The Need For Fundamental Change

Over the last 2 months I have given an overview of how our monetary and banking system work, particularly in the area of money creation (a complete exploration of this system would have to look at monetary policy and financial markets).  Over the last 4 weeks I’ve tried to show the connection between this system and our cycles of boom and bust, and the systemic flaw that lies at its heart – that money can only be created by private debt, and repayment of that debt reduces the money supply.

What I see is a need for fundamental change.  Reform is too weak a word – mere reform of the current system is not enough, the systemic flaw will still be there.  We need fundamental change – a transformation of the current system.

I’m not going to say I hope I’ve “convinced” you of this – please never allow yourself to be convinced of anything be reading a few blog posts!  But I hope I have demonstrated that what I am saying is rational, logical and backed up by evidence.

In terms of the central theme of the blog – creating an economy that provides enough for everyone – clearly we cannot achieve this with such a defective monetary system.  But I’m afraid that such reform, however transformative, is not the answer.  It’s necessary, but it’s just one element of what is required – and it’s not even the most important element.  What we really need to understand is how wealth flows around the economy, funding investment to increase productivity and providing people with the means to participate in the economy.  But before you can understand that, you needed to understand the monetary system, which is why I had to cover it at this point in the blog.

But nonetheless, we do need to talk about the nature of the change required.  Before I start on that next week, it is worth reflecting in explicit terms on the role of the banking system in the current process of money creation.  We’ve seen that a bank creates money out of nothing, with no cost to itself, when it makes a loan.  It then charges us interest on those loans, making profit in the process.  So as well as the economy having to grow enough for businesses to be able to repay the loans, it needs to grow even more to be able to repay the interest as well – it’s like a fee or a form of rent paid to bankers for providing us with a banking and monetary system.

And of course, this “rent” would be well worth paying if the system worked well.  When I said that there is no cost to the bank in making a loan, I meant that it costs them nothing at that moment in time.  The costs to the banks come later, as they need to back the payments made by their customers, and cover the interest payments of their own borrowing (for example, in the interbank market).  Hence, there is risk for the banks:  as we’ve seen in previous posts, if they do not make good decisions in allocating credit, they can go bankrupt.  In fact, the economic history of the last 200 hundred years is basically a constant procession of financial crises and bank runs and bankruptcies.  So what we’re paying banks for is taking that risk and providing us with a functioning monetary system.

There are two problems with this – one is that when banks fail, we all suffer, not just the banks.  There is a massive public cost and therefore this process should be subject to significant public intervention.  And secondly, we are now in the era of banks that are “too big to fail”.  We pay them to bear the risk, but then bail them out when their bad decision-making causes the system to crash.  And banks know we do that, and it makes them far more tolerant to risk.

And ultimately, they aren’t providing us with a functioning system – they are providing us with one that is inherently unstable, prone to crashes, and at the present time continuously redistributing wealth into the hands of the wealthiest corporations and individuals.

Clearly we need to transform our entire monetary and banking system, so next week we will look at the prominent ideas coming from the movement for monetary reform.

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