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"Bad men need nothing more to compass their ends, than that good men should look on and do nothing." attributed to Edmund Burke

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Tuesday, 5 April 2011

Flaws in our Economy - Loans for interest are made out of fiat money

“Neither a borrower nor a lender be;” said Polonius in Shakespeare’s Hamlet.
”For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.”1

I have been writing recently of various flaws in our Western economic model. I have discussed the fact that the model as it stands is simply not sustainable, and does not value the human input. Now I come to the part that always amazes many people; Money can be created out of nothing.2

This happens when it is created by bank debt against the payment of interest. It is fiat money. This is not widely understood by the general public outside the banking world and usually comes as a surprise. A Canadian journalist has estimated that only one person in a thousand really understands how money is made!3 It is certainly not something that is widely publicized. What is more each bank also has what it calls its Reserve Ratio. This means the proportion of cash invested into its bank deposit accounts that the bank estimates it needs to retain in case the customer wishes to withdraw again against their deposit. If for example £1000 is put on deposit with the bank and they calculate their Reserve Ratio to be 10%, then they reserve £100 and the remaining 90% of the deposit or £900 is available for the bank to lend on. And it does. The bank sets up a loan of £900 to another customer for interest, neatly increasing the supply of money available in the economy by a simple accounting entry in its books. The bank has not only made money out of nothing but it is also making an interest profit on that money that it has created out of nothing. And the bank almost certainly charged a fee for arranging the loan as well. The more times the same money can be recycled and recreated in this way the greater the arrangement fees and the interest profit that the bank can make, all from the creation of illusory money out of nothing. What is more, the amount borrowed by the customer is likely to be placed on deposit again elsewhere and the creation of further debt out of nothing can continue in another bank. The multiplier effect of this exponential increase in debt is astounding and very dangerous.

Money has to continue to grow to maintain this system and to avoid financial collapse, even though actual standards of living may remain stagnant. With consumer spending the lifeblood of the economy and a personal consumption now nearing 75% of GDP, which truthful and brave politician will urge us to spend less? It is not hard to see that such a system is unjust and unsustainable. (A government can and does make money out of nothing also, but this is only to the extent of new notes and coins it issues.)

As long ago as 1939 American President Abraham Lincoln warned that: ‘The Government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the Government and the buying power of consumers. By the adoption of these principles, the taxpayers will be saved immense sums of interest.’4 But fiat money is still issued by banks.

I was shocked when I read that 98% of the $2 trillion changing hands in the foreign exchange markets each day is purely speculative and has nothing to do with wealth creation. Only the remaining 2% relates to real goods and services.5 As Edward Cahn observes: ‘Money has taken on a life of its own: its function is to produce for the sake of reproducing – regardless of the impact on the health of the human community… increasingly what we are witnessing in the world’s money markets looks more and more like cancer.’6 Cancer is dangerous and often fatal, requiring unpleasant treatments along the way.
In such loan systems there is an impersonal relationship between the borrower and the lender with a minimal flow of information needed between them. Such loans are therefore cheaper to administer. In addition the tax system favors such business fund raising by allowing tax relief on the related interest.
Because such loans are not linked to the success or otherwise of the business, there is no reward to the lender if the business is successful and conversely the lender can foreclose on an ailing business that can no longer afford to repay. This makes the problems of the business worse and it may need to curtail its production and make efficiencies of staff by laying-off, with all the inherent human and social consequences that then arise. This is of course harmful to the economic cycle, and means that interest based economies have exaggerated cycles of ‘boom and bust’.
One of the most harmful aspects of this interest on loans is that it is almost invariably charged by compounding year on year. Typically a home ‘owner’ with a mortgage will pay at least 2-3 times the original loan before the mortgage is fully paid off.
Our debts on credit cards have also reached massive amounts and many regularly pay double figure interest rates on their cards each year. A significant number of college students and undergraduates have credit cards and amass debt on these as well as on their other student loans. This encourages an extravagant attitude of spending among students who no longer need to budget expenditure within their means.
When I first wrote of these imperfections in our debt system a few years ago I was saying that alarm bells should ring. I was far from alone. In 2001 Bernard Lietaer predicted a 50:50 chance of a global money meltdown within 5-10 years unless steps were taken to heal what he called the global foreign exchange casino.7 It feels that we have drifted perilously close to that meltdown.
Unfortunately those in charge of our finances do not appear to consider alternative economic models. They want us to spend and consume our way out of recession. The problems and dangers of debt, at personal, corporate, national and international levels, are the cause of huge social disease. Such debt involves the transfer of wealth from the poor to those who are already wealthy. The system does not reflect the skill or the labor of the participant and encourages short termism.8 Interest based economies cause unemployment, social violence and pollution.9

Sabine McNeill, organizer of the Forum for Stable Currencies, and co-founder with John Courtneidge of the Campaign for Interest-Free Money, observes that ‘compound interest is for the monetary system what carbon dioxide is for the earth’s atmosphere: man-made and unsustainable.’10

And that is no way to heal our wounded earth.

The good news is that there are sustainable economic systems that could be used if our governments had the courage to change. Few of us as individuals really understand the economy and how it works, or appreciate that we could be making a difference in this sphere. Nonetheless there are millions of citizens worldwide who are already making their own practical contributions to a fairer and more sustainable economic system using some of the ideas that I will come back to describe and explore in later posts.


1. Lord Polonius in Shakespeare's Hamlet, 1603.
2. See for example Darryl Schoon, 2008.
3. Cited on the Forum for Stable Currencies website
4. Senate Document 23, 1939 http://www.uhuh.com/unreal/lincoln.htm 3 March 2009.
5. Bernard Lietaer, 2001.
6. Edgar S Cahn, 2000, p. 68.
7. Bernard Lietaer, 2001.
8. Bernard Lietaer, 1997.
9. The Campaign for Interest-Free Money at http://www.interestfreemoney.org/index.htm 3 March 2009.
10. http://www.monies.cc/ 3 March 2009

© Eleanor Stoneham 2011

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