Democratizing Money

Excerpt from new economics foundation, 28 September 2010

'...But one area that is not prominent on the agenda of the Banking Commission’s review, nor across any mainstream debate on the financial crisis is an analysis of money itself, how it is produced and allocated.

The first point to make here is that money is not, as orthodox economics would have us believe, a natural phenomenon. Contrary to what you will read in most the textbooks, modern money did not naturally ‘emerge’ through market forces as a more effective tool for exchange than bartering. Whilst it’s true that money does enable more efficient exchange, modern money is a creation of the state and has only been with us, in its current form, for less than 160 years. In 1844, the Bank of England Act outlawed the creation of money (then mainly coins and notes) by anyone other than the Bank. Prior to this, a range of private regional and local currencies circulated. Today, there remain a range of ‘complementary currencies’ existing independently of the state, including commercial currencies such as Air Miles and loyalty points schemes and social currencies that nef has promoted, such as time-banking and the Transition currencies, not to mention a rapidly increasing virtual money scene enabled by the internet. Money is as much a socially and politically constructed institution as the health service, the welfare state, the police or the education system.

These institutions are the subject of intense and healthy political debate and scrutiny. Moves to remove them from the democratic sphere through privatization tend to be fiercely resisted. Not so with money. Whilst the 1844 Act outlawed the creation of notes and coins by anyone other than the state, it didn’t mention digital money. As advances in ICT developed, more and more of the money in circulation became digital, issued by private banks as IOU’s through fractional reserve banking. Today 97% of money in circulation is ‘created’ by private banks as interest-bearing debt while only 60 years ago, this was closer to 50% with the remainder issued – debt free - as coins and notes by the state.

How does fractional reserve banking work? When you put £100 in the bank a strange thing happens. The bank holds on to a ‘fraction’ of your deposit (say 1/10th) and lends the remainder out, charging interest upon it. This £90 loan is described as an ‘asset’ by the bank – it has created it, as if by magic. It charges interest upon the loan and it must be repaid by the debtor with the interest or they will commit a criminal offence. The debtor pays the £90 in to another bank who can then loan out £81, again at interest. The process goes on and on and eventually through this ‘money multiplier’ process, £987 of completely new debt-money is created.

This capacity of banks to create money on the basis of maintaining very small fractions of deposits is one of the most important elements of modern capitalism. Indeed the great German economist Joseph Schumpeter believed it to be the distinguishing feature of capitalism from all previous economic systems. It certainly helps us to explain the astonishing pace of growth we have seen in the Western world (where this system is most developed) over the past 200 years.

It has become clear, however, that our economies cannot keep on growing at the exponential rate we have seen over the past two centuries. Even if we weren’t facing disastrous climate change, there simply isn’t enough cheap oil to maintain such levels. As economist Herman Daly puts it, fractional reserve banking is not growth neutral, but a ‘growth pusher’:

“…For all those loans to be paid back with interest the borrower must make the money grow by a rate at least as high as the rate of interest… The result is that economic growth is required just to keep the money supply from shrinking as old loans are repaid.” (Daly, H., 1999: 133).

Daly’s quote also points to the inherent instability of our financial system. If virtually all the money in circulation is created as debt by banks then money is effectively, credit (or debt). The problem is that if debtors default on their debt (as with the sub-prime crisis), or, indeed, all suddenly choose to pay off their debts and stop borrowing, suddenly the magical ‘multiplier’ goes in to reverse. This is exactly what is happening now across the western world following the recession. People are tightening their belts, concerned about their jobs. They’ve stopped borrowing, whether it be for holidays, cars or, most importantly in the UK, homes. As a result, the money supply is shrinking.

On top of this, many banks are still attempting to rebuild their capital reserves following the financial crisis so are also reluctant to lend unless they are very sure about their investments. Small businesses are feeling the brunt of this as they tend to be seen as riskier investments by banks. Lacking working capital, they shed jobs or close down, further weakening demand and increasing people’s reluctance to borrow and further shrinking the money supply. We are then caught in the disastrous ‘debt-deflation’ scenario that has afflicted Japan for the last 20 years...

The academic and policy research on alternatives to fractional reserve banking is thin on the ground. This needs to change. nef is working to try and change the way the public and the government thinks about modern money. We’re supporting Positive Money, a new campaign helps build momentum for change and educate the wider public about how the monetary system really works...'