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Taking the debt out of money creation

By Kevin Cox - posted Tuesday, 25 August 2009

The world is experiencing a Global Financial Crisis. It is called a financial crisis because it started as a problem with the financial system and has spread to the "real" economy. We can see the symptoms and effects of the crisis but there is little confidence that after we come through the problem it will not happen again. In this article we look at the problem from the fundamentals of money and propose a solution that may stop the same problem reoccurring.

Money has two basic functions. The first is as a measure of value for the exchange of goods and services. The second is as a store of value. The problem with the first function is that there are many measures of value (such as different currencies) and the measures keep changing because of inflation or in rare instances, deflation.

When it comes to money as a store of value, the issue is equally murky. Credit money is created through loans and is a representation of the value of something else. That is, the abstraction has no value but the thing it represents has a value. So when credit money is described as a store of value what we really mean is that what it represents is of value. "Fiat" or printed money does not represent anything and is used to facilitate trade rather than act as a store of value. Credit money and fiat money are indistinguishable because once they are in circulation no one can tell the difference.


So, despite the fact that we have a money system where, when we take out a loan from a bank we increase the money supply, and despite the fact that we can simply print something and say it is money, all money itself continues to have value because people will pay interest to gain use of it. And interest in and of itself is not an issue, while ever there is an asset backing money, because interest can be viewed as rent of the asset that backs the money.

So what is the problem with money?

The first issue is that we have world-wide targeted inflation. Allowing the value of money to change over time is not a sensible idea. It makes it very difficult for people to measure the value of things. Imagine how difficult it would be if the meaning of a metre changed each week! This week it is the length of a rod that is kept in France and next week it is the length of a rod kept in Berlin. The week after we cut a bit off the rod in France and that is now a metre. It sounds absurd but this is exactly what happens with money. The measure of value changes minute by minute with random fluctuations.

The second problem is that the world has too much money to act as a store of value. There is more money issued than there are assets to back it and there is much more money issued than is needed for trade. When the sum of money in existence becomes too great the system corrects itself by the money being destroyed or through changing the value of money through inflation. If there is not enough money, the result is deflation, whereby the value of money becomes greater causing trade and industry to contract because there is no longer enough money to keep commerce operating.

This waxing and waning of the amount of money creates the so-called business cycle of economies, complete with the occasional recession and a few crises.

How can we both have too much money yet not enough and why do we have such widely varying and changing meanings of value?


The problem arises because of a quirk in the way we create credit money. Most money in existence is credit money and it is created when a bank gives a loan against an existing or future asset. To do this the bank uses some money that is already on deposit and then creates the remainder (and majority) of the money required by issuing extra money to the value of the loan. This in itself will not cause a problem because when the loan is repaid, the bank destroys the amount of money it created. If the loan is not repaid the bank is required to make up the difference from its reserves. (If the loan is not repaid then the bank is also entitled to seize the assets against which the loan was made and sell those assets to make up the money not repaid.)

This process seems reasonable and sensible except that banks can issue loans that are backed by money itself and this creates more credit money. Also banks are free to use another currency as the asset backing to create money in different currencies. What this means is that we increase the amount of money without requiring an underlying asset to earn enough money to pay the interest on the loan.

Because it is so easy to create extra credit backed by credit most transfers of money are now speculative transfers where money moves to try to take advantage of differing values of different currencies and money moves to take advantage of different interest rates. In and of itself this is useful, but when the main trade is trade in the measure of value then that trade comes to dominate the "real economy" of trade in other goods and services.

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About the Author

Dr Kevin Cox is an entrepreneur. Previously he has taught Information Systems in Canberra and Hong Kong and worked with computers for various multinationals in Australia, the USA and Indonesia.

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