Money creation by bankers, central banks or individuals

That the Swiss are going to have a referendum on changing the way in which they create money is great news. That the referendum is certain to fail is even greater news.

(First link and second link.)

As regular readers of Economics 102 will know this blogger is extremely committed to reforms in how we create money. You will also know that I am strongly opposed to state control over the economy. I also believe there is an urgent need for reforms in the way we produce and exchange goods and services. There is a 99.99 percent probability of economic turmoil as the economy continues its downward decline and without major changes there will be a lot of human suffering.

CurrencyThe Swiss proposal is that the creation of money be restricted to the central bank rather than the current fraction reserve process in which money is created when banks make loans. The authors of the proposal should be lauded for recognizing that there are big-time problems with money based on debt and that charging interest on money created makes our economic problems even worse.

My problem with the proposal is that it wants all money creation to be in the hands of the central bank. The central bank would have direct control over lending. “The money created by the monetary authority would be transferred to the Treasury and would come into circulation by public spending; thus, it would benefit the public purse and contribute to the reduction of national debt. ” Money creation and this type of spending would also mean a lot of economic control by the government.

The essay about this proposal lists private control as one of the problems with the current system. Control is a major economic issue and I can see where a lot of people are strongly opposed to anything but “public” control.  However “public” control is just control by different people with slightly different interests from the bankers. They will still be acting in their own interests – such as getting re-elected. I want an economic system in which control and decision-making is by individuals and I believe the way to get this with a true competitive market economy which we do not have. I also figure the current system is marginally better than money creation in the hands of a government agent.

The authors also point out there is a need to “secure the independence of the monetary authority.’ This is a serious concern as the people who control money creation get to determine which economic projects go ahead and by whom. There are very few prime ministers of any political leanings who would allow that kind of power into any hands but their own.

There is an alternative to money creation by a central bank and that is to combine money creation with a guaranteed annual income scheme. This would solve the problems of lots of people without jobs and it would put primary economic decision-making into the hands of all of us as individuals.

This guy has written extensively about this on this weblog and in an e-book Funny Money: Adapting to a down economy. The book is available free by following the link on the sidebar.

Any changes in how money is created, whether to a central bank or to an income scheme, would hit the profits and power of bankers. Expect them to be more than just vocal in their opposition if either becomes a serious threat.

I figure economics is largely about relationships and to be satisfactory relationships need to be based on a more or less equal two-way exchange. I also believe money should be considered a tool to facilitate the exchange of goods and services and it should encourage good relationships rather than be an instrument for exploitation. To maintain good relationships money should not give power to some people over others. I fear that giving a central bank the sole right to create money would make it easy for governments to exploit their citizens.

There are lots of serious problems with the fractional reserve way of creating money and there is an urgent need for reform. The big question is what the reforms will do to the way in which we exchange goods and services and how we relate to each other.


Some concerns about the Swiss money creation referendum

The Swiss are going to hold a referendum on a proposal to change the way in which money is created by transferring this function from private banks to the central bank.  The more I think about this the more I see it as an attack on banks by people who do not really understand what money is and how the financial system functions, or should I say by people whose understanding of money is different from mine.

I believe there are some serious problems with the current fractional reserve way of creating money and anything which might lead to reform is to be encouraged.  However, I would like to see some debate rather than letting those who would tell the rest of us how to live win by default.  I want to see a libertarian reform in which decision-making is by all individuals rather than a select few.

Here are two links to information about the referendum. One, two.

Money is a tool to facilitate the exchange of goods and services and is backed by the agricultural surplus of which we have a huge amount although its continuation is somewhat precarious.  The fractional reserve way of creating money gives great power to bankers who create money each time they make a loan.  The Swiss critics are right about that. Money represents purchasing power for people who hold it and those who create money can decide to whom they will transfer that purchasing power. Transferring the money creation function to the central banks would be transferring power from one small group to another. I am not certain bureaucrats would be any better at making decisions in the public interest than private bankers.

A more libertarian approach would be to combine monetary reform with a universal income scheme and to call money agricultural surplus credits.  This is explained in my just released ebook Funny Money: Adapting to a Down Economy.  The book also talks about the problems with fractional reserve banking. (You may get a free copy of this book from Smashwords until March 19, 2016. See previous post.)

In reforming the way in which we create money two other factors need to be considered.  The total amount of money available needs to be flexible up and down as the quantity of good and services exchanged varies. If it is not flexible we should expect inflation or deflation, both of which rob people of their savings.  The Swiss proposal says the central bank would use its statistics facilities to help in this.

The other concern is interest.  I believe the charging of interest on loans is a Ponzi scheme which leads to periodic financial crises.  This too is in the book. I did not see anything in the proposal to indicate how interest would be handled.  It could be the people who crafted the proposal do not see that interest is a problem in money creation.

I fear that not too many people truly understand how money works in the economy and how the fractional reserve way of creating money is a serious problem.  Reforms are needed although I can not see that transferring money creation from one small group to another small group will be a satisfactory reform.

Free Funny Money

Here is a free promotional giveaway of the new ebook Funny Money: Adapting to a down economy.  This book is now available on Amazon Kindle and Smashwords.  The next step is for me to make some formatting corrections so Smashwords can distribute it to a number of book stores.


Smashwords allows authors to create coupons for discounts and free giveaways.  I have made a coupon to give this book away free for about two weeks. The code is HS63E and it expires on March 19, 2016

The book is available at:

The book is also available at the Kindle book store at*Version*=1&*entries*=0  

at the regular price of 99 cents. So far as I know Amazon does not allow the free giveaway for the publishing option I have chosen.

This book is critical of some aspects of economics and endorses others. The author, who has also read history and anthropology, questions economic growth and the fractional reserve way of creating money. He has come to terms with the market economic model as a set of guidelines for economic policy. The current economic crisis is resource based in that we have used up the most easily accessible of energy and mineral resouces.  We need a guaranteed income scheme and a new way of creating money.

Will the coming infrastructure crises be one of finances or resources?

Following a weekend of driving a highway in British Columbia one has to believe this article in The Economist which claims it will cost $57 trillion to build and maintain the infrastructure the world needs between now and 2030.  And the road (Part of the Trans Canada highway between Sicamous and Golden) really wasn’t that bad.

The Economist writer is concerned with who will provide the finances for the needed work.  I think financial people are generally very good at creating money when there is a need.   The real problem is: will there be enough energy and mineral resources at a reasonable cost?   There will be lots of resources but we have already used up the most easily accessible and those that are left will take a lot of energy to access. Energy for infrastructure will be competing with all the other things we want to have and do.

One of the issues will be priorities.  Most of us, most of the time act and think in our own short-term interests as opposed to the long-term interests of our communities and even own long-term interests.  We may know that a bridge is past its prime but so long as it remains intact it will be a long-term project and sacrificed for other things that are short-term.  When the bridge was first built it was a short-term need.

Most of the current infrastructure was built during our golden years of prosperity and people were optimistic.  Most of us are now aware there are problems in the economy even if we don’t know why.  There will be people who will risk their savings on long-term investments for a good potential return but I suspect a lot of people will be hesitant to take the risk.

The current infrastructure projects mentioned in the article are along way from the total of $57 trillion which will be needed.  We might be wise to stock up on duct tape.

Speaking of Bridges, the pictures are of one of my favorites: The Kicking Horse Pedestrian Bridge in Golden, B.C. A link.






















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Payday loans, slavery and money creation

What is the marginal cost of making a payday loan? Or any other type of loan?  The answer to this question should help to answer a question about interest rates on loans raised in the Buttonwood column of The Economist, November 30, 2013 issue. What interest rates should lenders be allowed to charge?

Unfortunately loans and credit are complicated beyond simple economics because the making of loans is an instrument of exploitation even to the point of slavery and because credit is involved in how we create money.

Economic theory tells us that so long as there is competition the price of a product should be equal to the marginal cost of producing that product.  Therefore for loans the marginal cost would be the cost to the lender of acquiring the money to loan (i.e. the interest paid to the depositor of for payday lenders to their source of funds) plus the operating costs and the cost of loans written off.  The legitimate interest rate to charge on a loan should be easy to calculate and for banks we can compare the rates they pay on deposits and the rates they charge for loans.

It appears the need for credit is almost universal at least in large-scale economies.  I’m not sure about hunting and gathering groups which practice a sharing economy.  It appears there has always been a need for short-term lending of the type done by payday lenders.

The problem is that the making of loans can be an instrument of exploitation.  One of the quickest ways to get control over a person is to lend them some money.  In peasant societies people borrow to put on funerals and weddings and if they cannot repay they sometimes find themselves in slavery.

In our own society there are probably lots of people with dreams of doing something other than the daily employment but they are unable because of their debt load.  All this consumer debt works as an instrument of social control for the one percent.  So long as we are in debt we work to support their goals and interests rather than for our own.  If a person wants to be truly free one should try to live without  borrowing.

As for payday loans Mr./Mrs./Miss/Ms Buttonwood says:

“Provided the terms of the loan are made clear, then it should be up to borrowers to decide whether to accept the costs involved. An interest rate is simply the price of money.”

Once again this is simple economics without the human factor.  For many people there are times when  it may not be easy “to decide whether to accept the costs involved.”

The other complication with lending is that our money supply is based on fractional reserve loans by financial institutions.  As money is essential for the exchange of goods and services it is also essential that we carry a debt load.  Says Buttonwood

“But businesses and consumers are positively encouraged to borrow. Indeed, when debt growth slows, as it has in recent years, an air of panic develops about how to get it going again.”

There are a number of problems with the fractional reserve method of creating money, most of which have been discussed elsewhere on this weblog and especially in the essay “LETS go to market: Dealing with the economic crisis.”  Basically it is a Ponzi scheme which is urgently in need of reform.

The reform proposed in that essay, a national Local Exchange Trading System (LETS) should also help with the need for short-term credit.  It would be a lot less exploitive as no interest would be charged and control over the money supply would be in the hands of all people.  A national LETS system would transfer a lot of economic decision-making from bankers and governments to individuals.

There are consumer loans and there are business loans.  Loans are a transfer of purchasing power from one person  to another and interest is compensation for the transfer.  A LETS system  should take care of the need for short-term consumer  credit.  The compensation for business loans should come out of the profits in which case they should be considered equity.

Back to the question of caps on interest charged on payday loans.  Is it the role of government to prevent some of its citizens from exploiting others?  If yes, then governments should limit interest  rates  charged (marginal cost is a guideline) or find another way of creating money so that the need for short-term consumer credit is easily satisfied.

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Government debt default and the money supply

A United States debt default will hit the economy as a reduction of government spending and it could also  hurt by forcing changes in the money supply.

The first thing to say about debt is that there is so much of it around the world that there is a high probability most of it will be written off either by defaults of inflation.  This debt is not so much borrowing from children as a transfer of purchasing power within this generation, some/most of which will never be returned. And those with the most are likely to lose the most but will still probably be more comfortable than the rest of us.

The second thing to say is that the probable root  cause of the economic crisis is in the real side of the economy as well as the financial sector.  We have used up most of the easily accessible energy and mineral resources and those that are left take a lot more work to extract.

If the United States defaults  some of its debt the government will have less money to spend.  As government spending is a component of gross domestic product there will be a reduction in economic activity.  Government spending currently makes up about 20 percent of GDP but only a small part of this will likely be cut immediately.

The effect of a debt default on the money supply is more complex and uncertain.  A drastic reduction in the money supply would bring a lot of economic activity to a halt.

Money is based on loans issued by the banks, involves fractional reserves (they are required to keep a percentage of deposits as reserves)  and dependant upon what is called high powered money which is subject to a multiplier because of the fractional reserves. (for and explanation of how money is created see these links, one, two.)  In a default one issue would be how much the losses fall upon institutions subject to fractional reserves because losses would reduce their reserves.  A reduction in their reserves would bring down the quantity of loans they could make – by a multiplier.  Thus the money supply in the economy would be reduced and without money the exchange of goods and services becomes difficult.

Under normal circumstances a reduction in the money supply would mean a reduction in the real economy.  But the real economy is already in trouble as noted above.

At this point I need to remind you of the formula MV=PQ.  The money supply times its velocity or the rate at which it changes hands is equal to prices or a price index times the quantity of goods and services.

In an attempt to stimulate the economy central banks have been using “quantitative easing” to inject more high powered money into the financial system so the banks will have more money to lend.   If the above formula is correct then there should have been a reduction in velocity or an increase in prices (inflation) or economic activity.  It may be that velocity has fallen but there is little evidence that inflation or GDP has increased.

If the formula is correct then something has to have happened to one of the other variables.   One possibility is that at least some of this extra money has gone into the financial markets and inflation has hit stocks.  If this is correct, then a reduction in money supply could hit the financial sector.

So there you have it a U.S. default would probably lead to a reduction in economic activity and it could also cause problems in the financial markets.  I just had a horrible thought.  What would happen if a lot of the major countries were to default at the same time?

Why we can’t let banks fail

It appears investors are putting money into banks in the belief the banks are safe because governments can be relied upon to bail them out the next time they get into trouble.  These investors could be right.

It’s not so much that banks are too big to fail, it is more that they are too important to let fail.

Banks are essential in creating the money supply. When banks make a loan they create money and the total money supply is increased.. When the loan is repaid, the money supply decreases until the money is re-loaned and the supply goes back up.   Thus the money supply is constant – until a central bank purchases government bonds.  Because the central bank pays for these bonds by adding to the liabilities of its balance sheet, this is the creation of new money.   But because of fractional reserve requirements (banks are required to hold a percentage of deposits in reserve against withdrawals) money created by the central bank is called high powered money and the money supply goes up with a multiplier effect.

institution_iconAll this is explained in any textbook on the economics of money and banking. What I have never seen explained is the effect on the money supply when a bank writes off a loan. Probably it has the reverse effect of high powered money – a decreased money supply subject to the same multiplier. (Here is a link to the wikipedia article on money creation.)

In most cases the writing off of loans will have little effect on the money supply However, if the amounts to be written off are large as was the case with the American housing crisis or is likely to be the case with any sovereign debt write off, the impact on the money supply will be substantial and it we lead to an abrupt decline economic activity. People will invent alternatives to the lost money but the initial devastation will be  a problem.

 The Americans are considering cutting back on their food stamp program.  My prediction is that when the next financial crisis happens, keeping the banks going will come before feeding people.

One way to reduce the importance and power of the banks would be to find a new way of creating money.  One proposal for doing this is in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.

Let’s end this post with the following quote attributed to Henry Ford.

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

(This is an update of a post originally published in June, 2011.)


If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

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