If we contrast the state of Ireland today with that of Ireland in, say, 2006, two very different pictures become apparent. Seven years ago, Ireland was awash with money, and with the stories of excess that this ‘wealth’ had brought with it. Today, credit is inaccessible to many, while it seems that the rivers of boom-time money that flooded down our shopping streets have dried up to a trickle. Where did all that money come from, and where did it go? If the banks don’t have it, we don’t have it, and the government doesn’t have it…surely it can’t just disappear?
It was questions like this, along with being unable to figure out why Ireland’s spiral into recession could not be arrested that moved structural engineer and maths whiz Paul Ferguson to investigate how the money supply system actually works. He was shocked by what he found.
According to Ferguson, money is not created in the way that people think. “Only 3 per cent of euros exist as cash & coins,” explains Ferguson. “The other 97 per cent is electronic, and consists of the numbers in our bank accounts. Most of us are familiar with the fact that the central bank creates the cash & coins for the Government. However, very few people understand where digital money comes from. And even fewer understand why there’s less of it during a recession.”
Most people believe that banks take in deposits from savers as savings, and then lend that money out again to borrowers. But believe it or not, Ferguson says, digital money comes from bank loans. Banks create the money they lend virtually out of thin air, “by simply increasing the borrowing customer’s current account” to quote Paul Tucker, deputy Governor of the Bank of England. Or as Graham Towers, former governor of the Central Bank of Canada put it: “Each and every time a bank makes a loan, new bank credit is created—new deposits—brand new money”. As a result, however, every digital euro has a corresponding interest-bearing debt to the banks. Ferguson claims that this process of money creation is the root cause of the debt crisis and, indeed, many of our social problems. One of the perversions of this system is that, because banks also charge interest on loans, they create more debt than they do money. If the amount of debt is greater than the amount of money generated, it is then impossible for everyone to repay their loans. A further problem with creating money this way is that, if no-one is willing or able to get a loan from a bank (e.g. such as during a recession), there is no significant source of the lifeblood of the economy: money.
Hard to believe? Wait for the next part. If you repay a loan to a bank, the money no longer exists, says Ferguson. Former Chancellor of the Exchequer, Reginald McKenna, explained it as follows: “Every repayment of a loan…destroys a deposit.” On processing a repayment, your bank will lower your account balance, and simultaneously lower your debt to them. No-one else’s account is affected, and the money becomes a victim of double entry bookkeeping, although the banks keep the interest on the loan. This is why there’s less money during a recession, and it also means that we cannot reduce our personal and business debts without shrinking the money supply.
Read the last two paragraphs again, and let it sink in—if the banks aren’t lending, or if everyone is tightening their belt and is unwilling to borrow, the money supply simply dries up. Then, if everyone tries to pay back their existing debts without borrowing more, the supply of digital money is greatly reduced. This is exactly the scenario we are faced with in Ireland today, says Ferguson.
“I realised that banks actually create the money they lend—it doesn’t actually come from other peoples’ deposits,” says Ferguson. “So fundamentally, the money system is different to how most people, including many economists, think it is. I realised that every euro was created with an even-higher debt, and that this was going to be a real hindrance to resolving the debt crisis. And when you repay the loan, the money no longer exists, the electronic money. So reducing our debts doesn’t actually help!”
“Reducing our debts doesn’t actually help.” Now there’s one in the eye for any austerity programme!
The way Forward
Thinking that there must be a better way to run an economy, Ferguson teamed up with three other like-minded individuals—Tony Weekes, James McCumiskey, and Ros Brannick—to found sensiblemoney.ie. Passionate about finding a solution to our economic travails and to explain the actual functionality of the money system to economists, policy makers and the general public, they created a website to explain why money, as it currently works, is anything but sensible.
Sensible Money, along with UK organisation Positive Money, the German monetative.de and other similar groups, advocates a modern variation of full reserve banking, where the banking system functions much as people understand it to—first separating current accounts from savings accounts, and having banks lend from savings accounts. In this way, a loan repayment doesn’t destroy money, and all money is issued without a corresponding debt at the start.
According to Ferguson, the current system (banks creating money they then lend) has worked relatively well—up until the recent crisis. The end of the road for the current system appeared when young people were borrowing vast sums of money as mortgages, with repayment terms extending practically over thirty years for two incomes. There was simply no more capacity to take on credit.
The Fix
According to Ferguson, fixing the current system is relatively straightforward—an adaptation of full reserve banking. “Our solution involves running the economy the way most people think it runs,” he says. “The central bank would create the entire money supply in all forms (cash and digital) while the banks would just do banking. They‘d facilitate any electronic payments between accounts within the economy and they’d act as financial intermediaries between investors and borrowers. Crucially, the banks would only lend existing money and a loan repayment would not cancel money out of existence.”
Banking Prudence
With the power to create or destroy money now resting solely with the central bank, the economy would prove intrinsically more stable. Banks would return to their traditional position of living off the interest of loans they would make. At the moment, however, banks have a free license to create money and lend it to whomever they deem creditworthy, a huge temptation in their drive to earn higher profits.
“Because banks charge interest on loans, they create more debt in the economy than they do money through each loan transaction, and in practice it’s not possible for the banking sector to behave prudently. They (the banks) can’t possibly behave prudently under the present system. …what’s owed back is (the principal plus) the three-fold plus interest (on loans), so it is inevitable that people have to default under this system,” he says.
Referring to the freedom of the banking services market, Ferguson says: “Under the current system, we don’t have capitalism—we can’t allow bust banks to fail. Under the proposed system (modified full reserve banking) we certainly could…It would actually be a full capitalist system.” Sensible money advocates a transition to a version of full reserve banking, gradually cementing the role of the central bank in money creation, and reforming the system without shocks.
With its focus on education and the greater good, Sensible Money also provides a wealth of high-quality online resources to explain the concepts behind the functioning of our monetary system, including videos, presentations and links to similar organisations.
Seems like the fundamental problem is with the system. With the laughter from the Anglo tapes still ringing in our ears, let’s leave the last word to the team at Sensible Money: “We cannot blame the banks for irresponsible or excessive lending. The banking system cannot behave prudently even if all the intentions to make it do so are there.”
