Taking the debt out of money creation

The world is experiencing a Global Financial Crisis. It is called a financial crisis because it started as a problem with the financial system and has spread to the "real" economy. We can see the symptoms and effects of the crisis but there is little confidence that after we come through the problem it will not happen again. In this article we look at the problem from the fundamentals of money and propose a solution that may stop the same problem reoccurring.

Money has two basic functions. The first is as a measure of value for the exchange of goods and services. The second is as a store of value. The problem with the first function is that there are many measures of value (such as different currencies) and the measures keep changing because of inflation or in rare instances, deflation.

When it comes to money as a store of value, the issue is equally murky. Credit money is created through loans and is a representation of the value of something else. That is, the abstraction has no value but the thing it represents has a value. So when credit money is described as a store of value what we really mean is that what it represents is of value. "Fiat" or printed money does not represent anything and is used to facilitate trade rather than act as a store of value. Credit money and fiat money are indistinguishable because once they are in circulation no one can tell the difference.

So, despite the fact that we have a money system where, when we take out a loan from a bank we increase the money supply, and despite the fact that we can simply print something and say it is money, all money itself continues to have value because people will pay interest to gain use of it. And interest in and of itself is not an issue, while ever there is an asset backing money, because interest can be viewed as rent of the asset that backs the money.

So what is the problem with money?

The first issue is that we have world-wide targeted inflation. Allowing the value of money to change over time is not a sensible idea. It makes it very difficult for people to measure the value of things. Imagine how difficult it would be if the meaning of a metre changed each week! This week it is the length of a rod that is kept in France and next week it is the length of a rod kept in Berlin. The week after we cut a bit off the rod in France and that is now a metre. It sounds absurd but this is exactly what happens with money. The measure of value changes minute by minute with random fluctuations.

The second problem is that the world has too much money to act as a store of value. There is more money issued than there are assets to back it and there is much more money issued than is needed for trade. When the sum of money in existence becomes too great the system corrects itself by the money being destroyed or through changing the value of money through inflation. If there is not enough money, the result is deflation, whereby the value of money becomes greater causing trade and industry to contract because there is no longer enough money to keep commerce operating.

This waxing and waning of the amount of money creates the so-called business cycle of economies, complete with the occasional recession and a few crises.

How can we both have too much money yet not enough and why do we have such widely varying and changing meanings of value?

The problem arises because of a quirk in the way we create credit money. Most money in existence is credit money and it is created when a bank gives a loan against an existing or future asset. To do this the bank uses some money that is already on deposit and then creates the remainder (and majority) of the money required by issuing extra money to the value of the loan. This in itself will not cause a problem because when the loan is repaid, the bank destroys the amount of money it created. If the loan is not repaid the bank is required to make up the difference from its reserves. (If the loan is not repaid then the bank is also entitled to seize the assets against which the loan was made and sell those assets to make up the money not repaid.)

This process seems reasonable and sensible except that banks can issue loans that are backed by money itself and this creates more credit money. Also banks are free to use another currency as the asset backing to create money in different currencies. What this means is that we increase the amount of money without requiring an underlying asset to earn enough money to pay the interest on the loan.

Because it is so easy to create extra credit backed by credit most transfers of money are now speculative transfers where money moves to try to take advantage of differing values of different currencies and money moves to take advantage of different interest rates. In and of itself this is useful, but when the main trade is trade in the measure of value then that trade comes to dominate the "real economy" of trade in other goods and services.

What is the solution?

There are many solutions to the problem. One way is to attempt to regulate banks and restrict how they create loans and hence create money. Unfortunately this has not worked very well to date and to improve the regulations requires the agreement of all countries.

A different solution is to create money that we are assured will be used to create an asset that will back the money created. There are various ways to do this. One simple way is for banks to issue zero interest loans that may only be used for the creation of new assets. Banks would be repaid - potentially more than was originally loaned - over the life of the asset providing the asset earns enough money. Such an approach would gradually remove the need to create extra credit money by having enough money already in existence to act as a store of value and to be used for trade.

Will banks do it?

Under existing banking regulations banks may not be allowed to do this because there may be no asset backing the loan when it is first issued. However, if it is highly likely that the money would create a productive asset or an asset that is of value to the general public, then the banking regulator could allow it.

So, will the banks be interested? Banks are only likely to support such an approach if they are guaranteed not to have to make up the money from any failed loans from their own reserves. A simple way to ensure this is for the money created for zero interest loans and then used for the creation of new assets is backed by the government. We have this already with the recent bank guarantee of deposits which is far more onerous as the government is guaranteeing the money created for all loans created by banks and not just money created for new assets.

And there is a way for banks to cover their risks. They create loans but only if the borrower deposits a sum of money at zero interest that reverts to the bank if the loan defaults. The other way is to build systems that make it highly probable that the money will create a new productive asset. It is the ability of modern information systems to ensure this occurs that makes this approach viable.

Will depositors deposit money at zero interest to get a loan at zero interest?

They will, provided the deposit is much smaller than the loan given and if the asset created can earn enough money to return the loan to the bank.

Should governments be involved?

If governments are going to guarantee the money created for zero interest loans then they must be involved. Banks can still issue zero interest loans without the guarantee provided they are confident most loans will be repaid and if the system works as expected and the default rate on loans is small. However, in the first instance it is expected that governments will use the approach so that they can direct investment - via zero interest loans - to areas of the economy where new investment is needed but cannot compete for funds currently being used to purchase existing assets.

For example the Australian government could guarantee the money created for zero interest loans for investments in new assets that would reduce the level of greenhouse gas concentrations in the atmosphere. If the government did this then the cost to the government would be a permanent increase in the money supply equal to the value of the new assets created. Provided the value of the new assets created was in total greater than the money invested then there would be no net loss to the economy.

If, as expected, this method of financing new assets proves successful then governments may be needed to stop the runaway creation of money for zero interest loans. Governments may need to put a cap on how much money is created this way and to determine which areas of the economy should be encouraged with such loans. This is what governments now try to do through diverting taxes to particular areas of the economy or through schemes such as emissions trading. A move to create money through investment in productive assets will mean less need for these other ways of encouraging investment.

Will it stabilise the value of money?

If it is done on a grand scale this method will stabilise the money supply because zero interest loans to create new assets will become the preferred method of funding the creation of new productive assets and hence the preferred method of increasing the money supply. Purchasing existing assets will still be funded by credit money but asset bubbles are less likely to occur. Let us take the example of housing. If some new houses were financed through zero interest loans, where the loan had to be repaid immediately the house was sold, then it becomes less likely that people will pay inflated prices for existing houses because it will be cheaper to build a new house.

The price of money for loans (interest) will act as prices are meant to act - as a signal to the market to produce more money. If the price rises, governments can encourage money and asset production by guaranteeing the money created for zero interest loans for worthy community projects that have little economic benefit but large social benefit.

A major impact is that it will become less attractive for money traders to speculate in money values because the price of money will stabilise and traders will know that the government can easily turn on and off the creation of zero interest loans. Governments will be able to defend their currencies and stabilise value as they have a method of increasing supply if demand for money increases or decreases.

Doesn't this require massive changes to the financial system?

It requires NO changes - only the creation and monitoring of zero interest loans. Everything else can remain the same.

Where does a government start to encourage zero interest loans?

Any area where a government feels there is a need for investment can use this approach. Perhaps the most pressing example is the need for investment in ways to reduce greenhouse gas concentrations.

But won't everyone want zero interest loans?

The right to have a zero interest loan is of value. The simplest form of rationing is to allocate the right equally to anyone who wants to apply and to allow the right to a loan to be tradeable. The other form of rationing is to require a higher proportion zero interest deposit before the loan is given or to increase the amount of money to be returned to the bank for the loan.

Are there any examples of this approach?

Contingent loans, such as Australia's HECS, are examples of this approach. The book Government Managing Risk by Bruce Chapman describes the theory behind this concept.

The movement of micro loans is based around the same concept of giving loans to people without assets so they can build more assets.

We can increase the money supply through the concept of Rewards or through giving away common stock in companies building community assets like the National Broadband Network. Giving away assets that are not currently owned by anyone (because they exist in the future) has the effect of increasing the money supply.

While giving away restricted money to build productive assets is an approach that will increase the money supply quickly the idea of giving away the right to zero interest loans is more likely to gain acceptance and will be easier to adopt. It can even be introduced without government involvement by socially aware banks, such as NAB, who already provide micro loans without the recipients of the loans having existing assets to back the loans.