The current financial crisis is now entering its fifth year. No one seems to know how to solve it, which I find puzzling. The crisis was cause by two things: 1) Too much debt and 2) a flawed monetary system. The reason why I find this puzzling is that simply switching to a full reserve monetary system will solve both problems fairly quickly. Our current fractional reserve monetary system actually caused the crisis in the first place and makes the problem worse because fractional reserve systems are inherently un-stable.
My background is control systems engineering. I understand best strategies for controlling mechanical systems, I studied it and I spent many years putting it into practice, with good success. The cause of the financial crisis, and why it cannot be solved using our current (flawed) monetary strategy is obvious to me. In this article I will explain how why tinkering with our current system is a waste of time.
I will simplify the details below for the sake of clarity, the principals I describe will hold for the less simple case.
Too much debt
The money system in the UK, in simple terms, is made up of coins and notes (real money) and the balances in bank accounts (bank deposits, we shall call electronic money). Real money is created only by the bank of England. Electronic money is created by private banks (including the high street banks and building societies) when they make loans. About 97% of all sterling money is in the electronic form. We are highly dependent on money, without it the economy will grind to a halt. We are therefore highly dependent on electronic money (created by banks) because electronic money makes up almost our entire money supply.
Electronic money comes with a very high price, debt. When banks make loans they create new electronic money (as bank deposits) but they also create a matching debt PLUS an additional debt, the interest due on the loan. So, when £10,000 of new electronic money is created into the money system free to be spent, a debt of £11,000 is also created (if the interest on the loan were 10% = £1,000). WHAT?
The financial crisis was caused by banks making too many loans, too quickly following the de-regulation of the banks in the 1970′s
The rapid increase in loans led to the rapid increase in money in the system but also, crucially, a rapid increase in the level of debt. For rapid, read EXPONENTIAL (Ref: 1 at the bottom). Is an exponential increase in debt, sustainable? No of course not. You do not need to be an engineer or a mathematician to see that, why the economic advisers to government also did not see this coming is a very good question.
A flawed monetary system
There is about £2,200bn of electronic money in circulation but about £2,500bn of matching debt. If we paid off all of our debts as advised by the prime minister, then there would be no electronic money in circulation and STILL £300bn of debt to pay off. This extra £300bn is interest payments owed to banks. The gap between money in the system and money owed to banks will simply get wider, thats compound interest at work.
We can never pay of our debts. And due to the effect of compound interest, we will keep getting further into debt FOREVER
The alternative to this upward debt spiral is to simply stop paying off your loan. This is called default. What happens if you stop paying your mortgage? you loose your house. What happens if you fail to pay your business loan? You loose your business and all the people working for you lose their jobs.
The fractional reserve money system currently operating in the UK is flawed. It flawed because electronic money can only be is created with a matching debt plus interest. This creates an upward debt spiral which is mathematically impossible to escape from due to the effect of compound interst. Anyone with a GCSE in mathematics and a few hours internet research time can demonstrate that our debt based money system is flawed and needs to be replaced.
To answer the original assertion “Why QE will not solve the financial crisis”. Quantitative Easing give more money to the banks to encourage them to make more loans to businesses. How is this going to get us out of the upward debt spiral? Simple answer it won’t. What else won’t solve the crisis?
- Credit easing. No. Too much credit got us into this mess in the first place
- Helping business get better access to cheaper loans. No. More debt
- Tax cuts. Best case scenario, it stimulate spending and we get a consumer led recovery. Hoorah? No! Rising consumer confidence means more borrowing and more debt and an acceleration of the upward debt spiral
- Bringing forward public spending projects. No! more government debt, same problem
- Pay off your debts, as advised by David Cameron. No! the money supply will shrink and even if we paid off all our debts, there would be no money left
These measures obviously do not work when more spending means more debt. If more spending did not result in more debt then they would work fantastically. This is why we need a full reserve system, where money is created, when it is needed, without creating more debt.
1. Have a look at the graph on this page, it shows how money in circulation growing with debt at an exponential rate (i.e. getting faster) and also note that the gap between debt and money in circulation is getting wider http://www.positivemoney.org.uk/2011/10/icb-leaves-inherent-shortcomings-system-fester/
Search the internet for ‘money reform’, ‘money as debt’ and don’t believe everything you read on wikipedia!