The Current Currency System
The natural conclusion of commodity-based money.
This article is meant to serve as a brief overview of the current currency system before we look at the alternative that I am proposing. The current currency system used by pretty much every country in the world is an unbacked fiat currency system. I view it as the evolutionary endpoint of the gold standard currency system which existed before it. We started with a fixed ratio between the amount of issued currency and actual gold available. The banks and the governments gradually increased the ratio between currency issued and actual gold until the amount of gold was small compared to the amount of currency in circulation. They could do this because people generally did not redeem their currency for the gold in the banks. This also made it easy for them to eventually cut off the link to gold completely, resulting in an unbacked fiat system.
Fractional Reserve Banking
The key to how the existing currency system works is the so-called fractional reserve banking. It is an evolution of the idea of having a reserve ratio between currency and gold, as in the gold standard, but gold is replaced by the currency itself. Instead of keeping some amount of gold to back the currency they have issued, banks have to keep some amount of the currency to back what they have issued in the form of loans.
Currency creation in most countries starts with the central bank. The central bank issues base money in the form of banknotes, coins and bank reserves held by the central bank on behalf of the commercial banks. This money is literally created out of thin air, by printing banknotes or minting coins, or by entering a number on their balance sheet. The central bank injects money into the banking system usually by purchasing bonds, using the reserves they create out of thin air. The details vary from country to country but the general idea is the same. What is important to note, and why this approach is not good, is that the central bank does not provide any good or service to the banks in exchange for the financial assets purchased. They only provide new money in the form of reserves, which are created out of thin air.
With the reserves in hand, the banks can then use fractional reserve banking to multiply it. What a lot of people don’t know is that in addition to the reserves created by the central bank, there is another form of money in circulation, which is bank credit. Bank credit is significantly more abundant than the reserves due to fractional reserve banking. Both reserves and bank credit are legal tender, and the public is required to accept them as payment for goods or services provided and for the settlement of debts. Bank credit is created when a bank loans out money to someone or a business. When you go to a bank and take a loan, the bank does not give you money it already has. It creates new money by entering the loan amount on its balance sheet and crediting your account. This money then goes into circulation and is used as currency by the public. When the loan is paid back, the bank destroys the money by entering it in the other column of its balance sheet, leaving the interest as their profit. To give an example of how fractional reserve banking works, let’s say the bank has $10,000 in reserves, and the reserve requirement is 10%. One might think that this means the bank can loan out $9,000 and keep $1,000 to meet the reserve requirement. What it actually means is that the bank can create up to $90,000 in bank credit, and keep the $10,000 to fulfil the reserve requirement. That is nine times the amount of money they actually have, created out of thin air. This is how most of the money in circulation is created.
Money as Debt
A question naturally arises when money is created this way. If money is injected into the economy via loans, doesn’t that mean that money is debt, at least in the current paradigm? Indeed it does. In fact not only is money debt, but it is also debt that cannot be paid back completely. To illustrate, supposed the banks loan a total amount of X dollars to the public. The banks, of course, do not give out the money for free. They expect the public to pay back with interest. Suppose the banks charge a 10% interest on average. Then the public is expected to pay back X plus 10% of X. However, the obvious problem is that there are only X dollars in circulation. The public cannot pay back the interest because there isn’t enough money in circulation to pay back the interest. To pay the banks back, the public has to take more loans, enough to cover their new needs plus the old interest payments. But the new loans will also require interest payments, so in future, they will have to take on even bigger loans to cover the new interest payments. Thus you have a growing debt that cannot be paid back. As the money supply grows, debt also grows but even more rapidly. This is part of the reason why there is so much debt today. The banks benefit because people are indebted to them, and this results in a transfer of wealth to the banking and financial sector as people lose their properties to the banks because they cannot pay back the loans.
One may ask, if interest is the reason for the growing debt and wealth transfer, why not abolish interest. I don’t think the problem is with interest in and of itself. It is okay for a person or bank loaning money (which they actually have), to charge interest. That is the whole point of lending. The lender would prefer to have the loan amount plus interest in the future, rather than just the loan amount now. Without interest, there is no motivation to loan. The problem is when we use loans as the way to inject money into the economy. Then you have a situation where debt is growing exponentially faster than money supply and there is no way those debts can ever be settled.
The current currency system evolved from the gold standard. Under the gold standard, there was physical gold which was supposed to act as a check on government and the banks. However it did not provide the necessary restraint, and eventually, gold was removed completely from the equation. We now have a system of regulations that are supposed to keep the government and banks in check. But debt continues to grow unsustainably, and governments spend beyond their means, saddling the taxpayers with an unsustainable debt burden. I believe the governments and banks have too much much power when it comes to currency creation and distribution. Ordinary citizens need to be on the same footing as the government and the banks. Gold was supposed to provide that power to the people under the gold standard, but it failed, and was replaced by an even more imbalanced system. I believe the solution is to give people the power to determine what they want to use as currency, instead of forcing them to use the currency issued by the government and the banks through legal tender laws. The new currency system I will be proposing does exactly that. It puts all people, including the government and banks, on the same footing.
