My claim is based on two simple facts.
1. In the current system governments are required to balance their budgets over the economic cycle. All money spent into the economy is removed by taxation. What this means is that they do not create money.
2. Conversely, commercial banks create almost all the new money. They do this by making loans, which involves adding credit to borrowers' bank accounts.
This combination of policies, whereby there is little or no money creation by the state and almost all new money is created by commercial banks, is doomed to fail because money created by commercial banks is always matched by an equivalent debt. So commercial bank lending CANNOT create NET financial assets within a currency zone. For anyone to accumulate profits or savings, someone else has to accumulate losses or debt. The economy becomes a zero-sum game. For there to be winners there HAVE to be losers.
1. In the current system governments are required to balance their budgets over the economic cycle. All money spent into the economy is removed by taxation. What this means is that they do not create money.
2. Conversely, commercial banks create almost all the new money. They do this by making loans, which involves adding credit to borrowers' bank accounts.
This combination of policies, whereby there is little or no money creation by the state and almost all new money is created by commercial banks, is doomed to fail because money created by commercial banks is always matched by an equivalent debt. So commercial bank lending CANNOT create NET financial assets within a currency zone. For anyone to accumulate profits or savings, someone else has to accumulate losses or debt. The economy becomes a zero-sum game. For there to be winners there HAVE to be losers.
It makes no sense in such a system for the wealthy to castigate the indebted. Wealth accumulation is only possible if some people borrow money to fund purchases that enable wealth accumulation by sellers. If no new borrowing took place then it would be impossible for someone to accumulate new wealth.
Such a system is clearly not sustainable, but it can persist for a surprisingly long time on the back of asset price bubbles, especially if central banks intervene to support credit creation, as they have done repeatedly in the past 30 years.
Such a system is clearly not sustainable, but it can persist for a surprisingly long time on the back of asset price bubbles, especially if central banks intervene to support credit creation, as they have done repeatedly in the past 30 years.
This is how it works. Banks preferentially create money for the purchase of assets such property. They are happy to make these loans because the are secured against the property. Because there few external limits on money-creation by banks, and their profits increases with the amount they loan, there is a tendency for house prices to start rising, driven by excessive money creation by banks. Over time sustained increases in house prices leads, paradoxically, to INCREASING demand for houses as banks are happy to make secured loans for the purchase of assets the price of which increases. This bubble continues to inflate. All the while this injects more money into the economy and the economy grows.
The problem is that this growth is accompanied by massive increases in private (mainly mortgage) debt. Furthermore, this debt can never be fully paid off, because all new money being created is created by commercial banks and so is always matched by an equivalent debt. In fact if the debt is all paid off the money supply would contract dramatically as debt repayment 'destroys' this money.
The problem is that this growth is accompanied by massive increases in private (mainly mortgage) debt. Furthermore, this debt can never be fully paid off, because all new money being created is created by commercial banks and so is always matched by an equivalent debt. In fact if the debt is all paid off the money supply would contract dramatically as debt repayment 'destroys' this money.
People with mortgages to pay off rely on a continuous supply of new purchasers, most of whom will need to take out new loans to buy their houses at inflated prices. So debt can only be paid by new debt. Those first in the market can profit (since their house price increased), but only at the expense of new entrants. The most recent entrants into the market depend on house prices continuing to rise, which depends on further borrowing. That is the essence of a PONZI system.
When prices start coming down the whole debt edifice comes crashing down. The bubble pops. All the debts can only be paid off when the money created with the debts is destroyed. Once the process of debt creation reverses itself the money supply begins shrinking, which has a devastating effect on the wider economy. One effect is rising government budget deficits. This happens because of increasing spending (on unemployment benefits, bank rescues etc) and collapsing tax revenues (as income and profits collapse).
When prices start coming down the whole debt edifice comes crashing down. The bubble pops. All the debts can only be paid off when the money created with the debts is destroyed. Once the process of debt creation reverses itself the money supply begins shrinking, which has a devastating effect on the wider economy. One effect is rising government budget deficits. This happens because of increasing spending (on unemployment benefits, bank rescues etc) and collapsing tax revenues (as income and profits collapse).
At this stage central banks has to step in and create (debt free) money which it injects into the banking system, typically by quantitative easing. That is essentially what central banks have been doing around the world. It was absolutely essential to prevent a complete collapse of our economies. The question is what do we do now.
The sensible approach would seem to be to change the way we create money. Instead of depending on commercial banks to create most new money, and allowing them to do so even when this money creation is resulting in house price-inflation, we should introduce a balanced approach. Allow much, if not all, of the new money to be created by central banks. The amount should be tightly regulated using consumer prices and asset prices to judge the amounts. The power of banks to create money should by tightly regulated and possibly even eliminated. If eliminated banks could only lend on money they already have on deposit. In other word they would only be able to act as intermediaries between savers and borrowers. This should not be controversial since it is how most people, even economists, think banks actually do work! It is described in more detail in a previous post.
The advantage of this process is that money created by central banks is debt free. This means that the private sector AS A WHOLE can increase its financial wealth, unlike the current system in which wealth can only be accumulated somewhere at the expense of debt elsewhere. Economic growth is no longer a zero-sum game as net financial assets increase in line with economic growth.
Such a system is sustainable as growth does not absolutely depend on ever increasing debt. We would no longer have a PONZI system.
There may well be other sustainable alternatives to the current monetary system. Before they are seriously considered, however, mainstream economists need to recognise the PONZI-like nature of our current system.
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