The current economic model is a debt based system using fractional reserve banking and fiat currency. What does that mean and what does it look like?
Money is created almost exclusivley by commercial banks who create the money supply through debt, this is called fractional reserve banking. By issuing more debt and loans they increase the money supply but only keep a fraction of the paper money in reserve. The majority of money now is digital money…numbers on a screen.
Currency is termed fiat because it is intrinsically worthless and derives it value from confidence in the currency only. The alternative would be to have a gold or silver backed currency.
I’ll explain fractional reserve banking by giving an example:
Imagine you deposit £100 into Bank A. Assuming a 10% fractional reserve ratio, Bank A then takes 10 percent of it, £10, and sets it aside as reserves and then loans out the remaining 90 percent, or £90. At this point there is actually a total of £190 in the system, not £100. The bank has loaned out £90, kept £10 in reserve, and substituted a newly created £90 IOU claim for the depositor which charges interest and is a profit loan for the bank. At this point Bank A still holds £100 reserves on its books, but £90 of those reserves are soon going to be needed to satisfy the loan recipient. The loan recipient soon spends the £90. The receiver of the £90 then deposits it into Bank B. Bank B demands £90 to be delivered from Bank A to Bank B.
Bank B is now in the same situation as Bank A started with, except it has a deposit of £90 instead of £100. Similar to Bank A, Bank B sets aside 10 percent of that £90, or £9, as reserves and lends out the remaining £81 thus creating £81 of IOUs to its depositors. As the process continues, more electronic number money is created.
Fractional reserve banking and its effects on the money supply have reaching consequences for the business cycle, monetary inflation, price inflation and interest rates. What disturbs me is that the banks are creating and benefiting from the interest generated from creating new money, rather than the UK itself. Should we as a country not issue the money and charge the banks for the privilege?
A study by Huber and Robertson ‘Creating New Money‘ (2000) suggested that the loss to the government of allowing commercial banks to create money was in the order of £49bn per annum. Plus the cost of servicing the national debt, at £32bn per annum and the cost of stimulating a recovery during recession after inevitable recession, runs to hundreds of billions, if not trillions.
What does our debt based system look like compared to other countries and is it working?
The UK as a country is no longer in control of its finances. We have a GDP/Debt ratio of over 900% and with bank debt over 600% of GDP. Our financial sector is disgustingly over-leveraged, couple that with close to zero percent interest rates which allows banks to speculate for free. They take riskier and riskier bets and its the UK public who pick up the tab if it all goes wrong! Iceland had a debt to GDP ratio of 1000% before it collapsed.
We need to be in charge of our currency, move on from a debt based currency and return to sound economic principles. The system hasn’t failed, its just coming to its logical conclusion and history has plenty of examples how this will play out.