In several questions I mention the reserve barrier. Banks hold money in reserves. Since only the central bank (the Federal Reserve (Fed) in the US) can change reserve account balances, this creates a barrier to free movement from those reserves. I call money moving around in bank reserves the financial side of the reserve barrier. All Fed operations and most government financial operations take place on the financial side of the reserve barrier.
Money created by banks and the financial documents that support them are part of the economic side of the reserve barrier. When a bank sells a private debt to the Fed, the money paid for that exchange moves to the bank’s reserves where it stays on the financial side.
Money moved to a bank’s reserves can be credited to a private bank account, but that is an accounting entry that doesn’t change the amount of money on the other side of the reserve barrier. Banks can move money out of reserves as cash, but otherwise, paying back debt is the only way to extinguish those reserves.
Why do sovereign governments borrow money but banks create it out of nothing?
This is not a question anyone asks but is the most important question they should ask. The governments give the power to the banks to write loans which create money, yet they, themselves, borrow money. This is the reason all money is debt. Economists ignore this process so their models cannot study its effects.
You say most money is created by banks. Isn’t all money created by the government?
This is the most common question I hear about money created as debt. It usually isn’t phrased as a question but a statement–“Banks don’t create money, governments create money.”
While there are multiple sources making the claim that banks create money, Richard Werner (See Research) has the most credible analysis of how banks create money. He debunks that banks only loan out deposits. He also debunks that it is only through banks acting in concert that money is created.
When a bank writes a loan, it creates money. The banks have a license from the government to do that. No other lending creates money, not even lending to the government. (The government is borrowing from one of 24 securities dealers.)
Government spending does put money in private bank accounts but it is preceded by borrowing. The money put in private bank accounts had been previously borrowed so the net to the economy is that no money is created in the process.
The money put in private bank accounts is an obligation to the banking sector that was exchanged for a piece of paper (a treasury security). The banking sector cannot use that piece of paper in the general economy so to meet the obligations imposed by government spending, the banking sector lends more to the private sector to make up the difference. (See the question below about government borrowing crowding out private borrowing for a better explanation.)
There is some money created by the Federal Reserve. Money created by the Fed generally does not reach circulation in the general economy but stays in the circulation surrounding treasury securities and other financial instruments. This money stays on the financial side of the reserve barrier. Over a 30 year period (generally the longest period of a loan) the net impact of Fed activity is to draw money out of the general economy and move it to the financial side of the reserve barrier.
I have no debt and money in the bank. How can all money be debt? If everyone were to pay off their debts, wouldn’t our money problems go away?
Banks create money by writing loans and borrowers destroy money by paying back the loans. An economy needs money to function and a reduction of money in the economy reduces economic activity.
Our system of money creation is a negative sum game. This means that it takes more money to keep the game going than was originally injected into the system.
Since all money is created as debt and the interest on that debt is not created at the time of the money creation, the interest must be borrowed as well. This is hidden because the person borrowing the money isn’t the one that borrows the money to pay the interest. That is done by others who borrow to consume or to start businesses. This then gets injected into the economy and the money circulates to those who have interest payments.
Because money is created as debt, the more money that circulates, the greater the debt load to the macroeconomy. While some accumulate money to become debt-free, someone else had to go further into debt to provide that money. The net result is a negative. This also means no amount of frugality could allow everyone to pay off their debt. Someone has to go further into debt, always.
Government debt is substantially different from private or corporate debt. The government has unlimited borrowing capacity. The issue of government borrowing is covered in greater detail below.
Wouldn’t returning to the gold standard be better? Wouldn’t that stop the loss in value of our money?
Gold Circulates
There are several ways gold could be used as a standard. Let’s first assume gold IS the currency. Then the money supply is relatively fixed as it would require a “gold strike” to increase the amount of gold. If there is a gold strike, there is immediate inflation and then the money supply is relatively fixed again.
But lending requires interest payments. Lending gold means interest payments are paid in gold. This creates an exponentially increasing movement from those who use the money to those that lend money.
Profitable businesses can also accumulate gold. Eventually, though, even those businesses will lose their money to the lenders as the lenders bankrupt the businesses’ customers.
Arguing that competition will take some of that gold back from businesses by competing businesses doesn’t change the argument. One or another business will concentrate the gold until the lenders have bankrupted the customers.
Gold Backs Circulating Notes
Now let’s consider issuing a piece of paper that guarantees that the holder can exchange that piece of paper for gold. The first question is if the issuer of those notes is allowed to issue notes in excess of the gold holdings. If not, the money supply is fixed and we have the same problem as with only gold circulating as money.
To alleviate that problem, assume the issuer can issue a multiple of notes greater than they have the capacity to redeem. Historically, only about 10% of the holders of notes of this nature choose to redeem them. This allows the circulation of notes to increase the money supply by up to 10 times what the supply would be if only gold circulated. Gold notes adds some flexibility to expanding or contracting the money supply as seasons and time change the demand for money.
The transfer of gold and notes will still accumulate to lenders and businesses but there will be 10 times as much money availability before problems occur. Since exponents are involved, that means it will be less than 10 times as long as before–only about 3 times as long.
Gold Standard and Stability
The original question implies that money should maintain its value relative to gold. We’ve seen that gold accumulation removes gold or its substitutes from circulation and the economy stagnates. So, the first problem is to prevent the excess accumulation of gold so it stays in circulation.
The government power to tax could tax gold holdings to remove it from where it is concentrating and then spend it back into circulation. This may delay the inevitable, but unless government spending is high enough to remove most or all of the accumulation, money will still accumulate with the wealthy and stagnation will be the result. It buys some time, but it is still problematic.
If it buys enough time and there are high inheritance taxes, there might be a way of making the system work.
All this assumes that the economy and/or population doesn’t grow. If the population doubles, then the demand for money will double too or we lose price stability. If the economy and the population both double, the demand for money will quadruple.
If gold is discovered at the same rate of population plus economic growth, you may be able to maintain price stability. That’s a lot of ifs.
Also, there are many other economic factors that interact with the money supply. As those economic factors change, maintaining the optimum flow of money becomes difficult.
Fiat Currencies are More Flexible
Trying to maintain stability using a relatively fixed amount of money is nearly impossible in a large country. A fiat currency who’s volume is infinitely flexible allows for stability.
The reason it isn’t working with out current system is because that money is created in a way that causes an exponentially growing demand for money. An exponentially growing demand for money causes other economic factors to take on exponential growth and balancing all those exponential growths becomes unsustainable. (See the question about more debt being the solution for an example of exponential growth problems.)
Wouldn’t we all be better off if everyone, including governments, saved their money and paid off their debt?
We cannot all pay off debt at the same time. Since banks create money and interest must be paid, the debt load goes up exponentially. Foreclosures in and after 2008 reduced debt but this was done at the cost of losing real assets and a decline in the money supply and subsequent economic stagnation.
The only way to allow debt to function as a tool for economic growth is to introduce money other than through borrowing. This means sovereign governments would need to reclaim their right to create money. In all but three countries, governments have abdicated that right.
This website hopes to improve understanding of money and its relationship to debt.
If debt is what creates money circulating through the economy, more debt sounds like the solution that could result in an ever expanding economy, right?
No. The Federal Reserve Economic Data (FRED) shows the exponential rise in debt. The exponential rise in debt creates ever steeper increases in the need and supply of money to keep the economy running. Exponential curves driving real events create imbalances as the speed of increase shortens time periods in which to react.
Other economic activities generate exponential curves as well: wages, prices, GDP, productivity, wealth, profits, trade… Their interactions with debt and financial wealth create instabilities. Those instabilities cause the booms and busts that allow the wealthy to purchase real assets at bargain prices. Eventually, this destroys the middle class and will destroy the current system.
Models show better ways an economy could function. If we continue to create and tax money the way we do now, it is impossible to have an efficient economy.
Here’s an exercise that demonstrates the problem with exponential curves. Take a relatively smooth exponential curve from FRED and note how steeply the curve is rising. Then, take just a small section of the curve at a position that looks relatively flat. When examining this smaller selection with the earlier selection, the curve looks almost the same as the first curve with a steep ending.
This exercise may lead you to thinking that things were the same 50 years ago as they are now so what’s the problem? The problem is the time frame. The slope of the curve will tell you how rapid the change is occurring. Even if the angle of the slope is the same in both cases, dividing that slope by the time shows that the change is much more rapid in the original curve. This rapid change does not allow economic factors to stabilize before another change occurs.
Shouldn’t the government spend less to keep from competing with private borrowing?
Government spending and the interaction with the general economy is more complicated than a simple exchange of less government spending leaving more for the private sector. A detailed analysis of government spending shows that government spending puts money in private bank accounts.
What government spending has done is to place an obligation on the banking sector to provide money to those recipients. What the banking sector got in exchange is piece of paper in the form of a debt instrument (treasury security). While that appears to be the same thing as the bank exchanging an obligation for a debt instrument, there is a significant difference.
When the bank lends, it created the money from nothing and has the loan document as an asset. When government spends, it borrows money that had been created by private lending and offers another debt instrument in exchange. The removal of money from bank reserves though government borrowing is taking money that had been created by private borrowing; so now there is a double claim on that money. The government gave a piece of debt instrument for that money and the bank already holds a piece of paper making claim on that money.
Economists can argue that all the banking sector needs to do is to exchange the government security through the central bank which can create the cash in exchange. And since that cash is created from nothing, all is good.
But, that just transfers the second claim from the bank to the central bank. There is still a double claim on the money. Besides, the central bank creation of money is a negative sum game on the other side of the reserve barrier just like bank lending is on the economic side of the barrier.
The reserve barrier creates other issues that are described in blog posts.
Shouldn’t we abolish the Fed?
Federal Reserve bank members own the Federal Reserve (Fed), not the US government. Creating the Fed in secrecy and conspiracy leaves a legacy of suspicion. (See “The Creature from Jekyll Island,” by G. Edward Griffin for a complete story about the creation of the Fed.) While there should be Fed reforms, the problem isn’t the Fed.
Dissolving the Fed would create a need for another entity that provided most of the same functions as the Fed. Some entity would still need to regulate the banks, cash checks, circulate money, facilitate inter-country banking transactions, be the lender of last resort, etc. There are other solutions which could simplify some of these steps, but I’ll leave that to blog posts to explore.
The problem isn’t the existence of the Fed but how the operation of banks removed the government’s ability to create its own money. The law requiring that the treasury must have money in its bank account at the Fed before it can spend is the primary problem. Government borrowing creates a debt instrument that circulates as money on the financial side of the reserve barrier. And as we’ve seen from the previous question, that borrowing creates a double demand for the same money that was created by private borrowing.
Rather than eliminate the Fed, allow the treasury to overdraw its account at the Fed to whatever level it wants. That overdrawn amount would be money circulating in the economy that was not created as debt. If all the money that was needed to maintain economic activity (say to the amount of GDP) were debt-free money, it would be possible for the macroeconomy to have net positive financial assets. That solution would require a law change in the US.
There is still the problem that all government spending stays on the financial side of the reserve barrier. That issue would also need to be addressed.
Another solution, that wouldn’t require a change to the law, would be for the government to authorize the mint to produce a trillion dollar coin and deposit that into its spending account. (See this.) The trillion dollar coin solution would probably require the Fed to place the cash in the treasury account in exchange for the coin. At some later date, the Fed would want to sell the coin back and the treasury would need to trade it for debt again.
A better solution to the trillion dollar coin concept would be to issue 100 billion $!0 platinum coins. These could then be spent into the economy and circulate as debt-free money in the general economy. Overall, a better solution would be to change the law so the treasury can introduce debt-free money simply by spending it into existence and also allow banks to transfer money across the reserve barrier.
Doesn’t government deficit spending cause inflation?
Inflation has many causes. The root cause of inflation is the supply of money exceeds the expansion of economic production. Economic bubbles are inflation confined to a single or a few sectors of the economy and usually caused by excessive bank lending in that (those) sector(s).
There are further complications to understanding inflation. Government spending stays on the financial side of the reserve barrier. We’ve seen from the question about government borrowing crowding out private borrowing that government borrowing places a double claim on private loans.
It is the bank lending to compensate for those double claims that can trigger inflation. If the government continues to deficit spend, it does not exercise its claim so the banks don’t have to expand their lending to compensate. However, it does incur interest that increases borrowing and exponential growth in public debt. Eventually, these interest payments can overwhelm the government’s creditworthiness or ability to pay for existing programs. While it has unlimited borrowing capacity, there is some point where they will have to force borrowers to take on its debt.
However, the additional debt instruments generated by the spending can be used as money in financial transactions that take place on the financial side of the reserve barrier. These types of transactions don’t interact with the general economy. This addition to the financial money circulation can trigger inflation in financial assets that aren’t reflected in the common measures of inflation.
High government spending since 2008 did not trigger inflation as measured by the CPI or the PPI because every time the financial markets hiccupped, the government spent some more and those financial assets, especially corporate stocks, rose but private lending relatively languished.
The Austrian school of economics has a measure of inflation I prefer. While their True Money Supply (TMS) calculations do some double counting, the idea of measuring inflation as the amount of money increase has some merit. It is somewhat complicated by the reserve barrier and the exclusion of money in the TGA in money counts. Also, the double claim created by government borrowing complicates the process of counting money.
How big can government debt get before the economy can no longer function?
Government debt can continue to grow indefinitely; there is no limit. But, as the debt rises, an ever growing percentage of government spending goes to paying interest on the debt.
The limit will come when the world economy loses faith that the country can continue to borrow. Then the market for government securities will dry up and the treasury will have to force the dealers and banks to buy their debt.
Government debt puts a strain on the banking sector. If the government could spend without borrowing, it would relieve stress on the banking sector while reducing the debt load on the general economy. To totally eliminate government borrowing would throw financial markets into panic mode. Some compromise solution is needed to resolve both issues simultaneously.
Didn’t our economic problems start with the introduction of fiat currencies? If the gold standard isn’t a solution, wouldn’t a basket of commodities serve the same function?
Economic problems long predate fiat currencies. Fiat currencies allowed more economic flexibility than with the gold standard. A basket of commodities would have the same limitations as returning to the gold standard. (See the question about returning to the gold standard above.)
Tying currency to anything adds unnecessary additional complexity. The goal of tying the money supply to a fixed commodity is to prevent inflation. The problem is that if the supply of all the commodities don’t increase at the same rate, there will need to be a constant adjustment of the ratios in the basket. Also, not every country’s economy would grow at the same rate so each country would need to constantly adjust its currency relative to the basket.
The flexibility of a fiat currency is an improvement; it offers more fiscal and monetary options. Fiat currencies allow the ability to create money not based on debt. That would solve many more problems than trying to tie money to gold or other commodities.
The Bank of England is considering digital currency. Could we adopt a digital currency as our national currency? Would that solve our economic problems?
The rationale for CBDC is to expedite settling banking transactions. There is evidence to believe that a more sinister motive is behind CBDC. Concentrating all economic transactions can allow government monitoring of every aspect of your life.
In addition, in a banking crisis, like 2008, CBDC would allow the imposition of negative interest rates. In 2008 there was fear that we would experience deflation. Interest rates were dropped to zero but still the economy was sluggish. Negative interest rates would cause people to spend the money before their bank balances went more negative.
The digital currencies being proposed are not like bitcoin. They would not create money any different than what is currently done. They would act more like a regular bank holding account balances in dollars that were created by lending. Whether the central bank would write loans isn’t clear.
Just keeping all money as digital files isn’t the same thing as a digital currency. Most money is already mostly digital.
Just like the US sanctions banking operations of other countries, digital currencies will allow governments to sanction individuals in their own country. If they suspect you of a crime, it will be like the asset seizures that assume you are guilty of an offense and you must prove you are not to get your assets back.
What about public banks? Would our economic problems go away if we removed or reduced the number of private banks?
The problem isn’t the private banks but that money is created only by banks. That money creation requires payment of interest so the net effect on the macroeconomy is negative. Someone needs to go further into debt to create new money.
Public banks would be an improvement. The advantage of public banks is that local and regional governments could drastically reduce their costs. The cost of government capital projects is 50% in financing and underwriting. These are mostly the fees for issuing bonds and then paying interest on those bonds. Plus, banks charge these governments fees for “managing” the money sitting idle.
With public banks, local and regional governments would no longer have to have “rainy day funds” to anticipate unexpected expenses. The funds for emergencies would easily be available through the public bank.
Public banks assist smaller community banks counter-cyclically. Banks are reluctant to loan money during an economic downturn because the additional cost of borrowing makes more projects unprofitable. This deepens the downturn. Public banks will loan more and assist community banks more during the downturn. The inverse is also true. During a boom, banks are willing to lend. This prolongs a bubble. Public banks assist less during a boom which moderates the peak.
Private banks take unnecessary risks with depositors’ money. Depositor’s money should come first on the creditor’s list, not last as it has been since Basel 3.
Public bank loans would create money. Borrowing by local and regional governments would be creating their own money by loaning it to that government’s departments. With local and regional governments, their borrowing limit would be the tax rates necessary to repay the loans.
What is wrong with our economy?
The biggest problem with the economy is the declining middle class. Without a strong middle class capitalism fails. This large pool of customers fuels the economy.
The middle class decline accelerated since the 1980s. The ideas of trickle down lowered tax rates on precisely those accumulations of financial assets. Low tax rates where money accumulates causes myriad economic issues that eventually remove tools for stimulating economic growth.
Tax structures that target income and sales remove money from the economy before the money can do its work. Imposing taxes after it has done its work maintains economic efficiency. Also, it is far too easy to hide income so many (especially large) businesses pay disproportionally lower tax rates than everyone else.
The bottom 39% of our population don’t have enough to pay off an unexpected $400 bill. (Recent reports suggest that number is closer to 60% (2023). I haven’t done the research to verify that latest number.) Large pools of homeless beg for handouts on street corners. These people don’t contribute much to the economy.
This website attempts to identify the problems and identify solutions.
Is capitalism inherently unstable?
As long as we continue as we are now, yes. But socialism is equally unstable; it just delays the inevitable. See the previous question.
Isn’t your plan just socialism? Doesn’t it just transfer wealth?
No. Conservatives define socialism as a swear word. Then all they have to do is tack the socialism label on something and then dismiss all discussion about the topic as something contemptable.
Socialism curtails the private ownership of property. Socialism exists across a spectrum from Communism, where the government owns all property, to pure capitalism, where the government owns no property. Most countries, even those who consider themselves strongly capitalist, have socialist elements.
The next time you encounter the socialism label, ask the labeler the nature of the private property confiscation.
If your concern is confiscation of property, why not talk about the banking system that has confiscated the government’s ability to create its own currency. That means that every dollar you have in your pocket or bank account comes at the expense of someone borrowing it from a bank.
The proposals found in this website mostly describe how money works. Government spending or distribution doesn’t inherently impact property ownership. Sovereign taxation is necessary under any system to prevent excess creation of money which triggers inflation. The system ensures that money moves from the poor to the rich with an ever growing pool of poor people. Progressive tax methods can slow down the accumulation of money to the rich, but over century long time frames, the outcome is inevitable.
This website may address other aspects of social engineering in the future, but for now it primarily addresses the role money plays in the economy. Money fuels the economy. It is most efficient when there is a smooth flow of money into and out of the economy. There are much better ways of introducing money into the economy than through controlling interest rates.
The most efficient flow of money through the economy is to inject it at the bottom of the economic engine and extract it from the top. Creating a Universal Basic Income (UBI) program and a jobs program creates an efficient way of achieving the injection at the bottom of the engine. The tax structure needs to change to efficiently extract it from the top. Taxing income and sales are inefficient. Then there is still the problem of exponential growth in demand for money, even with these tax and money injection changes.
I still think capitalism is the best method of structuring an economy. The concentration of each sector of the economy into just a few corporations is of concern. Also, corporate takeover of government ignores the will of the people.
You have mentioned changing the tax structures. What would change?
Taxing income and sales removes money before the consumer has a chance to spend it. If the wage earner were able to spend all of their wages, economic activity would increase.
There should be two major sources of taxation–a tax on money as it sits idle in bank accounts and a tax on every exchange of money (every money transaction). While a tax on money transaction is similar to a sales tax in that it costs money at the time of a sale, the major advantage is that it would target those that normally avoid paying taxes. Also, the shear volume of transactions would only need a small tax rate to collect enough money to balance the budget. Financial money transactions would also be part of this transaction tax; in fact, since those only churn money, the rate should be higher on any transaction that does not touch the productive economy.
For most people, when they get paid, the money is parked in bank accounts. These pools of money are reserves for use at other times for future purchases or investments. Since money needs to be removed from the economy, taxation should target money while it is parked.
On any day the money is sitting in the bank, it is idle. By collecting the tax daily, those with small bank balances would never need to pay a tax because the government usually ignores taxes that are less than a dollar. The rate would be so low that you’d need something on the order of $10-20 thousand before the daily tax would exceed a dollar.
Since these bank balances are already digital, a slight change to bank programming would allow the banks to collect that tax and pass it on to the treasury.
Nearly every transaction already incurs fees of some kind. The transaction tax would be just another one of those fees that would be collected.
Income taxes would be eliminated. Those complicated tax forms that allow companies and individuals to claim they aren’t making money, (as their bank balances balloon) would go away. IRS agents could avoid poring over tax return details to find cheats and instead can spend their time finding people who are hiding their overseas bank accounts or avoiding transaction taxes.
For those hiding money in overseas accounts, perhaps some method of adding a serial number to those funds could collect taxes when they came back into the country. Or, maybe a fixed (high) tax on money coming back to make up for back taxes. Or maybe the tax on bank accounts can be made low enough that people don’t need to hide it overseas. Increase the transaction tax to make up the difference.
Corporations and wealthy individuals would be forced to pay their fair share of taxes. The tax would be a flat percentage for everyone. There would be no need to create progressive tax rates. Those with higher amounts in their bank accounts would automatically pay more in taxes. Those who move large amounts of money would pay higher taxes even though the rates are flat.
Changing taxes isn’t a complete solution. We still need to tackle the creation of money as debt to fully solve our economic problems. Changing the tax structure might buy enough time to fully analyze our economic options.