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

4 thoughts on “A Word on Finance”

  1. There is still the question of whether interest is not wanted. A fall in money would always hit the little man harder than a bank. If the problem is known, why the politics does not react, it is ultimately about the well-being of the respective country
    Gold in a bag is better than mony on Paper 😉

    1. Thank you for your comment.

      I think Interest is a vital part of treating money as a commodity. I am sure there are other solutions but the solution outlined in this brief, has one important benefit: It can be easily implemented without changing existing models, yet it solves the underlying problem.

      Gold is good but completely unusable as currency, currency has to inflate (just a little bit is enough) otherwise the economy stays still. People just hang onto their currency instead of spending or investing them, or renovating their house with it because they know if they hold on, just a little longer, they will get more for it. The same is true for bitcoin and other value stores that tend not to inflate.

      Money has essentially four functions, “medium of exchange”, “measure of value”, “standard of deferred payment” and “store of value”. The first one “medium of exchange” is by far the most important. If currency does not move it’s dead and so is economy. If the velocity of money drops it’s real bad for everyone. With non inflating “mediums of exchange” the speed of exchange crawls to a hold. Gold is fantastic “store of value” no doubt, but as a “medium of exchange” it’s pretty useless if it’s the only one you’ve got.

      Interest is actually alright because money loaned is supposed to be used to create extra value which then can be returned to the lender while still leaving enough extra for the borrower. What is not OK is asking for interest on money that did not exist in the first place without creating the interest money as well (remember the debt was created out of nothing to begin with; you have to create the money needed to fulfil the obligation including the interest) . This is what ruins a currency and economy. While it appears that the M2 money supply is doing OK the, what I call the “Free money” (money not already ear marked to pay back debts), is constantly declining. This is what causes spiralling out of control indebtedness of nations, hyper inflation, starvation of the poorest and dismantling of the middle class.

  2. I understand the article as I am very familiar with book keeping. Do it for  half a dozen organizations.
    Yes, credit is created out of thin air just by one booking record on both sides of the ledger.
    But this can not be called money.
    You should differentiate between money and credit.
    Think at the old trick of two noble man, who exchange an I-owe-you of a certain large amount, let us say $1000.
    A gives the $1000 IOU to B and B gives one to A. So they are in exchange and do not demand anything from each other.
    Now both can go to town and use this IOU to buy something. So people think, this is a kind of “money” and use it and circulate it similar to real money. They trust these IOUs as they come from the noble man and they trust them. And it is practical to store money in such a light paper compared with 1000g of silver money, which might have the same value. A heavy load.
    But why should noble man have the right to create this money out of thin air, while the average man has to work hard for his silver coins?!
    You wrote: “The banks can continue to keep the actual interest paid by the customer as profit.”
    What is this interest an exchange for? The bank did not risk any money in the first place. They just risk a booking record. If the customer can not pay the credit back, then the bank can just create a reverse booking record, same amount as the loan on both sides but with negative value and all is ok again in the ledger. So there is no harm, if the customer can not pay. No one has lost any money. It was no money in the first place, it was a credit.

    So what would be a sane solution?
    You are right: “Money has essentially four functions, “1. medium of exchange”, “2. measure of value”, “3. standard of deferred payment” and “4. store of value”.”
    The best solution for 4. is real commodities, which do not age: like gold, silver, palladium and platin.
    For 2. you need something, which does not change. So inflating money would not be a good measure. Gold and Silver could be a good measure. It is stable.
    For 1. and 3. I can agree, that any Fiat-Money would be fine. Even easier: It is just a question of book keeping. For a booking record there is no need that a bank creates a credit. Every “noble man” – and today we all should qualify as noble man – can create the credit, until he fails to stay in exchange. But this is just a question of information, book keeping. The book of crypto currency came about, as we can bypass the banks. We create our own money. And we do not need a central database for the book keeping, this is done in blockchains among all users.
    And of course: no interest on IOUs. Interest is ok on real money. If I lend someone my gold or silver or land, then I need interest as a payment as I can not use these commodities for myself any more. But for FIAT-money to claim interests is criminal: out of exchange: One demands money for something he is not giving anything of value out.

Leave a Reply to Andreas Cancel reply

Your email address will not be published. Required fields are marked *