Saturday, November 1, 2008

The Infinite Economy

Note: This is an essay I have written for my soon to be launched website - My current goal is to have it up and running by mid-November, but that might change if I'm lucky enough to find someone who actually wants to hire me for a real-world job. Anyways, I'd appreciate any feedback you have for this article. Also, if anyone knows how credit cards receive the authority to loan money or if reserve requirements differ for savings vs. checking accounts, I'd love to learn more.

Ever wonder why the business world seems obsessed with growth? Open up the Wall Street Journal, Forbes, The Economist, or the business section of your local paper. Growth, increasing profits, and expanding markets – this is the objective. When businesses don’t grow at expected rates, stock prices plummet and CEO’s get canned.

From microeconomic perspective, the point of view of the individual, our society offers countless reasons to work for growth. A salesman who sells more makes more money in commissions. A mid-level manager drives his employees to perform at a higher level so that one day she can be promoted to corporate. A CEO might point to his legal duty to increase the company’s equity for stockholders. A self-employed contractor knows that without building more homes, he cannot afford to send his daughter to private.

At just about every level, we are a society oriented toward growth.

I believe an unending growth economy is impossible in a finite world. An always-growing economy requires an ever increasing number of resources. Thanks to the laws of physics, we have little hope of creating an infinite world, so we best stick with creating a sustainable economy.

In this series, The Infinite Economy, I will examine various parts of our economic system and growth-oriented society. Once we’ve had a chance to explore our current system, we will be in a better place to forge a new economic paradigm.

First, a bit of background: I have been intrigued by business, the economy and investing for my entire life. My parents were especially careful to make sure I learned to be responsible with money. I was probably 8 years old when I opened my first savings account. The idea that someone would pay me to hold my money sounded really good. When I was about 10, I used a 1-year CD with my paper route money, since that paid out even MORE money than my savings account. When the year was up, I took the money and purchased shares in a mutual fund. This past summer I opened up an IRA and bought stock in several companies.

What does this have to do with anything? I’m not someone who has an innate dislike of business or investing. I am not morally opposed to corporations. When I say that our monetary, financial, and economic policy needs to be completely rethought and overhauled, I almost feel as though I’m condemning a loving uncle, someone has been good to me my entire life. Yet when I consider the facts of the world, I see no other alternative.

The Infinite Economy – Banking and the Creation of Money

Money is the primary median through which business is conducted in modern society. Most people think money is created by the government. I did. I’ve seen pictures of the mint and the printing presses. I’ve read the text on the bills: “This note is legal tender.” Its got those little fake signatures from the Secretary of the Treasury and the Treasurer of the United States. Its government created money, right?

In a sense, this is right. Through laws and judicial enforcement, the government maintains this faith in the dollar by declaring any debt paid in dollars fulfilled. The money is deemed worthy by government fiat. But just as the FBI and Justice Department don’t create the laws, the government doesn’t create dollars, even if it facilitate its existence and enforces its acceptance in the market.

The responsibility for creating money is the duty of the quasi-governmental Federal Reserve and private banks. More importantly, the system these banks use to create money requires a growth-oriented economy to function.

I used to assume that for every dollar a bank loaned out (in the form of a mortgage, car loan, or what have you), was a dollar someone else had deposited at the bank. I deposit $100 in the banks, and they pay me a 2% interest rate. Then they turn around and loan out my $100 at 6% a interest rate and keep the 4% difference to pay operating costs and keep what they can for profit.

But that’s not how it works, at least not for members of the Federal Reserve system.
Modern banking operates on what is known as the fractional reserve system. A typical fractional reserve rate is 9:1, about the rate modern commercial banks operate under. This means that for every dollar of high-powered money a bank has deposited at the Fed, it can loan out nine dollars to customers. For this loan, Bank A must pay the Fed the going interest rate as determined by the Federal Reserve Chairman, currently Ben Bernanke. As I write this, the Fed’s interest rate is 1.0%, which is unusually low.

(Aside: Not all banks are members of the Federal Reserve system. As of April 2008, about 75% of all bank assets (loans) at FDIC-insured institutions are with member banks, so member banks make up the majority of domestic banking. Non-member banks include many small savings and loan institutions and credit unions.)

Lets start with a hypothetical Bank A, a member of the Federal Reserve. The Fed deems it necessary to increase the money supply. To start this process, they purchase $100,000 worth of high-quality securities (U.S. government bonds) on the open market from Hannah the stock broker. Hannah then deposits this money in her bank, Bank A.

When Mohamed the insurance salesman comes into Bank A and asks for a $90,000 loan to put an addition on his home, the bank types the loan into the computer and writes him a check. At that moment, the bank has created $90,000 that didn’t previously exist.

Next, Mohamed takes that $90,000 and gives it to his contractor, who in turn deposits the money in his account at Bank B (it could be any bank, as the cumulative effect on the system will be the same). So, when Jose the financier goes to Bank B and asks for a loan to buy herself a fancy new sports car, Banker B can say, “Sure, here’s $81,000. Knock yourself out.” Why $81,000? Bank B must keep a 9:1 reserve ratio for all deposits, the same as the Fed. Bank B is required to keep $9000 as “reserves” and may loan out the other $81,000.

Bank B’s loan to Jose creates another $81,000 in new money. Remember, Mohamed’s contractor still sees the full $90,000 in his bank account, and he can withdraw that at any time.

The cycle can continue indefinitely with shrinking amounts of money. Each round of lending creates new money. From the original $100,000 securities purchase, a 9:1 fractional reserve ratio has the potential to create upwards of $1,000,000 in new money. Before the 2008 financial crisis, some investment banks were allowed to have reserve ratios upwards of 30:1, though I don’t think they could borrow from the Federal Reserve.

Another interesting aspect of the current financial system is that if, theoretically, all debts were paid, no money would remain in the system. When a bank takes on a depositor, it creates a liability on its balance sheet, since it owes this money to the depositor. A loan, on the other hand, is an asset. It is money that is expected to come into the bank. Once the debt is paid off, the bank can “pay off” the liability, and keep the interest as revenue. The asset (money) that was created when the loan was written, disappears. Debt creates money. Payment of debt eliminates money.

I don’t take to the position that this system is an inherent sham, that creating money from nothing is somehow a moral failing on the part of the financial sector. Like every monetary system developed by human society, this system is based on symbolism. The money created by the fractional reserve system is just as valuable as the shells, stone disks, or gold coins used as money in the past. All of these are equally as good at feeding your family and keeping them warm in the winter (ok, paper has the edge there).

The problem with the current monetary system is that to function, it requires perpetual economic growth.

Banks don’t just give out money as a service for the good of society. They expect repayment of the principle, with interest. If all money is created as debt, where does the money to pay the interest come from?

The answer is that it comes from the creation of more debt. Debt/money increases exponentially while the economy – the number of products and services available – remains at a constant level or even contracts. In a world without growth, this system would soon collapse under the weight of inflation.

(Aside – Of course, instead of taking on more debt, the percentage of loans equal to the interest rate could default. But that wouldn’t lead to a functioning system, would it?)

Growth allows this system to function. Money is a claim on real things. If the economy is producing more and more goods and services every year, there is more stuff for the increased money supply to lay claim upon.

The unending growth that is required to support our economic system is not possible. As the supply of oil, timber, fish, fresh water, and fertile soil plateaus and decreases, our ability to grow ceases. We need a new paradigm, a system for living that is tenable over the long run.

Note on sources – Much of my analysis in this article is inspired by the video, “Money as Debt.” You can view it here. While I don’t agree the implications made in the video’s last few minutes and haven’t been able to verify all of the video’s assertions, it is an enlightening video. If anyone can send me (E-MAIL Link) an authorities source on the use of “high-powered” money as discussed in the video, I’d be much obliged. I’d also like to thank Wikipedia and the Federal Reserve Bank of Chicago for publishing this helpful booklet

1 comment:

Landon said...

Mohamed the insurance salesman is the perfect counterpoint to Joe the Plumber. Thank you.

Also, I liked the essay a lot and would have more to say about it if we hadn't already discussed the topic in person months ago.