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How I’ve Responded to the Financial Crisis

by Andrew Fanning

Since reading Herman Daly’s “Nationalize Money, not Banks,” my head has been whirling with notions of how to help restructure the financial system to support a steady-state economy that respects ecological limits. The current system creates debt-based money by allowing banks to hold only a very small fraction of demand deposits while lending out the rest (with interest) to be re-deposited and then loaned out again (with interest), and on and on. Why is this so important? Besides according gratuitous profits to the private banks for producing money (a public resource that could just as easily be produced by a public institution), the fractional reserve system also creates a structural dependency on economic growth because, as Bill McKibben observes, “without the growth, you can’t pay off the interest.”

But the purpose here is not to repeat our dire situation. Instead, I want to share a plan that I’m using both to disentangle myself from the flawed financial system and to put pressure on the system to change. My plan consists of three steps.

Step 1: Get informed

“The process by which money is created is so simple the mind is repelled.” (John K. Galbraith)

Wow, did Daly say that the financial sector captures 40% of all profits in the United States? While I’m no authority on financial matters, I do have a master’s degree in economics and was even a teaching assistant for Macroeconomic Principles. Maybe I missed it, but I don’t ever recall hearing the term “seigniorage,” and we definitely didn’t focus students’ attention on the fact that “growing the money supply” is profitable. After reading “Nationalize Money, not Banks,” I was left with the familiar post-Daly feeling that I had been blind(ed) but was starting to see.

Fortunately, I received my copy of Enough is Enough in the mail shortly thereafter, and Chapter 8 (Enough Debt) provides more ideas on the issue of debt-based money creation and policies for reform. Also, issue no. 63 of the Real World Economics Review, a pluralist, open-access journal, offers excellent papers on the recent financial crises and money markets. So, having been acquainted with a number of alternatives to the current system, I was ready to roll on to the next step.

Step 2: Start worrying (more)

“Thus, our national circulating medium is now at the mercy of loan transactions of banks, which lend, not money, but promises to supply money they do not possess.” (Irving Fisher)

Cyprus recently joined Greece, Spain, Ireland and Portugal to become the 5th country in the Eurozone that has needed outside assistance to bail out its troubled financial sector. When the Cypriot authorities meet in early April to sign the agreement with representatives of the “Troika” (International Monetary Fund, European Commission and European Central Bank), every man, woman and child in Cyprus will effectively take out a €12,000 loan.

That sounds pretty bad, but actually, in the current system, the bailout should have been even bigger. In an unprecedented move that ought to shake the rotten foundations of the fractional reserve system, depositors holding more than €100,000 in Cyprus’ two largest banks have been subject to levies of 100% and 37.5%, respectively, in order to “recapitalize” their coffers. The original plan, voted down by the Cypriot parliament due in large part to public outrage, was to levy all depositors. This sends a very clear and ominous message to people (like me) holding deposits in the Eurozone: the governments of the Eurogroup — representing the world’s largest common market — have proven unwilling to fully guarantee demand deposits in this crisis. And if Europe can’t guarantee deposits, is there anywhere else that can really be considered safe?

Step 3: Take action

“The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks.” (Lord Acton)

There are two simple avenues for someone like me (or you) to take action against the banks.

First, I plan to continue using my voice as a citizen to spread the word concerning the inherent instability of the fractional reserve system and get involved with efforts to promote an alternative vision of a financial system — one that serves the needs of the economy and society, while respecting the limits of a finite planet.

Second, and more immediately, I wanted to get my deposits out of the system ASAP. If enough people stash their money under the proverbial mattress, then banks should get a warning message from their balance sheets that they need to finance more of their loans with real equity and long-term bonds rather than debt.

However, I found that I couldn’t easily abandon my checking account because that’s where my employer deposits my salary and where companies bill me for utilities. As a working compromise, my partner and I closed our accounts with Bankia — the giant Spanish conglomerate that has siphoned away more than half of the €40bn in bailout funds spent by Spain so far — and started banking with Triodos Bank.

Although Triodos still creates debt-based money from our deposits, they lend it to initiatives that benefit people and the environment, and what’s more, they publish each and every loan made. They are co-founders of the Global Alliance on Banking for Values, a network of 22 “values-based banks” that have recently issued a declaration calling for greater transparency, sustainability and diversity in banking. Consider the following excerpt:

Banks play a critical role in the transition towards a more sustainable economy. Therefore social and ecological criteria must play a critical role in the creation and use of financial products. […] Banks have to serve the real economy and include broader societal perspectives in their considerations.

Can you believe this is coming from a group of bankers managing more than $60 billion worth of assets?

My three-step plan isn’t exactly revolutionary, but it is helping to secure my own financial situation and putting pressure on the system at large. If enough of us take steps like these, the day will come when the Triodos perspective on banking is the norm.

Andrew Fanning grew up on the blustery east coast of Canada where he eventually earned a master’s in economics. His interests include lots of things, especially the capacity of the planet to support life.

Nationalize Money, Not Banks

by Herman Daly

Herman DalyIf our present banking system, in addition to fraudulent and corrupt, also seems “screwy” to you, it should. Why should money, a public utility (serving the public as medium of exchange, store of value, and unit of account), be largely the byproduct of private lending and borrowing? Is that really an improvement over being a by-product of private gold mining, as it was under the gold standard? The best way to sabotage a system is hobble it by tying together two of its separate parts, creating an unnecessary and obstructive connection. Why should the public pay interest to the private banking sector to provide a medium of exchange that the government can provide at little or no cost? And why should seigniorage (profit to the issuer of fiat money) go largely to the private sector rather than entirely to the government (the commonwealth)?

Is there not a better away? Yes, there is. We need not go back to the gold standard. Keep fiat money, but move from fractional reserve banking to a system of 100% reserve requirements on demand deposits. Time deposits (savings accounts) would have zero or minimal reserve requirements and would be available to lend to borrowers. The change need not be abrupt — we could gradually raise the reserve requirement to 100%. Already the Fed has the authority to change reserve requirements but seldom uses it. This would put control of the money supply and seigniorage entirely with the government rather than largely with private banks. Banks would no longer be able to live the alchemist’s dream by creating money out of nothing and lending it at interest. All quasi-bank financial institutions should be brought under this rule, regulated as commercial banks subject to 100% reserve requirements for demand deposits.

Banks cannot create money under 100% reserves (the reserve deposit multiplier would be unity), and banks would earn their profit by financial intermediation only, lending savers’ money for them (charging a loan rate higher than the rate paid to savings or “time-account” depositors) and charging for checking, safekeeping, and other services. With 100% reserves every dollar loaned to a borrower would be a dollar previously saved by a time account depositor (and not available to the depositor during the period of the loan), thereby re-establishing the classical balance between abstinence and investment. With credit limited by saving (abstinence from consumption) there will be less lending and borrowing and it will be done more carefully — no more easy credit to finance the leveraged purchase of “assets” that are nothing but bets on dodgy debts.

Why are private banks controlling this public utility? Photo credit: Steve Rhodes

Why are private banks controlling this public utility? Photo credit: Steve Rhodes

To make up for the decline and eventual elimination of bank-created, interest-bearing money, the government can pay some of its expenses by issuing more non interest-bearing fiat money. However, it can only do this up to a strict limit imposed by inflation. If the government issues more money than the public voluntarily wants to hold, the public will trade it for goods, driving the price level up. As soon as the price index begins to rise the government must print less and tax more. Thus a policy of maintaining a constant price index would govern the internal value of the dollar.

The external value of the dollar could be left to freely fluctuating exchange rates. Alternatively, if we instituted Keynes’ international clearing union, the external value of the dollar, along with that of all other currencies, could be set relative to the bancor, a common denominator accounting unit used by the payments union. The bancor would serve as an international reserve currency for settling trade imbalances — a kind of “gold substitute.”

The United States opposed Keynes’ plan at Bretton Woods precisely because under it the dollar would not function as the world’s reserve currency, and the U.S. would lose the enormous international subsidy that results from all countries having to hold large transaction balances in dollars. The payments union would settle trade balances multilaterally. Each country would have a net trade balance with the rest of the world (with the payments union) in bancor units. Any country running a persistent deficit would be charged a penalty, and if continued would have its currency devalued relative to the bancor. But persistent surplus countries would also be charged a penalty, and if the surplus persisted their currency would suffer an appreciation relative to the bancor. The goal is balanced trade, and both surplus and deficit nations would be expected to take measures to bring their trade into balance. With trade in near balance there would be little need for a world reserve currency, and what need there was could be met by the bancor. Freely fluctuating exchange rates would also in theory keep trade balanced and reduce or eliminate the need for a world reserve currency. Which system would be better is a complicated issue not pursued here. In either case the IMF could be abolished since there would be little need for financing trade imbalances (the IMF’s main purpose) in a regime whose goal is to eliminate trade imbalances.

Returning to domestic institutions, the Treasury would replace the Fed (which is owned by and operated in the interests of the commercial banks). The interest rate would no longer be a target policy variable, but rather left to market forces. The target variables of the Treasury would be the money supply and the price index. The treasury would print and spend into circulation for public purposes as much money as the public voluntarily wants to hold. When the price index begins to rise it must cease printing money and finance any additional public expenditures by taxing or borrowing from the public (not from itself). The policy of maintaining a constant price index effectively gives the fiat currency the “backing” of the basket of commodities in the price index.

In the 1920s the leading academic economists, Frank Knight of Chicago and Irving Fisher of Yale, along with others including underground economist and Nobel Laureate in Chemistry, Frederick Soddy, strongly advocated a policy of 100% reserves for commercial banks. Why did this suggestion for financial reform disappear from discussion? The best answer I have found is that the Great Depression and subsequent Keynesian emphasis on growth swept it aside, because limiting lending (borrowing) to actual savings (a key feature of 100% reserves) was considered too restrictive on growth, which had become the big panacea. Saving more, even with the intent to invest more, would require reduced present consumption, and that too has been deemed an unacceptable drag on growth. As long as growth is the summum bonum then we will find ways to borrow against future wealth in order to finance the present investment needed to maximize growth.

Why would full reserve banking not crash on the rock of the growth obsession again, as it did before? One answer is that we might recognize that aggregate growth today increases unmeasured illth faster than measured wealth, thereby becoming uneconomic growth. How can loans be repaid out of the net illth they generate? Should we not welcome full reserve banking as a needed financial restraint on growth (uneconomic growth)? Another answer is that, thanks to financial meltdowns, the commercial banks’ private creation of money by lending it at interest has now become more obvious and odious to the public. More than in the 1930s, fractional reserve banking has become a clear and present danger, as well as a massive subsidy to commercial banks.

Real growth has encountered the biophysical and social limits of a full world. Financial growth is being stimulated ever more in the hope that it will pull real growth behind it, but it is in fact pushing uneconomic growth — net growth of illth. Quantitative easing of the money supply does nothing to counteract the quantitative tightening of resource limits on the growth of the real economy.

The original 100% reserve proponents mentioned above were in favor of aggregate growth, but wanted it to be steady growth in wealth, not speculative boom and bust cycles. One need not advocate a steady-state economy to favor 100% reserves, but if one does favor a steady state then the attractions of 100% reserves are increased. Soddy was especially cautious about uncontrolled physical growth, but his main concern was with the symbolic financial system and its disconnect from the real system that it was supposed to symbolize. As he put it: “You cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest], against the natural law of the spontaneous decrement of wealth [entropy].” Wealth has a physical dimension and is subject to physical limits; debt is a purely mathematical quantity and is unlimited.

How would the 100% reserve system serve the steady-state economy?

First, as just mentioned it would restrict borrowing for new investment to existing savings, greatly reducing speculative growth ventures — for example the leveraging of stock purchases with huge amounts of borrowed money (created by banks ex nihilo rather than saved out of past earnings) would be severely limited. Down payment on houses would be much higher, and consumer credit would be greatly diminished. Credit cards would become debit cards. Long term lending would have to be financed by long term time deposits, or by carefully sequenced rolling over of shorter term deposits. Equity financing would increase relative to debt financing. Growth economists will scream, but a steady-state economy does not aim to grow, for the very good reason that aggregate growth has become uneconomic.

Second, the money supply no longer has to be renewed by new loans as old loans are repaid. A continuing stream of new loans requires that borrowers expect to invest in a project that will grow at a rate greater than the rate of interest. Unless that expectation is sustained by growth, they will not borrow, and in a fractional reserve system the money supply will shrink. With 100% reserves a constant money supply is neutral with respect to growth; with fractional reserves a constant money supply imparts a growth bias to the economy.

Third, the financial sector will no longer be able to capture such a large share of the nation’s profits (around 40%!), freeing some smart people for more productive, less parasitic, activity.

Fourth, the money supply would no longer expand during a boom, when banks like to loan lots of money, and contract during a recession, when banks try to collect outstanding debts, thereby reinforcing the cyclical tendency of the economy.

Fifth, with 100% reserves there is no danger of a run on a bank leading to a cascading collapse of the credit pyramid, and the FDIC could be abolished, along with its consequent moral hazard. The danger of collapse of the whole payment system due to the failure of one or two “too big to fail” banks would be eliminated. Congress then could not be frightened into giving huge bailouts to some banks to avoid the “contagion” of failure because the money supply is no longer controlled by the private banks. Any given bank could fail by making imprudent loans in excess of its capital reserves (as opposed to demand deposit reserves), but its failure, even if a large bank, would not disrupt the public utility function of money. The club that the banks used to beat Congress into giving bailouts would have been taken away.

Sixth, the explicit policy of a constant price index would reduce fears of inflation and the resultant quest to accumulate more as a protection against inflation. Also it in effect provides a multi-commodity backing to our fiat money.

Seventh, a regime of fluctuating exchange rates automatically balances international trade accounts, eliminating big surpluses and deficits. U.S. consumption growth would be reduced without its deficit; Chinese production growth would be reduced without its surplus. By making balance of payments lending unnecessary, fluctuating exchange rates (or Keynes’ international clearing union) would greatly shrink the role of the IMF and its “conditionalities.”

To dismiss such sound policies as “extreme” in the face of the repeatedly demonstrated colossal fraudulence of our current financial system is quite absurd. The idea is not to nationalize banks, but to nationalize money, which is a natural public utility in the first place. The fact that this idea is hardly discussed today, in spite of its distinguished intellectual ancestry and common sense, is testimony to the power of vested interests over good ideas. It is also testimony to the veto power that our growth fetish exercises over the thinking of economists today. Money, like fire and the wheel, is a basic invention without which the modern world is unthinkable. But today out-of-control money is threatening to “burn and run over” more people than both out-of-control fires and wheels.

Defusing the Debt Bomb

by James Johnston

If it didn’t have such explosive consequences, you’d have to laugh at the comedy of errors unfolding in the U.S. political arena. Politicians are proposing farcical “solutions” to the debt crisis in a competition to see who is better at pandering to the electorate. Are citizens really supposed to believe that raising taxes or cutting expenditures will provide meaningful relief on ballooning bank-inherited interest payments — payments so stratospheric that the human mind lacks a conceptual reference point for them? Each and every government service could be cut and it still wouldn’t help pay off the debt. The problem can’t be solved by reining in an overgrown government bureaucracy because much of it was created by an unregulated, overgrown banking system.

On the advice of conventional economic sages, we are to believe that the “credit crunch” is an event that took place in the past, with the words “growth” and “recovery” being used instead. But the transfer of debt from the private sector to the public sector in 2008 has merely postponed the inevitable detonation of a debt bomb that started ticking many years ago. If the government manages the bank-inherited debt in such preposterously piecemeal terms, it will never be paid off. Propping up the same broken banking system won’t solve the problem and will eventually cause history to repeat itself.

Only meaningful regulatory and monetary reform — reform that lowers the leverage ratio of lenders and discourages irresponsible gambling with the money earned by average people — can truly diffuse the debt bomb and prevent this from happening again. The result will increase the stability of the financial system and bring us closer to an economic steady state. But it means that we have to give up our collective obsession with the meaningless, self-destructive growth provided by an overgrown banking sector. First, government leaders must stop celebrating the growth of debt-inflated GDP figures like unthinking, euphoric addicts.

How we got here

No one can pinpoint the causes of the Great Depression with certainty, but prominent economist Irving Fisher argued that the predominant catalyst was over-indebtedness and speculation, which fuelled asset bubbles (Fisher, 1933). Sound familiar? After the Great Depression, the U.S. government initiated reforms based on Fischer’s explanation of the problem. The purpose was to avoid another debt-driven crisis. New regulations prevented bankers from speculating with depositors’ savings, and the U.S. economy experienced many years of prosperity without financial crisis. Investment banking was a more conservative endeavor and savings and loan funds were not used for speculation or risky business investing.

Fast-forward half a century. During the 1980s, the deregulation of banking allowed savings and loan banks to make increasingly risky bets with borrowers’ money. Some banks failed during the savings and loan crisis, yet the process of deregulation continued. Meanwhile, bankers’ wages skyrocketed. So-called new financial “products” facilitated speculation and fueled an illusion of growth and prosperity. The illusion enshrouded bankers in a mystical aura. Everything they touched turned to gold, and politicians and citizens began to regard them as sages. Only the most intelligent people, one might suppose, could create so much wealth so quickly.

The illusion of growth produced illusions of stability and prosperity; bad decisions were rewarded while lessons from history were either disregarded or forgotten. In 2008, as the American economy inched uncomfortably close to detonation, the big banks revealed that the debt bomb was much larger than initially thought. Still the regulatory bomb squad sat idle. At no point did they come up with a useful plan for truly defusing it — it was simply postponed through the transference of debt. This occurred in spite of the risks associated with a pending disruption of the monetary system: the potential disappearance of savings, the foreclosure of homes, disruptions in the flow of goods and services, and unemployment. As a bomb counting down to detonation, here is the timeline we need to bear in mind:

  • At ten seconds to detonation, advances in computing technology allow for “bankers” (many of whom were in fact physicists and computer scientists) to create investment products called “derivatives,” products that Warren Buffet called “financial weapons of mass destruction.”
  • At nine seconds, the financial sector consolidates into gigantic firms — something that was illegal following the Great Depression. Laws are changed under the guise of “modernization,” paving the path for the debt economy to balloon (and for history to repeat itself). Attempts to regulate derivatives fail and banking practices become increasingly risky.
  • At eight seconds, the euphoria reaches new heights. Loans are used as a means of generating investment funds for large banks. It becomes harder to track the risk associated with certain kinds of debt, as they are lumped together into an untraceable electronic mass (including commercial and residential mortgages, car loans, student loans, credit card debt and corporate debt). The products — “collateralized debt obligations” or “CDOs” — are given high ratings by credit rating agencies.
  • Seven seconds. Despite high ratings, many of the loans held in these portfolios are borrowed by people who cannot repay them. The banks don’t care, however, because insurance and default mechanisms allow them to avoid repaying any of the bad loans they issue. Besides, they argue, defaults like that are historically unprecedented.
  • Six seconds. As dot-com stocks crash due to over-speculation, investment money flows into sub-prime mortgages, which become all the rage. Mortgages reach their highest prices in history and home values skyrocket around the country. Indeed, many countries around the world see home values spike faster than ever. In the process, big financial firms (including JP Morgan, Credit Suisse, Citibank, Freddie Mac/Fannie Mae and UBS) defraud their borrowers to push profits ever higher.
  • Five seconds. The leverage ratio between borrowed money and reserve money reaches new heights (from 20:1 to 30:1). For every dollar a bank has, it loans out 20 to 30 times that amount. Limits on leverage are relaxed, enabling banks to bet more with the money of depositors.
  • Four seconds. U.S. home prices double over their 1986 levels. The IMF and a handful of economists warn of crisis.
  • Three seconds. Big firms declare bankruptcy and the giant debt bureaucracy (the big banks) take a tumble.
  • Two seconds. As if covering a bomb in duct-tape, the U.S. government bails out the banks and transfers debt from the private sector to the public sector, tripling U.S. debt overnight. And yet, the same system that caused the crisis is propped up.

At this point in history, with the debt reaching more than 14 trillion dollars, U.S. leadership has a choice between defusing the bomb with meaningful regulatory and monetary reform — reform that lowers the leverage ratio and punishes irresponsible institutional gambling — or further bandaging a broken system that meaninglessly consumes government expenditures and cripples the real economy to the benefit of big banks. Choosing the latter will again postpone the inevitable, maintaining an unstable economic status-quo obsessed with illusory growth derived from debt-inflated GDP.

If the U.S. government refuses to defuse the bomb now, it will explode in the foreseeable future as risky banking practices continue and interest payments (penalties for past mistakes) soar to super-stratospheric heights. The irresponsible actions of financially bloated bankers are being overlooked by a government distracted with irrelevant ideological arguments. When the debt bomb finally detonates, those responsible will likely avoid the fallout in the comfort of their unjustifiable excess. And while average people can try to shield themselves by minimizing their exposure to the debt-inflated growth economy, they will undoubtedly suffer the most. If only those elected to represent their interests would overcome petty illusions and turn their attention to more critical reforms than cutting and taxing.

Money and the Steady State Economy

Historically money has evolved through three phases: (1) commodity money (e.g. gold); (2) token money (certificates tied to gold); and (3) fiat money (certificates not tied to gold).

1. Gold has a real cost of mining and value as a commodity in addition to its exchange value as money. Gold’s money value and commodity value tend to equality. If gold as commodity is worth more than gold as money then coins are melted into bullion and sold as commodity until the commodity price falls to equality with the monetary value again. The money supply is thus determined by geology and mining technology, not by government policy or the lending and borrowing by private banks. This keeps irresponsible politicians’ and bankers’ hands off the money supply, but at the cost of a lot of real resources and environmental destruction necessary to mine gold, and of tying the money supply not to economic conditions, but to extraneous facts of geology and mining technology. Historically the gold standard also had the advantage of providing an international money. Trade deficits were settled by paying gold; surpluses by receiving gold. But since gold was also national money, the money supply in the deficit country went down, and in the surplus country went up. Consequently the price level and employment declined in the deficit country (stimulating exports and discouraging imports) and rose in the surplus country (discouraging exports and stimulating imports), tending to restore balanced trade. Trade imbalances were self-correcting, and if we remember that gold, the balancing item, was itself a commodity, we might even say imbalances were nonexistent. But of course the associated increases and decreases in the national price levels and employment were disruptive.

2. Token money would function pretty much like the gold standard if there were a one-to-one relation between gold and tokens issued. But with token money came fractional reserve banking. Goldsmiths used to loan gold to people, but gold is heavy stuff and awkward to carry around. Token money was created when a goldsmith gave a borrower a document entitling the bearer to a stated quantity of gold. If the goldsmith were widely trusted, the token would circulate with the same value as the gold it represented. As goldsmiths evolved into banks they began to make loans by creating tokens (demand deposits) in the name of the borrower in excess of the gold they held in reserve. This practice, profitable to banks, was legalized. Statistically it works as long as most depositors do not demand their gold at the same time—a run on the bank. Bank failures in the United States due to such panics led to insuring deposits by the Federal Deposit Insurance Corporation (FDIC). But insurance also has a moral hazard aspect of reducing the vigilance of depositors and stockholders in reviewing risky loans by the bank. Fractional reserves allow the banking system to multiply the money tokens (demand deposits that function as money) far beyond the amount of gold “backing.”

3. Fiat money came when we dropped any pretense of gold “backing,” and paper tokens were declared to be money by government fiat. Currency is printed by the government at negligible cost of production, unlike gold. As the issuer of fiat money the government makes a profit (called seigniorage) from the difference between the commodity value of the token (nil) and its monetary value ($1, $5, …$100 …depending on the denomination of the paper note). Everyone has to give up a dollar’s worth of goods or services to get a dollar—except for the issuer of the money who gives up practically nothing for a full dollar’s worth of wealth. Nowadays the fractional reserve banking system counts fiat currency instead of gold as reserves against its lending. The demand deposit money created by the private banking sector is a large multiple of the amount of fiat money issued by the government. Who earns the seigniorage on the newly created demand deposits? The private banks in the first instance, but some is competed away to customers in the form of higher interest rates on savings deposits, lower service charges, etc. It is difficult to say just what happens to seigniorage on demand deposits, but clearly that on fiat currency goes to the government. (With commodity money seigniorage is zero because commodity value equals monetary value—except when the mint purposely debased gold coins). Under our present system, money is currency plus demand deposits. Currency is created out of paper by the government, and no interest is charged for it; demand deposits are created by banks out of nothing (up to a large limit set by small reserve requirements) and interest is charged for it. For example, when you take out a mortgage to buy a house, you are not borrowing someone else’s money deposited at the bank. The bank is in fact loaning you money that did not exist before it created a new deposit in your name. When you repay the debt, it in effect destroys the money the bank initially loaned into existence. But over the next 30 years, you will pay back several times what the bank initially loaned you. Although demand deposits are constantly being created and destroyed, at any given time over 90% of our money supply is in the form of demand deposits.

***

If phase 3, our present system, seems “screwy” to you, it should. Why should money, a public utility (serving the public as medium of exchange, store of value, and unit of account), be largely the by-product of private lending and borrowing? Is that much of an improvement over being a by-product of private gold mining? Why should the public pay interest to the private banking sector to provide a medium of exchange that the government can provide at no cost? Why should not seigniorage, unavoidable in a fiat money system, go entirely to the government (the commonwealth) rather than in large part to the private sector?

Is there not a better away? Yes, there is. We need not go back to the gold standard. Keep fiat money, but move from fractional reserve banking to a system of 100% reserve requirements. The change need not be drastic–we could gradually raise the reserve requirement to 100%. This would put control of the money supply and all seigniorage in hands of the government rather than private banks, which would no longer be able to live the alchemist’s dream of creating money out of nothing and lending it at interest. All quasi-bank financial institutions should be brought under this rule, regulated as commercial banks subject to 100% reserve requirements. Credit cards would become debit cards. Banks would earn their profit by financial intermediation only — i.e. lending savers’ money for them (charging a loan rate higher than the rate paid to savings account depositors) and charging for checking, safekeeping, and other services. With 100% reserves every dollar loaned to a borrower would be a dollar previously saved by a depositor, re-establishing the classical balance between investment and abstinence. The government would pay some of its expenses by issuing more non interest-bearing fiat money in order to make up for the eliminated bank-created, interest-bearing money. However, it can only do this up to a strict limit imposed by inflation. If the government issues more money than the public voluntarily wants to hold, the public will trade it for goods, bidding the price level up. As soon as the price index begins to rise the government must print less, tax more, or withdraw some of the previously issued currency from circulation. Thus a policy of maintaining a constant price index would govern the internal value of the dollar (providing a trustworthy store of value and constant unit of account). In effect the fiat money would receive a real backing—not gold, but the basket of commodities in the price index. The external value of the dollar could be left to freely fluctuating exchange rates. These policies are not new—they go back to Frederick Soddy in1926, and to similar proposals by Frank Knight and Irving Fisher, the leading American economists of the 1920s. The fact that bankers and their friends in government and academia have willfully ignored these ideas for 90 years does not constitute a refutation of them, but rather is a tribute to the power of vested interests over the common good.

How would the 100% reserve system serve the steady state economy?

First, as just mentioned it would restrict borrowing for new investment to existing savings, greatly reducing speculative growth ventures—for example the leveraging of stock purchases with huge amounts of borrowed money would be severely limited.

Second, the fact that money no longer has to grow to pay back the principal plus the interest required by the loan responsible for the money’s very existence lowers the general pressure to grow. Money becomes neutral with respect to growth rather than biasing the system toward growth.

Third, the financial sector will no longer be able to capture such a large share of the nation’s wealth, leaving more available for meeting the needs of the poor. A steady state economy is not viable if it means a steady state of poverty for any significant proportion of the population.

Fourth, the money supply would no longer expand during a boom, when banks like to loan lots of money, and contract during a recession, when banks try to collect outstanding debts, thereby reinforcing the cyclical tendency of the economy. Reducing the risk of recession reduces the need to accumulate more to get us through the bad times.

Fifth, with 100% reserves there is no danger of a run on the bank leading to failure, and the FDIC could be abolished, along with its consequent moral hazard.

Sixth, the explicit policy of a constant price index would reduce fears of inflation and the resultant quest to accumulate more as a protection against inflation.

Seventh, a regime of fluctuating exchange rates automatically balances international trade accounts, eliminating big international surpluses and deficits. US consumption growth would be reduced without its deficit; Chinese production growth would be reduced without its surplus. By making balance-of-payments lending unnecessary, fluctuating exchange rates would greatly shrink the role of the IMF and its “conditionalities.” It also introduces more short-term risk and uncertainty into both international trade and investment. Many economists would see this as a disadvantage, but steady state economics favors a greater degree of national production for national consumption, and fluctuating rates would offer a bit of protection in the form of adding an extra element of cost (exchange rate risk) to international transactions. Like the Tobin tax it “throws a bit of sand into the gears” and reduces global commerce and interdependence to a more manageable level.

To dismiss such sound policies as “extreme” in the face of the demonstrated fraudulence of our current financial system is quite absurd. The idea is not to nationalize banks, but to nationalize money, which is a natural public utility in the first place. This monetary system makes sense independently of one’s views on the steady state economy. But it fits better in a steady state economy than in a growth economy.