Why your savings and pensions are at risk

The fractional reserve way of creating money means a lot of people are at risk of losing all or part of their savings and pensions.

If there is too much money supply in the economy then we have inflation and people with savings or pensions lose some of their purchasing power and those who owe money benefit because they repay their loans with less purchasing power.  Now you know why governments and the people who speak on their behalf promote mild inflation.  This is at least unauthorized taxation if not theft.

pexels-photo-2105902If you have deflation, then people who are owed money win because they are repaid with more purchasing power than they loaned.  The borrowers lose because they have to repay with more purchasing power.

To be fair to everyone we need to manage the economy so that just the right amount of money is available at all times.  At a time when the economy is on a down trend, this is very important as too much money puts us in danger of hyperinflation.

Getting this amount right has long been a challenge to central banks although the common sense answer is fairly simple.  The money supply should vary with the quantity of goods and services we want to exchange and it should be flexible up and down.

The wrench in the simplicity is the fractional reserve way of creating money.  When banks make loans they must (or should) keep a fraction of the amount on reserve for when the depositor wants his/her money returned.  As the amount is only a fraction banks are at risk of a “run” if depositors lose faith.  And because of the fractional reserve there is a multiplier effect involved.  Does not this sound like a set up for a crisis?  The mechanics of this process are a little complex although I have always found it easy to understand. To figure it out I suggest you Google “fractional reserve” or look at my free e book Funny Money: Adapting to a Down Economy or look at the essay Going to Market on this weblog.

The other end of the wrench is  that interest is charged on the loans made by the banks.  Mainstream economists have given little or no thought to the consequences of this. Because all of our money is created by the making of loans, if all the outstanding debt were to be paid off at one time there would not be enough money to repay it all because of the interest.  The charging of interest on the debt/money means there is never enough money available to repay all outstanding debt. Inflation is built into the fractional reserve way of creating money.

The system works only so long as the economy and the money supply continues to grow.  An upset in either means crisis of which we have had many.

The relationship between money supply and economic output is expressed in a formula, MV=PQ, some times known as the quantity theory of money.  Money times the velocity at which it circulates in the economy is equal to a price index times the quantity of goods and services produced.

I get ticked off because this is frequently taken to mean there is a direct, proportional relationship between the money supply and the inflation rate or price level.   Can’t people see there are four variables in this formula?  Total output is an important part of this formula.  If it should happen to go down something needs to happen to another variable.

Our society has a strong commitment to economic growth and a need to keep it growing so that people will not suffer from unemployment.   Some desperate people are trying to stimulate growth by increasing the money supply. This may increase inflation but it will not lead to growth unless we can find inexpensive energy and mineral resources to support it.  I suspect the new American president has  his eye on parks and reserve lands to encourage more economic activity.  He will probably succeed in the short term to be followed by a major economic collapse.

This blogger thinks we need some major economic reforms, not only in our financial system but in our commitment to economic growth.  We need to minimize our production and exchange of goods and services so we are using fewer energy and mineral resources.

A lot  of people operate on faith in our financial system and ignore suggestions we need reform.  I think the risk is so great that prudent people will at least give some thought to these issues.  It is your savings and your pensions and your future that is at risk.



Please help promote this weblog

Please send the link to this post to your friends and social media.  Promoting a weblog can be difficult.  I get some referrals from LinkedIn.  I used to get quite a few from Reddit but I have been “shadow  banned” for linking to my own weblog.  Self promotion (and free speech?) are serious offenses on Reddit. I figure my strength is in the thinking that goes into the posts and I thank you for helping.  (r/economics   r/libertarian   r/economiccolapse  r/Degrowth )

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: https://www.smashwords.com/books/view/620310

The book is also available at the Kindle book store at http://www.amazon.ca/gp/product/B01CH1LF6W?*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.

This columnist from The Economist is encouraging theft

This post is to accuse the Buttonwood columnist in The Economist of encouraging the theft of people’s savings.

In the Nov 30th 2013 issue he/she says “Debt needs to be reduced by default, inflation or financial repression (keeping interest rates as low as possible).”

Lots of others including economists concerned with government policy make similar statements.

The problem is that one person’s debt is another person’s savings.  Therefore when debt is reduced by default or inflation it is going to take away from somebody’s savings.  This might be more visible if loans were made directly from a saver to a borrower without the financial intermediation of banks.

It might also be easier to understand if we were to define money as something representing purchasing power.  Thus a loan is a transfer of purchasing power from the lender to the borrower.  If the loan is not repaid because of default or is reduced by inflation then the lender has lost some of his/her purchasing power.

Some people might say the losses from default are carried by financial institutions.  This is true only if the banks are making excess profits.  If they are not making excess profits and maybe even if they are the losses are most likely to be spread over all their depositors in the form of reduced interest payments.

Of course people who owe lots of money, especially governments, benefit from inflation because they don’t have to repay as much purchasing power.  The ideal should be price stability – zero inflation and zero deflation.

However it happens default or inflation reduces the purchasing power previously owned by savers.  To me this is theft by or on behalf of borrowers.

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.

Let this time be not different

Please, let this time be not different.  Please let this recovery be the similar to all the previous recoveries.

I have just finished reading This time is different by Carmen M. Reinhart and Kenneth S. Rogoff.  They bring together statistical data on all the world’s known debt and banking crises and look for patterns that precede them.  Their title comes from people saying during each boom that there will not be another crisis because we now have knowledge and experience from previous crises and  “this time will be different.”

Following each crisis there has been recovery in which the economy has grown to a new high. For the sake of all the people who are suffering from the current crisis it would be good if this time is not different and we could have a full normal recovery.  It would be even better for the planet and our long-term well-being  if we could adapt our economy so that people would not suffer from zero or negative economic growth.

One of the things which is different for this recovery  is that the marginal cost of extracting energy, mineral and agriculture resources has increased.  We have used up the most easily available of these resources and those that are left take a lot more work to extract.  This is bound to limit the potential for further economic growth.  We should beware of believing economic growth can continue forever.

I think there is an element of truth in the Elliott Wave Theory which applies to economics as well as the stock market. This theory says ups and downs run in series of fives and after the fifth the overall trend reverses.  Within each up and down there are series within a series.  I don’t  know about the fives but I believe the economy is fractal in nature and that there can be major turning points.  We should not rule out the possibility that we have passed a major turning point and that for some time to come we will have a series of downs and ups with each down going even lower.

As I read this book I wondered how the crises impacted people’s lives.  How serious was the unemployment?  How did people cope with unemployment?  Who were the people who lost their savings from defaults or inflation and how did they cope?  Did some of the one percent find themselves joining the poor?

In the current crisis, the headlines indicate young people are being hit hard and are the lost generation.  Meanwhile the cruise ships are packed with older people planning their next cruise.

It could be that during an economic boom we have a psychological need for economists to be telling us the boom will not end in a crisis.  Then we can work hard to prepare for retirement and to provide short-term profits for people in the financial industry.   We want to hide from ourselves the possibility we will lose the benefits of our hard work to defaults, haircuts or inflation.

As I was reading about all the financial crises I was saying “why oh why oh why would anyone want to put effort into the financial industry when there is such a high probability we will lose a lot of our savings?”  But then I have never been much for ambition.

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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