James Galbraith and others prepared a statement to the US Senate Judiciary Committee, Subcommittee on Crime, apologizing for economists failure to effectively control for fraud in the financial system that led to the global financial crisis since 2008.  The fraud he described related to passing on of worthless financial securities (debt).

However, there is a greater injustice being perpetrated in the guise of legitimate financial transactions.  To appreciate that injustice, it is necessary first to understand the role of money in the economy. 

Money is a record of our entitlements and obligations.  A credit balance with a bank is a record of entitlements.  Similarly, cash is a record of entitlements.  These are current entitlements.  That is, when we spend our money (exercise our entitlements) we expect that money to be honoured.  

A debt with a bank is a record of an obligation. There cannot be an entitlement without a corresponding obligation.   

Silver and gold coins have been forms of money in the past but trade with valuable coins is closer to barter than trade with money in the form that we use it.  That is, trade using valuable coins is an exchange of goods (silver or gold for another commodity).  It is different from a trade of goods that arises from a transfer of entitlements to goods (money) or creates an obligation to supply goods (debt). 

Many people continue to consider modern money as the equivalent of gold and silver.  However, if money is badly managed, it quickly loses its resemblance to those precious metals.

To effectively manage money, it needs to be kept secure.  People who hold cash keep it secure to avoid it being stolen.  Also bank notes have security features to make them difficult to forge. 

Bank accounts are records of entitlements and obligations.  These need to be kept exceptionally secure.  They would be useless if people could alter their accounts so as to raise their deposits or reduce their debts.  Banks have an extremely important role in securely recording the entitlements and obligations of people and other entities.

Money serves an important economic role in constraining expenditure to income; consumption to production.  That is, the money we earn from producing goods and services for the economy entitles us to buy goods and services from the economy up to the value of the goods we supplied.  If we spend only the money we earn, we can never buy more than we have produced. 

This constraining function is an important role for money in the economy. This attribute of money is similar to other tickets and tokens.  For example, a ticket to a theatre must be constrained to the number of seats in the theatre.  If tickets were issued regardless of the capacity of the theatre, the people who had purchased the tickets would feel cheated if there was no room for them.  They would ask for a refund and would be reluctant to buy tickets to that theatre again.

Banks could abuse their role if they were to, say, register additional deposits in the accounts of their owners.  Accounting rules for banks do allow this.  However, the credit entry in the owners’ accounts would require a corresponding debit entry either reducing the equity of the owners in the bank or treating the deposit as a loan. 

If the debit entry were against reserves, the owners would be paying themselves the reserves that they already owned.  Rules on bank lending is often link lending to reserves so that banks that reduced their reserves would hamper their ability to continue to lend.  Hence there is an incentive for bank owners to constrain the amount they pay themselves in this way.

However, if the deposit registered in their account were treated as a loan, then the owners could spend it without necessarily hampering their other activities.  According to the bank’s books, the owners would be borrowing from themselves.  This may seem pointless.  But in the economy, the bank deposits would be entitling the borrower to goods and services from the economy without the borrower having to contribute to the economy.

If banks could, by a simple account entry, create deposits for people, then those people would be able to buy products from the economy without having first contributed products to the economy.  If that were to happen, the banks would be abusing their role in the economy.  

Yet bank credit is just that.  When banks lend, they enter a deposit into the borrower's account in exchange for a debt of a similar amount.  The do not take money out of anyone else's account to lend it to the borrower.  The deposit that the bank creates is an obligation of the bank and it is offset by an asset in the form of a debt from the borrower.  The bank's books are balanced.  Similarly, the deposit is an asset of the borrower and that is offset by the obligation in the form of a debt to the bank.  The books of the borrower are balanced, also.

As discussed above, money is a record of our entitlements. These are current entitlements.  That is, when we spend our money (exercise our entitlements) we expect that money to be honoured.  But the bank debt that created that money may not be a current obligation: it is most likely to be a debt payable at some future date.   

So while the bank is lending current entitlements, these are not necessarily balanced with current obligations.  That is, the bank's accounts are balanced while the economy's ability to supply products that are demanded are not.  In the long term, borrowers would have to repay their loans and the supply would increase then.  But until then, the bank is giving borrowers rights to goods without anyone being obligated to supply those goods.  

Bank lending is balanced if bank lending equalled loan repayments.  In that case, the current entitlements created by the loans would equal the current entitlements being removed from the economy by the borrower when they repay their loan to the bank.  

If new bank loans are greater than the loan repayments, the banks would be continuing to create additional entitlements without a surplus of additional products being supplied to meet these additional entitlement.  The banks would be enabling people to buy more goods than the country has produced. This is likely to cause current account deficits, reduce foreign reserves and/or raise foreign debt (see Figure 3). 

It is for this reason that throughout most of bank history, bank lending has been highly regulated and constrained.

In the US, following the expansionary spending of the Second World War, the growth of bank lending had been constrained in the 1950's, except for 1958 which was followed by constraint in 1959 and 1960.  In the 1960's, bank credit had been allowed to grow faster, followed by constraint between July 1969 and June 1970.  However, as shown in Figure 1, in the early 1970's  bank lending grew rapidly. 

Figure 1: USA - Annual growth of bank credit (Jan 1948 to March 1973)

Also, in 1968 and again in 1971 and 1972, the US government was experiencing large fiscal deficits, borrowing heavily from the banking system to finance the Vietnam War. Foreign capital investment appears to have increased at time, possibly to buy the government bonds as shown in Figure 2.  Hence the growth of bank credit is likely to have been the main cause of the collapse of the US gold reserves and the depletion of US foreign reserves.

Figure 2: USA - Bank credit, fiscal deficit, foreign owned assets and the current account deficit

Figure 2 compares the growth of bank credit, the fiscal deficit and the current account deficit.  Clearly the growth of bank credit is significantly larger than the growth of the fiscal deficit.  Therefore, it is likely to have a more significant effect on the current account balance.  Note that the rise in the fiscal deficit in 1968 and again in 1971 and 1972 had no apparent effect on the current account deficit. (Note that the difference between the growth of bank credit and the current account deficit represents lending that was offset by savings.  These savings were the exports greater than imports that would have been the outcome if there were no growth in bank credit.)

Whatever the principal cause, the combination of the fiscal deficit (which the financial market perceived as irresponsible fiscal policy), the growth of bank credit (lending greater than saving), the current account deficit and falling foreign reserves put pressure on the US government to close the gold window,  devalue and eventually to float the exchange rate which it did in March 1973.

As we have discussed, money is a record of income.  Floating the dollar meant that the money entering the US had to equal the money leaving the US.  In other words, the entitlements that the US earned from exports was required to equal the entitlements it spent on imports.  This had the effect of preventing the US from raising its earnings or income from exports without a corresponding reduction in earnings elsewhere as more money was required to shift from buying domestic products to buying imports. 

This caused the rate of economic growth to decline. As "high tech" industries increased their exports, the exchange rate adjusted to make imports cheaper and the competing US manufacturing industry collapsed.  What was once the heart of US industry was transformed into a rust belt. (See The Impact of Floating Exchange Rate System on Employment and Growth).

Yet most economists would consider the demise of manufacturing industry to be a fair and reasonable outcome  of an effective market.  They consider the current account deficit to be the outcome of people behaving rationally in their own best interests.  They consider the economy to be open to free trade and the exchange rate to be fair and reasonable.

The US has become dependant upon bank credit to increase the money supply and stimulate the economy. This is because exports no longer created additional money. Yet as we have seen, bank credit is a source of money that causes imports to exceed exports, leading to current account deficits that raise foreign debt. 

Most economists accept that it is reasonable to constrain the economy so that the money entering and leaving the economy must be equal.  But this means that trade is being manipulated to achieve that monetary outcome.  It is an outcome that prevents the economy prospering from trade and raises foreign debt.  It is an outcome that slows economic growth: making imports cheaper and local products uncompetitive.    

The economists that defend the current failing monetary system attribute the trade imbalances to the inefficiency and low productivity of industries and workers.  However, the trade imbalances, the collapse of industries and the rise of foreign debt is not the result of US industries and workers being unproductive or inefficient.  The industries in the countries that have displaced them have been less efficient and productive.     

The floating exchange rate system has stacked the cards against domestic manufacturing industries.  These industries, and the workers in them, are the victims of a system designed to prevent money entering the economy.  It is a misguided system that stops the economy prospering from trade.    

An economy without money created from export growth requires the banking system to be deregulated to create money to stimulate the economy.  However, as we have seen, the more money the banking system creates, the greater the current account deficits and the higher the foreign debt.  It also causes increased inflation.  This leaves those managing the economy in a dilemma, having to trade off economic growth with external and internal stability.  

Figure 3 shows the close relationship between the current account deficit and the growth of bank credit.  It is clear that the current account deficit does not follow the fiscal deficit. 

 Figure 3: USA - The source of excess demand creating the current account deficit

As people and businesses must hold money not only to purchase goods, but to pay both domestic and foreign debt, bank credit must grow faster than GDP just to sustain the economy.  If debt must grow faster than the rate of growth of the economy, it means that debt must be growing faster than the ability of the economy to sustain that debt.  This debt is unsustainable.  (See: Money and Unsustainable Debt.)     

As domestic debt grows and existing borrowers become saturated with debt, financial institutions must look for new borrowers.  That is likely to result in financial institutions lending to people who are less able to repay.  Banks need to keep on lending otherwise it will cause a recession. If there were a recession, then even more people will not be able to repay their debts.  They are caught in a Catch 22 situation.

We have seen that the banks have a significant role in the economy to keep money secure.  But they have abused that role, forcing changes to monetary policy that have been extremely damaging to the economy.  The growth of bank credit has affected the whole economy, turning it from prosperity into insolvency. This change is a far greater injustice than selling worthless financial instruments.

Bank credit must be managed to prevent the growth of bank credit in the economy from exceeding national savings.  Trade must be allowed to generate additional money and income for the economy. The alternative is likely to be slow economic growth and rising foreign debt.   

It is possible to change the monetary system and to do so without any great drama.  The optimum exchange rate system and the guided exchange rate system are examples of monetary systems that can be used to mange bank credit and the exchange rate in such a way that it lowers debt, raises employment and brings prosperity to the economy.  These systems are based upon policies that have been applied and proved effective.   

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Last update: 19 June 2010