8/26 (五) 7:30pm Our World Balances on a Sea of Debt

Who creates money?
Is our economy based on the actual value of goods and services exchanged?
Do governments have any real control over the economy?
How does economic ‘growth’ actually work?

Instead of our usual series of questions to think through an issue, This week and next week I would like to study two article written by Darius Guppy for the Telegraph, a British newspaper, that was published in February, 2010. The points he makes are quite similar to an idea brought up earlier this year when we were discussing Time Banking, the idea that if your economy is based on interest, it means that it is based on permanent growth, which is ultimately unsustainable, considering that the planet has a finite amount of resources.
I’ve made a summary of the article, as he uses quite educated English to make his points. The original article can be found here.

Darius Guppy was educated at Eton and was a member of the Bullingdon Club, of which David Cameron (prime minister of Britain) and Boris Johnson (Mayor of London) were also members. He was once a close friend of the brother of Princess Diana, Charles Spencer, but later Guppy became angry at him and broke the friendship. Guppy now lives in South Africa. The articles he’s written have been dismissed since he was once put in jail for insurance fraud, but I think they’re the clearest descriptions I have yet read about what is going on in the finance system.

The summary:
Our current money system is a global fraud—a pyramid scheme in which the people at the bottom are giving money to the people at the top. We need to do a systematic re-evaluation of money, how it is created, how it circulates within an economy and how it can best be used to serve the interests of the community itself. But first we need to understand how it is that money actually works.

First you must understand the difference between ‘money’ and ‘legal tender’. Most people believe that money is created by the State. This is wrong. Governments create ‘legal tender’: the physical notes and coins that circulate in an economy, which is only 3 per cent of the total money in circulation in the global economy. The rest of the money is created by commercial banks.

Here is a simplified example, to show how banking originally worked. Imagine a goldsmith-banker who has a vault. In this vault ten of his customers each deposits a bar of gold weighing 1 kilogram - for safekeeping and in the hope of a return for lending it out. Classical economic theory says this banker fulfils a useful social function—bringing together those who have a surplus of money with those who don’t have enough, but who have the energy, work ethic and vision to make a profit for all concerned. So the banker lends out the ten gold bars, and the profit means that there’s an eleventh gold bar within a year, to pay the original investors.
This process, which depends upon economic ‘growth’, continues to be refined, in logical ways. It’s too difficult to keep gold around, and it’s heavy to transport. So the banker comes up with the idea to create a token, which is itself valueless, like a piece of paper, that represents a given quantity of the gold. This token can then be circulated and exchanged within the economy in a manner that is relatively hassle-free. (Historians credit one of the first examples of such an instrument – the cheque – to the Knights Templar. In this way, a pilgrim could encash a cheque drawn on a European preceptory at a Templar branch in the Holy Land.)
So far so good, as long as for the face value of the pieces of paper in circulation there’s a corresponding amount of gold somewhere in the real world. The virtual economy reflects the real economy.
But then the banker and his friends take an imaginative leap. In the bankers’ experience, the people owning the paper, the tokens rarely claim the gold their paper represents. So the banker thinks, “Hey, it doesn’t matter how many pieces of paper we create to represent each kilogram of gold. If for this one kilogram of gold we issue 10 pieces of paper to ten different clients, each representing one kilogram of gold, as long as two people don’t come to the bank on the same day demanding the gold, everything will be alright.

All they have to do is create a culture of confidence, so that people feel secure that their paper can turn back into gold any time they like. So they give names to their institutions such as ‘prudential’, ‘guarantee’, ‘trust’, ‘security’, ‘fidelity’ and so on.

The reader will appreciate the beauty of the scheme: for now, instead of earning interest on a single piece of paper our banker can earn interest on ten such pieces of paper! Moreover, whilst charging interest on these ten pieces of paper, he has only to pay out a reduced rate of interest on the single gold bar that has been deposited with him!
And, incredibly, this is indeed exactly what happens.
Currently the average fractional reserve requirements for banks amount to under 10% which means that for every dollar (or equivalent) the banks have on deposit they can lend out at least ten such dollars – virtual dollars which they summon from nowhere – and on which they charge interest.
Just as incredibly, this fact – the key to understanding how the international financial system actually operates and why the world is in such a mess – is discussed virtually nowhere in mainstream circles: not in The Financial Times, not in The Economist, not in the broadsheets, not in Parliament, not in the City and not in the economics departments of most Universities.
Either they don't know, which means they do not understand their business, or they do know, and deliberately don’t share this information.
So supposedly ‘sovereign’ Governments – representative of their people, at least in theory – do not control the single most important mechanism when it comes to their economies: namely the production and distribution of money. That role has been given to the banks which manufacture money out of nothing and charge interest on that conjured-up money. Governments actually have no real control of their own economies.

Of course it’s even more complicated now. We don't even use paper any more, just electronic numbers on a screen. And ever more complicated financial instruments are created. Collateralised Mortgage Obligations, Put and Call Options, Floating Rate Notes, Preference Shares, Convertible Bonds, Semi-Convertible Bonds and endless other ‘derivatives’ – in essence these additions constitute mere variations of the same basic Three Card Trick.
The virtual economy has become so far removed from the days when wheat landed on the docks and merchants met in coffee houses and bazaars to haggle over things they could feel.

Now, you can argue that money is created by creating loans to the banks clients, and so that money is destroyed when a loan is repaid, but the interested on that money remains within the system, and it compounds. So money grows exponentially while the wealth it is supposted to represent cannot grow at the same pace for very long. In short, while there is no limit to the number of zeros we can create on a computer – zeros which represent claims on us and on what we own - there is a very real limit to the amount of oil in the ground, the amount of wheat in the fields and the amount of livestock in our farms.

In the 16th and 17th centuries the discovery of continents and the economic explosion of the industrial revolution helped the real economy keep pace with the virtual one. But there comes a day when the resources of the world cannot match the amount of compound interest in the virtual economy.

This is not only true for banks but for the finance industry in general. A company makes a certain profit; a multiple of many times can be applied to that figure to arrive at a ‘value’ for that company (the price-earnings ratio) – based, as ever, on the assumption of future growth. That value can then be leveraged yet further for it to raise debt against its share price and so on and so forth. Taken to ever more ethereal extremes, this means that a single company with nothing more than an idea to be applied to the internet and a turnover less than your average Fish ‘n Chips can create yet more tokens – share certificates - worth several times the entire annual production of diamonds for the continent of Africa, a process known, retrospectively, as the dotcom bubble.

There are a couple of points to be made about our system.
First, this system is in effect a redistribution mechanism from the poor to the rich which is of course precisely why the banks and Western Governments are so desperate to ensure its survival and the hegemony which results from it. This includes the idea that an institution is ‘too big to fail’. Basically, the bigger you are, the more money people will give you, or be forced to give you.

Second, such a system relies entirely, as do all Ponzi schemes, on the assumption of continued growth, hence its inherent instability. Once that growth is threatened the edifice collapses. So: lend ten times more money than you possess and when the economy grows – or at least pretends to grow – Porsches galore, but when the lack of growth is exposed it requires only 11% of the loans on your books (in value terms) to be bad and you are bust. The truth is not that these institutions have suddenly become insolvent, but that they were never really solvent in the first place since the assumptions on which they were founded could not apply in the real world. Simple false-accounting has meant that by rolling over their debts they have been able to keep them on their books as ‘assets’ rather than losses and forestall the evil hour.

So it doesn’t matter what ‘remedies’ are put in place by the government, they’re basically a totally inadequate band-aid. Politcians, financial journalists and the financial industry fail to grasp what is in fact a simple and devastatingly effective swindle, a swindle largely invisible because it has become so deeply embedded in our culture. The consequences of this swindle are huge: the desperate need for economic growth, the consumption and the wastage, and the environmental and cultural despoliation. We need some radical thinking to get us out of this mess.