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A Word on Finance

The Error Behind Financial Crisis

I was asked to write down my ideas as to why the global economy is on a downtrend and exponential indebtedness downwards spiral and what can be done about it.

In it, you find the major single reason for the decline of the global economy and unprecedented and exponential indebtedness of individuals and nations. If you inspect the figures it is hard to debate that something is not right. Political parties and interest groups are debating at length the reasons and solutions.

The problem and its solution are entirely apolitical. No matter what the political party or whichever system or government is followed no longterm success can be achieved without the single correction that is described in this paper. Notably,  it is the correction of an error, not the invention of something new. Fixing it does not involve changing a political agenda or direction. Furthermore, the solution does not require any major change in existing financial systems. While the mistake was introduced with the introduction of the fractional reserve banking system it does not require the system to change in order to fix it.

The error and the ensuing problems are caused by a bookkeeping error that has been overlooked since the inception of the fractional reserve banking system. The origins of this mistake might have been intentional at the time, or not. The fact remains that there is an error in basic bookkeeping that affects every nation on earth employing the fractional reserve banking system, no matter the political inclinations. As far as I know, there is only one small island off the coast of France called Guernsey which is not employing the fractional reserve banking system in its economy. Since every country employing this method is affected you can see the far reach and effects of this error.

Part A. The Problem:

There are a couple of points that have to be understood to grasp the error made. The first is in bookkeeping. You should have a general idea on how bookkeeping is supposed to work, specifically, it would be helpful if you understood the basic principals of bookkeeping, specifically the Revenue, Expense and Matching Principals. But even if you do not have a rudimentary education on bookkeeping you should still be able to follow this brief. Also, it would be helpful to understand how exactly money is created in the fractional reserve banking system, but again, you will be able to follow along even if you are not an expert.

To recap: Money is simply created by banks (in most countries commercial banks, in some countries the national central bank – it does not matter for this brief) by lending money. In bookkeeping terms in issuing a loan the lending bank simply does two things. 1) It applies a credit to the customer’s account with the amount loaned. 2) It applies a debit in the same amount as the loan to a separate account. That is all there is to it.

An actual review of core banking software shows that that is all that is happening. The books of the bank balance. The two accounts equal each other. The only thing that happens in terms of bookkeeping is that the balance sheet of the bank has expanded by the amount of the loan.

When the loan is repaid the payments are added to the debit account to slowly move it back towards zero. The interest charged for the loan is taken as profit by the bank. Of course, there are regulatory requirements by which the bank has to have certain amounts of cash in reserves etc, but for this brief this can be disregarded as it does not affect the error described.

So, what is the problem? 

The problem is that whenever interest is charged on created (previously non-existing) money more debt is created than money to repay the debt. I.e. more money is needed to pay back the loan than was ever created in the first place. Because of this, when this system is perpetuated (as it has), the amount of money that exists ends up being no longer enough to pay all of the loans that are outstanding with banks. In other words, because of this, there is more debt in the world than there is money and the gap continues to widen.

This causes numerous problems to all strata of society. The whole paying off of loans becomes sort of an affair of musical chairs. Someone is going to end up with insufficient funds to service his loan. In years past, the economic effects became not immediately obvious since the relationship between the difference in supply and debt vs supply is exponential. In other words, for years the difference between the amount of money owed vs the supply was tiny in comparison to the overall supply of money.

Since the 70s the economic effects are beginning to be felt. In the 90s the impact became more pronounced. Currently, the actual gap is hard to ignore and if not reverted will result in certain failure.

None of this is new, previously unknown or a revelation. What is new is that we now know what the basic error is and the solution.

Part B: The basic error and the solution:

The basic error in one simple statement is this: The amount of money equal to the interest charged to the customer is never created like the principal was at loan creation.

To clarify: The amount of money for the loan is created on loan approval on one side of the ledger. To compensate for this a credit account is debited on the other side. This equals and balances the books.

However, as time goes by the bank debits the credit account of the customer for the amount of interest without ever compensating for it on the other side of the ledger as was done on loan creation. The final result is a progressively worsening global imbalance and one that has arguably near-catastrophic proportions. 

Yes, the bank creates the loan amount that debits the customers with the amount of the principal at the moment of creation of the loan and successively of the interest due. But on the other side of the balance sheet, it only ever credits the credit account of the customer with the principal not ever the interest. This forces the balance sheet out of balance. Of course this can appear to be rectified with some bookkeeping gymnastics which is what is currently done, but it does not change the fact that the books are out of balance. In fact what really happens is that the error in the balance sheet gets transferred to the national and then global level. The national/global balance sheet then has more debt booked against it than there is money. Plainly this is wrong.

The basic principle is that the amount of interest charged on created money must be created as well. But why is this not being done?

It appears that this was overlooked in basic bookkeeping because it appears at first sight that this would create a double profit for the bank. In order not to have this problem the bookkeepers at the time just proposed the current system, not realising that this upsets the balance sheet on a macroeconomic scale. To balance the books properly and ensure the stability and longevity of the monetary system the interest due that is debited from the debit account needs to be created and find its way into circulation. Since obviously, you can’t just credit the customer’s account, another third credit account is needed. This third account must get credited with the same amount as the interest is debited from the customer’s account. That way the debit and credit side of the ledger stay in balance and the amount of interest paid for the loan is also created at the time the interest is paid. The actual money incoming from the customer as interest on credit payments is the income of the bank as a recompense for their risk taken of possibly having to write off the debt as bad.

Without doing this the “global/national ledger”, for the lack of a better word, goes out of balance, more and more money gets created and the creation of money produces debt that eventually can’t be repaid.

It is interesting to note that this only applies to interest asked on money that was created and did not previously exist. If a person gives a personal loan to his neighbour and asks interest this is not a problem because no money was created. Only money that was already in circulation was given. Money is a commodity after all. No money was created that now is due with interest. 

Part C) Implementation:

There are a variety of ways that the solution can be implemented, the important fact is that the interest created must flow back into circulation.

I propose what I believe to be the simplest and least invasive. Leave everything the way it is except using the money created to offset the interest as a “loan tax”.  What that money is used for then is up to the government officials. It could also be envisioned to raise the amount of interest money created as a sort of damage control for the damage already done over the years but this would need to be carefully weighed against the productivity of the country so as not to create macroeconomic consequences.

In summary: The banks in order to keep the sides of the ledger balanced create the amount of money paid in interest on the other side of the ledger in a separate account and forward it to the government as a tax. The banks can continue to keep the actual interest paid by the customer as profit. The governments duty is then to spend the money to ensure it enters into circulation so as to be available to repay interest on loans.

Final words:

The important and key part is that the amount of interest charged to the customer on created money is also created and allowed to flow back into circulation to not deplete the amount of money in circulation not needed to service existing loans. As an important note: It is not the M2 money supply that is getting depleted by the current system but the amount of money that is leftover from the M2 after you subtract money needed to service existing loans. To my knowledge, there is currently no statistic that tracks this as means of managing macroeconomic activities. It is a lack of this supply that is causing social rift, destabilization of the middle classes, economic depressions, and hyperinflation.

Refernces:

https://www.ecb.europa.eu/stats/ecb_statistics/html/index.en.html

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr684.pdf

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489665

https://en.wikipedia.org/wiki/Fractional-reserve_banking

https://en.wikipedia.org/wiki/Money_creation

https://en.wikipedia.org/wiki/Money_multiplier

https://en.wikipedia.org/wiki/List_of_central_banks#cite_ref-6

https://en.wikipedia.org/wiki/Federal_funds_rate

https://en.wikipedia.org/wiki/Post-Keynesian_economics

https://en.wikipedia.org/wiki/File:CPI_vs_M2_money_supply_increases.png

https://en.wikipedia.org/wiki/Velocity_of_money

https://en.wikipedia.org/wiki/Endogenous_money

https://en.wikipedia.org/wiki/Heterodox_economics

https://en.wikipedia.org/wiki/Quantity_theory_of_money

https://en.wikipedia.org/wiki/Money_supply

Getting broad agreement-possible?

This is taken from a comment on one of my earlier posts A Word on Finance to which I wrote a long reply and which I felt warranted its own post. If you haven’t read it you should do so first otherwise this will make little sense.

The solution stated in that post is a solution that is fixing one point and one point only: Only the biggest departure from what would otherwise be an ideal situation. It does not create a complete solution for a perfect system. But it does handle the biggest point, which, when corrected fixes the largest part of the problem at turns things around. Certainly, once this is implemented, other correction could be envisioned.

A big factor on establishing this solution was that it had to be doable.

I’ve virtually read 100s of “solutions” which were all glorious and some truly magnificent. The one drawback I found though is that they established no path to implementation, or the path of implementation was so radical, that it would be near impossible to achieve widespread agreement. This is contrast is easy to implement.

It is also a solution which will actually benefit everyone.

  • The banks continue to make money out of nothing but also achieve higher certainty that the funds to repay the loans do actually exist in the economic system and are not being depleted.
  • The super rich will love it, as returning the balance to the economy and ridding the society of the super poor will greatly increase social stability which in term means they can continue to enjoy their riches.
  • Same for the – not quite as well off as the superrich – upper strata of society.
  • For the middle classes, it will be a gods send as finally they are no longer being throttled further and further onto the cliffs of indigence.
  • The poor will love it because finally there are adequate resources available to provide the education and support systems needed to help them to make a living and live a happy life.
  • Governments will love it because the money created in interest is flowing to them as an extra.

I really can’t think of any political party, regime or strata of society who would not want to embrace this once it’s understood.

Where does the money of a loan really come from?

Well, good question. In September I wrote an article on the solution to the international financial crisis A Word on Finance and while the article was well, received I have been receiving many questions on a specific point: Where does the money of a loan really come from? Readers seem to not get that point fully.

Let me lay it out here, one more time, really clearly:

When you get approved for a loan by a commercial bank, the money you get given did not previously exist. Period. This is really hard to get your wits around sometimes. But the fact is that the second the banker approves your loan the money appears in your account. That’s it, nothing more. The money is not transferred into you account out of some reserves or you are given the money an old lady gave the bank to look after.

The simple fact is that in our world today, money is simply created whenever a loan is approved. That’s it. From now on there is more money in the world because of it.