The Nature of Money
The creation of our economic systems is political. Our present banking system, the power given to those that create and control money, is a result of political decisions. Our present economic system is not a natural system: it is a system that was created to serve those that created it. The lifeline of our financial system is money, and in order to fully understand economics, we must first understand the nature of money, how it is created or destroyed, the effects that this process has on the economy and the benefits accruing to those that partake in this process.
What must be made clear, is that before an economist can provide an
analysis of an economy, this person must first understand the financial
system. Otherwise, all analysis becomes meaningless, because different
financial systems affect the economy in different ways. Moreover, if we
do not understand the basics of our financial system, then this leads us
only into logical contradictions and errors. While economists have several
definitions of what money is, we will consider money to consist of deposit
accounts in banks or similar institutions, and government bank notes. Of
these two, deposit accounts make up almost 99% of all money. As such, we
will begin our analysis by examining deposit accounts, how they are created
or destroyed, and the effects this process will have on an economy. Today's
financial system consists of a fractional reserve banking system. In such
a system, deposit accounts, being a liability of the bank, are offset by
loans, which are the assets of the bank. By contrast, in a 100% reserve
banking system, deposit accounts (liabilities of the bank) would be offset
by government notes, which would be the assets of the bank. In a fractional
reserve banking system, money is created when a new loan is given. The
borrower has increased the amount of money he has, while the money held
by all other persons has remained the same. An economist must understand
this before anything else, and failure to understand this will only lead
to an illusion of reality. Next, an economist must understand how the creation
of a loan affects the economy. When a loan is created, this allows the
borrower to increase expenditure, which will affect GDP (Gross Domestic
Product), since expenditures make up GDP. Secondly, the creation of a loan
also results in the borrower having to make payments of interest and principle,
which causes expenditures to be reduced, which again affects GDP. The payment
of either principle or interest will reduce the amount of money held by
the borrower, and since the amount of money held by all other people has
not changed, this must reduce the amount of money. In addition, money is
also created whenever a bank purchases an asset, or is destroyed whenever
a bank sells an asset. To confirm and clarify these points, we will examine
the effect of these transactions on the banks balance sheet.
Consider a cash-less society in which all financial transactions are handled by cheque, and assume the initial bank balance sheet.
Assume that a person borrows $3, which the bank deposits into his account. In the bank, the loan clerk completes two bookkeeping entries. The loan clerk credits the borrows account by $3 and debits the banks general ledger loan account by $3.
Total 34 34
Total loans and total deposits have again increased by $3. The borrower,
now having an extra $3, can write a cheque against his account. However,
this will have no net affect on the banks balance sheet, as another depositors
account is increased by an equal amount. Since we are dealing with bookkeeping
entries with no physical limit, it then follows that there is no limit
to the amount of loans and deposits that can be created. Now governments
can place artificial limits to loan growth, such as restricting total loans
to a total dollar figure, restricting total loans to a certain multiple
of total Gov. Notes, restricting total loans to a certain multiple of owner
equity, or some other factor. However, this not change the fact (and I
stress the word fact), that in a fractional reserve banking system, deposits
and loans are created through simple accounting entries (hence the concept
of money out of nothing), that in the absence of artificial restraints
can increase without limit, so long as banks are willing to lend, and people
are willing to borrow. In many countries, loans are no longer restricted
to a multiple of Gov. Notes. While loans may be restricted to a percentage
of owner's equity, in reality this has little effect. Banks can always
increase their equity through the issuance of new shares, even if a small
percentage of newly created money must be allotted to purchase these shares.
Similarly, consider the effects of the purchase of an asset by the bank, in this case being a government bond.
Total 34 34
Now, the bank will purchase a government bond for $5. The initial transactions are for the bank to issue a bank cheque to the government for $5. The balance sheet adjusts as follows:
Total 39 39
The bank now purchases the $5 government bond, with the government depositing the cheque in its bank account.
Again, these transactions involve only simple bookkeeping entries, and
in the absence of artificial restraints, can be created in unlimited amounts.
In the above example, let us consider what happens to the banks balance sheet when a $2 principle loan payment is made. In the bank, the loan clerk again completes two bookkeeping entries. The loan clerk debits the depositors account by $2 and credits the bank's general ledger loan account by $2.
Total 37 37
Loans and deposits have both decreased by $2. Now, consider the effect of a $1 interest payment. The bank completes two bookkeeping entries, a depositors account is debited by $1, with the banks equity account being credited by $1. The balance sheet adjusts as follows.
Total 37 37
Loans and assets have remained constant, while deposits have decreased and the bank's equity has increased. Thus, the payment of interest has decreased total money supply by the interest paid. I should stress here, that it is because the payment of interest destroys money, that a fractional reserve banking system is an unstable financial pyramid. This will be expanded upon shortly. Now, consider the effect of the bank selling $3 in government bonds. The purchaser of the bonds will have its account debited to purchase the bonds, with the net affect as follows.
Total 34 34
It is useful to reflect on how the banks equity position affects the banks ability to make loans or purchase assets. Does the increase in equity through profits or share offerings affect the banks ability to create loans or purchase assets? While it may be useful that a banks equity be at a certain level to satisfy some outside financial regulator, technically, it has no bearing on the creation of loans or the purchase of assets. Since each time a bank purchases an asset or creates a loan, an equal and offsetting deposit is created, these transactions can continue to occur regardless of the equity level of the bank. In the granting of a loan, it is also wrong to think of a bank re-lending money (as some conventional economic theory teaches), for this is not what happens. In the process of giving a loan, the bank both creates the loan and the deposit, both being balancing entries on it's balance sheet. This really has nothing to do with the existing assets or liabilities of the bank. In a fractional reserve banking system, debt is first created, and then used to create money. We must contrast these loans with loans where money first exists, and then it's ownership is transferred by a loan contract. These are very different contracts, with totally different effects on the economy.
Before proceeding, I believe that it is important to consider the legality
of these transactions. While this ultimately will be decided in the courts,
I raise the following questions.
Questions to be asked, are first, can banks legally create money out
of nothing? Secondly, in contract law, is something created out of nothing
valid consideration for a contract?
Separately, but with keeping with the same ideas, we must examine the
legality of government income taxes, and ask if these taxes are not an
attempt to defraud taxpayers.
This is the first problem with letting banks create money, the fraudulent
transfer of wealth. The second problem is the amount of money that is created,
and how this money is used, both of which fall under the control of bankers.
This allows them to control or fuel economic expansions, and create financial
bubbles in specific areas. This gives them the knowledge to speculate at
the right time in the right investments. We must remember that the key
to controlling the world is the creation and control of economic contractions.
It is here that the majority of wealth is transferred to the money people.
Moreover, it is at these times that these same people bring about political
change. As bad as the banks ability to create money is, it is their ability
to destroy money that is even more frightening. We will now consider how
a fractional reserve banking system affects the economy.
When we discuss money, it is important to remember that money is used
both as a store of value as well as a medium of exchange. That is, some
people hold money as a preference to holding some tangible asset such as
real estate. Money is also used as a medium of exchange; it is used as
a means of payment for goods or services. The total amount of money therefore
consists of the total amount of money used as a store of value plus the
total amount of money used as a medium of exchange.
This represents the Quantity Theory of money, which basically says that economic activity is an exchange of money for goods and services and that the two sides of the equation must at all times be equal.
With the amount of money remaining constant, an increase in the number
of units produced will not effect nominal GDP; it will only decrease the
price per unit. This follows with conventional economic thought that says
when supply increases, prices will fall. An increase in production will
lead to a fall in price/unit, and with costs remaining constant, will see
profit margins decrease. Since the greater the increase in production,
the greater the fall in price, an economy that continually increases production
will eventually see the price/unit fall to or below the cost/unit, making
production uneconomic and leading to production shut downs. If however,
the money supply was increased at the same rate as the increase in production,
the price/unit would remain constant and the profit margins would not be
affected. This clearly points how the manipulation of the money supply
will affect profitability and ultimately production.
In discussing the effects of loans on GDP, I will consider three types of loan growth, for they all impact the economy in different ways. Specifically, we will consider loans that increase expenditures, loans that increase production capacity, and loans that are used to purchase existing assets.
First, let us consider a fractional reserve banking system when loans are used to finance expenditures. This new debt is spent and increases GDP by the amount of the increase in debt multiplied by the velocity of money. The next year, new loans must increase by interest costs plus principle loan payments just to maintain GDP at last years levels (this maintains a constant money supply). Put mathematically;
If "new loans" = NL; "interest payments" = IP; "principle payments"
GDPy1= MSy1 * VLy1
If we consider a financial system where loans are first introduced in Year 2, then we have the following;
GDPy2 = GDPy1 + (NLy2*VL)
For simplicity, if we assume that no
GDPyn = GDPym+ (NLyn -(r*(sum(NLym:NLy2))))*VL
These relationships are also shown in the equation;
Considering the above analysis, it might be useful to reflect on the
thoughts of C.H. Douglas and his views on monetary reform.
In a classical sense, Douglas was wrong in his concept of "lack of
While Douglas appeared to intuitively know that there was something
Now, let us consider a fractional reserve banking system when loans are given to increase production capacity. This will increase the number of units produced (which will act to lower the price/unit) as well as increase the amount of money (which will act to increase both price/unit, and the number of units produced). The change in the price/unit will be dependent on relative change in these variables. In subsequent years, the amount of increase in the amount of money will be the difference between new loans to increase production less any payments on principle and interest on previous loans. Even if initially, the percentage increase in the price level is greater than the percentage increase in the amount of production, in subsequent years, the increase in the amount of money must continually fall, even as the increase in the amount of production continues at a set rate, by virtue of ever increasing principle and interest payments acting to decrease the amount of money. Thus, over time, the price/unit must fall and will eventually fall below costs, which will lead to closing of production. Should no new loans be given, this process will only accelerate, as the continual decrease in the amount of money due to principle and interest payments, will decrease the price level below cost at an even faster rate. Put mathematically, we have the following equations;
Let Z be the increase in production for every $1 increase in new loans
GDPyn =GDPym +(NLyn –PPyn- Ipyn)*VL
The price level (P/Uyn<P/Uym) will turn negative prior to the money
supply turning negative (NLyn<PPyn+IPyn). As we have already described,
for any constant NL, PP+IP will eventually exceed NL even if PP=0.
A point should also be made that the effects of technological growth
or inflation will have no effect on this financial model.
"For, under the 10% system it is true, as we have seen, that an increase in business, by increasing commercial bank loans, and so increasing the circulating medium, tends to raise the price level. And, as soon as the price level rises, profits are increased and so business is expanded further. Thus comes a vicious circle in which business expansion and price expansion act each to boost the other- making a "boom". Reversly if business recedes, loans and prices also recede, which reduces profits and so reduces business volume- again causing a vicious circle, making a "depression". But take away the 10% system and you take away these unfortunate associations between business and the price level." (p.164 100% Money)
Irving Fisher felt that the expansion of bank lending would lead to
booms, and the contraction of bank lending lead to depressions, mainly
due to the change of the price level as a result of lending activities.
He thus desired to move away from a financial system where the level of
money was determined by the amount of bank loans which he saw as being
unstable (though he felt that the 10% system combined with a stabilization
plan would work better than an unmanaged 100% system).
A financial system with money based on debt will be unstable and eventually implode, regardless of how efficient or technologically advanced an economy is.
Let us now consider the effects on both GDP and the financial system
as a result of this investment or speculative debt.
Money (start) Loans(start) Money(end) Loans(end) Land value(start) Land value(end)
Year 1 10.00
After reaching a high of 20, the money supply has fallen to 3.20, which has reduced the price of land from 2/unit to .32/unit
The next points to consider the effects of these loans within
open economy. In our previous examples, we have assumed that money was
either only used as a medium of exchange in economic production or consumption,
or as a medium of exchange in purchasing existing assets. Since money is
used for both of these, we will show the interaction between both of these
While this may be a theoretical truism, in a world that is constantly
changing, with peoples perceptions of value subject to change and manipulation,
over a certain period of time what we can observe is something quite different.
Price changes occur at the margin, generally representing a small percentage
of the whole yet affecting the perceived value of the whole.
In any case, in most cases, the following generalities will be observed.
GDP = (amount of money)*(velocity of money) = (# units produced)*(price
There are two sources of repayment of loans. Either money circulating in the economy can be reduced, or some money held in lieu of property can be reduced, or some combination of both. In the first case, GDP will fall as the money circulating in the economy falls. In the second case, the price of land will fall, as there is now less money held in lieu of land. In reality, some combination of these two is likely to occur. This will change the rising price trend to a falling one and will alter future expectations. Should market values have risen substantially above any equilibrium price, they will now start to fall towards the equilibrium price, mindful that the equilibrium price is also falling as the money supply is falling. The effect on GDP is to decrease GDP by the amount of principle and interest paid as a result of reducing expenditures multiplied by the velocity of money. A point should be made here about the stability of the banking system. Loans are generally secured by collateral (land) and repaid by income. As the granting of loans will increase both land values, and GDP, this will have a positive effect on both collateral values, and income repayment ability. However, once credit creation stops, both collateral values and income will fall. A relatively large credit expansion will increase GDP while increasing land values substantially above equilibrium values. When such an expansion stops, and land values fall back to equilibrium values, many loans will be left unpayable, especially those made in the latter days of the credit expansion. As banks are highly leveraged businesses, this could easily lead to significant bankruptcies in the banking industry.
In our example so far, we have assumed that the land does not earn a
return. In fact, it does not matter if the asset class earns a return
or not. Earnings were earned before any loans were given and were
part of GDP. In that new loans will increase GDP, they may have a
positive effect on the earnings of the asset class, only to have a negative
effect when credit creation stops. What we should be aware of though
is that differences between the investment return on land and the interest
costs of debt will have an effect on the stability of the overall financial
structure. That is, if investment rates on land are greater than
interest costs, then the stability of the financial structure is more stable
than if investment rates on land are less than interest costs. This
comes down to a matter of individual loan quality.
The collapse of the Japanese real estate market in the 1990's or the asset bubble in SouthEast Asia in 1997 provides a good example of this phenomenon. Observing what will happen to the holders of margin debt in the U.S stock markets will provide a further opportunity to observe this relationship.
Again, to emphasis the mathematics of these three loan types;
In any economy, all three types of loans will have a cumulative effect,
and in the short term this effect will appear to be positive. Credit growth
that finances both increased expenditures (either by consumers or governments)
as well as business investment will both increase GDP. In addition, the
deflationary effects of the business expansion will provide a balance to
any inflationary effects of expenditure expansions. Credit growth that
finances existing assets will increase asset values. As asset prices rise,
they will provide security for increased borrowing while providing the
justification for lowering the savings rate.
One of the policy points in this exercise of examining a debt-money
based economy, is that it is deflation, not inflation, that is the cause
for concern. It would also appear that a deflationary spiral would be difficult
to stop. In an economy financing the increase in productive capacity, prices
will turn negative while loan growth and money supply growth are still
positive. This will lead to a contraction in demand for loans to increase
production, which further reduces prices, and so a downward spiral is created.
The question must now be asked if there is a maximum level of debt,
and what factors could influence future debt increases. Since the creation
of debt (and money) is a simple bookkeeping entry, these can be increased
without limit, and so there is no maximum level of debt. However, with
each type of debt creation, there are factors that will tend to restrict
new debt (unless these factors are ignored). For debt created to increase
expenditures, loan growth will exceed any income growth. It then follows
that the value of loan payments will increase faster than income, and at
some future date, loan payments will exceed what can be repaid from income.
Even here, people can continue to borrow, and banks continue to lend, if
they ignore the repayment of loans.
In order for the economy to function, loans must continue to grow. As
we have shown, there must come a time when new loans do not make logical
sense if we consider that loans have a requirement to be repaid.
When something happens that causes people to stop borrowing, or stops banks
from lending, then the economy will begin to implode. The greater the extremes
of credit creation, the more powerful will be the implosion. There is another
factor that must be maintained for this system to continue to operate.
Not only must people continue to borrow, or bankers continue to lend, but
also depositors must leave their deposits within the banks, even knowing
that the loans securing these deposits can never be repaid. This can hardly
be considered to be a stable financial system.
A fractional reserve banking system also gives bankers the capacity to create severe financial distortions. At the heart of today's bubble is a massive credit expansion within America. As noted, increasing loans increases spending which increases incomes, profits, and government tax revenues, all of which have a positive effect on GDP. However, with a creation of such a bubble, there are forces that tend to counterbalance this bubble. In a consumer driven economic bubble such as we find in America, increases in consumer demand will lead to an increase in imports. This in turn leads to a decrease in the exchange rate, which in turn leads to higher inflation. Generally speaking, this increase in inflation in an economy experiencing a credit expansion will lead to higher interest rates which will tend to decrease demand and counterbalance the expansion. Should central banks attempt to keep interest rates low, thus creating an environment of low or negative real interest rates, capital will begin to flow out of the economy, again limiting the credit expansion. Thus, in order for the bubble to intensify, measures must be developed to counter the effects of an increasing trade imbalance. This has been accomplished through what is called the "Yen Carry Trade". The "yen carry trade" is a series of paper financial transactions within the Japanese banking system that has not only allowed the American financial bubble to be created, but has added greatly to it's rise. Within the Japanese banks, offsetting bookkeeping entries have created vast amounts of new loans and new Yen. This new Yen has been sold for U.S. dollars in sufficient quantity to not only offset the effects of a trade imbalance, but significantly increase the value of the U.S. dollar. This Japanese created liquidity has had a significant effect on America, providing funds not only to finance the trade imbalance, but also funds for the purchase of U.S. government bonds (thus holding down long term interest rates) and investments in the U.S. stock markets (thus helping to fuel the speculative fever). The combination of a rising U.S. dollar, and higher investment returns in America have allowed investors in the Yen carry trade to show significant paper profits. It must be stressed that the creation of such a large financial bubble in America would not be possible without the "Yen Carry Trade". It truly attests to the power given to bankers to manipulate the world economy through the creation of money from nothing, even to the point of creating money in one country to control the economy of another.
For the purpose of this article, I will discuss the events that will
occur, should the loans involved in the "Yen Carry Trade" be repaid. The
United States trade deficit is now approaching $250-300 billion. In addition,
as the worlds largest debtor nation, there is a significant capital account
deficit. Offsetting these outflows has been large capital inflows into
the U.S., such as the "Yen carry trade". As these capital inflows slow,
due to the large current account deficit, we will notice a fall in the
value of the U.S. dollar. As the dollar continues to fall, there will be
pressure on many of the investors in the "Yen carry trade" to sell their
U.S. assets and repay their Yen loans. This will first involve a major
sell off on the U.S. bond and stock markets to convert to U.S. dollars.
Then, this massive sale of U.S. dollars at a time when the trade deficit
is about $250-$300 billion/year will accelerate the decline in the value
of the U.S. dollar. This will add greatly to future inflation expectations,
further accelerating the sell-off of the bond and stock markets. Consumers,
seeing the value of their savings fall, will further accelerate the fall
as they sell to meet margin calls or salvage their savings before further
falls. More importantly, there will be a major reduction in consumption
due to rising interest rates, a falling dollar and stock market, all creating
a negative wealth effect. In effect, what we will observe is a severe contraction
in credit growth. This will put the economy into a major downward spiral
with falling employment, profits, and government tax revenue further diminishing
demand. It is important to note that a major source of government tax revenue
is due to capital gains income, and that once taxpayers start claiming
capital losses, the change in tax revenue will be severe. The banks will
now be re-evaluating how new loans are given, paying greater attention
to the ability of the consumer to repay loans from income. Due to the fall
off of income and the major credit expansion over the last few years, very
few new loans will be given. In addition, it will be much more difficult
to use stock margin accounts to fund consumer purchases.
Without elaborating further on events occurring in such a nightmare scenario, it must be understood that when a credit contraction does occur, based on logical reasoning, the above events will happen. It must be also be understood, that the solution to the financial Armageddon described above lies first in understanding how our present financial structure operates, and finding the political will to alter this structure.
To stop financial Armageddon, the negative effects of present loans
must be neutralized, and bankers must be prevented from creating money
from nothing. Neutralization would come from replacing all bank loans
with government notes. For example, the government bonds held by
the banks would be replaced with government notes. This would be
non-inflationary, as no "new" money would be created. The only effect
would be to replace government bonds with government notes as bank assets.
Should depositors wish their money, the bank would have the notes to go
Debts are owed to commercial banks, or to organizations like the IMF and World Bank which obtain much of their funds from loans from commercial banks (often with a government guarantee), or to Western governments which again obtain their funds from commercial banks.
For debts owed directly to commercial banks, Western governments would print up bank notes totaling the loans outstanding. These would be deposited with the commercial banks as repayment for the Third World debt held. Essentially, the balance sheets of the commercial banks would be strengthened, for instead of having loans that could not be repaid as assets, these would be replaced with government notes. Depositors will be more confident in their financial system, knowing that if they wish the return of their money, that the banks will have government notes to give them, and not have their money invested in bad loans to Third World countries.
For Third World loans to organizations like the IMF and World Bank, governments would print up government notes as repayment for the Third World Debts. The IMF and World Bank could then deposit these notes in commercial banks in repayment of their loans with commercial banks.
For Third World loans directly to Western governments, Western governments
would cancel these loans whiles printing up an equal amount of government
notes. These notes would then be deposited in the commercial banks
as repayment of government loans (the purchase of government bonds held
by commercial banks).
In summary, the major concerns with a fractional reserve banking system
In examining the problems with a fractional reserve banking system, I have shown how all of these can be eliminated by changing to a 100% reserve banking system, which we will discuss in more detail. In this case, when a loan is created, the lender must transfer money to the borrower. No money has been created, only ownership has changed (the lender now has less money while the borrower now has more money). In a 100% bank reserve system, the bank must hold a dollar in government notes for each dollar on deposit. As such, no deposits are available to lend. In order for banks to lend in such a financial system, they would first have to borrow money from depositors, and then re-lend it at a profit. What we would observe is for every loan transaction, one persons deposit value would increase, with another persons deposit balance decreasing by an equal amount. The ability of the borrower to increase expenditures is offset by a reduction in the ability of the lender for expenditures, and thus it tends to have a neutral effect on GDP. When the borrower makes a payment of principle or interest, his reduction in money is offset by an equal increase in money by the lender. Again, the amount of money does not change with the repayment of loans. Again, when a borrower makes a payment of either principle or interest, this will reduce his capacity to spend while increasing the capacity of the lender to spend by an equal amount. This will tend to have a neutral effect on GDP. While borrowing and lending will tend to have a neutral effect on GDP, it is important to understand how each will affect demand and hence GDP as neutrality is not guaranteed. Savings represent a withdrawl from economic activity, and hence a reduction in GDP. Loans represent an increase of money for economic activity and an increase in GDP. Savings and loans are not necessarily equal, and this points to the need of efficient financial markets to distribute savings back into the economy. Interest and principle payments, by taking money out of economic activity, will reduce GDP. Dis-savings will put money into economic activity and increase GDP. Simply put, savings , as well as interest and principle payments will reduce demand (GDP) in an economy, while loans and dissavings will increase demand (GDP). Money would no longer tied to debt, which would make the system self-sustaining. The government could create additional money each year, that would maximize economic output, and distribute the benefits of this new money in an equitable manner. Government notes would function as a bookkeeping entry, more than a means of exchange, with most financial transactions being conducted as they presently are. In fact, these notes could be purely digital. . We should think of money as a community utility, a utility that will be used to enhance the well-being of every person, especially the most marginalized. As an economist, we would determine the optimun level of money in an economy, and the level of annual increase in money that would most benefit the economy. As a policy maker, we would have to consider who should benefit from the annual increase in the money supply. A centralist would have all the benefits remain with the government, which would distribute at according to it's policy's. A decentralist, would have an annual payment made to all citizens.
Now I do not recommend replacing banking, or even the form of exchange. Indeed, our present form of exchange would appear to be quite efficient. The real question is how is money created, and who benefits from its creation. At present, money is created when banks give a new loan. The real question we must ask, is this the best way of creating money, and what other alternatives are available.
The key point that I am making, is that what money is, and how it is created, will create very different economic effects. In today's financial system, money is either created through the printing of Government Notes, or in the banking system by increasing loans or purchasing assets. With Government Notes making up just over 1% of bank assets, most money is created through new loans. While we consider both Government Notes and bank deposits to both be money, we must understand that they are very different, and it is in understanding how they are different that we are able to more fully understand how our economic structures operate.
A point should be made about other models of the business cycle. Real-business cycle models ommit monetary disturbances as a source of the business cycle. Thus, the inability of a person to get a new car loan should not affect consumption, or having to make loan payments should not affect the ability of a person to consume the whole of his earnings. Such models are not true on a microeconomic level, and by expansion on a macro-economic level.
Keynsian theory also lacks microeconomic foundations. It gives current
income an important role in determining consumption, yet does not consider
how consumption is affected by new loans (increasing it) or by loan payments
(decreasing it). Nominal money supply is considered set by the government,
totally ignoring the role of banks in creating money. The role of money
in determining interest rates is seen as affecting investment, but the
effects of creating money on the economy are ignored.
As I mentioned at the start of this article, the understanding of our present financial system is crucial in economic analysis. While some have understood that the creation of bank loans also creates money, and the repayment of bank loans destroys money, none have applied this understanding to the Quantity Theory of money. Most importantly, it does not appear that others have understood that the payment of bank loan interest also destroys money, and that this has a most profound and major affect on the business cycle. It is this fact alone that ensures a total economic collapse under a fractional reserve banking system.
After reflecting on the above analysis, it is useful to consider the
status of the United States stock market. When the S & P 500
hit it's high in July 99, the average Price/ Earnings ratio was 37/1.
Assuming an 8 % interest rate, the Net Present Value (NPV) of earning $1
per year is about $12, valuing the S&P 500 at 308% of its NPV.
Not only is the S&P 500 index overvalued by over 300% based on present
fundamentals, future adjustment of NPV are very much likely to be to the
downside. Firstly, we are nearing the end of a massive credit induced
grow cycle which has increased business profits. When credit expansion
stops or contracts GDP and profits will fall. Secondly, current risks
are currently for a rise in interest rates, which will only increase once
the U.S. dollar begins to fall. Moreover, these adjustments are likely
to be much greater than many anticipate. It is also important to note,
that the value of current earnings may be substantially overvalued. . Specifically,
in that the credit expansion within America and Japan (financing the Yen
Carry Trade) has lead to an increase in American economic activity, this
has been supportive of American profitability. Secondly, with a rising
stock market, the defined pension plans of many companies have risen in
value to such an extent that no company contributions are now required,
inflating company profits by the savings of pension contributions.
On August 16,1999, Morgan Stanley issued a report titled, "U.S. Fears
of a Consumer Debt Squeeze are Overblown". They note that the decade long
consumer borrowing and spending binge has left households with record debt
levels, now totaling 101 percent of disposable income. The concern is that
rising interest rates will cause consumers to spend less due to higher
debt costs. However, Morgan Stanley argue that with rising incomes and
falling interest costs over the last year, scheduled payments of principle
and interest have fallen to near 16 percent of disposable income over the
last year, and that consumers are somewhat insulated from rising interest
costs due to fixed rates on part of their loans. Accordingly, they
do not expect a significant impact on consumer spending. However, what
Morgan Stanley has completely ignored, is the level of the national savings
rate in assessing the ability of the consumer to continue on its spending
binge. While making debt payments of 16% of disposable income is not a
concern when the savings rate is 20%, it is quite another matter when the
savings rate is the current –1.2 percent. Simply put, with a savings rate
of 20%, consumers still have the capacity to increase expenditures even
if debt service costs increase slightly. However, with a savings rate of
–1.2 percent, consumers must already borrow 17.2 percent of disposable
income just to make present loan payments and personal expenditures, and
rising interest rates will only magnify this distortion.
On August 18,1999, China's State Economic and Trade Commission announced a ban on all new projects involving a broad range of consumer investment. After many years of over investment, deflationary pressures are resulting in most companies now making little or loosing money. Beijing has already attempted to slow the deflationary pressure by imposing price floors. China is also stopping the construction of luxury apartments, hotels, department stores, and office buildings. With office vacancy rates in Shanghai now up to 70%, China has now entered into a major deflationary spiral. This will only accelerate as investment spending slows. Given that China is in a major deflation, with insolent companies, an insolvent banking system, bloated inventories, and soon to be contracting investment, those economists that have pointed to rising GDP as a sign of strength may have missed the dynamics underlying what really happens in an economy.
Today, we tend only to look at the surface, and not understand the forces
that control and manipulate our economies. A report has been written by
the Federal Reserve Bank of Cleveland called; "Beyond Price Stability:
A Reconsideration of Monetary Policy in a Period of Low Inflation", and
is available at
"As we entered 1999, the pace of real economic activity once again exceeded
market expectations of substainable growth by a wide margin. Consumers
continued to aquire houses and durable goods at a fast clip, and financial
institutions provided the credit necessary to support a prodigious rate
of national spending. The United States is borrowing from abroad to consume
far more than it produces and, at the same time, through Social Security,
it is transfering resources from future generations to bolster the consumption
of current retirees. This spending frenzy finds additional support from
equity markets, where price levels and earnings multiples continue to set
I would suggest that those economists that are presently looking at only inflation and GDP growth as a sign of a healthy economy are creating a dangerous illusion. While I would not expect the Federal Reserve Bank of Cleveland to provide a truthful analysis of our fractional reserve banking system, in their own way, they have provided a definite warning of future events, a view that is most consistent with what I have presented.
This paper represents an economic viewpoint that may be unique in it's
understanding, and is certainly directly opposite conventional economic
thought. The question that one must ask is what is the truth? Is
not every work subject to the criticism of those who are unable to commit
themselves to understanding it in depth? In my writings, I have argued
that mankind seems to have lost the ability to distinguish reality from
illusion, mainly because he has lost his ability to distinguish good from
evil. He has lost the ability to trust his reason to know the truth
and is so swayed into various false doctrines. Those same people, who do
not take into account decisive arguments in favor of the truth, will latter
follow doctrines and opinions without foundation. Indeed, it is our failure
to understand sound economic doctrine that ultimately will lead to our
The ultimate test of any theory is its ability to predict and explain
actual events. My writings, using logical arguments and sound mathematics
have shown that unless we change our financial system, and eliminate our
fractional reserve banking systems, that we will see the collapse of world
stock markets, bond markets, currency's and economies. Mankind must once
again seek the truth, and once found live by this truth. The consequences
of living a lie will be most traumatic under the light of revealed truth.