Written by Michael Reiss (guest author) on November 10, 2011. Tweet The lifecycle of money: Stay in touch Please enter your name. Please check your email is valid. not in the UK? 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Unsubscribe with single click. Trackback from your site. Noel Fascinating diagram of a commonly told story. Question: can anything useful or relevant be said about the interest that both Jim AND Bob have been paying to the bank during the lifetime of this cycle? Is it new money? What can the bank do with it? Is it their ‘profit’? Michael Reiss (guest author) Th question of interest does not fit so neatly in this cartoon – but it just so happens that I am writing an article on how interest gets paid as we speak. It should be ready in a few days. Anentropic Isn’t this the essential problem we have… the interest is never created by the banks, so to pay back the interest you have to out-compete other people in the economy for that money. It’s like a game of musical chairs, the interest ensures there’s never enough to go around and acts to keep society in debt and the banks in power. There are other factors of course, the ‘real wealth’ and productivity of the society can grow, or shrink I suppose, and the tendency of the banks to lend and create new money can vary too. Michael Reiss (guest author) Here’s a first draft of my piece on how interest gets repaid. It will appear on the PM website later. http://www.fullreservebanking.com/interest.htm RJ A good article But my advice is to take out the bit on fractional reserve banking at the end. These fractional lending restriction (bank loans to base money held) were ignored by banks and then dropped. We no longer have a fractional banking system. We now have a debt based money system (as we did before) but today without any base money fractional restrictions Michael Reiss (guest author) I agree that giving a name to our monetary system is problematic. But it can still be described as a fractional reserve one, even if that fraction is not stipulated by law. RJ What’s wrong with our debt based money system. It is a debt based system and always has been. Even fractional based was a FRB system within a debt based money system. Michael Reiss (guest author) “our debt based money system” is fine, but its just a matter of name recognition. There are simply more people that know of it as fractional reserve banking. This is not an opinion I hold really strongly – I can see your point. RJ But it is wrong and confusing to people to still call it a fractional banking system. It is no different to calling our current money system a gold backed system. Bank money was partly backed by gold once as a way to restrict bank lending but like base money no longer is. Ben Dyson (Positive Money) And the Treasury and Bank of England still refer to it as fractional reserve banking. RJ A lot of people do. But fractional banking has been dropped yet few seem to realise this and the implications for our money and banking system. If education is one aim of PM not calling our money system fractional reserve banking would be one small starting step. Bank lending is no longer restricted by a fraction of base money. And really has not been for some time. Its one of the reasons why the money supply increased by so much. And why banks like RBS and Halifax got themselves into trouble. Anentropic Thanks, I’ve been staring at the diagram for a while and I get it now. It works because it’s a dynamic process… just like if everybody tried to withdraw their deposits at once the banks would fail, if everybody tried to repay their debts at once there wouldn’t be enough to go around. But this is attempting to take time out of the equation and that’s why it’s false. I did wonder a bit if it isn’t a problem that only 95% of the total can be active in the economy. It seems also that, yes the bank spends the interest back into the economy, but in the process they must be gradually acquiring ownership of an increasing portion of society’s assets? RJ How are bank share prices at present. They can make good money but banks can and do go bust. And if everyone tried to withdraw their deposit from one bank. The depositors would likely transfer money to another bank. If the banks losing depositors debt asset holding is sound they could use this asset to acquire reserves to settle with other banks if necessary. And the central bank acts as lender of last resort if necessary. So banks in the Uk will only fail if the bank loans money badly so that their debt asset holding does not adequately back their customer deposits . Not because of a bank deposit run. Notes and coins and bank reserves can always be obtained by a bank when required. As a last resort the Govt takes over the bank in exchange for BoE reserves. Sjaak Adriaanse I agree that when you see all of the economy as a whole, it is theoretically possible to keep paying interest without increasing the money supply all the time. But this is not what happens. Interest divides the world into separate sections, with a enormous net flow of money from the 80% poorest (call it section A) to the 10 % richest people (section B), according to Margrit Kennedy and Helmut Creutz. This is because interest on loans in the whole production chain makes up a considerable component of all prices (on average 40% for consumer products). Only the richest 10% receive more interest that they pay, and the ‘poorest’ 80% pays the bill. (Of course the top part of this 80% is not poor at all, but still they pay more interest than they receive.) So money is lent into existence in section A and then a part of it flows to section B, where most of it is reshuffled there, f.i. by speculation. That money never returns to section A, so many section A people can not pay their loans back, let alone interest, and all the time the enormous amounts of money in section B keep adding a compound interest debt to section A, just by existing. The amount of money in section B that is returned to banks as repayment of loans is negligible: why would the richest 10% make a loan in the first place? Don Swenson Another issue with bank lending via a no reserve policy is that they often lend to borrowers who do not create a real physical good for the market. This lending to non-good borrowers, tends to create price distortions, inflation, and malinvestments…reducing the prosperity of a society in time. The goal of lending should be increasing the material WEALTH of society. Michael Reiss (guest author) I totally agree. RJ Don Do you mean housing finance. And what do you suggest if people are in short term financial strife. Should the banks turn them down so they have to turn to loan sharks And who do you suggest should determine if loans are made. And on what basic if not ability to pay it back I would not like to see a Govt body take on this roll. Govt can run deficits funded by bonds to finance projects as they see fit without determining who gets bank loans as well. Michael Reiss (guest author) I cover all those issues in chapter 10 of my book which you can download free here: http://www.smashwords.com/books/view/85595 Joao Granchinho I say let the banks loan to whomever they want so long as they use their own funds to do it. No more credit extension. A form of housing loans would be provided by the Gov’t based on that person’s income. If banks fail we let them fail and shareholders bite the bullet, as it happens with any other enterprise. At the same time government would provide digital money accounts for every citizen to prevent banks from holding people’s money hostage – the very reason we had bailouts in the first place. The privilege and responsibility of creating and allocating the money supply should be with those who are responsible for the country’s well being, not with those who look for profit. RJ So you want Govts to totally run our banking system. Because at present banks create money by lending to in exchange for debt Boz Yeahh ! What about the gross distortion in house prices caused by the style of bank mortgage lending which took average house prices from about 3.5 average earnings forty years ago to more than ten times average earnings now. DISGUSTINGLY VENAL BANK BEHAVIOUR. And the root trigger cause of the World wide economic problems. RJ But people buy the houses at these prices not banks. Banks just loan money if they believe someone can pay the loan back Do we trust adults to make purchasing decisions or have the Govt treat us all like children and make these decisions somehow for us. Joao Granchinho RJ you say “do we trust adults to make purchasing decisions”, well do they make those decisions by themselves at all? Don’t those decisions have to be approved by the bank that grants the loan? So aren’t the banks actually “making those decisions somehow for us”? What about the subprime? Didn’t the banks give their approval there? So what happened? Do you “trust adults to make purchasing decisions” after the subprime, RJ? You make it sound like the government lending would be like a dictatorship where we are told what to do, when it is a clear solution to the problem. The Government lending wouldn’t be any diferent from a commercial bank one, except for the fact that the profits from the lending would finance directly the government – less tax burdens on the people and economy, less bond auctions, less government debt. RJ I’m referring to house purchasing. People find a house they want to buy, agree to the price and then raise the finance if they do not have enough money themselves at this point in time. Banks advance money based on ability to pay the loan back. Investment advice (ie is this a good investment or not) is not really the banks field unless they provide this service and charge for it. To blame the banks for bad purchasing decision by people in this situation is silly. Its bank bashing when in this case it is not justified. (there are practices by the banks however where criticism is justified). RJ “You make it sound like the government lending” Do you want Govt to own all the commercial banks. This is Ellen’s Browns preferred solution (web of debt) and partly applies in the UK (eg RBS). But just remember that the Uk Govt owns banks because they went bust. It is not always the gravy train (to produce profit to reduce tax) that some believe it is. Profits only result if the bank is well run. Michael Reiss (guest author) Read chapter 16 of this… http://www.smashwords.com/books/view/85595 …before getting too enthusiastic about our freedom to buy houses. Joao Granchinho The banking sector keeps returning profits while the rest of us suffer through austerity. This happens because they can extend credit, they can create the money individuals and the economy need to run smoothly, and then collect the interest for themselves. If we stop credit extension (or the fractional reserve system, as some prefer) the banks can only lend what they actually have. By stopping credit extension the private sector can no longer create and control the money supply to the beat of their drums, instead the Gov’t does this as it should as the sole accountable entity for the nation’s welfare. With this power, the Gov’t can finance itself (balancing between new money issuance and tax collection, to keep inflation at bay), it can stimulate the economy and society’s living by reducing taxes, and it won’t ever have to pay the interest to any private blind profit seeking unaccountable groups (commercial banks). I’m not an adept of the government owning any commercial banks in the sense of part of an agreement for a bailout, for these are toxic assets for any government to own. People won’t ever trust these banks again, and government will very hardly return profits with these banks. What I’m in favor of, is the end of credit extension, and the beginning of Government debt free money. Though separate from Gov’t debt free money, I also like the idea of government lending as another form of government financing, why let the banks cash in on the lending business when the government can do it itself? This government lending would be directed at the real economy and never speculation. Things like housing or student loans for example, conditions that a proper government should provide for its people. I’d leave consumerism loans to commercial banks (and if they really wanted, now that they’d be gambling their own funds, speculation). If you want to accuse me of something, you can accuse me of fighting to destitute commercial banks from their privileges, as I believe it would make for a better and prosperous society. If you feel commercial banks should be allowed to extend credit, then give me and any other willing individual the ability to also extend credit and profit from it, does this not seem fair? Why should banks get that privilege? Brian Leslie This ignores the time factor. Imagine rates of flow: loans being paid off, including interest on them; new loans being made; banks adding to capital, paying shareholders and staff, buying goods and services. Thus spending interest- but much of this money would not be available to purchase current goods & services on the market, so a higher rate of issue of new loans is needed to allow outstanding loans to be paid off. Shillwatcher I believe somewhat has conflated money with currency here, and folk have fallen for the error. Money has one key component in monetary law – STORE OF VALUE. Yes the euro and BofE are currency, but they are NOT a store of value. In other words, BofE issued notes are NOT money. Do you people have positive money require an artcle written explaining the difference between money and currency? Money can be currency by-the-way. ALL KNOWN fiats i.e. currency fail. That’s a 1005 failure record – bit like the record of PM’s begging to the BofE really. Sorry…..couldn’t resist. RJ The BoE is a central bank. The ECB is a central bank. Do you know the difference between a central bank and a commercial bank like Lloyds or Barclays etc. Central banks generate central bank credit (or commercial bank and treasury positive reserves) and central bank debt (minus reserves) . commercial banks generate commercial bank credit including the Euro (or plus or minus bank deposits or money) and debt (minus bank deposits / bank loans or overdraft). John Morrison Shillwatcher – I don’t know where you get your definitions from. I agree that there is ‘store of value’ and there is ‘currency’ and what is good as one is not necessarily good as the other. Gold is a commodity that acts as an effective store of value but it makes a lousy currency. According to Aristotle, money is a legal construct, a social creation. By this definition gold is not money and fiat currency most definitely is money. I think that one of the problems with modern currencies is that they try to be both an international reserve currency (trusted store of value) and at the same time the day to day currency of a nation. The Pound Sterling and the US dollar are still national currencies and therefore subservient to the needs of a nation and this result in store of value being compromised so that it may effectively serve as currency. The Euro is no-ones currency and store of value is its paramount concern. It is becoming increasingly problematic to use as currency because it has become too valuable. I don’t know on what you base your sweeping statement about fiat currencies always failing. Almost all the worlds’ currencies are fiat and they have worked very well despite the credit money of banks taking a free ride on them. TP To include ‘store of value’ in the defining element of a currency is a strong (text book) statement to make: it implies currency being the risk-free asset of last resort. Accepting ‘store of value’ gives currency an asset status whereas it is only the reflection thereof. As any real asset can degrade over time, why should currency not ? The concept of a risk-free asset is highly questionable itself (as holders of some government debt will have experienced). In a debt-deflation environment this allows commercial banks to hoard currency instead of refinancing ‘risky’ loans. As such it opens the door to moral hazard of being rewarded for not playing the game. We see this today with QE ending up as excess reserves with the Central Bank. Bank deleveraging is self-defeating by reinforcing systemic insolvency. To reignite the credit transmission mechanism it is therefore key to remove the risk-free component of currency. Negative nominal interest rates (or taxes, or fees) on institutional excess reserves could be a starting point for a transition from the current commercial bank credit system to a fully reserve-backed one.