Saturday 6 August 2011

Summary So Far

Before completing our look at the claims of "Money as Debt", let's look again at the summary of its claims which I started with on 24 August last year:

  1. People do not know how their monetary system works.
  2. Most money is created by private corporations, called banks.
  3. When someone takes out a loan from a bank, the bank does not lend out money previously deposited, but creates new money simply by pulling it from a hat in the film's portrayal.
  4. The new money is created directly from the borrower's promise to repay.
  5. The bank is getting a free lunch by creating money. It gets the borrower into debt to the bank, without having had to earn the money to lend the borrower first.
  6. The existence of interest makes the monetary system sustainable only if the economy continues to grow exponentially, and therefore the system is a primary cause of our overconsumption and destruction of natural resources.

In the light of what we have seen so far, let's address these, leaving the final one for the next post.

  • People do not know how their monetary system works.

True. At least it is for most people. I was one of these up to the point where I watched "Money as Debt", so I do appreciate that aspect of the film.

  • Most money is created by private corporations, called banks.

True. Most "money" is created by private banks. In my blog, I have gone into a little more depth, showing the difference between central bank money and retail bank credit, but both can be spent on goods and services and can validly be called money.

  • When someone takes out a loan from a bank, the bank does not lend out money previously deposited, but creates new money simply by pulling it from a hat in the film's portrayal.

True, but slightly misleading. The true part is that the bank creates bank credit by simply making a pair of entries in the accounts – a promise by the borrower to repay the bank (which is an asset of the bank), and a deposit assigned to the borrower (which is a liability of the bank). This is essentially cost-free.

The misleading part is that it shows the top-hatted retail banker pulling dollar bills out of a hat, after conjuring them into existence from the promissory note. Retail banks cannot do this, since dollar bills (or their equivalent in other countries) can only be created by the central bank. That would be the equivalent of me writing an IOU on your behalf without your permission — obviously fraudulent. A bank creates a different kind of money – bank credit, which can be redeemed at the bank for that quantity of central bank money on demand. But in order to give that central bank money to the borrower, the retail bank must have already acquired it (e.g. by selling shares in the bank), or at least be able to acquire it at very short notice (e.g. by selling, or borrowing against, its assets).

The deal between the borrower and bank is this: the bank gives the borrower central bank money now (or at a later time if the borrower desires), and the borrower has to pay the bank that amount plus some interest in the future. When a bank is solvent, everyone generally accepts its bank credit (a promise by the bank to pay central bank money) as money.

  • The new money (bank credit) is created directly from the borrower's promise to repay.

True. The bank has a new asset and a new liability, each for the amount borrowed, as described above.

  • The bank is getting a free lunch by creating money (bank credit). It gets the borrower into debt to the bank, without having had to earn the money to lend the borrower first.

False, but with a hint of truth. The bank must have the ability to provide central bank money on demand to anyone with bank credit, so it must have already earned the central bank money to lend to the borrower. It also runs a risk of losing money by lending — the money loaned cannot be recovered if the borrower fails to repay and the loan is unsecured. Even if the loan is secured, the amount recovered may not be the full amount of the loan e.g. a loan for a car.

The hint of truth is that banks know that not all of their bank credit will be redeemed for money all of the time, so they can increase their gearing (or leverage, as our American cousins call it). This is slightly simplified, but if a bank knows that only 10% of its bank credit will be redeemed for money at any point, it can lend 10 times as much (100% / 10%) as its owners invested. If the bank charges 5% interest per year, that means that it is making a huge 50% return per year on the original investment. However, with the big profits comes the potential for big losses. It only takes 5% of borrowers failing to repay for the profit to be wiped out completely.

  • The existence of interest makes the monetary system sustainable only if the economy continues to grow exponentially, and therefore the system is a primary cause of our overconsumption and destruction of natural resources.

False. This needs a whole post to discuss. Watch this space – I'm half-way through writing it.