Josh Ryan-Collins from the leading independent economic think-tank, the New Economics Foundation, has written a very good article on the nature of the current banking system, questioning the way we think about money and the system we should decide to use, and he also presents an introduction to a range of alternatives.

This article, copied below, is a good introduction to some of the problems with the current system and introduces a number of viable alternatives. The original article can be read here.

For those of you looking to get your teeth into something more in depth, nef have also just released an 82 page report entitled “Where Did Our Money Go”

The report finds that when considering the massive impact of the failure of the banks in the recent crisis, action to address systemic problems has been woefully inadequate. It also argues that the current banking system is not fit for purpose when it comes to addressing the major economic, social and environmental challenges that we will face in the 21st Century.

You can download it for free here.

Democratizing Money

Amid all the talk about financial reform, we rarely stop and think about what money is, and how it’s made. And yet money is just as much a social institution as a bank or a political party.

Two years after the collapse of Lehman brothers marked the nadir of the financial crisis, the UK Banking Commission last Friday announced a surprisingly wide-ranging remit of options to reform of the financial system.  Meanwhile, Ed Milliband, freshly crowned as leader of the opposition, got stuck straight in to the banking question in his first interview as leader on Sunday Morning, admitting New Labour had not done enough.  The signs are encouraging that the UK might just go further than the United States in reforming the banking sector.

But one area that is not prominent on the agenda of the Banking Commission’s review, nor across any mainstream debate on the financial crisis is an analysis of money itself, how it is produced and allocated.

The first point to make here is that money is not, as orthodox economics would have us believe, a natural phenomenon.  Contrary to what you will read in most the textbooks, modern money did not naturally ‘emerge’ through market forces as a more effective tool for exchange than bartering.  Whilst it’s true that money does enable more efficient exchange, modern money is a creation of the state and has only been with us, in its current form, for less than 160 years.  In 1844, the Bank of England Act outlawed the creation of money (then mainly coins and notes) by anyone other than the Bank.  Prior to this, a range of private regional and local currencies circulated. Today, there remain a range of ‘complementary currencies’ existing independently of the state, including commercial currencies such as Air Miles and loyalty points schemes and social currencies that nef has promoted, such as time-banking and the Transition currencies, not to mention a rapidly increasing virtual money scene enabled by the internet.  Money is as much a socially and politically constructed institution as the health service, the welfare state, the police or the education system.

These institutions are the subject of intense and healthy political debate and scrutiny.  Moves to remove them from the democratic sphere through privatization tend to be fiercely resisted.  Not so with money.  Whilst the 1844 Act outlawed the creation of notes and coins by anyone other than the state, it didn’t mention digital money.  As advances in ICT developed, more and more of the money in circulation became digital, issued by private banks as IOU’s through fractional reserve banking.  Today 97% of money in circulation is ‘created’ by private banks as interest-bearing debt while only 60 years ago, this was closer to 50% with the remainder issued – debt free – as coins and notes by the state.

How does fractional reserve banking work?  When you put £100 in the bank a strange thing happens.  The bank holds on to a ‘fraction’ of your deposit (say 1/10th) and lends the remainder out, charging interest upon it.  This £90 loan is described as an ‘asset’ by the bank – it has created it, as if by magic.  It charges interest upon the loan and it must be repaid by the debtor with the interest or they will commit a criminal offence.  The debtor pays the £90 in to another bank who can then loan out £81, again at interest.  The process goes on and on and eventually through this ‘money multiplier’ process, £987 of completely new debt-money is created.

This capacity of banks to create money on the basis of maintaining very small fractions of deposits is one of the most important elements of modern capitalism.  Indeed the great German economist Joseph Schumpeter believed it to be the distinguishing feature of capitalism from all previous economic systems. It certainly helps us to explain the astonishing pace of growth we have seen in the Western world (where this system is most developed) over the past 200 years.

It has become clear, however, that our economies cannot keep on growing at the exponential rate we have seen over the past two centuries. Even if we weren’t facing disastrous climate change, there simply isn’t enough cheap oil to maintain such levels. As economist Herman Daly puts it, fractional reserve banking is not growth neutral, but a ‘growth pusher’:

“…For all those loans to be paid back with interest the borrower must make the money grow by a rate at least as high as the rate of interest… The result is that economic growth is required just to keep the money supply from shrinking as old loans are repaid.” (Daly, H., 1999: 133).

Daly’s quote also points to the inherent instability of our financial system.  If virtually all the money in circulation is created as debt by banks then money is effectively, credit (or debt).  The problem is that if debtors default on their debt (as with the sub-prime crisis), or, indeed, all suddenly choose to pay off their debts and stop borrowing, suddenly the magical ‘multiplier’ goes in to reverse.  This is exactly what is happening now across the western world following the recession. People are tightening their belts, concerned about their jobs. They’ve stopped borrowing, whether it be for holidays, cars or, most importantly in the UK, homes.  As a result, the money supply is shrinking.

On top of this, many banks are still attempting to rebuild their capital reserves following the financial crisis so are also reluctant to lend unless they are very sure about their investments.  Small businesses are feeling the brunt of this as they tend to be seen as riskier investments by banks.  Lacking working capital, they shed jobs or close down, further weakening demand and increasing people’s reluctance to borrow and further shrinking the money supply.  We are then caught in the disastrous ‘debt-deflation’ scenario that has afflicted Japan for the last 20 years.

Reducing public spending under such circumstances will make things significantly worse of course, further weakening demand and shrinking the money supply.  Nevertheless, the UK does face an enormous structural deficit.  There are other solutions however.  We saw how easily the Central Bank can ‘create money’ itself during the financial crisis through ‘quantitative easing’ (QE).  This involved buying up corporate bonds, in effect ‘monetizing’ existing debt, pumping money in to the economy.  But it could just as easily spend money directly in to productive activity and allocate it to particular areas or sectors, as nef has previously argued.

In 1914, for example, the Treasury issued ‘Bradbury notes’ to fund the 1st World War effort.  There is no evidence of significant inflationary effects.  South Korea and many other Asian states used ‘strategic credit creation’ to ensure money was pumped in to key sectors, such as hi-tech manufacturing, which was key to their extraordinary rapid economic development in the 1980s and 1990s.  China continues to use similar approaches.

The Green Investment bank report estimates that £550bn is required in investment in green technologies to help us make the Great Transition to a low-carbon economy. So far, there is very little evidence that our banking system is very interested in investing in such sectors.  They are still rebuilding very shaky balance sheets and any spare cash they’d rather pump in to non-productive housing debt.

The academic and policy research on alternatives to fractional reserve banking is thin on the ground. This needs to change. nef is working to try and change the way the public and the government thinks about modern money.  We’re supporting Positive Money, a new campaign helps build momentum for change and educate the wider public about how the monetary system really works.  We hope the Banking Commission and Ed Milliband really do think out of the box and consider strategic credit creation and allocation as a key policies to build a more sustainable and stable economy.