The design of the world’s money system is fatally flawed. The most fundamental aspect of it – notably the concept of an interest rate – is contrary to the dictates of physical laws and results in skewed ownership and control of resources which must ultimately result in societal chaos. Since money ultimately represents the capacity of a person or group to direct resources, and resources are a direct consequence of energy flows, money can be regarded as a form of energy in and of itself. In any physical system, the accumulation of energy or matter in one part of a system to the detriment of another part of the system must eventually result in a flow of energy in the opposite direction, as captured in the idea of entropy and the 2nd law of thermodynamics.
It might be convenient to try and blame the banks and central authorities, but they are not to blame. The design of money as we know it is the conspiracy – if such a conspiracy is sought for the purposes of assigning blame. It seems to be a natural tendency of humans to seek out the most efficient method of attaining wealth and thereby power and the money system with its inbuilt ideas of interest provides the perfect vehicle. As noted by JW Mason “the complex of interest rates as a whole is not effectively captured by a single measure of the level of interest rates.” Monetary systems are complex and the purpose of this paper is to propose a broad idea based on empirical observations rather than to build a scientific justification for a theory – if indeed it is possible to apply the scientific method to economics at all.
In the conclusion of his paper, Mason makes the following observation: “Finally, from a Keynesian perspective, liquidity is central to the structure of interest rates. The interest rate is the price of liquidity (not the price of saving) and depends primarily on developments within the financial system. From a Minskyian viewpoint, liquidity refers to the capacity to meet cash commitments. This implies a world where the goal is to manage cashflows so as to make contracted cash payments where the payment that can be received by sale of hypothecation of an asset is in general lower (often much lower, or zero) than the present value of the income expected from holding the asset. As Minsky puts it “The fundamental speculative decision of a capitalist economy centers around how much, of the anticipated cash flow from normal operations, a firm, household, or financial institution pledges for the payment of interest and principal on liabilities.” . The extent to which the post 1980s financial system is less liquid than the postwar system, in the sense of having less reliable cashflows relative to its cash commitments, can help explain the increase in the credit spread.”
I have underlined “in the sense of having less reliable cashflows” deliberately. Post war liquidity is orders of magnitude greater than prewar liquidity, simply because prewar liquidity was based in the idea of reserving (or a promise if you will) against a standard – the gold standard. Since the abandonment of the gold standard in 1970, the measure of available money in the system is many multiples greater than the prewar period – even accounting for the increased size of economies and populations. But what is true is that cashflows are less reliable. This is to be expected. When a money is backed by a certain asset such as gold it stands to reason that it will be more reliably repaid (in the sense of being converted at some future point to a desired commodity) than a money which is not so backed, or only fractionally so.
However, as will be seen, the larger the spread the higher the rate at which banks capture an economy. This benefit doesn’t accrue only to the banks, but to the broader “upper tier” of owners of wealth. As will also be shown later, the growth in personal earnings in the financial sector has been exponential. This affects the growth in remuneration in other sectors too, as smart and equally qualified persons demand similar levels of lifestyles to their financial sector contemporaries. Greater levels of uncertainty thus give rise to greater expectations of remuneration to counter the effects of expected chaos – not dissimilar to the experience of entropy in physical systems.
To understand the impact of less certain money and how it comes about, we must turn to an understanding of how money in a modern economy is created. In the words of McLeay et al2, “Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.”
Banks create money by lending : simultaneously with the creation of an asset (the loan), the bank creates a liability (cash in the borrowers account). The interest rate, considered in classical Keynesian economics as the price of liquidity, has a spread - being the difference between the rate paid on loans and the rate paid on deposits. Worldwide this spread has ranged between 6% and 7.6% since 1992 (see figure 1 below). In other words, if a bank pays 2% on deposits, then it will charge 2%+6%=8% on loans. A 6% margin on 2% represents a gross margin of 200%. But it doesn’t work quite like that. Due to the wide range of different rates to different classes of credit, the average bank net return is around half of the interest rate spread (IE the banks write off a lot of their spread margin through riskier lending – but the riskier lending provides a greater opportunity to create new money). Furthermore, monetary policy sets the amount of cash reserves that a bank must maintain to ensure liquidity. This varies from country to country, but worldwide averages 7%.
In other words, based on the total reserves of a bank, the margin on bank loans is 3% (half of the 6% spread) on 100% of the total money available. On the actual reserves held by the bank, it is 3% divided by 7% = 42% lending margin on total reserves.
Figure 1 - Interest rate spread (lending rate minus deposit rate, %)
Looked at another way, we (society) allow banks to acquire for themselves by way of interest (and related charges) an annual average of 3% of each new dollar. However, this is 3% each year. Since we have an inflation rate of 2.9% (world average for 2016), this means that the present value of a new dollar declines each year, so the present value of the 3% spread also declines in present dollar terms.
In year 1, Bank earns 3% of $1. Year 2 it earns 3% of $0.971. Year 3, 3% of $0.943 – and so on.
If the interest is summed over 10 years, this equates to 26% of each new dollar created. Over 20 years, it’s 46% and over 100 years – all of the value in real goods traded by the newly created dollar is captured by the bank!
In 45 years, at the rates above, 76% of the wealth can be captured.
Have a look at Figure 2 (not to draw inappropriate causation conclusions):
Figure 2 - Personal remittances in the financial sector
The exponential growth of personal remittances (IE earnings) in the financial sector since 1970.
The gold standard ended in 1971. Figure 3 below shows how income disparity started to widen since 1970 in the United States.
Figure 3 - Share of Income Gains
So if you want any argument for the iniquity of the concept of compound interest (when combined with the idea of money creation by lending control in the hands of central and commercial banks, and fractional reserving), surely look no further!
This idea of money supply being controlled by central authorities also needs further investigation. Obviously someone has to make sure that money isn’t just spontaneously created at whim by anyone who wants to create it, as that would cause a complete breakdown in the system of “value-trust” that must be inherent in a money in order for it to serve its purpose. If it were the case that the money issuing authorities acted in the broader public interest, then such a system might survive intact. But because the authority to issue money is given to commercial banks which have a self interest in the form of an interest rate margin and also because the central banks are to a greater or lesser extent beholden to the whims of politicians, the greed and power aspirations of a relatively small number of people can completely upset the system. In addition to this, the marginal cost of money creation is virtually zero, since money no longer has any physical basis – so its rate of creation is subject to whim rather than the expenditure of physical effort (work).
The system is historically upset by way of revolution or war which is a condition in which those that do not have enough, facing those that have too much, decide to bring about a change – typically a violent one. Wealthy people generally do not revolt against a system that keeps them in their position of relative privilege.
The central authority system of money supply control combined with interest rate margins has really had no alternative until recently. The logical antidote is to create a money system that is self issuing and self regulating – free completely of the avarice of humanity. But to achieve that a few critical factors must be present:
1. The incentive to pervert the system (i.e. interest) must be removed
2. A mechanism for delivery that is independent of human agency must be readily available.
Figure 4 Income Inequality
Figure 4 doesn’t show the global figures (According to Wikepedia the top 10% hold 85% of the world’s wealth in 2013). But it clearly shows that the income distribution which was huge and growing up to the time of WW1, started to equalize quite dramatically. This also coincided with the invention of radio and other mass media communication tools, which resulted in wealth starting to become more equitably distributed (i.e. the world’s wealthy had a declining share all the way up to 1970’s). It has turned around since then – in my view as a result of allowing the creation of money to vest with the commercial banks since the dropping of the gold standard.
If it is your business to make money out of a margin on money supplied, then surely you would do everything in your power to increase the supply of money?
What is to be done about it?
I contend that
1. The concept of interest on money has led to the derivation of an
2. Interest spread margin, leading in turn to
3. Fractional reserving and then to the
4. Creation of money through debt issuance by commercial banks ultimately resulting in
5. The capture of greater and greater proportions of global resources by fewer and fewer people resulting in
6. Massive global inequality which must eventually lead to
7. Social chaos and possibly collapse
Furthermore, extreme concentrations of wealth tend to lead to the inefficient and wasteful use of resources. In turn this impacts on humanity’s unsustainable consumption of the Earth’s capacity to sustain human life, including perhaps Anthropogenic Climate Change.
Then what can we do? Clearly anyone starting an argument with interest and landing up at climate change is likely to be seen as a madman, so since I’m off to a bad start anyway, I may as well press on.
What if we were instead to design a money system that exhibited the following characteristics:
1. Was issued by a central system free of the control of human beings; and
2. Incorporated the antithesis of interest (i.e. used the idea of decay found in natural systems – a use-it-or-lose-it policy if you will – thereby removing the incentive to hoard and replacing it with an incentive to trade); and
3. Was issued equally to all people on a regular and consistent basis – in other words, a money system based on the value of people (which makes sense since people are the things that perceive that value in the first place and money is a function of the output of people)
Interestingly, we actually can do this. The convergence of technologies such as cellular phones, blockchain based decentralised secure ledgers, Internet, cloud computing – all point to the possibility of creating an alternative monetary framework that incentivizes the recovery of goods for reuse and the efficient allocation of ALL resources.
To find out more about how that might work, read about Project UBU at www.projectubu.com