Download Why Our Monetary System Is Broken and How The Scottish

Why Our Monetary System Is Broken
and
How The Scottish Independence Referendum Creates An Opportunity To Fix It For Scotland
This paper contributes to a discussion of the monetary system in the UK and how this relates to
Scotland today. It starts by explaining how commercial banks create the majority of our money (out
of nothing) and how the money created is actually debt. It then shows how interest payments lead to
a cycle of increasing debt and default, and how at any given time there is not enough credit in our
system to pay off existing debt, plus the interest. The case is made that our current monetary system
is actually at the root of economic instability, increasing inequality, the corruption of the democratic
process and environmental destruction.
The discussion offers a possible solution in the form of a reformed money creation process, where
money is created without an associated debt by a politically insulated committee, with a mandate to
maintain economic stability, which is accountable to the electorate and independent of government.
This paper concludes by arguing that the Scottish Independence referendum in 2014 presents the
most pragmatic opportunity to institute a reformed monetary system which is a fundamental
condition for the people of Scotland to create a fairer society, a more stable economy, a democratic
process with more integrity, and a more considered approach to the stewardship of our land.
1. The UK Monetary System
In the UK Central Bank system the Bank of England acts as a Clearing Bank that creates all
physical money (3% of money in circulation) and central reserves for clearing (the settling of net
flows of money) between commercial banks. Commercial banks create the rest of the money in
circulation (97%).
The relatively small amount of physical money circulating in the economy is of much less
consequence than the large proportion of money created by commercial banks, in relation to the
functioning of the UK's monetary system. This paper focuses almost exclusively on money created
by commercial banks – how it is created and its effect on the economy and other issues. Although it
is worth noting that commercial bank created money can be converted into cash/physical money,
but usually only temporarily.
- Most Money Created by Commercial Banks as Debt (out of nothing)
Of key importance in understanding how the current UK's monetary system works is an
understanding of how money is created. Most money (97%) in circulation in the UK is created as
debt by commercial banks out of nothing.
Sir Mervyn King, Governor of the Bank of England from 2003-2013, emphasised this point
succinctly when he said,
“When banks extend loans to their customers, they create money by crediting their
customers' accounts.”1
This is very difficult to accept. As economist J. K. Galbraith suggested,
“The process by which banks create money is so simple that the mind is repelled...”'2
1
Sir Mervyn King, Speech to the South Wales Chamber of Commerce at The Millenium Centre, Cardiff on 23rd October 2012:
2
www.bankofengland.co.uk/publications/Documents/speeches/2012/speech613.pdf
NEF, Where Does Money Come From: www.neweconomics.org/publications/entry/where-does-money-come-from
Money is created when commercial banks make loans. When a loan is agreed with a commercial
bank two things happen:
1) new money is created because the loan amount is credited – added - to the loan recipient's
account (this is done by typing the numbers that make up the loan amount into the banks
computer); and
2) a new associated debt is created because a new entry is made in the bank's records of
accounts to record a new asset (debt) on the bank's books (again, numbers are typed into a
computer).
Commercial bank created money can only exist with these duel aspects of credit - the loan (money)
- and debt - the bank's asset.
The destruction of money is the reverse process. Money ceases to exist when debt is either paid
back or when a person cannot pay back a loan – the debt - and the lender writes off the loan (when a
lender, such as a commercial bank, writes off a loan it deletes the debt and the associated asset from
its records). Both debt repayment and write offs have the effect of destroying money and shrinking
the money supply.
So, the process of creating and destroying commercial bank created money is extremely simple banks create money when then make loans simply by adding numbers to bank accounts. The money
does not exist until the bank creates it out of nothing and no money actually changes hands in order
to create it.
As associate editor and chief economics commentator at the Financial Times, Martin Wolf, says,
“The essence of the contemporary monetary system is creation of money,
out of nothing, by private banks’ often foolish lending”3
This is a conceptual leap that most people, including many economists, struggle to grasp. The
money creation process must be understood in order to understand how the monetary system
functions.
The important point is that 97% of money in circulation in the UK economy exists as debt.
- Commercial Banks Can Create Unlimited New Money
Because most money is created out of nothing there is no limit to how much can be created. It is
often thought that the Central Bank, the Bank of England, can control the amount of money
commercial banks can create using mechanisms built into the monetary system. These mechanisms
include control of central reserves and the level at which the base interest rate is set. However, in
practice commercial banks can retrospectively find central reserves and/or other capital required to
support the creation of new loans (money). The only factor that actually constrains commercial
banks from creating money is whether making new loans is likely to be profitable or not.
- Interest
Interest must be paid on all the money (credit) created by commercial banks. Interest is usually paid
3
Financial Times, 9th November 2010: www.ft.com/cms/s/0/f2e4dbb0-4caa-11df-9977-00144feab49a.html
as compensation to a lender for giving up the ability to use the money lent. However, commercial
banks make loans without having any money to loan in the first place.
2. The Problem With This System
The core problem with the UK's current monetary system is that commercial banks have an
unhealthy privilege to create money as debt in unlimited amounts and collect interest payments on
the debt. It is helpful to consider these three issues separately:
1) the privilege to create money as debt (97% of money in circulation in the UK)
This is a problem because linking money (credit) with debt has disastrous consequences for
a large number of people and businesses, especially poor people and businesses with low
profit levels. Combined with the fact that interest payments are required from those that hold
debt, debt-money creates a system that inevitably means money (credit) accumulates in
fewer and fewer hands while most people must necessarily accumulate more and more debt.
2) the ability to create money (effectively) in unlimited supply
Increasing the amount of money in the economy can be helpful if it is allocated towards
investing in developing better ways of creating wealth for society and/or if any increase is
proportionate with increases of goods and services. Because there is no effective limit to the
amount of money (loans) commercial banks can create and bankers have incentives to create
new money (make new loans), commercial banks inevitably create more and more money
regardless of the needs of society or the effect on the economy;
3) the unreasonable privilege to collect interest payments on the debt (money) they create
The unreasonable privilege to demand interest payments on money (effectively the leasing
of the money supply to the nation) for the benefit of a few, rather than for the benefit of all,
is dangerous to society. There is no reasonable argument for the privilege, to create money
out of nothing and charge interest, to benefit commercial banks. (There is an argument for
commercial banks charging a fee for providing services such as genuinely acting as financial
intermediaries. However, this is an entirely separate issue.)
Ultimately the combination of these systemic factors - the privilege to create money as debt in
unlimited amounts and collect interest payments - means that debt in the economy can never be paid
off. If all the debt were paid off, most money (97% which is created as debt) would cease to exist,
bringing about economic collapse (this is also the the danger when large amounts of simultaneous
defaults and write offs are triggered). This locks the economy into an addiction for more debt to pay
the interest on previous debt leading to inevitable financial collapse (and government bale out to
stop economic collapse) whereupon the cycle starts again.
It is these fundamental factors (discussed above) that together create a deep systemic problem with
the UK's monetary system, a system that inevitably creates highly negative consequences for the
stability of the economy, society, the environment and our political system.
- Economic Instability – Boom & Bust
Because of the cycle of ever increasing amounts of debt in the economy, the economy is forced to
grow to create new profits to feed the debt/interest cycle – boom periods. When the amount of debt
in the economy grows to a level that cannot be sustained a cycle of debt defaults, loan write offs and
rapid shrinkage of the money supply is triggered – bust events. A boom and bust cycle is inevitable
under the current monetary system.
“By ceding the power to create money to high street banks – private sector corporations –
the state has built instability into the economy, since the incentives facing banks guarantee
that they will create too much money (and [therefore] debt) until the financial system
becomes unstable. This is a view recently vindicated by the chairman of the UK's Financial
Services Authority, Lord (Adair) Turner, who stated that: 'The financial crisis of 2007/8
occurred because we failed to constrain the private financial system's creation of private
credit and money”4
- Increasing Inequality
Interest payments to commercial banks for access to credit (money) functions as a huge wealth
transfer from the peripheral areas of the country (Scotland, Northern Ireland, Wales and Northern
England etc) and disproportionately from the UK's poorest people and businesses everywhere, to
the City of London and its bankers.
“In 2011 the Bank of England calculated that [commercial] banks [“]earned[“] just under
£109 billion in interest a year. However, this figure is artificially low due to the historically
low interest rates. For example, before the Bank of England lowered interest rates (in 2008),
banks earned just over £213 billion in interest payments alone.”5
By way of contrast, in 2008 total spending on welfare by government was under £50 billion.
Spending on unemployment benefit was under £7 billion.
Also, the government guarantees commercial banks debt-money with its Deposit Guarantee
Scheme, which acts as a huge subsidy to the commercial banks and another form of wealth transfer.
This is because,
“... those that lend to the [commercial]bank[s] (including depositors) are willing to accept
lower interest rates on their loans than they otherwise might, because the loan is less risky
to them. [However,] … it is the Government, and by implication the taxpayer, that
underwrites the risk of the loan going bad. The Bank of England has calculated that some
years this subsidy is worth in excess of £300bn … [per year, to the commercial banks].”6
- The Corruption of the Democratic Process
Another, and potentially even more troubling consequence of the way that the money creation
system works, is that it dangerously undermines our democratic political system. The campaign
organisation for monetary reform, Positive Money, argue that thirty to forty key board-members of
the five largest commercial banks in the UK have more financial influence over the British
economy than the British government. This is because commercial banks have more 'spending
power' than the government.
“In the five years running up to the start of the financial crisis, the banking sector's gross
lending to households and individuals alone (not including lending to businesses) came to a
total of £2.9 trillion. Meanwhile, total government spending during the same period was less
4
5
6
Jackson & Dyson, 2012, pp22
Ibid, pp156
Ibid, pp152
at £2.1 trillion. Because the banks decide where to lend ... they can shape much of the
spending and activity in the economy...”7
Commercial banks lending decisions influence the shape of the economy. In recent years just under
£1,750 billion of lending, and therefore money, has been channelled into property and financial
speculation, and only around £400 billion into the productive economy.8 By focusing commercial
banks’ lending policies on mortgage lending and lending for financial market speculation,
board-members shape the economy in line with the bank's lending imperatives and requirement to
maximise shares holder profits and bankers’ incentives to maximise salaries and bonuses.
This system is damaging to our political system because commercial banks’ profits are partly used
to maintain bankers’ privileges by, for example, engaging in,
" … huge PR efforts, a permanent recruiting circus drawing in top academic talent; clever
sponsoring of, say, an ambitious politician's cycling scheme; vast lobbying efforts behind
the scenes; and highly lucrative second careers for ex-politicians. [And ]There is also plenty
of money to offer talented regulators three or four times their salary.”9
- Environmental Destruction & Labour Exploitation
Economic instability is bad for the environment and for labour because of the need for increased
profits to make debt and interest payments during boom periods and to counteract the reduction in
the money supply during busts.
The forced growth, that the system of debt-money and interest payments creates, demands
increasing consumption of natural resources and is a process that has no regard for the rate at which
the planet can replenish natural resources.
Collapse creates pressure to bring more natural resources into production to compensate for loss of
wealth – in the form of profits, taxes and wages - in the economy. This is done by the dismantling of
environmental and labour protection regulations so that extra resources can be brought into
production at minimum financial cost to maximise profits.
Technological innovation to some extent smooths this process by increasing productivity. However,
over time debt builds up in the economy at a far greater rate than increases in productivity can
support. Pressure to increased profits is a factor during both parts of the boom and bust cycle. The
majority of the increase in profit margins is found by increasing the use of natural resources and by
lowering wages.
3. Reforming the Monetary System
A reform of the UK monetary system which separates debt (a commercial bank's assets - the
“loans” made by commercial banks) from credit (money - the same “loans” made by commercial
banks) is the key to tackling these problems.
This could be achieved by establishing a system for creating government issued non-interest
7
8
9
Ibid, pp167
Jackson & Dyson, 2012, pp 113
The Guardan, Our banks are not merely out of control. They're beyond control:
www.guardian.co.uk/commentisfree/joris-luyendijk-banking-blog/2013/jun/19/banking-britain-beyond-control?
mobile-redirect=false
bearing money. This money would not be in the form of debt - it would be introduced into the
economy without a debt attached. New money would entry circulation in the economy by being
used to fund public spending, reduce taxes and pay down the national debt which would help create
economic stability and socially beneficial economic activity.
However, both politicians and bankers have powerful incentives to abuse the power to create money
– to get rich and/or boom and bust the economy for political gain.
The government issued money must be created by an accountable public body, such as a
reorientated Bank of England, Monetary Policy Committee (MPC). Importantly the issuing body
must be insulated from political and financial pressures. How this could achieved in practice has
been comprehensibly thought through by the campaign organisation Positive Money and clearly
laid out its draft government legislation.10 This accountable public body must have a clear mandate
to act counter-cyclically i.e., to introduce new money into the economy when the economy starts to
slow and withdraw money from the economy when the economy starts to grow too fast. How new
money is introduced into the economy would be an entirely political decision for our democratically
elected representatives to make. This is similar in theory to so called Quantitative Easing (QE).
However, it is very different in practice and outcome. Importantly it will seek to achieve conditions
of economic stability by controlling the creation of money for the benefit of the economy.
4. Scottish Independence – A Pragmatic Opportunity for Scotland
Currently bankers exert a great deal of influence over our government at Westminster which means
it is unlikely that meaningful monetary reform could take place at the UK level.
"This [monetary] system is highly dysfunctional, deeply entrenched, and enormously
abusive, both to its own workers and the society it operates in. 11
The Scottish Independence referendum is bringing change to Scotland regardless of the outcome.
Even in the event that Independence is voted against it is highly unlikely that maintaining the status
quo will be an acceptable outcome. In reality, whether Independence is won or lost, change will
follow.
Therefore the question we must ask ourselves is will we the people of Scotland drive the change or
will we be driven by it?
The answer to this question lies in how we choose to the answer the following two questions:
1) will the people of Scotland develop a cohesive vision for the future?
and
2) have we got the conviction to implement such a vision?
One key to a new vision for Scotland is implementing a reformed monetary system that works for
the benefit of all. In order to ensure the implementation of this new vision, a strong coalition of
people and institutions must be built to push through this reform when the opportunity arises.
If we do not develop a vision or have not got the conviction to implement it then history informs us
10 Positive Money Draft Legislation: www.positivemoney.org/our-proposals/draft-legislation
11 The Guardan, Our banks are not merely out of control. They're beyond control:
www.guardian.co.uk/commentisfree/joris-luyendijk-banking-blog/2013/jun/19/banking-britain-beyond-control?
mobile-redirect=false
that established interests will work hard to high-jack this historical opportunity for their own
benefit. The opportunity that Scotland has is only valuable if it is not used to further entrench
benefits to the few.
Independence for Scotland (rather than more devolved powers) is the most pragmatic route
available for people in Scotland to implement monetary reform – a key reform necessary to create a
fairer, more stable, more democratic, and a more environmentally responsible society.
As this paper has demonstrated, money reform is the underlying structural issue that constrains
change on all other issues. How we respond to this issue will shape our daily lives for years to
come. Therefore, the opportunity to implement a reformed money system in Scotland is one of the
primary reasons that Scottish people should consider voting for an Independent Scotland.
In a stronger economic position Scotland would be better placed to provide economic leadership
and help to others. Thus Scottish Independence could be better for the people of Scotland, as well
as, the people of England, Wales, Northern Ireland and other countries around the world.
O Lord, grant us that love which can never die, which will enkindle our lamps but not
extinguish them, so that they may shine in us and bring light to others.
- St. Columba of Iona ca. 521-597
Much of the information about the UK's monetary system and how to reform it is based on work by
Positive Money: www.positivemoney.co.uk
Mike Edwards
Edinburgh, July 2013