Monetary Systems

This section of discussions seeks to understand whether there are any alternatives to the system of monetary and fiscal control that currently dominate most developed economies. In this context, a monetary system extends beyond the debate as to what to use as a basis of currency, e.g. fiat, gold or bit-coins, to the more fundamental issue of currency inflation, debt, interest rates and wealth inequality. For the sake of simplicity, this discussion will attempt to provide a basic balance sheet comparison between the existing monetary system and one that might generally be described as a ‘sovereign monetary system’. While the details of a sovereign monetary system can become quite complex, we might initially introduced the idea as follows:

Note: A sovereign monetary system seeks to control the currency of a nation state via a monetary policy that can  authorise an adjustment of the currency in circulation, although the actual method of currency adjustment may be subject to fiscal policy. As a generalisation, monetary policy is considered to be within the remit of the central bank, while fiscal policy is considered to be within the remit of the treasury. However, it is assumed that both monetary and fiscal policy are developed to benefit the economy as a whole rather than the self-interest of financial institutions. In this key respect, a sovereign monetary system would seek to remove the ability of private banks to create new currency.

However, before we can really start to outline some of the details of a sovereign monetary system, we possibly need to clarify some of the terminology to be used within a number of balance sheet models. When initially discussing the historical developments of various forms of gold standards, a distinction was made between ‘money’ and ‘currency’, where the former is assumed to have some form of intrinsic value, e.g. its weight in gold, while the latter was simply a fiat promissory note. This distinction will be essentially dropped in this discussion because most references on the subject of sovereign money are naturally bias to use the word money, which could therefore make wider cross-reference confusing, although some clarification is required as to what is and is not money.

Note: In many respects there is no universal concept of ‘intrinsic value’ especially if we considered the idea in terms of earlier economic systems, e.g. the barter system. For example, a hungry man will value food over another, while a thirsty man will value water over yet another. In this context, gold really has no more intrinsic value in terms of basic survival given that you cannot eat it or drink it. Therefore, the idea of money is simply a representation of value that may only be transitory.

In many respects, the financial status of any institution, e.g. central or  private bank or even an individual, can be presented in the form of a balance sheet of assets and liabilities, such that liquidity of this institution or individual might be summarised in terms of  an equity balance:

Equality = Assets - Liquidity

However, both assets and liabilities can represent some level of perceived value, which we might try to quantify in terms of ‘money’ and ‘non-money’. Initially, ‘money’ might be equated to a fiat currency, which has some stated promissory value, e.g. $1, £1, €1, although this promissory value makes no guaranteed of its exchange value in terms of goods and services due to inflation or foreign exchange rates. In contrast, the idea of ‘non-money’ is something that has a perceived value, which may not be precisely determined or necessarily immediately exchanged. So, within the simplification being made, money has a promissory face-value that can be requested at any time, although what can be purchased with a single unit of money in the future cannot be guaranteed. As described, non-money has some notion of value, which may either go up or down, and may not be immediately realised if subject to some restrictive caveats. However, in order to better describe the overall balance of the equity held within most monetary systems, we need to introduce a few further distinctions within the basic framework of money and non-money. As indicated, money has a promissory value that can be realised on exchange at any time, such that we might substitute the word ‘cash’ instead of ‘ fiat currency’ as a specific example of ‘money’. However, the basic idea of a bank ‘deposit’ on a balance sheet might also be described as a form of money, if the stated value of the deposit can be immediately withdrawn without restrictions. However, in order to trade as a private bank, a deposit called a ‘reserve’ must be given to the central bank. Although this reserve can be described in terms of a deposit, it may not be money in the sense that any withdrawal of the private bank reserve cannot simply be demanded as it may be subject to many legal restrictions. Likewise, a government bond might also be seen as having a promissory value like money, although it may have a maturity time clause that prevents the immediate realisation of its value, such that it does not fully comply with the description of money. Finally, for the purpose of this outline discussion, we might introduce that concept of a ‘loan’, which is a liability to the borrower, but an asset to the lender and while having a stated value, it can also be subject to a borrower default, such that its actual value may depend on any remaining equity held by the borrower.

Note: Assets and liabilities can be quantified in terms of both money and non-money terms. Therefore, within a transaction or contract between buyer-seller or borrower-lender, one party’s asset might be the other party’s liability. However, all monetary systems rely on a promissory value, which may not stand the test of time and be subject to many contractual obligations and restrictions. It is also highlighted that the term ‘private banks’ is simply being used as a convenient shorthand to represent any form of financial service.

While this discussion has reduced the terminology to a minimum, it is hoped that it provides enough scope to introduce an initial balance sheet model of the treasury, central bank, private banks and consumers within the current monetary system. In this system, central banks are responsible for issuing only 3% of money in the form of cash, while private banks are responsible for adding the remaining 97% of electronic currency in circulation.

First, it should be explained that the treasury and central bank are assumed to have a (1:1) relationship, although the central bank may have a (1:N) relationship with many private banks. The private banks in-turn have a (1:M) relationship to its customers, while simply highlighting that a single customer may have multiple accounts with different private banks. In terms of the simplified balance sheet model above, the equity of each institution is the sum of its positive assets and its negative liabilities. While these assets and liabilities could be identified as money or non-money, the model has simplified money in terms of the physical cash notes printed by the central bank, i.e. the 3% of the currency in circulation. However, the idea of non-money has been sub-divided into different classes to better identify its purpose within the system. Therefore, within this model, one of the treasury assets is identified as the ‘ tax revenue’ income per year, while its liability is the total ‘public debt’, which includes all the governments liabilities in terms of the welfare state and all other expenditures. In contrast, the central bank assets are only identified in terms of non-money, which in practice may include government bonds purchased using quantitative easing (QE). The liability side of the central bank balance sheet shows the ‘reserve accounts’ held on behalf of all private banks plus the ‘cash’ issued to them along with any other ‘non-money’ liabilities. On the private bank balance sheets, we see its assets defined in terms of its ‘reserve account’ deposited with the central bank and the ‘cash’ purchased along with its ‘non-money’ assets, while its liabilities are defined in terms of all its customer deposits separated into ‘current accounts’ and ‘savings accounts’ plus any ‘non-money’ liabilities.

Note: ‘Current accounts’ are assumed to be zero interest, low risk and immediately accessible like money. In contrast, ‘savings accounts’ imply some level of interest, variable risk and access restrictions like non-money. These accounts can also have some level of protection supported by the government should a private bank default.

Customers are assumed to have assets separated into private bank deposits, i.e. their ‘ current accounts’ and ‘savings accounts’, plus ‘cash’ and any other ‘non-money’ valuables offset by their liabilities. Within the simplicity of this initial model, the assets and liabilities of the central bank, privates banks and customers are assumed to balance, although in the case of the treasury, we might assume that the public debt liability may exceed its assets.

So what happens when a private bank issues a loan in the existing monetary system?

In part, the simplified balance sheet model of the existing monetary system is only intended as baseline for comparison against the sovereign monetary system. In this respect, the previous balance sheet only shows the effect of the loan after it has been issued by the private bank to its customer.

Note: By way of clarification, ‘loan capital’ represents the sum lent by the private bank and borrowed by the customer, while ‘loan deposit’ is the sum received by the customer and paid by the private bank. After the issuance of the loan, the ‘loan capital’ has to be repaid by the customer along with the additional ‘loan interest’.

For the purposes of this exercise, we might assume that the loan relates to a 25 year mortgage of £250,000, as previously discussed, where a 5% interest rate on the loan would approximate to £7,544/year or £188,600 over the full term. As such, the private bank sees the ‘loan capital’ as an asset to be repaid along with the ‘loan interest’, which is partially balanced by the ‘loan deposit’ assigned to the customer. On the customer side, the ‘loan deposit’ is seen as an asset, while the ‘loan capital’ and ‘ loan interest’ both represent liabilities. After the loan is issued, the state of the treasury and central bank balance sheets is essentially unaffected, although the discussion entitled Private Bank Money provides more details regarding the interactions between the private bank and central bank.  However, what really needs to be highlighted at this stage is that the private bank has effectively created £250,000 of new money, which enters the wider monetary system via the loan to the customer, who pays for his new house by subsequently making a monetary transfer to the seller, who can then exchange this ‘new money’ within the wider economy. However, this ‘new money’ inflates the currency in circulation, especially within the property market that is often favoured by private banks due to the perception of minimal risk. Now, while we might reasonably assume that the private bank must destroy the ‘ loan capital’ asset along with the customer’s liability at the end of the 25 year contract, such that this ‘new money’ ceases to exist on any balance sheet, the question that still needs to be addressed is:

How does the ‘system’ remove the ‘new money’ created, which has been already dispersed throughout the economy?

In part, the stylised graph above might suggest the answer in terms of the devaluation of fiat money over time. As ‘new money’ is created, inflation increases prices within the wider economy, such that the value of each unit of fiat currency is reduced, where the graph suggests that £1 in 1971 now only has the purchasing power of less than 15p. Of course, this situation is also compounded by the ‘loan interest’ seen on the asset side of the private bank, which amounts to another £7,544/year or £188,600 over 25 years of ‘new money’ entering the monetary system, which may not be removed other than by a price inflation resulting in a further devaluation of the fiat currency. However, while this process of new money creation might initially appear detrimental to the economy, an increase in the currency in circulation can be extremely important when attempting to maintain economic growth.

So what is the balance between loan-debt and economic growth?

In the earlier discussion of ‘cyclic dynamics’ , it was suggested that growth could be leveraged from both increased productivity and increased borrowing, i.e. debt, which has the effect of increasing income of both businesses and individuals. However, during a period of recession, increasing productivity is extremely difficult, such that the overall monetary system can become very dependent on loan-debt to help maintain income and to kick-start new growth. From a business perspective, companies need consumers to keep buying their products in order to maintain profits and employment levels, which a recession threatens. Of course, an uncontrolled increase in the amount of currency  in circulation could simply lead to hyper-inflation, which is extremely bad for the economy and the people who depend on it, so we therefore need to table another question.

How is the loan-debt spiral managed?

One of the arguments for introducing the alternative sovereign monetary system is that the current monetary system is not really being managed, but rather badly controlled via a seemingly never-ending series of escalating boom-bust cycles, where the mismanagement of the wider economy results in inflated stock and house prices, which typically results in any inflationary ‘bubble’ finally collapsing.