Why debt is a huge problem

Generally accepted wisdom tells us that excessive debt is a serious problem although some people question why government debt to a central bank is problematic. After all what is wrong with one government agency owing money to another?  Why not just let the debt build up?

In this case the generally accepted wisdom is probably correct because debt is an important part of our money supply.   If we were to lose our money supply our economy would be in big trouble.

Money is a complex part of our economy and I suspect few people, including a lot of economists, really understand how it works.  Fractional reserve banking is complex but I have found it relative easy to understand.  I have explained it in the essay  LETS go to market: Dealing with the financial crisis on this weblog and there are numerous explanations that can be found with any search engine.  I encourage you to figure it out.

About 90 per cent of our money supply is based on the debt created in fractional reserve banking. This is a problem for three reasons.

The first is that the money supply needs to be flexible up and down.  The amount of money we need to facilitate the exchange of goods and services must be proportional to the quantity of goods and services we need to exchange.  I know economists like to model the economy on a least squares regression formula which gives an upwards line with a steady slope.  However, the reality is that the economy behaves like a fractal which means there are a series of ups and downs and more ups and downs within each trend. The amount of money needed varies with each up and down but fractional reserve money can only keep on increasing.  This sort of works when there is continuous economic growth but if growth slows or reverses, then there are problems.

The second problem with fractional reserve banking is that interest is charged on the debt created. This adds a purely financial demand for more money in that it is not needed for exchange of goods and services.  If all outstanding debts plus interest had to be repaid at the same time there would not be enough money in the economy. From time to time this feature of fractional reserve banking catches up with us and we call it a financial crisis.

The third problem is that when there is a financial crisis lots of people lose their savings.  The need to save for a rainy day, or retirement, is a part of our psyche and fully exploited by the marketing arm of the financial industry but there are three ways in which we can lose our savings: a financial crises, inflation or a major economic downturn. these are more likely when the economy is not growing or declining. With the current economic climate most of us would probably be better off to live for today and worry about tomorrow when that day comes.  The best way to secure one’s future is probably a market garden.

These are real problems and from time to time they cause havoc in the lives of most of us.  Therefore we are right to worry about excessive debt.  The good news is that there are other ways of creating money and the bad news is that money is such an emotional concept that most people are not prepared to consider other ideas.

One of the other ways of creating money is discussed in my ebook Funny Money: Adapting to a down economy which is available free from the link at the top of this weblog.

We tend to take money for granted so long as the economy is working but it is such an important concept that we would do well to try to understand it and make changes.  I cannot see that happening so in the meantime we should remember the advise of Shakespeare: Neither a lender nor a borrower be.

 

Answering concerns about an income scheme

A discussion forum on the Canadian Broadcasting Corporation website brought out a number of concerns about proposals for a basic income scheme. There were more than 2,000 comments.  Here are answers to some of the concerns.

How do we pay for a basic income scheme?

There are two answers to this question.  The first is that it would replace a range of existing social welfare payments and would make these payments with more efficiency.  Employing fewer people this would increase the need.  Also I believe subsidies should be given to consumers rather than producers so this would release a lot more money for an income scheme.

For the second answer we have to focus on the agricultural surplus, the excess production by each agricultural worker which allows food for people to do other things. Without the agricultural surplus we would not have civilization as we know it.

Until now the agricultural surplus has been distributed via employment but the current level of technology is making this more difficult.  Thus the interest in a universal basic income scheme.  We should note that the agricultural surplus is based largely on petroleum and could be somewhat precarious.

As most of the technology that has gone into the agricultural surplus has been developed over the last 2,000 years and most if not all of us have ancestors who worked on that, we should consider it a part of our inheritance. We are all entitled to a share.  We should have a collective responsibility to ensure everyone has the opportunity for the same standard of living as most other people.  The amount of payments should depend upon the population and the quantity of goods and services we are able to produce.  If this ratio goes up then the payments should go up and if this ratio goes down then the payments will have to go down.

I believe there are some serious problems with the way in which our economy creates money.  As an income scheme involves money this would be a good time to deal with that problem.

How do we stop people from smoking dope all day?

The simple answer to this question is that we do not. We do not need everyone to work all the time to maintain the agricultural surplus.    We no longer need a work ethic.

A basic income scheme would be a tremendous transfer of decision-making power to individuals (from governments and from bankers who create money via the fractional reserve banking system) and we have to allow people to make their own decisions and to take or benefit from the consequences.  The agricultural surplus should give us all the right to decide what to do with our time.

An income scheme would be communist.

This blogger dislikes the isms because they tend to be mostly meaningless.  As I understand communism it involves treating people humanely and government control of the economy.  It seems to appeal to people who wants to tell others how to live their lives.    I believe we should try to treat people humanely and I do not want others telling me how to live my life. As decision making power goes with money an income scheme would be a transfer of power to individuals.  It is difficult to think many communists would want that.

A guaranteed basic income scheme would help with a lot of social and economic problems but such major changes would go against a lot of vested interests.  Even people who would benefit the most are likely to fear the unknown.  Therefore concerns need to be taken seriously.

This blogger has just published an eBook Funny Money: Adapting to a Down Economy which discusses a lot of these issues. The price is only 99 cents.  I encourage you to have a look at it. Until April 19, 2016 you can get a free copy from Smashwords.  Use the link and code at the top of this weblog.

Hiding from the economic crisis

Why are interest rates so low?  It’s a question which has apparently been occupying a couple of North America’s top economists but this blogger sees the discussion as a screen hiding some very important economic issues.such as the root cause of the economic crisis and values which will guide us in trying to  find a solution.

On the surface the answer is simple.  Interest rates are the price of money and are determined by supply and demand.  They are low  because that is where the two balance.  They appear low because we are used to high returns on our investments and are reluctant to give them up.  There is no reason why interest rates could not be zero and maybe they should be.

To understand the root cause of the economic crisis we need to go into a macro economics classroom and watch the lecturer draw his basic diagram on the blackboard.  It is in the shape of an”x” with one side representing the financial side of the economy and the other the real or physical side.   This is important.  As we measure the physical part of the economy in financial terms it is easy to forget the distinction and analyze economic problems only in financial terms.  We need to ask what is happening to the physical side of the economy because it could be that is where the problem is.

This blogger figures the problem is with the resource base.  There are lots of energy and mineral resources left on this planet but we have exploited the most easily accessible.   Those that are left take a lot of time and energy to extract and this is causing a lot of economic problems.  It could even force us into negative growth.  This is a much more serious problem than why interest rates are low.  It is also an extremely difficult problem because it challenges some deeply held beliefs and values.  It’s a lot easier to talk about why interest rates are low.

Some ideas about how to fix the economy are included in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.  A major feature of that essay is a proposal to change the way in which we create  money.

The emotions surrounding money make it a such a difficult subject that few people understand the economics of money and banking. This is unfortunate as money is so essential to how we exchange goods and services.  I encourage you to take a look at the essay.

While I prefer to see low interest rates as a symptom rather than the problem here are  some observations.

Money should be considered a tool to facilitate exchange rather than as a commodity with a value of its own As the quantity of goods and services we want to exchange varies up and down  so does the amount of money supply we need,  If there is too much money there will be inflation and if there is too little money there will be deflation.   Some people believe there should be mild inflation but this reduces the value of savings and should be  considered theft.

Quantitative easing has been an attempt to stimulate economic activity by increasing the money supply.  It has resulted in a rising stock market but has done little for the real economy.  That has to be a sign of a serious problem which has not been identified.

The way in which we create money, known as fractional reserve banking, is a heavy-duty problem because it is based on loans on which interest must be paid.  If all debts had to be repaid at one time there would not be enough money in the economy.  It is a Ponzi scheme on a grand scale and it is no wonder we experience frequent financial crisis.  For more on this topic see these previous posts on this weblog.

I believe we are facing a serious economic problem in that it is not clear there can  be a return to economic growth.  Dealing with this will require some major changes in our way of life.  It is disappointing that two of our most well-known economists are protecting us from having to deal with this with a frivolous argument. It’s as if they are playing in the turkey poo on animal farm and producing gobbledygook.

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.

The future of money: inflation, deflation or disappearance into thin air

The future of money has been getting a little attention lately.  It could go one of three ways – inflation, deflation or part of it could disappear into thin air.  Concerns about money probably reflect concerns and uncertainty about where the economy is going.  Frequently behind these concerns lurk people who want a fixed money supply such as gold or bit coin.

This blogger figures money should be defined as a tool to facilitate the exchange of goods and services.  I do not like definitions that make it a store of wealth or a measure of value because these give money an intrinsic value which it does or should not have.  Money should only have value as a tool. 

One of the most important features of money should be the amount available  in the economy needs to be flexible.  It should be able go to up or down  with changes in the quantity of goods and services we want to exchange.  If the money supply is not flexible then as we change the quantity of goods and services then either prices must go up or down or the velocity, the rate at which money changes hands will change.  It is dangerous to assume there will be only growth.

Inflation happens when the money supply increases faster than the rate of economic growth and deflation happens when the money supply goes not keep up with the rate of growth.    Inflation is good for borrowers as the can repay their loans with money which has less real value.  This is one reason governments and their agents want to see mild inflation.  Deflation is good for lenders as they will be repaid with money which has more value.  The ideal should be price stability so nobody loses.

Our understanding of inflation and deflation has been distorted by the long period of economic growth we have just experienced. Most inflation has happened along with growth and most deflation has resulted from banking authorities trying to restrict the amount of money available.  This happened in the 1930s and todays central bankers have sworn to never again let that happen.

There is some evidence that our time of economic growth has terminated.  It is unclear how this will affect prices.  Quantitative easing which is an attempt to increase the money supply has not led to high inflation.  Past hyperinflations have occurred when governments have increased to money supply faster than the economy was capable of growing.  It appears the money created by quantitative easing has led to inflation in the financial markets rather than consumer markets.

Economists generally understand how fractional reserve banking works to increase the money supply but I am not aware of anyone who has thought out the opposite process.  Money that can be created out of thin air can just as easily disappear into thin air.

In fractional reserve banking banks are required to keep a portion of their deposits as reserves for protection against runs. The rest is loaned out and redeposited with the new deposits subject to the same fractional reserve.  The result is that a large proportion of our money supply is  somewhat precarious.  This blogger and many other people on the internet have explained the process.  Just search “fractional reserve banking.”

Central banks can add money to the system by purchasing financial instruments or by changing the reserve requirements.  The could also reduce the money supply by selling financial instruments or by changing the money supply although it is unlikely they will do either under current conditions.

Another way the money supply could be reduced is if the banks suffer large losses.  Any loans the banks have to write off will directly decrease their available reserves.  (The technical term is high powered money.)  This means they will have to decrease their outstanding loans with the same multiplier effect as the money supply was increased.  We will hear about it as a contraction of credit.

So if the banks experience unusually large losses there could be a drastic decrease in the money supply which could have dire consequences.  ( I have read that a number of Canadian and British banks are highly exposed to the energy industry with unsecured loans.)

If a large part of the money supply were to disappear into thin air in the short term a lot of economic activity would come to a screeching halt.  People have in the past used playing cards or candies as a substitute for money.  In the long term the level of activity would depend upon the physical resources available.

People who talk up monetary reform often want a return to a gold standard or facsimile (bit coin).  It is not clear that either of these would correct the problems inherent in the fractional reserve way of creating money.  Nor would they provide the flexibility that is needed in the total amount of money available.

We all think we know everything there is to know about money.  That is a part of what our parents teach us. However, it is a complex subject which few people understand and there are a lot of unknowns, especially if we have to deal with an extended period of low or negative growth.

Why we have financial crises

I believe the root cause of financial crises is in the fractional reserve system of creating money.  Therefore the way to avoid future crises is to change how we create money.

Dear Reader,  This post requires you to understand how money is created by the banks.  I’m feeling too lazy to write that up now so if you don’t already know I encourage you to figure it out.  Google “fractional reserve money”  or look at my essay “LETS go to market: Dealing with the financial crisis” or these other posts on this weblog.  It may appear complicated and overwhelming but if you think it out it should be easy to understand.  I think very few people understand this process which is unfortunate because we can not reform something people don’t understand.  There is a lot of emotion when dealing with money.

There are two aspects to the economy – the physical and the financial.  It’s a distinction which is easily forgotten because we measure the physical side in financial terms.    Both of these can cause economic crises and solutions probably require knowing where the problem originates.  A complication is that a physical problem can and usually does trigger a financial problem.  I believe our current economic problems are largely physical in that we have used up the most easily accessible energy and mineral resources.  There are lots of resources left but they are becoming more and more difficult to extract.

The big problem with fractional reserve money is that  interest is charged on the money created by the banks.  But the process does not create money to cover the interest.  So long as the economy and the money supply continues to grow there is no problem.  However, when growth ceases and the money supply contracts there just isn’t enough money in the economy to repay all the loans with interest.  It’s sort of like a Ponzi scheme.

Fractional reserve banking is about increasing the money supply but to the best of my knowledge not much thought has been given to when the process unfolds.  Just as money can be created out of thin air it can just as easily disappear into thin air.  This is a problem because money is essential in our economy for the exchange of goods and services.  Even a small reduction in our money supply can cause severe economic hardship because losses on bank loans come out of the reserves.  Thus losses are high powered money or leverage in reverse.  A run on the bank would also be a loss of reserves if the money is put under some mattresses.  If the money is transferred to another bank then there would be no loss of money supply to the economy although it would take some time for the adjustments to work through the system.

During the crisis of 2008 I figure the losses to the banks reduced the money supply forcing a slowdown in the physical side of the economy.  During the crisis people talked about a shortage of credit and the need for banks to start lending.  As our money supply is based on loans this is the same as saying we didn’t have enough money to facilitate the exchange of goods and services.

The U.S. officials dealing with the crisis were aware of the danger to the economy. They were also aware that a large part of the economy was sound and that the banks had to be saved so as to not have a complete collapse.  They were in a bind because saving the banks appeared to be saving people who did not deserve to be saved.  To have let the banks fail would have hurt all of us.  That is the power of the banks.  They are too important to fail.

The financial intermediation industry is focused on the double  R – risk and rewards.  The great  profits and bonuses of the industry are based on maximizing the rewards and passing the risk on to others.  As a general rule the higher the risks the greater the rewards.  In an ideal world the rewards would go to the people taking the risks but bankers have ways of grabbing the rewards while leaving the risks with the depositors.

The first thing they do is that their  marketing focuses on expected returns.  The risks involved are seldom mentioned so that customers don’t demand the rewards to go with the risk they are taking.  Governments try to protect savers with deposit insurance schemes although the real reason is to prevent runs on the bank.

The second trick is leverage.  If you did your homework you know that banks are required to keep a fraction of deposits on reserve for people who want to withdraw their deposits.  The smaller this reserve requirement the greater the leverage and the more money they can create and the larger the profits.  Regulated banks are told how much they must keep on reserve.  Unregulated financial institutions can get away with greater leverage – until things go wrong and they cannot repay their depositors.

The third profit-making stunt is to finance long-term loans with short-term deposits.  As short-term interest rates are generally lower than long-term interest rates this increases the spread/margin for the banks.  Some people claim this conversion of short-term deposits into long-term loans is a great accomplished of the financial system.  In fact it is a very dangerous practice and through the centuries many bankers have lost their businesses, if not their shirts. (But the profits were great while they lasted.) This is because when there is a crisis people will refuse to roll over their short-term deposits.  With no way to call in their loans the banks become bankrupt even though most of their outstanding loans are good.

If banks were to match the terms of their deposits with the terms of their loans their business would be financial intermediation rather than speculation and the risk would go to depositors  who are carrying the risk in any case.

I hope you can see from these notes that there are serious problems within the financial industry and the fractional reserve way of creating money.  Money is such an emotional issue and the interests of the financial industry are so strong that I believe it will be impossible to make reforms.  

 

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.

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.

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.

The risks of making loans

Crowd funding for unsecured personal loans is interesting in that it spreads the risk and potentially dangerous in that  it may attract investors who ignore the risk factor.  It is also unique in making loans that do not add to the money supply via fractional reserve banking.

An article in this week’s The Economist reports on some American firms that are making crowd sourced loans to individuals usually to consolidate and reduce the cost of credit card borrowing.  This model means borrowers get a cheaper interest rate and depositors get more on their deposits.  This is different from crowd sourced funding for business development although both involve risk.

CCBill_20120401When ever one makes a loan, either directly or though an intermediary (a bank deposit) one is transferring purchasing power to somebody else.  Mostly one hopes to get more purchasing power (interest or dividends) back.  There are three risks in doing this:  a government may decide to give you a haircut, the person may default or you may get caught by inflation.  We can try to protect ourselves from default by purchasing deposit insurance.  I don’t know how to protect ourselves from a haircut or inflation.  Maybe by supporting the Tea Party.  These risks will always be there no matter how bankers try to offload them.

As I understand it the crowd loan companies allow you to put a small amount of money into a number of loans.  Each amount is tied to that loan and your deposit is returned to you if, as and when the borrower repays the loan.  This allows you to spread your risk among a number of borrowers.  This may let lenders think they are reducing their risk but most business and financial models work well when the economy is growing and have problems when growth declines.  There is some probability our economy will continue to decline for some time to come.  Here is the risk statement of one of these companies.

I like that this way of funding loans does not involve fractional reserve banking and thus has a neutral impact on the money supply.

I fear that too many people will see the higher interest rates being paid on deposits and  ignore or not realize the risk involved.  If and when the risk becomes reality, there will be a lot of crying and screaming and possibly a lot of suffering.

It may be that the risk in crowd funding is no greater than with other forms of saving/making loans.  It is just a little more obvious. I still think that given the current economic situation the best investment is a market garden.

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