OK, what follows here is my own analysis of how the banking system with fiat money works.
I've decided to put my career as a banker (six months as a wet-behind-the-ears school leaver working in a London branch of one of the major UK banks) on the line, and discuss what I now regard as banking "sophistication".
Many column inches have been devoted to this elsewhere but I want to simplify it so that any school-leaver today can understand it. Whilst the overall situation is (weasel word warning!) "complex", the principles involved are simple enough.
I may fall short, since the argument depends upon the "dismal science" of economics, but someone has to do this. When learned accountants think that the way it works currently is all perfectly fine, I am concerned - have they mastered all the sophistication of book-keeping and accounting, only to miss the most basic of the basics?
Read on, and see if you agree with my analysis ...
First, a crash course in basic supply and demand
If I want to buy a house and the seller asks £250K, and I have only £249K (including any mortgage), then I can try to negotiate, but if the buyer stands firm then I can't buy it.
If I can scrape together £250K then I can make the seller an offer which he may accept, but if another buyer offers him £260K then he can back out of the deal and I have been gazumped.
What this illustrates is that the prices that can be charged by a seller are limited by the amounts of money that can be offered by the prospective buyers. Prices will rise until not enough buyers are prepared to pay the asking price, and the sellers can’t sell (or can’t sell enough). The same is true for groceries, computers, cars, you name it. The more money available for purchases, the higher the prices will rise.
Likewise if the government raises taxes so that buyers have less money to spend, prices will either fall or sales will fall, since fewer buyers will have enough money to buy the things that they would otherwise have bought.
So far, so simple. More money to spend in the markets means higher prices, less money leads to lower prices, all other things being equal (which in the longer term they are not, but that's out of scope for now). In effect, the value of money in terms of what it can buy is flexible.
Indeed, markets may be the best (and maybe only) price discovery mechanism known to man. Markets are not perfect, just better than anything else yet devised. Like communism, if it doesn't work it's because it hasn't yet been done properly!
Now I'm going to (re)define "wealth" for the purposes of this article
According to one dictionary: "Wealth is determined by taking the total market value of all physical and intangible assets owned, then subtracting all debts. Essentially, wealth is the accumulation of scarce resources".
For my purposes in this article I am going to redefine wealth up front, specifically to mean the goods and services (excluding currency) available to be purchased in the market for money. Wealth excludes money/currency on principle because money is of no use except to buy goods and services.
Wealth is hard to quantify and usually measured in a convenient currency, but for my purposes it excludes money.
In the market, money and wealth are different animals. Money is currency (pounds, dollars, francs, euros etc) that we can see on our bank statements. Wealth is what we buy (or could buy) with that money. The price we pay for this wealth is the relationship between money and wealth at point of purchase.
Because the goods and services that we buy are so disparate in nature (teaspoons, daffodils, motor cars, houses, a garden maintained tidily by a gardener, a car properly serviced by a competent mechanic, a clean oven in the kitchen), it is common practice to estimate our total wealth by converting it all to a monetary measure; but wealth isn't fundamentally money, it is the stuff that we buy with money. Money is just a convenient measure by which we can estimate the aggregate total of all our disparate wealth at a point in time, but money in the bank is currency, of no use whatever until we choose to spend it. It is, if you like, purchases deferred, but my definition excludes it because it isn't wealth in hand.
Now a bit of monetary theory
Money is supposed (amongst other things) to be a store of value (to the extent that it represents potential purchases). When I get paid by my employer, I may need to save for my retirement, or for big expenditures like a house, or a car etc, so I need to put money aside until I have enough to pay for such needs. I want that money to retain its value!
The government / central bank have other ideas ... they think inflation (loss of buying power of our money) should be 2% annually in the UK, so they actually plan to reduce the value of our savings each year by 2%. How does that value disappear? Where does that value, that potential wealth, disappear to? Cui bono?
Now, putting my spending power aside in a savings account is fundamentally deflationary. I earned it by helping to create goods or services, so if I don't spend it there will in aggregate be more goods and services (that I was paid to help create) chasing less money in the marketplace (because I haven't spent my earnings), and prices will fall - balance will be restored when I finally get around to buying something. If everybody worked only to save their money, then nobody would be buying and market prices would collapse! This is deflation, the opposite of inflation and of what happens overall.
The banks help us out here by lending this unused spending power to somebody else who does want to spend it.
Banking theory and practice
If I can't in the short term save enough money to buy what I need, I can go to the bank and ask for a loan or a mortgage.
Scenario 1:
The bank has lots of money on deposit from its depositors, so it could lend me some of it. Some of it will be in fixed term savings so could be lent to me until the saver wants it back. Of course, that money is hypothecated for their depositors, so it needs to be available when their depositors want to withdraw it, but using statistical analyses the bank can estimate how much it can safely lend out so that it doesn't let its depositors down when they want their money back.
Lending me the money for a while will put that money back temporarily into the market for goods and services because I want to buy something with it, and will counter the deflationary effect of it being so far unspent by the depositor.
So I get a loan, and I pay repayments and interest to the bank, from which it in turn pays interest to its savers and replenishes the funds held on behalf of its depositors (note the slight confusion here between depositors and savers - not all depositors are savers and not all depositors get paid interest, but that's a different argument for another day). I’m happy to pay some interest because the depositor has lent me real deferred wealth and should be compensated for the small risk of not getting the loan repaid.
In this scenario, money stores the purchasing power (ie: potential wealth) of the saver-worker (who earned it by creating goods / services for his/her employer/customer). The bank performs a service to the depositor by paying him some of the interest that it accrues by lending. Because it can never lend all its deposits out (work with me here), and has costs to defray, the rate of interest the bank can pay on savings is lower than the rate it charges on loans.
Under this scenario, loans made are reflective of and limited by the real wealth of goods and services already produced by depositors and banked with the bank in the form of money from earnings. The total of money in the system continues to reflect the wealth originally created from employment. Bank lending of savers’ deposits counters the deflationary effect of savings and stabilises prices in the marketplace. A win all around.
Inflation would result if the money supply were to exceed the wealth (goods and services) available to purchase because prices would then rise, but in this scenario where an overall balance is maintained, prices will remain stable.
Scenario 2: The bank has lots of money on deposit from its depositors, so it could lend me some of it - if it hadn't already loaned all it could to others under scenario 1.
But instead of balancing new loans against its deposits, it can simply click a few keys on its computers, create a loan account for me with a debit balance (book-keepers work with me here) and put the same credit to my current account for me to spend! The total amount of money in the system remains the same as for scenario 1, since the positives and negatives balance out, and all looks wonderful from the book-keeping aspect, but there is now no direct constraint upon how many loans of this type that the bank can make.
Whereas under scenario 1 loans are related to the wealth of goods and services already produced by depositors, that limit no longer applies. Inflation results when the money supply exceeds the wealth (goods and services) available to purchase, so such lending is inherently inflationary in the marketplace because more money is chasing goods that have not yet been produced – prices will rise ...
Indeed by writing many more loans than it has deposits, the bank can make much more money, as it doesn't have corresponding savers to pay, so it can pocket most of the interest payments for itself whilst it books the repayments to reduce the original loan account. It receives real interest payments and real loan repayments that both arise from the creation of real wealth, against inflationary money loaned that did not represent any prior wealth creation. So repayments result in reduced inflation in the market place as goods and services supplied in the market restore the pre-loan balance between supply and demand over time.
It is in fact highly incentivised to write as many loans as possible because it is very profitable.
Whilst the loan resulted in more money chasing the same goods, the later repayments represent the same goods chasing less money available in the market ... and the interest payments (less expenses) are all income for the bankers which can be spent in the market. Over time it's all supposed to balance out, meanwhile the result is inflation. Loan duration can be many years.
An expanding population leads to continuing inflation as more new loans are made than loans repaid, whilst a declining population leads ultimately to deflation as fewer new loans are written than those repaid.
Loans over long periods (such as mortgages) are inherently inflationary and in addition divert not inconsiderable potential wealth into the banker’s pockets via interest payments which are not passed back to savers.
(My guess is that this is why some circles regard loaning money at interest as usury)
Defaults on repayment make the residual loan inflation permanent by denying the subsequent deflationary repayments. The bankers make out once more by calling in the collateral … repossession in the case of a mortgage, but if all else fails they can simply write off the balance of the loan – money they invented with a keystroke in the first place can be disinvented by the same method. After all, to whom could they pay their cash reserves to pay off the loan?
Profit from interest payments may be offset by the bank performing some of its services "for free" of course (test this by asking somebody whether they think their interest repayments are justified by their "free" banking). If you are living on loans then you are giving the banks a sizeable chunk of your income!
Of course there is still a limit as the banks must keep some cash on hand to meet the withdrawals of depositors, but it's a vastly more elastic limit than scenario 1, because most people keep most of their money in a bank for "safekeeping" and convenience at all times. One man's withdrawal is another's deposit - the banks as a group still hold the money! So provided that you don't want a cash withdrawal, the sky's the limit ...
And the central bank can always "temporarily" lend to a bank that is caught short, and who is to call the central bank to account? (NB: out of scope of this article!)
Overall, we lose spending power, the banks gain it.
It’s nice work if you can get it, but for some reason you will need a banking licence.
Central Banking
The central bank is a bank that has two types of customer – retail banks and the government.
Indeed, ultimately the only restraint on retail bank lending is the interest rate set by the central bank (the "Bank Rate") in an attempt to discourage borrowers from taking out more loans! If retail banks have to pay for money borrowed from the central bank then they need to recoup that money from their customers – you and me.
So the banks profit handsomely from interest payments from real wealth creation, whilst loaned money is simply more money in the markets now chasing goods and services not yet produced, leading to inflation.
Central banking works similarly to retail banking but on a national scale. It has the worst possible customers that are gloriously incentivised to over-extend themselves – can anybody remember the last time the government account was in credit? It doesn’t give “loans” to the government but it does buy “gilts” – government bonds (promises to repay) with a redemption date (a loan by any other name).
Central banks like to control the economy by changing interest rates and if all else fails by "quantitative easing" - that’s another story that some believe simply inflates bubbles in the financial markets to the benefit of over-extended financial institutions ... thankfully it’s out of scope of this article. The same principles as explained above apply, except that the "wealth" in play is that which is available in the financial markets rather than stuff you can buy in the High Street - draw your own conclusions.
Globally, the central bank of central banks is the Bank of International Settlements in Basle, Switzerland. It isn’t a Swiss bank, it has diplomatic immunity and is law unto itself, an independent body owing allegiance to nobody.
What could possibly go wrong?
To Sum Up
It's all a sophisticated mistake. Or some unkind people might consider it a fraud. The bottom line is that at the macro level, they have (to a significant extent) severed the link between money and wealth - especially over the lifetime of a mortgage - they give us money (which isn't backed in the market by any wealth) as a loan, then take back the interest and repayments (which is backed in the market by real wealth produced by us).
Inflation is the measure of the difference. It’s temporary over the life-time of the loan, but corporate loans can get rolled-over (paid off by a new loan!) and mortgages can be remortgaged. Some loans can approach permanence ...
So back to the original question: When learned accountants think that the way it works currently is all perfectly fine, I am concerned - have they mastered all the sophistication of book-keeping and accounting, only to miss the most basic of the basics?
What do you think?
As said earlier, I claim no higher authority than my own logical analysis for these views, so you must come to your own judgement about the accuracy of this viewpoint. Of course the argument is overly simplistic when compared to all the intricacies in operation in the real world, but this article is long enough already.
E&OE
