will encourage money to flow from MI
to ME, thus increasing income (GDP), and reducing asset prices until an
equilibrium is reached. Similarily, an increase in ME,(say from new loans
to purchase automobiles), will increase income without changing asset prices.
This will increase investment returns, and money will flow from ME to MI
until the equilibrium is reestablished. The reverse of these flows is also
true, when money is reduced from payments of principle or interest.
The above analysis can be used to provide a greater understanding of
the factors affecting the U.S. stock market. This market has increased
due to a large amount of money flowing into the market. If this money had
come from reducing expenditures, this would produce a negative effect on
GDP. If this money was created through new loans, then this would not affect
GDP. If people decide to sell some assets to increase expenditures, this
will increase GDP and reduce the value of these assets. If people decide
to borrow against the value of these assets to finance expenditures, this
will increase GDP while maintaining the value of the assets.
Now let us consider the effects when new loan creation stops, and repayment
begins. The first point to remember is that new money is created
by the amount of new loans created. However, money is destroyed by
the amount of loans repaid plus the amount of interest paid. That
is, even if the total amount of loans outstanding remained the same, each
year money would be destroyed by the amount of interest paid.
Thus, over time, in a system where money is created through debt, if new
debt creation stops, all money will eventually be destroyed (even if no
loans are repaid) as a result of interest payments.
There are two sources of repayment of loans. Either money circulating in the economy can be reduced, or some money held in lieu of property can be reduced, or some combination of both. In the first case, GDP will fall as the money circulating in the economy falls. In the second case, the price of land will fall, as there is now less money held in lieu of land. In reality, some combination of these two is likely to occur. This will change the rising price trend to a falling one and will alter future expectations. Should market values have risen substantially above any equilibrium price, they will now start to fall towards the equilibrium price, mindful that the equilibrium price is also falling as the money supply is falling. The effect on GDP is to decrease GDP by the amount of principle and interest paid as a result of reducing expenditures multiplied by the velocity of money. A point should be made here about the stability of the banking system. Loans are generally secured by collateral (land) and repaid by income. As the granting of loans will increase both land values, and GDP, this will have a positive effect on both collateral values, and income repayment ability. However, once credit creation stops, both collateral values and income will fall. A relatively large credit expansion will increase GDP while increasing land values substantially above equilibrium values. When such an expansion stops, and land values fall back to equilibrium values, many loans will be left unpayable, especially those made in the latter days of the credit expansion. As banks are highly leveraged businesses, this could easily lead to significant bankruptcies in the banking industry.
In our example so far, we have assumed that the land does not earn a
return. In fact, it does not matter if the asset class earns a return
or not. Earnings were earned before any loans were given and were
part of GDP. In that new loans will increase GDP, they may have a
positive effect on the earnings of the asset class, only to have a negative
effect when credit creation stops. What we should be aware of though
is that differences between the investment return on land and the interest
costs of debt will have an effect on the stability of the overall financial
structure. That is, if investment rates on land are greater than
interest costs, then the stability of the financial structure is more stable
than if investment rates on land are less than interest costs. This
comes down to a matter of individual loan quality.
If we consider debt that is created to purchase existing assets, the
creation of this debt is likely to partially increase GDP and partially
increase asset prices, though the creation of debt is likely to have a
much smaller impact on GDP than debt created to fund expenditures.
Repayment of this debt can come from the sale of assets purchased, or by
reducing expenditures in the economy. Should none of the existing
assets be sold to repay debt, then all of the payments of principle and
interest must be made by reducing expenditures, which will reduce GDP,
by the amount of principle and interest payments multiplied by the velocity
of money.
In this way, the creation of a credit asset bubble can have a
very negative effect on GDP. In this case, ever increasing amounts
of debt will cause a substantial increase in asset prices. This propels
prices of these assets far above the real value and we generally see the
interest costs on these loans far exceed investment returns. Once
credit expansion stops, asset prices will fall to a fair value, which will
leave loan balances far above asset prices. New loans cannot be repaid
at all from the sale of assets, and can only be repaid from a reduction
of expenditures, which will reduce GDP, by the amount of payments of principles
and interest.
The collapse of the Japanese real estate market in the 1990's or the asset bubble in SouthEast Asia in 1997 provides a good example of this phenomenon. Observing what will happen to the holders of margin debt in the U.S stock markets will provide a further opportunity to observe this relationship.
Again, to emphasis the mathematics of these three loan types;
Loans to purchase existing assets will increase these asset prices
in a model where the newly created money is not spent in the productive
economy. As the prices of these assets rise, the value of investment returns
fall given that the investment return has remained constant. In extreme
cases, loan growth and asset valuations will be such that loan payments
far exceed investment returns. When such a credit expansion stops, asset
values will fall to a level that reflects their investment return. Loan
values will then be far in excess of asset values and loans can not be
repaid from the sale of assets or from investment income.
Loans to finance expenditures will result in loans increasing at a
much faster rate than income. When such a credit expansion stops, the resulting
decrease in expenditures will significantly decrease GDP, which will decrease
incomes, which will further decrease GDP, creating a downward spiral. With
loans and debt repayment remaining constant, and income falling, loan repayment
is impossible.
Loans to finance increased production will lead to falling unit prices,
which will decrease investment returns. Thus, the greater the increase
in loans, the greater is the fall in unit prices and the ability to repay
these loans. When such a credit expansion stops, the absence of new loans
as well as loan payments will decrease GDP. This will further reduce either
the number of units produced or the price/unit of both, further reducing
the ability of business to repay loans. Again, once the credit expansion
stops, loan repayments are impossible.
In any economy, all three types of loans will have a cumulative effect,
and in the short term this effect will appear to be positive. Credit growth
that finances both increased expenditures (either by consumers or governments)
as well as business investment will both increase GDP. In addition, the
deflationary effects of the business expansion will provide a balance to
any inflationary effects of expenditure expansions. Credit growth that
finances existing assets will increase asset values. As asset prices rise,
they will provide security for increased borrowing while providing the
justification for lowering the savings rate.
However, once credit expansion stops, the financial system will implode.
When the productive economy is intimately connected to the financial system,
the effects will be most traumatic.
One of the policy points in this exercise of examining a debt-money
based economy, is that it is deflation, not inflation, that is the cause
for concern. It would also appear that a deflationary spiral would be difficult
to stop. In an economy financing the increase in productive capacity, prices
will turn negative while loan growth and money supply growth are still
positive. This will lead to a contraction in demand for loans to increase
production, which further reduces prices, and so a downward spiral is created.
A decrease in interest rates will reduce the total interest paid, which
will have a positive affect on the money supply and the price level. However,
this is only temporary, as for any given interest rate, the total interest
paid will again start to increase over time.
What is evident from a debt-money based economy, is whenever debt stops
increasing, the economy will enter a downward spiral. Thus, the only way
for such an economy to continue operating is an ever-increasing level of
debt.
The question must now be asked if there is a maximum level of debt,
and what factors could influence future debt increases. Since the creation
of debt (and money) is a simple bookkeeping entry, these can be increased
without limit, and so there is no maximum level of debt. However, with
each type of debt creation, there are factors that will tend to restrict
new debt (unless these factors are ignored). For debt created to increase
expenditures, loan growth will exceed any income growth. It then follows
that the value of loan payments will increase faster than income, and at
some future date, loan payments will exceed what can be repaid from income.
Even here, people can continue to borrow, and banks continue to lend, if
they ignore the repayment of loans.
For debt created to finance production increases, the continual increase
in production will eventually lead to falling prices. This will continually
reduce profit margins and eventually make the business unprofitable. Here
again, it is still possible for banks to continue to finance losses, and
even increase production further.
For loans to purchase existing assets, this will lead to rising prices
for these assets. This will lead to lower investment returns for these
assets. Eventually, interest costs will exceed investment returns, but
even here this does not mean that loans will stop, with new loans to pay
interest expense and further purchase of assets. People paying 8% on loans
to purchase stocks paying dividends of 1% is a good example of this.
In order for the economy to function, loans must continue to grow. As
we have shown, there must come a time when new loans do not make logical
sense if we consider that loans have a requirement to be repaid.
When something happens that causes people to stop borrowing, or stops banks
from lending, then the economy will begin to implode. The greater the extremes
of credit creation, the more powerful will be the implosion. There is another
factor that must be maintained for this system to continue to operate.
Not only must people continue to borrow, or bankers continue to lend, but
also depositors must leave their deposits within the banks, even knowing
that the loans securing these deposits can never be repaid. This can hardly
be considered to be a stable financial system.
Money is the lifeblood of our financial system, and in order for economies
to continue to expand, the money supply must continue to grow. The major
problem with an economy based on a debt-money system is that such a system
both creates money as well as destroys money. What is required is a financial
system where money can not be destroyed, but grows at the same rate as
the productive economy. We must move away from a system where growth can
not occur without the increase of debt.
A fractional reserve banking system also gives bankers the capacity to create severe financial distortions. At the heart of today's bubble is a massive credit expansion within America. As noted, increasing loans increases spending which increases incomes, profits, and government tax revenues, all of which have a positive effect on GDP. However, with a creation of such a bubble, there are forces that tend to counterbalance this bubble. In a consumer driven economic bubble such as we find in America, increases in consumer demand will lead to an increase in imports. This in turn leads to a decrease in the exchange rate, which in turn leads to higher inflation. Generally speaking, this increase in inflation in an economy experiencing a credit expansion will lead to higher interest rates which will tend to decrease demand and counterbalance the expansion. Should central banks attempt to keep interest rates low, thus creating an environment of low or negative real interest rates, capital will begin to flow out of the economy, again limiting the credit expansion. Thus, in order for the bubble to intensify, measures must be developed to counter the effects of an increasing trade imbalance. This has been accomplished through what is called the "Yen Carry Trade". The "yen carry trade" is a series of paper financial transactions within the Japanese banking system that has not only allowed the American financial bubble to be created, but has added greatly to it's rise. Within the Japanese banks, offsetting bookkeeping entries have created vast amounts of new loans and new Yen. This new Yen has been sold for U.S. dollars in sufficient quantity to not only offset the effects of a trade imbalance, but significantly increase the value of the U.S. dollar. This Japanese created liquidity has had a significant effect on America, providing funds not only to finance the trade imbalance, but also funds for the purchase of U.S. government bonds (thus holding down long term interest rates) and investments in the U.S. stock markets (thus helping to fuel the speculative fever). The combination of a rising U.S. dollar, and higher investment returns in America have allowed investors in the Yen carry trade to show significant paper profits. It must be stressed that the creation of such a large financial bubble in America would not be possible without the "Yen Carry Trade". It truly attests to the power given to bankers to manipulate the world economy through the creation of money from nothing, even to the point of creating money in one country to control the economy of another.
For the purpose of this article, I will discuss the events that will
occur, should the loans involved in the "Yen Carry Trade" be repaid. The
United States trade deficit is now approaching $250-300 billion. In addition,
as the worlds largest debtor nation, there is a significant capital account
deficit. Offsetting these outflows has been large capital inflows into
the U.S., such as the "Yen carry trade". As these capital inflows slow,
due to the large current account deficit, we will notice a fall in the
value of the U.S. dollar. As the dollar continues to fall, there will be
pressure on many of the investors in the "Yen carry trade" to sell their
U.S. assets and repay their Yen loans. This will first involve a major
sell off on the U.S. bond and stock markets to convert to U.S. dollars.
Then, this massive sale of U.S. dollars at a time when the trade deficit
is about $250-$300 billion/year will accelerate the decline in the value
of the U.S. dollar. This will add greatly to future inflation expectations,
further accelerating the sell-off of the bond and stock markets. Consumers,
seeing the value of their savings fall, will further accelerate the fall
as they sell to meet margin calls or salvage their savings before further
falls. More importantly, there will be a major reduction in consumption
due to rising interest rates, a falling dollar and stock market, all creating
a negative wealth effect. In effect, what we will observe is a severe contraction
in credit growth. This will put the economy into a major downward spiral
with falling employment, profits, and government tax revenue further diminishing
demand. It is important to note that a major source of government tax revenue
is due to capital gains income, and that once taxpayers start claiming
capital losses, the change in tax revenue will be severe. The banks will
now be re-evaluating how new loans are given, paying greater attention
to the ability of the consumer to repay loans from income. Due to the fall
off of income and the major credit expansion over the last few years, very
few new loans will be given. In addition, it will be much more difficult
to use stock margin accounts to fund consumer purchases.
Without new loans to help repay old ones and finance consumption, consumers
will now face a major decline in consumption. For example, if loan payments
equal 16% of current income, in the absence of new loans, consumption will
decrease by over 16%(with a negative savings rate).
Corporations, facing rising interest costs and collapsing demand, will
see profits greatly diminished. This will be another factor driving down
the stock market. Layoffs and insolvency's will be common place as corporations
attempt to deal with falling demand, tightening profit margins (as over
capacity leads to more competitive pricing), and rising interest costs.
Without elaborating further on events occurring in such a nightmare scenario, it must be understood that when a credit contraction does occur, based on logical reasoning, the above events will happen. It must be also be understood, that the solution to the financial Armageddon described above lies first in understanding how our present financial structure operates, and finding the political will to alter this structure.
To stop financial Armageddon, the negative effects of present loans
must be neutralized, and bankers must be prevented from creating money
from nothing. Neutralization would come from replacing all bank loans
with government notes. For example, the government bonds held by
the banks would be replaced with government notes. This would be
non-inflationary, as no "new" money would be created. The only effect
would be to replace government bonds with government notes as bank assets.
Should depositors wish their money, the bank would have the notes to go
with them.
The only difference is that while government bonds pay interest and
have to be repaid, government notes do not. Thus, the taxes collected
to pay the interest and principle on the bonds could be eliminated.
In a similar manner, all bank loans could be replaced with bank notes.
This could destroy the ability of banks to collect vast sums of money as
well as manipulate the economy. It must be emphasized that banks have already
created vast sums of money. What must not be allowed to happen is for this
money to be destroyed, either through repayment or default, as this will
have a major negative effect on world economies. As a special case,
all debts to the third world country's can be eliminated at no cost to
Western governments and taxpayers, while improving the financial soundness
of the worlds financial system. Most Third World debts are structured as
follows.
Debts are owed to commercial banks, or to organizations like the IMF and World Bank which obtain much of their funds from loans from commercial banks (often with a government guarantee), or to Western governments which again obtain their funds from commercial banks.
For debts owed directly to commercial banks, Western governments would print up bank notes totaling the loans outstanding. These would be deposited with the commercial banks as repayment for the Third World debt held. Essentially, the balance sheets of the commercial banks would be strengthened, for instead of having loans that could not be repaid as assets, these would be replaced with government notes. Depositors will be more confident in their financial system, knowing that if they wish the return of their money, that the banks will have government notes to give them, and not have their money invested in bad loans to Third World countries.
For Third World loans to organizations like the IMF and World Bank, governments would print up government notes as repayment for the Third World Debts. The IMF and World Bank could then deposit these notes in commercial banks in repayment of their loans with commercial banks.
For Third World loans directly to Western governments, Western governments
would cancel these loans whiles printing up an equal amount of government
notes. These notes would then be deposited in the commercial banks
as repayment of government loans (the purchase of government bonds held
by commercial banks).
Thus, for the cost of printing government notes, the entire debt burden
of the Third World would be eliminated while improving the financial soundness
of the worlds financial system. It is important to note that this printing
of government notes is not inflationary and will not increase the money
supply. No new money is created with no one having any additional " money
". All that has happened is that banks have substituted assets, replacing
loans with government notes. Commercial banks, and their international
organizations, the IMF and World Bank, would no longer be able to steal
from the poor, and would no longer be able to control and manipulate these
people.
In summary, the major concerns with a fractional reserve banking system
are;
1) Banks are able to create loans and deposits by means of bookkeeping
entries, and by charging interest on these loans( that they have created
virtually out of nothing), they are able to transfer significant amounts
of real wealth into their hands.
2) Banks, by being able to create loans and deposits at will, can create
severe financial distortions as they direct this newly created money into
specific areas. The "Yen-carry trade" is a good example of this.
3) As banks create loans and deposits, this will be seen to have a
positive effect on GDP. However, as loan growth stops, this will lead to
a contraction of GDP. By being able to create and control periods of economic
expansion as well as economic contraction, bankers are able to effectively
speculate in the economy, further concentrating wealth and power withincontrol.
4) It is a classic pyramid scheme. It is based on fraud and deceit,
is not self-sustainable, and will implode. The amount of money created
( by new loans ), is always less than the amount of money that will be
destroyed in the repayment of loans( principle plus interest), it then
follows that it is impossible to repay loans. As bankers attempt to maintain
their pyramid scheme by ever increasing amounts of loans, as previously
shown, financial distortions are created that will eventually implode the
financial system.
In examining the problems with a fractional reserve banking system, I have shown how all of these can be eliminated by changing to a 100% reserve banking system, which we will discuss in more detail. In this case, when a loan is created, the lender must transfer money to the borrower. No money has been created, only ownership has changed (the lender now has less money while the borrower now has more money). In a 100% bank reserve system, the bank must hold a dollar in government notes for each dollar on deposit. As such, no deposits are available to lend. In order for banks to lend in such a financial system, they would first have to borrow money from depositors, and then re-lend it at a profit. What we would observe is for every loan transaction, one persons deposit value would increase, with another persons deposit balance decreasing by an equal amount. The ability of the borrower to increase expenditures is offset by a reduction in the ability of the lender for expenditures, and thus it tends to have a neutral effect on GDP. When the borrower makes a payment of principle or interest, his reduction in money is offset by an equal increase in money by the lender. Again, the amount of money does not change with the repayment of loans. Again, when a borrower makes a payment of either principle or interest, this will reduce his capacity to spend while increasing the capacity of the lender to spend by an equal amount. This will tend to have a neutral effect on GDP. While borrowing and lending will tend to have a neutral effect on GDP, it is important to understand how each will affect demand and hence GDP as neutrality is not guaranteed. Savings represent a withdrawl from economic activity, and hence a reduction in GDP. Loans represent an increase of money for economic activity and an increase in GDP. Savings and loans are not necessarily equal, and this points to the need of efficient financial markets to distribute savings back into the economy. Interest and principle payments, by taking money out of economic activity, will reduce GDP. Dis-savings will put money into economic activity and increase GDP. Simply put, savings , as well as interest and principle payments will reduce demand (GDP) in an economy, while loans and dissavings will increase demand (GDP). Money would no longer tied to debt, which would make the system self-sustaining. The government could create additional money each year, that would maximize economic output, and distribute the benefits of this new money in an equitable manner. Government notes would function as a bookkeeping entry, more than a means of exchange, with most financial transactions being conducted as they presently are. In fact, these notes could be purely digital. . We should think of money as a community utility, a utility that will be used to enhance the well-being of every person, especially the most marginalized. As an economist, we would determine the optimun level of money in an economy, and the level of annual increase in money that would most benefit the economy. As a policy maker, we would have to consider who should benefit from the annual increase in the money supply. A centralist would have all the benefits remain with the government, which would distribute at according to it's policy's. A decentralist, would have an annual payment made to all citizens.
Now I do not recommend replacing banking, or even the form of exchange. Indeed, our present form of exchange would appear to be quite efficient. The real question is how is money created, and who benefits from its creation. At present, money is created when banks give a new loan. The real question we must ask, is this the best way of creating money, and what other alternatives are available.
The key point that I am making, is that what money is, and how it is created, will create very different economic effects. In today's financial system, money is either created through the printing of Government Notes, or in the banking system by increasing loans or purchasing assets. With Government Notes making up just over 1% of bank assets, most money is created through new loans. While we consider both Government Notes and bank deposits to both be money, we must understand that they are very different, and it is in understanding how they are different that we are able to more fully understand how our economic structures operate.
A point should be made about other models of the business cycle. Real-business cycle models ommit monetary disturbances as a source of the business cycle. Thus, the inability of a person to get a new car loan should not affect consumption, or having to make loan payments should not affect the ability of a person to consume the whole of his earnings. Such models are not true on a microeconomic level, and by expansion on a macro-economic level.
Keynsian theory also lacks microeconomic foundations. It gives current
income an important role in determining consumption, yet does not consider
how consumption is affected by new loans (increasing it) or by loan payments
(decreasing it). Nominal money supply is considered set by the government,
totally ignoring the role of banks in creating money. The role of money
in determining interest rates is seen as affecting investment, but the
effects of creating money on the economy are ignored.
By comparison, this economic model has started with the basic trueism
of the Quantity Theory of money. It has considered how new loans as well
as debt repayments affect this equation. It has looked at two types of
loan creation and shown how these will have very different affects on the
economy. Specifically, it has shown that if the debt is first created,
and then used to create money( as in a fractional reserve banking system),
that this will have a very different effect then when money first exists,
and then is loaned, as in a 100% reserve banking system.
I have considered the views of other monetary reformers such as Douglas
or Fisher, and have shown that while they attempted to bring monetary considerations
inti their understanding of the business cycle, that their ideas, while
presenting worthwhile alternatives, fell short of a complete understanding.
As I mentioned at the start of this article, the understanding of our present financial system is crucial in economic analysis. While some have understood that the creation of bank loans also creates money, and the repayment of bank loans destroys money, none have applied this understanding to the Quantity Theory of money. Most importantly, it does not appear that others have understood that the payment of bank loan interest also destroys money, and that this has a most profound and major affect on the business cycle. It is this fact alone that ensures a total economic collapse under a fractional reserve banking system.
After reflecting on the above analysis, it is useful to consider the
status of the United States stock market. When the S & P 500
hit it's high in July 99, the average Price/ Earnings ratio was 37/1.
Assuming an 8 % interest rate, the Net Present Value (NPV) of earning $1
per year is about $12, valuing the S&P 500 at 308% of its NPV.
Not only is the S&P 500 index overvalued by over 300% based on present
fundamentals, future adjustment of NPV are very much likely to be to the
downside. Firstly, we are nearing the end of a massive credit induced
grow cycle which has increased business profits. When credit expansion
stops or contracts GDP and profits will fall. Secondly, current risks
are currently for a rise in interest rates, which will only increase once
the U.S. dollar begins to fall. Moreover, these adjustments are likely
to be much greater than many anticipate. It is also important to note,
that the value of current earnings may be substantially overvalued. . Specifically,
in that the credit expansion within America and Japan (financing the Yen
Carry Trade) has lead to an increase in American economic activity, this
has been supportive of American profitability. Secondly, with a rising
stock market, the defined pension plans of many companies have risen in
value to such an extent that no company contributions are now required,
inflating company profits by the savings of pension contributions.
Thirdly, an era of share buy-backs has been used to increase earnings
per share. For the most part, these buy-backs are financed through loans,
and not profits. For example, since 1995, IBM has reduced the number of
shares outstanding by 22%, while it's debt has increased from $22.6 billion
to $30 billion. According to the Federal Reserves flow of funds data, for
non-financial corporations, in 1994 a net $44.9 billion in stocks were
retired while corporate borrowings showed a net increase of $51.3 billion.
In 1998, a net $262.8 billion in stocks was retired while net borrowings
increased by $342.9 billion. We must ask why U.S. companies are buying
back their stocks on credit, which not only leverages their earnings, but
also further fuels an overvalued stock market.
Fourthly, the use of stock options, particularly by technology firms,
has significantly understated compensation paid to employees, and thus
significantly overstated profits. For example, Microsoft, with a market
value approaching ˝ trillion dollars is valued at over 20 times sales.
By some estimates, if the value of stock options given were shown as an
employment expense, the company would not be profitable.
On August 16,1999, Morgan Stanley issued a report titled, "U.S. Fears
of a Consumer Debt Squeeze are Overblown". They note that the decade long
consumer borrowing and spending binge has left households with record debt
levels, now totaling 101 percent of disposable income. The concern is that
rising interest rates will cause consumers to spend less due to higher
debt costs. However, Morgan Stanley argue that with rising incomes and
falling interest costs over the last year, scheduled payments of principle
and interest have fallen to near 16 percent of disposable income over the
last year, and that consumers are somewhat insulated from rising interest
costs due to fixed rates on part of their loans. Accordingly, they
do not expect a significant impact on consumer spending. However, what
Morgan Stanley has completely ignored, is the level of the national savings
rate in assessing the ability of the consumer to continue on its spending
binge. While making debt payments of 16% of disposable income is not a
concern when the savings rate is 20%, it is quite another matter when the
savings rate is the current –1.2 percent. Simply put, with a savings rate
of 20%, consumers still have the capacity to increase expenditures even
if debt service costs increase slightly. However, with a savings rate of
–1.2 percent, consumers must already borrow 17.2 percent of disposable
income just to make present loan payments and personal expenditures, and
rising interest rates will only magnify this distortion.
To look at the effects of the level of debt payments on future consumption
without considering the present savings rate presents a totally flawed
analysis. It either represents a case of the blind leading the blind, or
a deliberate attempt to present a false theory to manipulate opinion.
The reality is that Americans must obtain new loans totaling 17 percent
of disposable income just to fund present expenditures. This is in no way
sustainable, and either from the withdrawal of bank credit or voluntarily
stopping going further into debt, one day it will stop.
When Americans reduce expenditures by this 17 percent of disposable
income, it will have a very negative effect on GDP and thus corporate profitability.
This will only increase current price/earnings ratios, and further distort
the value between the S&P 500 and it's Net Present Value. It is my
opinion that should Americans decrease expenditures by 17 percent, that
profitability would fall by over 50 percent which would place the value
of the S&P 500 at over 600 percent above it's Net Present Value. Moreover,
as discussed previously, a fall in expenditures of 17% is likely to cause
a fall in employment, which will further decrease expenditures and so a
downward spiral is created.
According to the economic model that has been developed, new loans
with interest costs of 8-9% and used to purchase stocks paying dividends
of 1% that are presently valued at 308% of Net Present Value will one day
have a very negative effect on the economy.
On August 18,1999, China's State Economic and Trade Commission announced a ban on all new projects involving a broad range of consumer investment. After many years of over investment, deflationary pressures are resulting in most companies now making little or loosing money. Beijing has already attempted to slow the deflationary pressure by imposing price floors. China is also stopping the construction of luxury apartments, hotels, department stores, and office buildings. With office vacancy rates in Shanghai now up to 70%, China has now entered into a major deflationary spiral. This will only accelerate as investment spending slows. Given that China is in a major deflation, with insolent companies, an insolvent banking system, bloated inventories, and soon to be contracting investment, those economists that have pointed to rising GDP as a sign of strength may have missed the dynamics underlying what really happens in an economy.
Today, we tend only to look at the surface, and not understand the forces
that control and manipulate our economies. A report has been written by
the Federal Reserve Bank of Cleveland called; "Beyond Price Stability:
A Reconsideration of Monetary Policy in a Period of Low Inflation", and
is available at
http://www.clev.frb.org/annual98/essay2.pdf. I quote part of this report;
"As we entered 1999, the pace of real economic activity once again exceeded
market expectations of substainable growth by a wide margin. Consumers
continued to aquire houses and durable goods at a fast clip, and financial
institutions provided the credit necessary to support a prodigious rate
of national spending. The United States is borrowing from abroad to consume
far more than it produces and, at the same time, through Social Security,
it is transfering resources from future generations to bolster the consumption
of current retirees. This spending frenzy finds additional support from
equity markets, where price levels and earnings multiples continue to set
records.
The experiences of the 1920s and 1930s provide a perspective from which
to think about today's monetary policy. Real growth may indeed reflect
the transition to a permanently higher level of material well-being, ushered
in by the information technology revolution that began 20 years ago. Current
spending patterns may indeed be a justified response by current generations
to the prospect of permanently greater wealth for themselves and future
generations.
But exceptional demand conditions in the United States have also been
accompanied by torrid monetary expansion. M2 growth has been accelerating
for the past five years, reaching a nearly 9 percent rate last year. Its
growth rate exceeds what would normally be seen in an economy with 5 percent
to 6 percent nominal growth and relatively stable interest rates.
Surprisingly, consumer price inflation registers only between one and
two percent. The conventional explanation for reconciling strength in economic
activity and monetary growth with the benign inflation rate is a shift
in the demand for money. A surge in money demand means that people have
decided to hold more of their wealth in the form of money balances. This
could happen if the cost of holding money relative to other assets has
declined, or if people desire more liquidity. If money demand surges along
with an expansion of money supply, harmful inflationary developments or
other types of market instability might be considered unlikely.
There is, however, a significantly more troubling interpretation of
events, a view grounded in historical precedent. Suppose that people have
been overestimating the size of the productivity gain and confounding asset
price valuations. These mistakes may have converted a real burst of productivity-driven
output and wealth gains into speculative excess. In this view, asset prices
do not accurately reflect projections of the future earnings streams. Instead,
they reflect a situation in which earnings are overvalued and supported
by excess liquidity. Conventional consumer price inflation, then, becomes
only one concern.
Even worse is the possibility that when the speculative excess ends,
it will bring with it the type of real dislocation that has surfaced in
the past and has recently plagued Japan and other countries. Similar signs
were present in those economies- fast money growth accompanied by stable
prices but soaring asset prices. The warning signs were neglected, and
those economies paid for that neglect…
A particular problem arises when the absence of overt inflation acceleration
leads analysts, producers, and consumers to underestimate the corrosive
influence that easy monetary policy can accommodate in the economy. Do
these corrosive influences now exist in the U.S. economy? Households may
feel wealthier, but the most significant portion of that wealth now consists
of equities, not their homes. Consumer spending has been brisk lately,
but its pace has been achieved through declining savings rates and increased
debt-to-equity ratios. Consumers appear to be relying heavily on their
equity holdings as a financial cushion.
For their part, banks find it increasingly difficult to fund commercial
loan growth without purchasing funds in money markets. Banks' balance sheets
show that securities share of total assets has been dwindling, reflecting
reduced liquidity. Consequently, the economy could be vulnerable to a sharp
downward revaluation of stock prices, because consumer spending could fall
off and because equity finance has become a vital source of corporate financing.
Does this explanation of recent events require irrational exuberance
to hold it together? Yes and no. It certainly requires that mistakes are
made, but it does not necessarily imply that a chain of negative consequences
can occur only in the presence of widespread irrationality. Ordinarily,
economists would expect market forces to correct mistakes in judgement
about equity valuations and bond prices as more information becomes available
about the underlying strength of corporate profits and monetary policy.
But suppose that financial market participants think that monetary policy
will respond to unsettled market conditions by injecting more liquidity.
The results of such actions could short-circuit the normal forces that
would generate market corrections, at least for a little while. For its
part, the monetary authority could find itself in a sort of "expectations
trap." The best choice of action at each decision point may seem to be
one that validates private expectations and calms roiled markets, despite
the fact that excess liquidity conditions would still prevail."
I would suggest that those economists that are presently looking at only inflation and GDP growth as a sign of a healthy economy are creating a dangerous illusion. While I would not expect the Federal Reserve Bank of Cleveland to provide a truthful analysis of our fractional reserve banking system, in their own way, they have provided a definite warning of future events, a view that is most consistent with what I have presented.
This paper represents an economic viewpoint that may be unique in it's
understanding, and is certainly directly opposite conventional economic
thought. The question that one must ask is what is the truth? Is
not every work subject to the criticism of those who are unable to commit
themselves to understanding it in depth? In my writings, I have argued
that mankind seems to have lost the ability to distinguish reality from
illusion, mainly because he has lost his ability to distinguish good from
evil. He has lost the ability to trust his reason to know the truth
and is so swayed into various false doctrines. Those same people, who do
not take into account decisive arguments in favor of the truth, will latter
follow doctrines and opinions without foundation. Indeed, it is our failure
to understand sound economic doctrine that ultimately will lead to our
enslavement.
We are about to leave a century where many have identified it according
to their personal point of view. International capitalism has been pitted
against materialistic socialism, with few people having the understanding
that both are controlled by the same forces, who respect no frontiers and
play equally well on both sides. Both powers pretend to give people a total
solution to their problems while enclosing them in their nets.
The ultimate test of any theory is its ability to predict and explain
actual events. My writings, using logical arguments and sound mathematics
have shown that unless we change our financial system, and eliminate our
fractional reserve banking systems, that we will see the collapse of world
stock markets, bond markets, currency's and economies. Mankind must once
again seek the truth, and once found live by this truth. The consequences
of living a lie will be most traumatic under the light of revealed truth.
John Kutyn
September 13, 1999
Email jkutyn@voyager.co.nz
jkutyn@xtra.co.nz
