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Nairobi Business Monthly
Home»Money»Changing current monetary system only way towards a sustainable economy
Money

Changing current monetary system only way towards a sustainable economy

NBM CORRESPONDENTBy NBM CORRESPONDENT7th September 2017Updated:23rd September 2019No Comments9 Mins Read
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It is well enough that people do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning. – Henry Ford

BY ANTONY MUTUNGA

Long before the existence of governmental monetary authorities and financial institutions, the people used to save up their valuables by depositing them with the goldsmiths who would then issue them notes. In time, these notes turned into a medium of exchange and people would exchange them for the commodities they needed. As time went by, the goldsmiths who stored the valuables for a storage fee became the early bankers. They started making investments and giving out loans while still holding some reserves, which was a fraction of the deposits, thus leading to the existence of the fractional reserve theory of banking.

The Nairobi Law Monthly September Edition

In this banking system, banks would be able to create money collectively but each individual bank would only act as a financial intermediary. This was the dominant view until the 1960s when a new view came into play. The view stated that banks are only financial intermediaries, either individually or collectively, and they have no power to create money.

This was dubbed the financial intermediation theory of banking. The banks, under this view, had the power to only gather and re-allocate resources. They had a similar function to non-banking institutions except for when it came to their governing rules and regulations.

Nowadays, people believe that all banks do is take in deposits and from the deposits they let people borrow a fraction of the total amount deposited while leaving another fraction which acts as a reserve. However, after the global financial crisis of 2007/08, it was clear that this view was not entirely true. The global financial crisis brought into light a view, which differed from the financial intermediation theory, showing that private commercial banks were able to create ‘new money’ (electronic deposit money) which was not backed by anything. However, it was in line with the fractional reserve theory except for the fact that in the view banks would create new money individually. This view was referred to as the credit creation theory of banking and even though it has been around for a while, it is just beginning to hit the mainstream.

The view maintains that banks create new money out of nothing when they are giving out loans. It states that when one is approved to get a loan, banks do not transfer money from an internal/external account rather they tend to invent new money out of thin air, which is then credited into the borrowers’ account. Vincent Mutua, an economics professor at Jomo Kenyatta University of Agriculture and Technology says that in the current era, loans make deposits and deposits make loans because when one takes a loan from one bank they usually end up depositing it in another bank.

This has been supported by Modern Money Mechanics, a book by the Federal Reserve, which states that the actual process of money creation takes place primarily in banks. Checkable liabilities of banks are usually money. These liabilities are customers’ accounts. They increase when customers deposit currency and checks as well as when the proceeds of loans made by the banks are credited to borrowers’ accounts. Simply put, real money creation mostly takes place after banks loan out to the broader economy.

Even though private banks are able to create the electronic money basically out of nothing, they still have a limit, which is dependent on regulator policies and the competitive markets. In addition, the behavior of the consumers also constrains them from surplus money creation as some people use their money to repay up loans. However due to poor oversight from the regulation authorities, private banks do not always limit money creation. For example, during the global financial crisis 2007/8 the private banks became greedy and they created a lot of electronic money in the name of making profits from the interest rate of the loans they had issued. These loans caused the economy to have more electronic money in circulation than physical cash (paper notes and coins). In the United Kingdom for instance, only 3% of the money, about 60billion euros, was in the form of physical cash while the rest, 2.1trillion euros, was in electronic form.

Before the crisis, private banks were giving out loans to any person regardless of their financial positions including the unemployed and drug junkies. The money created was mostly loaned out to people in terms of mortgages, which saw billions of money being pumped in the real estate sector as well as the financial sector. However, because banks prefer speculative investment more than productive investment, less money was lent to the small and medium organizations, which usually have profound economic consequences for the society.

The more money was created and pumped into the real estate sector, the more the price of the houses was increasing hence leading to a bubble. This led to an increase in the level of debt as well. Still left with interest rates to pay and with the level of debt rising faster than that of incomes, a lot people ended up finding it difficult to pay up their debts creating, as a result, an economy where most people lived on debt. Eventually, in the long run some people ended up defaulting which put the banks in danger of bankruptcy.

As a result, banks were forced to reduce their lending to people and firms. This reduction in issuing out loans caused prices in the market to start falling which led the people who had taken up loans, expecting their prices to rise, to start selling their assets so as to repay their loans. Banks had no other option but to limit making new money further which caused the economic growth to reduce leading to recession.

As the economy experienced a recession, the private banks refused to give out loans, causing there to be less money in the economy. With the banks creating less money than the amount of money being repaid back from the loans, it caused money to disappear from the economy. This is because the same way that banks created money by giving out loans, the repayment of the loans causes the money to be destroyed.

With less money in the economy, people had to reduce spending which led to businesses making losses causing the economy to slow down further. Wages and prices of commodities started to fall while the level of debt remained the same in terms of value. This ended up affecting a lot of people because it left them in debt, creating an economy dependent on debt to grow. This created a major problem for the economies; as for them to grow they had to create more money and to do so it required people to go further into debt thus creating a debt trap, which ensures that the personal debt keeps growing since without this, the economies end up going into recession.

Whenever a recession occurs, it causes instability in the business sector that result in losses and in worst-case scenarios, collapse. In order to cut costs, businesses end up laying off employees and usually the first to be affected are those who have low paying or temporary jobs. Unemployment will resultantly rise in the economy leading to a further decline in growth.

In addition, as banks create new money in the economy through giving out loans, there has to be someone paying interest rates for them. This burden usually falls on the bottom 99% of the population who usually need the loans to better their lives. The small businesses end up working to pay up their interest rates instead of contributing towards the economy. This causes the economy to lose money to the financial sector. On the other hand, the money collected as interest rates ends up as profits for the banks, who are incurring no production cost, thus the top 1% of the population keeps getting wealthier while the poor end up in more debt.

Apart from encouraging inequality, the power to create new money by banks has by some extent affected the environment in the long run. For example, in order for the borrowers to repay their loans they need to make money by producing goods or services for sale. Since there is a time limit on repaying the debts, borrowers are usually incentivized to pursue activities that are able to produce quicker results. In some cases, for instance in a manufacturing company, this usually leads to the use up of resources faster than expected as well as impromptu production which might lead to environmental pollution, because the company doesn’t focus on their waste products rather they focus on increasing production. As banks only care about their profit and borrowers want to get out of debt, the environment tends to get the short end of the stick.

The power to create money leaves the people at the mercy of the banks; the financial sector has become so powerful because it has no legal obligation to use the power in the interests of the people, making it unaccountable. This has given banks the power to control the economy in their favor, which has seen them over the years make abnormal profits thus they end up hoarding all the real money.

Therefore, there is a need to make a law that takes away the power to create new money from the hands of the commercial private banks and take it to the central banks. The same way that central banks create paper notes and coins, they should also be in charge of making electronic money and leave banks to only act as financial intermediaries. This would ensure that the money goes into the economy through productive investments by the governments as compared to speculative investment. The new money also needs to be backed by something just as cash used to be backed by gold before. There would be no making money out of thin air as commercial banks do now. Instead the money can be backed by renewable energy, which unlike gold is in abundance.

Leading into a time that the world is expected to face certain challenges such as increased population, food crises and climate change, there is going to be need for a good and stable money system. With the current monetary system proving to be from the people, without the people and against the people, it is clear there is a need for change. The monetary system needs to work for the society and the economy as a whole.

The Nairobi Law Monthly September Edition
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