Debt-Free Money

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Margaret Legum

Now here is something different. Forget for the moment the arguments
over GEAR and NEPAD, and the battles for and against globalisation.
Enter the arena of how money is created and how that could be changed to
benefit you and me.

Don't be put off by the subject matter. The American economist J.K.
Galbraith, sainted for his ability to clarify economics and confound
economists, has said: The process by which banks create money is so
simple the mind is repelled. Where something so important is involved, a
deeper mystery seems only decent.  

Money is only a means of exchange and a store of value. It is not
valuable in itself. But for it to work we need the money stock to expand
at roughly the same rate as available goods and services. If there is
too much money you get inflation and if too little recession.

Governments see it as their job to keep that relationship between money
and goods roughly in line. But at present their influence is indirect.
Given the money that exists, the government can raise or lower taxes to
change consumption patterns. But that only tinkers with the problem,
which is about new money. To affect that governments must use the clumsy
instrument of interest rates to influence borrowing and saving.
The extraordinary fact is that new money is created not by governments
but by commercial banks - not, as we suppose, by lending one person's
savings to another, but out of thin air. When you ask for a loan, it is
granted (or refused) by reference to the collateral you offer and your
estimated capacity to repay - not because someone else's savings are
available. It is purely a ledger item, created from nothing. It becomes
part of the bank's assets; and when you repay, both the capital and the
interest swell the bank's wealth.

It is true that banks are obliged not to exceed a 'fractional reserve' -
a fraction of what they lend must be covered by others' deposits. But
this 'fraction' is only around 5%. Moreover, when a loan is given it
becomes someone else's deposit. Say I borrow R100 and pay it to you; the
bank can lend someone else R95. So the fractional reserve is practically

The implications are enormous. First, the supply of credit - new money -
is decided by banks on commercial principles - not by reference to the
monetary needs of an economy. Second, there is an almost total
disconnect between credit and savings. Third, debt is created every time
the supply of money is increased. Fourth, the bank creates the principal
but not the interest. So debtors must compete for inadequate money to
pay the interest as well as the loan.

In boom times this works, because more money is being created as new
loans. But that can't go on forever. Governments get worried about
inflation and raise interest rates, bank lending slows, people go
bankrupt and lose their collateral; we get recession. The cycle of boom
and bust is inherent in this system.

There is a small exception to the creation of money through loans.
Governments produce the notes and coins we use in everyday commerce. And
they spend that money into the economy directly as part of their
spending programme. It does not constitute a debt. Sadly that is only
between 3% and 10% in modern economies.

This is the clue to change. Originally all money was created by the
monarch. This right was known as seigniorage. It created no debt, since
the monarch simply spent the money into the economy to buy what he
needed as ruler.

Suppose governments were to restore that right to themselves as
representative of the people - extending the principle from creating
notes and coins to the electronic supply as well.

First, they would require banks to limit their activities to lending
only the savings of other customers. Second, the government would
calculate how much new money would be needed each year to match the
economy's capacity to expand, replacing the new money now created by
bank loans.  Third, it would spend that amount in the form of the
services and goods it offers. It would not borrow anything - relieving
its citizenry of the annual millions now paid as interest on loans.
Taxation would take care of expenditure needed above that paid for by
new money. None of what government spend would entail loans or the
payment of interest.

The danger that governments would create too much money - hence
inflation - for populist reasons must be countered by involving an
independent Reserve Bank or equivalent. It would be charged with the
task of estimating how much new money is needed, and then creating it
for spending through the Finance Ministry.

British MPs of most parties have signed an Early Day Motion calling for
the government to instruct the Bank of England to start such a process.
More detail on


Chris Keene
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