21 September, 2020

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Money Creation And Society

By Hema Senanayake –  

Hema Senanayake

Hema Senanayake

Above is the topic of a debate which is to be held in British parliament on November 20th 2014. A group of activists from the British academia and elsewhere informed me about it. This particular group identified themselves as Positive Money Team. The debate is going to be hosted by Steve Baker (Conservative), Caroline Lucas (Green), Michael Meacher (Labour) and Douglas Carswell (UKIP). Therefore the proponents expect to have cross party support for this debate. The proponents of this debate point out that this subject has not been debated since 1884 in the legislature; this means that this subject is to debate in the legislature after 170 years. In that sense this will be a historical debate.

The major economies of the world began to crash in late 2007. Factories, businesses, banks were closed down at an unprecedented scale. Jobs were slashed and as a result livelihood of people was shattered. The economies were in recession in 2008, which recession is now known as the Great Recession of 2008.

The governments and politicians blamed greedy bankers, investors and monetary/financial regulators for the crash. Some others in the far right of the political spectrum blamed the consumers for borrowing money in amounts that they can’t pay back. Economists and the Central Bankers were divided and supported both views. None of them believed that the crash was resulted due to systemic problem in our money system. But a small group of people mainly in British academia and financial sector did not buy these arguments and justifications. They did believe that the economic and financial meltdown happened due to a systemic error in our monetary system. As far as I know this group of people subsequently teamed up to form the Positive Money Team. Their relentless effort has now made the said debate possible in British parliament.

This is an important debate not only to the British citizens but also to each and every human being who is living right now and also to those who would be born in foreseeable future because in our contemporary economic system, the production, the distribution of distributable output and the economic growth are, I would say, completely depended upon the money system we use; this would remain so for foreseeable future. The supporters of the debate suggest that the money system we use is wrong. Hence, if the general public and the media picked up the true theoretical and practical substance of this debate, it would be a debate that would change the destiny of economic civilization of the human kind.

Money has to be created by somebody. There are two known methods to create money. The first method is that the government along with its Central Bank can print notes and mint coins. Also, as is happening now in the modern world the Central Bank can create money electronically too. This is easy to understand. The second method is known as Fractional Reserve Banking system. In this system money is created by certain banks known as “designated commercial banks.” The special feature of these banks is that they factually create a lot of money which they lend to borrowers using the deposits obtained from depositors. For an example if a bank gets £100 as a deposit, the bank can lend not £100 but multiples of £100, sometimes the bank could lend more than £900 using the deposit of £100.

In the first method of money creation, the banks are not allowed to create money or monetary substitutes. Hence that system is known as Full Reserve Banking system. In this system all financial institutions are just intermediaries.

So, which banking system we use now? It is the Fractional Reserve Banking system we use today in almost all countries. Positive Money Team believes that this system is bad and hence must use Full Reserve Banking system in which system commercial banks are not allowed to create money. Therefore, the said debate is about choosing a better monetary system. In other words the debate would focus on as to which money creation system would be positive on society.

Positive Money Team believes that the Fractional Reserve Banking system which enables the designated commercial banks to create money substitutes cannot ensure the wellbeing of all citizens all times because that system creates bad debt bubbles, financial asset bubbles, housing bubbles etc. which lead to financial crises and eventual recessions.

If so, would the creation of money under Full Reserve Banking system ensure the wellbeing of all citizens in all times preventing debt bubbles and financial crashes? This is a legitimate question. Isn’t it?

Positive Money Team would say “Yes.” But my answer is “NO.” The proponents of this debate have looked only the banking and financial aspect of the money creation process. You can’t resolve this important economic issue without digging deep into the macroeconomics. Our macroeconomic system has a very peculiar and unique feature. Let me explain it briefly:

In the contemporary economic system whatever goods and services sold have to be bought by somebody in a given time period. This is common sense because you can’t sell something if somebody is not buying it. When you sell, it is known as supply and somebody is buying it is known as demand. The same thing must happen at total output level. Therefore it is common sense to understand that supply and demand at total output, subjected to the above definition, must be in equilibrium.

However, sometimes, the supply and demand is in equilibrium at continually increasing output levels and those periods are known as economic growth periods. Also, sometimes, supply and demand is in equilibrium at decreasing output levels and these are the periods which are known as recessionary periods. Now, you know what happens in periods of economic stagnant.

The peculiar or unique feature of the macroeconomic system is that the supply and demand equilibrium at any output level is met with a component of non-repayable debt. This phenomenon has recently been explained by the System Gap Theory.

However, especially during the periods of economic growth, the Fractional Reserve Banking system is fully capable of creating the said portion of non-repayable debt in the system. It creates these debts in the public debt regime or consumer debt regime or in the stock and derivative market or in all three areas. Since, bad debts keep accumulating debt bubbles and associated financial crises are unavoidable. Whims and fancies of greedy bankers and investors would only aggravate these debt bubbles. But the true cause of debt and financial bubbles arises from the above said unique behavior of the macroeconomic system.

Even with the Full Reserve Banking system which would be proposed by the supporters of the debate, the said unique behavior will remain unchanged. But instead of creating debt to meet the non-repayable portion of debt, under this system, debt free money can be created by the government. In other words, since all the money is created by the government along with the Central Bank, all that money could be rightfully considered as debt free money. But in the case of Fractional Reserve Banking system the money substitutes that are produced are always associated with debt – And this system cannot produce debt free money.

Therefore the most important part of this debate is not the transition from Fractional Reserve Banking system to Full Reserve Banking system but to evolve a flexible mechanism to create the right amount of debt free money in the system to fill the gap which is now being filled by non-repayable debt created by the Fractional Reserve Banking system, to sustain growth without periodic crashes. So far, the supporters of this debate have ignored it.

The other important consideration is that U.K. by itself cannot implement the Full Reserve Banking system without a global convention, no matter however good that system would be. The reason is that the British financial assets or even other tangible assets could be easily bought by the competitors in other countries who still operate with Fractional Reserve banking systems in their respective countries.

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    Guess UK doesn’t have the empire to indulge in the Fractional Reserve Banking system anymore……fellows are completely out of ideas……US-China connection is coming up pretty neatly though.

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