T P W I

The Business Cycle

Largely as a consequence of the variation in the rate of money creation by the commercial banking system, a business cycle has developed that is unrelated to real factors such as climate variation or technological progress. When money creation by the commercial banking system increases sufficiently, the wider economy can experience boom conditions that are evidenced in due course by asset or consumer price inflation. At times when the rate of money creation decreases substantially, a contraction in business activity can result, accompanied in some cases by price deflation. The business cycle is not only an unnecessary feature of the modern economy, but one that can be highly damaging to economic development. Business and consumer confidence is undermined by economic volatility, long term planning and investment is discouraged and, once sacrificed to a recession, a firm’s resources and business relationships may be irreparably damaged.

Endemic inflation

Given that commercial banks have the power to create new money at zero cost, it is a rational business strategy for them to maximise money creation within the existing regulatory regime. The greater the amount of money created, the greater their interest revenue and the greater their profit. The growth in money supply may not therefore be in accordance with the growth in the demand for money arising within the real economy because of growth in population or trade, for example. It is therefore the case that the volatile business cycle described above plays out against a backdrop of endemic inflation in every major economy over the longer term. Often, the inflation that is experienced is disguised in that asset prices are not included in headline inflation figures (for example, house prices are often excluded from retail price indices despite the fact that houses are the most expensive item that many individuals ever buy). A monetary system that suffers from endemic inflation is widely acknowledged to weaken confidence and distort decision making processes. Yet, where one or more public or private entities have the legal right to arbitrarily create new amounts of money to their own advantage, history testifies to the impossibility of achieving stability in the purchasing power of money over the longer term. It is therefore a common thread among reformers’ arguments that the legal privilege to create money with a face value higher than its factor cost should at the very least be removed from private entities, and ideally from public ones too.

Banking patronage

The ability to create money, and subsequently lend it, grants to the banking establishment a substantial power of patronage over other members of society. At a simple level this power takes the form of choosing which entrepreneurs to finance. At a more sinister level, it takes the form of supporting political ideologies that accord with the ambitions of banking institutions. The major lending nations have enjoyed the benefits of this power of patronage over debtor nations for several decades. It should not go unremarked that they have in part been granted this power by virtue of those many debtor nations who have decided to adopt Western currencies to satisfy their trading and investment needs.

Financial leverage

The fractional reserve banking system is largely responsible for the ascendancy of interest-based financing techniques within the modern economy. At the practical level this is evidenced by the emergence of financial leverage as the dominant business model among modern corporations. In this model, entrepreneurs undertake projects where forecast returns exceed interest costs, maximising the amount borrowed in order to maximise profits. As a result, small scale economic activity is sacrificed to ever larger scale production techniques, and local control over community activities is lost to distant corporate headquarters. This process is often accorded the term “globalisation” or “business gigantism”.

Environmental degradation

The pervasive use of interest in modern finance has in turn sponsored the use of highly questionable tools in financial decision making. For example, discounted cashflow analysis has been shown in a number of studies to be very short term in its scope, reducing significant long term costs to an insignificant present value component in a financial appraisal. Why be worried about the costs of global warming or pollution to be suffered in two hundred years’ time if the present value of those costs today is very small? This factor works alongside the more direct pressures that are exerted upon society by interest-bearing debt. For example, the world’s major deforesting nations are also among its most indebted. When money is needed to service foreign debt, environmental considerations can easily take second place.

Wealth Inequality

The use of collateral as a criteria when making lending decisions is a key feature of interest-based finance. It often encourages resource allocation that is speculative, and promotes wealth inequality because wealthier members of society usually have the most collateral to offer as a basis for bank borrowing. New bank loans are therefore mostly provided to people who are already rich, meaning that the poor cannot finance good quality business ventures, and therefore tend to remain poor.

Conflicts in Monetary Policy

The setting of short-term interest rates is a common tool of monetary management in the modern economy, operating on the assumption that the level of interest rates determines the degree of borrowing and hence money supply expansion in an economy. In other words, management of the money supply is undertaken by affecting borrowers’ ability to borrow, not lenders’ ability to lend. In seeking to reduce new borrowing, increases in interest rates have the undesirable consequence of harming the cash-flows of all existing borrowers and are therefore a blunt weapon of economic policy. Meanwhile reductions in interest rates often spark a speculative boom as investors and speculators engage in financial leverage upon assets such as property in the expectation of future capital gains. In some circumstances, the level of interest rates must be chosen so as to satisfy two opposing requirements at the same time. This can be the case, for example, when high interest rates are deemed appropriate to support a weak currency while recession indicates that lower interest rates are necessary to help businesses. Such circumstances produce impossible dilemmas for monetary authorities operating in an interest-based monetary environment.

Increased Systemic Risk

Changes of expectations in regard to interest rates, company profitability, government debt levels, property prices, inflation, and so on, carry with them a risk to the general level of business and consumer confidence, and therefore to levels of domestic investment and consumer spending. While sudden changes in confidence can affect the stability of the banking system (for example, the collapse of the sub-prime bond market caused bank collapses in Europe and American in 2008), it is also true that changes in the commercial policy of banks can cause changes in confidence. For example, the contraction of lending to the property sector can cause a property market crash, a substantial expansion of bank money supply can cause inflation or a currency devaluation. In other words, our current banking and monetary system has the capacity not to dampen risk, but to amplify it. Systemic banking risks are typically higher in the less developed economies. Here, monetary policy may be lax or politically motivated, debt service ratios (debt repayment as a percentage of export revenue) may be high, regulatory regimes weak, institutional mismanagement more common and personal financial behaviour less predictable. Within the more advanced economies, whilst such risks exist, they are reduced by the existence of monitoring systems (publicly available accounts, published economic statistics, credit reference agencies, regulators, reliable legal systems, and so on) which protect the public and provide them with opportunities to take pre-emptive action.

Resource Misallocation

The privilege to engage in money creation is in effect a subsidy that is granted to the commercial banking sector under the authority of the state. The removal of this subsidy would substantially improve resource allocation to the rest of the economy. Resources would be diverted away from the zero-value-added production of banking “services” towards other sectors of the economy where there is genuine need, the health, education, and construction sectors, for example. One very visible consequence of the current misallocation of resources is the general dumbing down of product quality that is happening in many countries of the world today. Money that could have gone into producing a good quality product is instead diverted to pay interest to a bank. For example, in the construction sector, it is well known that more than half the lifetime cost of owning a property can go towards paying interest charges. The construction company must pay interest on the money that it borrows to buy land and materials, the home buyer must pay interest on the money that he or she borrows to buy the house once the construction company has finished its job. The result is that in order to buy one pound’s worth of house, one must pay two pounds. And if one cannot afford to pay so much extra, then the only option is to buy a house which is cheaper (because it is smaller or built of cheaper materials, perhaps).

Public and Private Sector Indebtedness

As the bulk of modern money supply is created by means of interest bearing loans, money has effectively become the balance sheet counterpart to interest bearing debt at the macro-economic level. The indebtedness of private individuals, corporations and the public sector has its roots in this relationship between money and debt. Reductions in debt imply reductions in money supply, hence efforts to repay the debts of a nation can be the cause of severe recessions. Sustained long term increases in indebtedness are therefore a feature of both developed and developing economies. The unwinding of the system that created this intractable debt problem would involve the creation of new amounts of state money by the government and its injection into circulation through the repayment of existing government and private debts, using methods similar to those deployed during the quantitative easing programmes of the post-2008 and COVID periods. A simultaneous regulation of the banking sector would be required in order to ensure that the newly created state money was not then used as a base of reserves for the subsequent expansion of bank money supply, and the recreation of new debt across the economy as a whole.