Everyone knows that money is important. In some sense we all “know” what it is. We have some of it in our purses or wallet and more in our bank accounts. We use it to pay for things we want. We keep some in the bank so as to be sure that we will be able to pay for things later. Since the bank will give us currency when we ask for some of our money back, we think of the money that it holds for me as being an extension of what we carry with us. The fact that generally we use checks and credit cards rather than cash does not seem significant.
Many of us have assumed that the paper money in our pockets is made by the government. We see that it consists of “federal reserve notes,” but we have assumed that the Federal Reserve is part of the government. We earned it by working, and we spent some and saved some for a “rainy day.” Basically we have understood money as a medium of exchange.
We have supposed that the bank accepts our money partly for safe keeping but also in order to lend it to others. It pays us a little interest and charges the borrowers more. That has seemed reasonable and proper. If we have quite a lot of savings, we may lend some to a business or to governments in order to receive a higher rate of interest. Obviously, this is a different function of money, but we think of it as an extension of the use as a medium of exchange.
We try, when it is not “raining,” to spend less than we earn so as to be ready for the “rain.” It seems that other people and organizations should do so as well. For example, we suppose that except in emergencies, businesses and governments should also stay out of debt.
Although many of us have thought in these ways, we have also seen that the real world functions quite differently. Businesses are constantly borrowing money, and national governments increase their debts year after year with no obvious harm. Most of us give up trying to understand and leave matters to the experts.
Although I knew that I did not understand these things, I did not realize quite how mysterious they were until I worked with Herman Daly on what became For the Common Good. We employed Whitehead’s idea of “the fallacy of misplaced concreteness” as a basis for critiquing a number of the ways that standard economic theory employs its concepts. This fallacy is to treat abstractions as if they corresponded to what is fully actual. For example, economists speak of Homo economicus. This term designates those aspects of human desires and activities that seem most relevant to behavior in the market place. As long as this abstractness is fully recognized, this concept can be quite useful. But the tendency is to think that, by using this abstraction, conclusions can be drawn about all human behavior in the market place, and even about human behavior in general. This mistakenly attributes concreteness to the abstraction. In fact, the same people who, for some purposes can be understood as Homo economicus, for other purposes are better understood as Homo politicus or Homo religiosus. And the full actuality of individual people is not captured even when all of these abstractions are combined.
Money would seem to be an excellent illustration of the fallacy of misplaced concreteness; since we so easily view it as something that is valuable in itself, when in fact it has no “use value” at all; so I asked Daly to draft a chapter on it. His reply was that nobody knows what money is; so he was not ready to attempt such a chapter. The book originally appeared with no discussion of money.
This seemed a striking lack in a book on economics, and it increasingly bothered me. On the other hand, this was not a topic on which I had the slightest possibility of writing the initial draft. So I twisted Daly’s arm, and when we prepared a second edition, the most important change was the addition of an “afterword” on money.
Whereas most chapters of the book are joint products so that we could not divide the book into his chapters and mine, my contribution to this “afterword” consisted only of asking questions for clarification. The idea that money is debt was quite new to me as was the idea that commercial banks create money. My questioning led Daly to helpful clarifications, but the ideas it contains are mine only in the sense that Daly has persuaded me that they are basically true.
Daly taught me that banks can lend the same money over and over again and that in making each loan the banks increases the money supply. Of course, repayment reduces it. I now understand that the amount of money created by the loan is sufficient only to repay the principal, whereas the loan must be repaid with interest. The amount of interest may be as much as, or even more than, the loan itself.
Speaking in this way may be misleading since it does not make sense if we are considering a single loan. Obviously, the loan is not literally paid back with the money that is loaned. That money may be used to expand a business, the profits from which are used to pay both principal and interest month by month for many years. As long as the expansion of the business is successful, the owners not only make their payments but also increase their income.
To understand the problem of finding the money to pay the interest, we do better to think of all the money that the banks collectively lend in a particular year. The amount of money put in circulation is the amount of the principal of the loans. Now suppose that this amount was roughly constant year after year. In that case the amount needed to pay back the principle on all existing loans is being pumped into the economy, but there is nothing left to pay the interest. Some borrowers may have plenty with which to pay, but it is not possible that all do so. Unless additional money is pumped into the economy through additional loans, so that the money supply is growing, there will not be sufficient money in circulation for all borrowers to pay the interest on their loans. This means that the economy as a whole can survive only as there is substantial growth in the money supply, created by increasing lending. The economy will collapse if it does not grow.
Daly has emphasized that the human economy operates in the context of the inclusive planetary economy. The latter is not growing. Much increase in product is possible by technological improvements without increasing use of planetary resources. Standard economics teaches that scarcity leads to rising prices and this triggers technological improvements or substitution of more plentiful resources. Often this works, but there are limits, and price signals do not guarantee wisdom in replacing scarce supplies.
The reaching and surpassing of limits is in the news today with respect to oil. The demand for oil rises, but production currently does not increase to meet the demand. Part of the problem is temporary, due to political and military disturbances, for example. Also some oil is being left alone for environmental reasons. But few now question that supply will be unable to keep up with growing demand. The price is rising, and over the next years will almost certainly rise more. Some who have seen this coming have begun seeking substitutes and finding technological solutions. The pace now quickens.
However, the response thus far illustrates the tendency to solve one problem while creating others. Oil can be made from crops such as corn. The enthusiasm for ethanol has led to a shift from producing crops for food to producing crops for ethanol. But this “solution” to the problem of “peak oil” has precipitated or exacerbated the shortage of food. Ironically, in the past, food shortages were avoided by the Green Revolution, which has greatly increased the use of petroleum in agriculture. Now so much oil is used in the farming by which ethanol is produced that the net gain in fuel is not impressive, while the reduction in food production is causing vast suffering among the global poor.
The evidence strongly supports Daly’s insistence on the reality of limits against the standard economic view of inexhaustibility of resources. Almost everyone now recognizes also that the capacity of sinks to deal with our wastes has already been exhausted in so far as the gases responsible for global warming are concerned. There are limits to how much the human economy can grow. The level of consumption of Americans could not possibly be generalized to the global human population. It is true that there are types of economic growth that are not limited, but to aim at growth in general hastens the coming of catastrophe.
Daly has recognized that our economy as currently organized requires growth. He comments that it is like an airplane that has to move in order to stay in the air. But he argues that there could be an economy like a helicopter, one that could stay still while meeting all human needs. As I have begun to understand the monetary system, I have become convinced that this must be radically changed if we are to move toward a steady state economy.
Currently almost all the creation of money is by commercial banks lending money into existence. This is why Daly and others have said that, today, money is debt. The banks must continuously increase the money supply in order for this system to work. That requires growth. If banks were nationalized so that the profit from creating money came into the government’s coffers, there might be many advantages. But if the banks continued to charge interest, the system would still require growth. The goal of a steady-state economy could still not be reached.
Is there an alternative?
There has always been another way in which the money supply can be increased. That is by the government spending new money into existence. This money is not to be repaid and requires no interest. If the government decides to improve the infrastructure, for example, it can pay those who do the work and supply the material with new money. There is no increase in debt and hence no requirement of interest.
This does not mean that taxes are never needed. If the government spends more money into existence than is required by the economy, there will be inflation. Some governments have caused runaway inflation in this way. There is then need for taxes is to avoid inflation. They can also be used for redistributive purposes. Taxes can also discourage use of scarce resources and encourage the development of alternatives. But to whatever extent the increase of the money supply by the banks is reduced, a similar increase in government spending of new money is not inflationary. Further, since this money is interest-free, there is no need to expand the money supply in order to provide funds for future payments.
To overcome the problems caused by the payment of interest on loans, one might propose that we follow the biblical mandate and forbid all interest. However, there will always be a need for borrowing money, and despite the problems connected with it, there are good reasons for charging the borrower interest.
Maintaining a system in which money is loaned at interest does not have to mean continuing to create money in this way. It is possible for people to pool their surplus funds for the purpose of lending them at interest, and it is possible for institutions to manage these. This does not increase the money supply. Limiting their loans to the amount of their deposits would not end the need for the creation of new money to pay the interest. But it would avoid the need to pay interest on the money borrowed to pay the interest. The money expansion would be interest free. Over time this would reduce the need to borrow, or at least it would stabilize this need at a more or less constant level. A financial system of this sort could operate within a steady-state economy.
Lending institutions of this kind could be run by the government, and around the world many are. However, one argument against nationalizing all banks is that then all borrowing would have to be from one source, the government. Favoring those who support the government would probably follow. In money-lending, as in other fields, competition is desirable.
Assuming that only the national government has the right to create money, governments at other levels continue to face problems and be caught in the cycle of interest payments requiring more borrowing. Advocates of shifting away from the debt economy propose that the federal government make long-term loans to state and local governments, especially for infrastructure, without interest.
Currently local governments recognize many needs that they cannot afford to fulfill. The infrastructure backlog grows steadily. Interest free federal loans would quickly reverse this unsustainable situation.
For example, a city may see the need for a subway to reduce dependence on automobiles and reduce congestion. Suppose the cost will be a billion dollars, and revenues can be expected to be sufficient to make payments of $30 million a year. A commercial loan over 20 years at 6% will require annual payments of $85 million. The city cannot afford the subway even if economists calculate that the citizens will save more than that from reduced need for private cars, reduced pollution, and time saved. If, however, the national government provides a 50 year loan charging only the cost of managing the loan, payments will be closer to $20 million a year. The subway can be built with money that is gradually spent into existence. (I depend for these figures on Richard Priestman, “Municipal Cash Crunch,” in Comer, June 2008, p. 4.)
The questions about who creates money and how it is created should be a part of mainstream political discussion. In this paper I will supplement what I learned from Daly with what I have learned from Ellen Hodgson Brown’s The Web of Debt, (Baton Rouge, LA: Third Millennium Press, 2008) about how money creation in the United States came to be completely privatized and, therefore, how money came to be equivalent to debt. If a financial system in which money is debt cannot be fitted into a steady-state economy, an alternative should be considered.
Brown shows that in the earlier history of the European settlement in North America, the importance of how money was created was much more widely recognized than it is now. Some of the American colonies before the Revolutionary War created money and attained considerable prosperity thereby. Benjamin Franklin was a major proponent of this style of financing government expenditures. In 1764 the Bank of England persuaded the British Parliament to forbid the colonies to issue their own money. This had severe economic effects, which had more to do with revolutionary feeling than the small tax on tea.
The Continental Congress financed the American Revolution by creating money.
In the end, the Continental currency lost its value, and this means of financing governmental expenditures lost favor. “Not worth a Continental” became a common description of what was worthless. However, some who have studied what happened note that part of the British strategy was to destroy the value of the continental currency by flooding the market with counterfeit. This strategy certainly made a major contribution to the decline of the value of the currency.
Abraham Lincoln financed the Civil War by issuing greenbacks. This was “fiat” money, similar to that issued by the Continental Congress. It was spent into existence and created no debt. Again there was considerable inflation during the war, but whether inflation would have been less if Lincoln had borrowed the money from banks instead is by no means clear. Since during war much productive facility is directed away from the general economy, some inflation is hard to avoid.
Opponents of “greenbacks” were aided by the “common sense” view, which they cultivated and promoted, that money should be backed up by some physical reality with real value. Gold was the preferred back-up of the banks. Because of the scarcity of gold, money creation was restricted. A major political issue was whether the United States should shift from the gold standard to the silver standard. William Jennings Bryan campaigned tirelessly for this change which, he thought, probably correctly, would make money more plentiful and ordinary people more prosperous.
Public opinion had been against a central bank, but a banking crisis in 1907 opened the question to serious discussion. This crisis may have been manipulated by the bankers themselves. In any case, to take advantage of the new public mood, in1910 leading bankers met on Jekyll Island and drafted proposals for a central bank that would be largely controlled by Wall Street. However, neither Congress nor the president was ready to implement the plan at that time. Woodrow Wilson was friendlier to banking interests; so his election in 1912, also partly engineered by the bankers, created a more favorable situation.
Congressional support depended on approval by Bryan who was deeply suspicious of the bankers. The bankers proposed a new bill just before Christmas in 1913. Its language was very technical and confusing, and Bryan was duped into thinking that “the right of the government to issue money is not surrendered to the banks; the control of the money so issued is not relinquished by the government.” (Quoted in The Web of Debt, p.125) With his support, “the Federal Reserve Act” was passed on Dec.22, 1913. It was signed by Wilson the next day. At the time, Wilson did not fully understand the implications of the bill. Before he died, he said: ”I have unwittingly ruined my country.” (Ibid. p. 126)
Bryan and Wilson are not the only ones who have been misled into thinking that the Federal Reserve Bank is an arm of the United States government. In fact, it consists of twelve regional banks owned by the commercial banks in each region. These banks jointly own the whole system. The Federal Reserve Bank of New York owns 53% of the stock, and of course the Federal Reserve Bank of New York is controlled by the largest banks there.
What led Bryan to think that the creation of this system did not transfer power over the economy to the commercial banks was in part that the Secretary of the Treasury and the Comptroller of the Currency both sat on the Board. In fact, commercial banking interests were clearly in control.
Franklin Roosevelt blamed the banks in large part for the depression and changed this pattern of governance of the Federal Reserve. He replaced the existing structure with a seven-member board of governors appointed by the president. This in principle gives the elected administration considerable power, although, to protect the board from undue political influence, members were appointed for fourteen year terms. Roosevelt himself used his power to appoint persons who would not undercut his program, and assuming that the Board would work with him, he increased its powers.
There were congressmen at the time who called vigorously for the issuance of money by the federal treasury to replace borrowing from the banks. Roosevelt, however, did not use the legal power of the treasury to spend money into existence as had the Continental Congress and Lincoln. Instead, following the desire of the banks, he financed his efforts to spend the nation out of depression by taxes and borrowing. This pattern has been followed by subsequent administrations and, as a result, the national debt, which was $22 billion in 1932, rose to $8 trillion in 2005. Roosevelt’s acts left the Federal Reserve Board strengthened, but he failed to overcome its close connection with the New York banks.
No subsequent administration has tried to spend money into existence instead of borrowing from the banks and paying them interest, although there are indications that Kennedy contemplated some such move shortly before his assassination. In any case, one of the first acts of Johnson on assuming the presidency after Kennedy’s assassination was to take the government completely out of the money-making business by replacing all treasury notes with those of the Federal Reserve System. The take-over by the banks was then complete.
The Bank of Canada, in contrast, is an agency of the government. Through it, Canada paid the costs of World War II in large part by creating money, and it financed social programs in the subsequent years in the same way. However, the influence of the banks has led to severely circumscribing governmental money creation in Canada as well, so that the government’s ability to maintain the services that it earlier offered is in question. Bankers complain that for the government to spend money into existence is inflationary, and they have persuaded the legislature to limit this practice.
Once the government turns over money creation to the banks, it becomes one borrower among others. However, its debt is endlessly rolled over. The problem is only that the interest must be paid. If the budget had not vastly expanded, it would have been totally overwhelmed by payment of interest on the national debt. Here again the debt system requires a growing economy in order to continue. Even so the cost of interest payments is growing more rapidly than either the economy as a whole or the budget as a whole.
Matters are further complicated by the fact that more and more of the debt is owed to other countries, which thereby gain considerable power over our national finances. If China stopped buying U.S. debt, and especially if it unloaded its huge holdings, the results would be highly inflationary. The dollar would rapidly lose much of its value. Since the value of Chinese holdings would shrink with the dollar, and since the United States would no longer be able to buy the products of Chinese factories, China is not eager to ruin us. But it has a huge threat to hold over our heads in the power games that nations play. Also the interest on the debt exacerbates the American balance of payments deficit.
I have argued that ending the power of the banks to create money and reassuming the government’s ability to do so is required in order move toward a steady-state economy. Obviously that argument will not move many, especially among economists, to support this change. As of now, the steady state economy does not have a mass following!
For this reason it is important to emphasize that there are other reasons for making this move. Massively increasing the national debt each year is not sustainable. Neither is the neglect of the nation’s infrastructure. Nor, I think, is the concentration of wealth in fewer and fewer hands. If it became widely recognized that these problems are caused, or, at least, exacerbated by the privatization of the creation of money, the possibility of the government’s retrieving that power might become a topic of public debate. That would be a gain. If the financial condition of the nation becomes sufficiently critical, some administration might lead in taking the needed steps.
Many might favor this move precisely for the sake of renewing the growth of the economy. The question of how to use the new economic possibilities would be a quite separate issue. Nevertheless, the situation would be far more favorable for this second discussion. At least the outlines of the further changes that would be needed for this purpose would be discernible in that context. In a world in which the consequence of transgressing limits has become inescapably visible, there would be a chance of getting a hearing for these next steps.
This is a chapter from Herman Daly Festschrift (e-book).
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