The 'credit crunch' and how to solve it

We are told that the there is a crisis in the world economic system because credit is drying up in the USA. This is only a crisis if we let it happen because it has a simple cause and an equally simple solution.

The problem symptom is that banks are unwilling to loan to other banks, and organisations are unwilling to loan to other organisations, because they may not get repaid. That is, the banks have "gone on strike".

Why is that? It is because many banks have been lending money to people who said they had assets but didn't. Lenders are worried that a lot of the loans they have already made may not be repaid so they are unwilling to lend any more just in case their new loans default along with some of the old ones. The underlying problem is that a lot of bad loans have been made but because of the way the financial system is structured banks and others have no idea who is holding bad loans.

This sounds incredible but it has happened because regulators have allowed complex restructuring of loans and allowed people to make new loans backed by bad loans - and because governments have an inflation target.

An estimate of how much money is being lent can be found by the increase in the money supply. In Australia for the past 30 years the money supply has increased at a yearly compound rate of around 11 per cent. Money is meant to reflect an asset of some sort. When we lend money we expect it to be repaid and if there is no money to repay we expect to get an asset in return. The fundamental problem is that too much money has been created and we now have money that is not backed by assets.

How can this be? We have allowed banks to make loans backed by loans. This is a sensible idea as a risk mitigation strategy or insurance but it falls down when the loans on loans are treated like a commodity in their own right. That is, as soon as we start to treat money as a commodity with intrinsic value independent of the asset backing it then it is almost inevitable for the system to run out of control. It is not bankers being greedy, or governments being incompetent, it is a system with an inbuilt flaw.

The inbuilt flaw is that we treat ALL money as though it were the same and as soon as we create some money we expect it to pay interest. That is we treat all money as though it had value independent of the asset backing it. We allow money to be created without an asset backing it and we charge interest on it immediately.

Each day in Australia the government and the major banks create about $500 million new dollars as measured by the increase in the money supply. As we have seen over the years they have been creating more money than the increase in our total wealth. Not only are they creating more money than needed, we are paying interest on the money before it is earning anything. If our productive assets do not generate more wealth to cover this interest we have to pay it by creating more money which in turn creates interest which in turn requires more money to be created to pay the interest …

In effect we have created a classic Ponzi scheme where the losers are the whole community through the device called target inflation. The government by encouraging this approach is sanctioning a broad tax equivalent to the inflation rate. Of course governments like this because it is not seen as a tax and it is rationalised away by saying it helps the economy adjust as different asset classes change relative value. This rationalisation is true but there are other ways of adjusting without taxing us through inflation.

We can solve the problem immediately and overnight by a simple rule change. Allow new money to be created but do not pay interest on it until it is turned into a productive asset. This is not a radical idea. It is done everyday of week as people invest in new ventures and do not expect a return on their money until it is earning something.

The idea of only issuing money that is backed by real assets is not a new one. The new idea is to issue money without an asset backing it. Requiring money to be backed by an asset is the reason why so many people call for a return to money backed by gold. That unfortunately is impractical because we need a lot more gold than exists but we are suggesting the same principle. Do not create interest bearing money unless it is backed by an asset.

There are various ways for a community to turn into an investment community instead of a spending community. That is, we do not allow interest on new money until it is earning its keep. Here are a couple of ideas.

1. Create some interest free money, give it to first home buyers, but require the money to be spent on building a new house. Until it has been turned into a new house the money earns no interest. The money can be used to buy a used house but it cannot earn interest until it has been spent building a new house and so increasing the asset base. As a side benefit it makes houses affordable for those who do not have one.
    
2. Create some interest free money, give it to people who consume little energy (and incidentally few greenhouse gas emissions) as a reward. The people get the interest free money as a reward for being frugal. Require those people to invest their rewards in infrastructure that will reduce emissions - such as windfarms, solar thermal energy production, solar cells, geothermal energy plants, insulation etc. As a side benefit this removes the need for emissions permits trading and if we create enough of this money we will have zero emissions within a few years as we invest billions in renewable energy infrastructure with money that has zero interest.

This approach is not inflationary as the special money does not accrue interest until it is invested in a productive asset that will in time return more money than it costs to build.

The credit crisis will be averted because the government creates some new money which is invested to create true value and real wealth in areas of obvious need. The Reserve Bank can control the issuing of special money and can use it to maintain an inflation rate of zero. The rest of the economy can continue in its own way secure in the knowledge that the value of the money in the system will not be eroded by inflation.