Economics Money and Banking

The Current Monetary System: Manageable and Reformable?

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As I have mentioned in previous posts, I have been having some interesting discussions on the Chris Martenson Crash Course website. Chris wasn’t very pleased with me because I (presumably quite effectively) challenged one of his core tenets – that the monetary system is intrinsically doomed. In his post asking me never to darken his virtual doors again, he accused me of ‘avoiding [his] points’ from his previous post and stated that he couldn’t ‘see a lick of daylight or imminent actions’ in the discussion.

In fact, I had avoided answering the points in his previous post partly because I wanted to see the ‘daylight’ of a consensus on reform of the monetary system, with a view to action of some sort – if possibly not ‘imminent’, since it depends on a lot of changed minds first! Secondly I believed I had addressed all of his ‘points’ before. But maybe the argument got scattered across a lot of posts, and so I present a detailed response here to that last substantive post. I hope, also, that this will stand on its own as an explanation of why we need to work with our current system, rather than expecting it to collapse under its own weight or tearing it down to replace it with some new and untried (or failed elsewhere) system.

Contrary to Chris Martenson’s view, I think that debate an important one, for reasons that should become clear when you read this. But I also hope that it can be moved on to one that is about reform and alternatives to our current monetary system.

Asking the Questions

We need to start by clarifying the important questions here. What is it about the monetary system, in terms of its accounting mechanisms for repayment, interest and default, that we need to know, if we agree on the fact that the monetary economy is in a mess?

1. Is the current system as an accounting mechanism involving promises of future revenue manageable? Can its current controllers keep it going and avoid some sort of crash?

2. Is the current system reformable? Can it be changed to provide equitable social benefit?

3. If the answer to 1 or 2 or both is negative, is there a viable alternative to the current system? Perhaps a ‘sovereign money’, a commodity money or a commodity-backed money?

Non-productive loans

Chris Martenson claims that ‘loans [that] do not add to production…cannot be serviced by the “immaculate interest flow theory…”’ by which he means that ‘all interest flows to where it’s needed when it’s needed’.

I think it’s fair to point out that, at least as far as I am concerned, this ‘immaculate interest flow theory’ is a bit of a straw man. We’ll see why later on. It’s also slightly disingenuous of Chris Martenson not to admit that rejecting an ‘immaculate interest flow theory’ is rather a different matter from claiming that

With every passing year, the money supply must expand by an amount at least equal to the interest charges due on all the past money that was borrowed

as he does in his piece ‘The End of Money’.

To return to the issue of loans for non-productive uses; from an accounting point of view it is actually irrelevant whether the uses of borrowed money are productive in the sense of producing new real usable output. A loan creates exactly the amount of money needed to repay the loan, as well as adding to the flow of money part of which the borrower and lender hope will be captured to provide compensating interest revenue.

To show this, let’s consider a mini-economy in which two loans are made, one productive and one ‘non-productive’. Employee E works for Firm F. Firm F borrows $1000 from Bank B and pays E this $1000 as wages for his labour in producing the firm’s output over 1 year. Firm F’s loan is repayable over 1 year, and Bank B charges interest of 10% per year of the loan.

At the beginning of this first year E wishes to buy a car that costs $1000. Since he also needs to purchase some goods from Firm F over the year, it is clear that he cannot afford to purchase the car without taking out a loan. He does so, borrowing $1000 from Bank B, and purchasing the car from C. The loan is repayable over 2 years, and again charged at 10% annual interest.

Over the first year E receives $1000 in wages, $400 of which he uses to purchase goods from Firm F, and $600 of which he uses to repay the first instalments of his loan and the annual interest. Bank B recycles $200 of the money it receives from E to purchase goods from F (directly or through its employees and shareholders). C also purchases goods worth $500 from F. F’s total revenue for the year is therefore $400 + $200 + $500 = $1100. F can thus repay Bank B as well as paying the interest due on his loan.

In the second year F borrows a further $1000, which he pays to E as wages over that year. E again spends $400 on purchasing goods from F, and pays $600 to Bank B, $200 of which again is used to purchase goods from F. C spends the rest of his proceeds from the sale of his car on goods from F. F’s revenue for the year is again $1100, and he can again repay his loan and pay the interest due.

Accounting-wise this works flawlessly. The fact that the car loan was ‘unproductive’ makes no difference. What has happened is that over the two years of the loan $200 worth of of F’s output that would otherwise have gone to E, now goes to Bank B.

Is there any real justification for the transfer of resources from E to B that this represents? Or is it just evidence of the rent-seeking power of a bank? The answer is that it depends on whether the additional benefit for E of acquiring the car earlier than he would otherwise have done is matched by the transfer of goods from E to B. To some extent this is a subjective issue, depending as it does on the additional utility gained by E, but there is an objective aspect in that it is largely possible to calculate the costs to B of administering, monitoring and bearing the non-repayment risk of the loan to E.

What impact does the loan to E have on the other parties here? F still
breaks even, paying off his loan and interest. C is enabled to sell his car and so purchase goods from F. Assuming the interest charged by B is matched by the bank’s real costs, then there is only gain, no losses, and the accounting position at the end of the process is the same as that at the beginning.

Now, of course we have grossly simplified reality here, and ‘immaculate interest flow’ is unequivocally present! There are in fact many Fs, many Es, many potential Cs and several Bs. When B makes the loan to F, he cannot be sure that enough of the money so created will flow, via E as well as via other banks, back to him. The repayment and interest on the loan to E, whether made by B or some other bank, also depends on the ability and willingness of F to pay E his anticipated wages over the period. So in the real world, there is of course no ‘immaculate interest flow’! But in an established economy with thousands, even millions, of actors some constant patterns will develop. This allows banks and borrowers to assess with some degree of confidence the likelihood that any particular loan and interest contract is actually repayable. Clearly, this likelihood depends in part on other loan and interest contracts that are being made! The degree of confidence that exists will be reflected in the rate of interest that is charged. If the degree of confidence is high, then interest is likely to be low; if the degree of confidence is low, then interest will be high. In the latter case the bank may wish to obtain additional risk protection by obtaining collateral, or may even perceive the risk as so high as to preclude any loan at all.

Particularly important to the working of this system is clearly the behaviour of banks. If they simply reabsorbed all money that flowed back to them, then obviously this system could not work. Debts could be repaid, or interest repaid, but never both. But reabsorption of all money is neither possible for real banks, nor would they wish to do this. Firstly, banks have real costs. They have employees and they own or lease buildings and equipment. To pay for these, money must flow out of banks and back into the economy. Secondly, of the surplus of revenue over costs, much will be paid out as dividends to shareholders or to purchase non-monetary financial assets (excluding government bonds, which have peculiar consequences of their own that I touch on below, and explain more fully here). Money that is not spent by banks will build up as reserves that earn relatively little return. In fact banks do require a certain level of such reserves, and this contributes to the start-up problem that probably requires government money (or some other money external to the private banking system). I say more about this below. But there is no reason from the point of view of the system itself why banks should keep the level of their reserves at anything other than the minimum level required to cover their loans and other risky assets. If the system can operate stably, then this level should be pretty much stable, with the result that money inflows and outflows from banks are more or less equal. What happens in the real world is not this simple, of course, and I explain why later.

It is also important here to note the existence of an important mechanism that both helps to prevent money and debt building up in the system, and keeps banks honest. At some point, when it becomes clear that a loan cannot be repaid, the loan asset is removed from the bank’s balance sheet and an equivalent negative entry is made in the bank’s profit and loss account. This has the effect of reducing the bank’s share capital and so limiting its future ability to pay out dividends or purchase additional capital, while keeping its balance sheet level. It is this cost, the risk of incurring which, banks must factor into their interest rate charges.

Assuming, temporarily, symmetry of information and power in the lending market between borrowers and lenders and no tendency for intermediate agents to hold onto money that is issued – banks should, as a whole, break even, and all money should be reabsorbed. The risk element of the interest payments will be exactly matched by losses to the banks from failures of the return flow of money. Neither of these assumptions hold in the real world. We’ll come back to the first one shortly, but I want to deal first with the tendency for money-holding.

Money Accumulation

Martenson argues that the ability and desire of individuals to accumulate money is another reason why the existing monetary system is either unmanageable, unreformable or both. It is inevitable that where money passes out of the hands of borrowers to those that have no debts, that some of the latter may wish to delay their spending to a later date. Since money (especially in the form of bank deposits) is possible to keep safely and, especially if earning interest, with minimal loss of value it may well be kept in this form. This certainly creates a problem, particularly in getting a credit-money system started. The risk of money being held and not returned to the bank may be so great as to make the interest rate that covers this risk unacceptable.

But clearly, since money is lent and interest is paid in the modern economy, this problem has somehow been overcome. I believe it has been overcome in two ways. Firstly, bank-created money is not the only form of money in circulation. There is also money created by the state, and this can fill in the gap created by the holding of bank credit-money. Secondly once the economy is established, and stocks of money are held throughout it, large changes in money holdings are less likely. The wealthy can be reliably assumed to calculate very carefully their optimal holdings of money as opposed to other forms of financial wealth, such as stocks and bonds etc. in proportion to their income. This reduces the risk to banks and borrowers that must be covered by interest.

The Martenson argument is that debts increase ‘exponentially’; that the addition to new debts each year is in proportion to the level of already existing debt. Now he makes great play of this, with alarming looking graphs and examples, but increasing numbers are hardly in themselves a problem. It is the underlying real consequences of these numbers that are important.

Biological growth tends to be exponential, and by extension quantitative social change might be expected to be. Economic exchange, as measured by real GDP, has risen exponentially in quantity over the last 50 years. Most people in the US and in Europe would regard this exponential increase as having (up to now) contributed to a considerable increase in their living standards – few would want to return to the world of 50 years ago. Now if more exchanges are taking place, we might expect more money to be circulating. If more money is circulating, we might expect more of it to be held. If more money is held, then the level of outstanding debt will also rise. It’s not unreasonable to expect that if exchanges are rising exponentially, money circulation, money holding and therefore debt will all also rise exponentially. But, note carefully, under this scenario debt could rise exponentially and be a constant proportion of money circulation and of people’s incomes. If debt is a constant proportion of income it is probably not an increasing burden on the debtor – since the ability to service it is rising in proportion.

So what matters is not whether money holding and debt are rising exponentially – this is really not unexpected – but whether it is rising in proportion to incomes. In fact, in general, it is, and I noted this as far back as 1998, rather before Chris Martenson apparently. And no doubt banks, too, have played their part in failing to keep debt and incomes in line, but this does not alter the overall picture. So there is indeed a problem, but the roots of the problem are not to be found in the exponential growth of debt but in the imbalance between the growth of debt and incomes.

So if money accumulation is a cause of a rising debt burden, then it is not enough that this money is accumulating exponentially, but that it must be accumulating faster than incomes are rising. For this to happen as a consequence of compound interest alone, then the interest rate applied to this accumulated money must be greater than the growth rate of incomes. The system does not set interest rates, so the system does not drive this – only the decisions of its human operators do so.


So, to summarise what I have said so far, although we have a system with exponentially rising debt, we also have a system with exponentially rising incomes, so the debt burden is not necessarily rising exponentially. To the extent that debt is rising fast enough to cause problems, the managers of the system have various tools at their disposal to mitigate these problems when they threaten the system itself. They can issue government money to fill the debt overhang. They can encourage banks to write-off debt that is obviously unpayable. They can convert government tax liabilities into interest-bearing financial assets, in the form of bonds, that can be sold to those that have accumulated large monetary holdings. As we have seen in recent years, the holding of these bonds gives huge leverage over government activity. All in all, it seems most unlikely that the beneficiaries of the current monetary system are going to allow it to collapse! They have all the levers to ensure that it persists in their hands. So I would say conclusively that the current monetary system is manageable. It is unlikely that it will crash under its own imperfections any time soon.

Equitable Social Benefit

So we move on to the second issue. Is the system reformable? Well, I hope that I have shown that the existence (and indeed the necessity) for interest does not automatically lead to the exponential growth of debt, even when ‘non-productive loans’ are being made, and that even when debt is rising exponentially this does not mean that a monetary system is necessarily unsustainable.

Instead what I would identify as problems are money incomes that are rising out of proportion with increases in activity that are humanly, socially and environmentally possible, and the imbalance between the growth of debt and incomes. Clearly the latter is likely to be caused by the former, as promises of future real growth are not matched by the actual incomes that are realised.

Which brings us back to two statements of Chris Martenson’s that I do agree with:

…that’s how humans operate within the debt based money system…


and referring more specifically to the Efficient Markets Hypothesis, but equally relevant here,

…complete garbage…due to such things as asymmetry of information and human greed…

These are indeed causes of the rising debt burden that we observe. But the money system, while enabling these features to cause it, does not itself drive it. Would these human behaviours and failures be problems without a monetary system? Of course they would, whatever system we construct. Indeed, they might be worse under any other system.

So, if we were to give up on the current monetary system on the basis of behaviour that is observed always and everywhere among human beings we are behaving irrationally, unless we are sure that we can replace it with a system that can tame these behaviours rather better. And I guess we can include among the possible systems the option of ‘no system’, where we allow systems of exchange to develop spontaneously from a sort of economic ‘null position’. It should be obvious that this is a very risky option, where the initial advantage will be with those with powers of physical force and natural resource control. Is the ‘preparation’ aspect of the Martenson Crash Course perhaps an acknowledgement of this? If so, I happen to think it a very, very nihilistic and perhaps dangerously self-fulfilling outlook.

Leaving the ‘no-system’ option to one side, once we have excluded any monetary systems that are logically unsustainable (and I think we have now proved that the current system is not one of these) then which system is best is always going to be an empirical question – which one actually works best when used? And given the nature of monetary systems this is an almost impossible task for whole systems, so it would seem that the only realistic approach is one of piecemeal trial and error of reforms.

So the answer to the second question that I posed at the beginning is that ‘We don’t know, but we will only find out if we try’.


Given that we have identified the problems that seem to lead to the current system producing the results that it does, surely the best first option is to try to find ways of mitigating these behaviours? After all, human beings have often found clever ways of dealing with their own problematic tendencies through institutional solutions – such as marriage, legal systems and insurance for a start. I think that the ongoing discussion between Damon Vrabel and myself shows that there are ideas for reform of the monetary system that deserve to be considered and hopefully implemented. So the answer to the third question is ‘Maybe – but I don’t think we’ve found it yet’. I don’t think there is any harm in pursuing this question alongside ideas to reform the current system. The two strands will hopefully inform each other, in any case.

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