The following will be broadcast on Perspective sometime before Christmas 2008.

Most people do not realise that some banks literally “make money” by giving loans without having money on deposit. The system is called fractional reserve banking and is used in most economies. It sounds as though it is safe because it says that banks have to keep a fraction of their deposits with the Reserve bank. What it means is that for every $100 in initial deposits a bank can lend $90. However this $90 is deposited in the same bank or another bank and another $81 is then loaned. Do this enough times and the first $100 turns into $1000. In Australia the first $100 of new money is created by the Reserve Bank and the next $900 is created by the commercial banks.

We create a lot of money. Last year we made $170 billion dollars out of thin air. This was up 12% from the previous year and is about $8,000 for every person in Australia.

This method of creating money leads inevitably to booms, busts, recessions, depressions, gyrating currencies and inflation.

To illustrate why this is so let us look at the way banks make loans.

Banks only lend money to people who already have money or who have assets. When you borrow money to buy a new house the bank is not concerned too much about the house value but more about your future earnings. The main criteria banks use for deciding whether to lend money is whether you are likely to pay it back and they make no distinction between lending “old money” or “new money”. If it is new money you pay interest even though there is no asset backing the money. Interest is meant to be a rent on an asset that money represents. As there is no asset earning money to pay the interest the system creates more money to pay the interest which in turn requires us to create more money to pay interest and so on. This leads to inflation.

The second problem is asset inflation. Remember banks will loan you money if you have an existing asset. If you already own a house the bank will lend you money for a second house if you use the first house as collateral for the loan. You do not care that the first or second house is overvalued because you expect both houses to increase in value and pay the interest on the loans. The government does not care if the prices inflate because they collect more taxes the higher the value. The banks do not care as they get money from interest.

Like all pyramid selling schemes sooner or later the bubble will burst. Banks now reduce lending because asset values have dropped. This leads to recessions or depressions.

Everyone wins except the last people to get a loan before the bubble bursts but they were active participants. The people who suffer the most are those with few assets or money because their sources of income dry up and they were not even involved.

The problem is not a lack of money. The problem is lack of assets because new money was not spent creating new assets. The system has failed us.

There is a solution and that is to treat new money differently from old money. Let banks only lend money if they have it on deposit.

Let the Reserve Bank, under the guidance of the government, take back control of creating new money and let it lend it at zero interest to citizens who agree to invest the loan in productive infrastructure. Let the loan be paid back from taxation on the income of the citizens who invest in productive infrastructure.

There are many ways this can be implemented and here is one.

A voluntary community organisation, open to all citizens, asks the Reserve Bank for a large zero interest loan and promises to spend it on public transport infrastructure. The loan is used to pay members a Reward each time they car pool either as a rider or driver. Rewards are converted into ordinary money when invested in public transport infrastructure such as building a bicycle way, interest bearing bonds in a light rail system, or a toll way etc. It is estimated that in Sydney alone each year there is a notional value of $100 billion in empty car seats and so the potential to issue car pooling Rewards to be later invested in infrastructure is enormous.

This can be repeated in other areas of the economy. We could give Energy Rewards to people who consume little mains electricity but require the Rewards to be spent on infrastructure to reduce green house gas emissions.

We could give Water Rewards to households who use little water but require their Rewards to be spent on ways to increase the supply of water to the community.

The scheme stabilises the financial system by creating infrastructure assets from new money before the money starts to earn interest. It will lead to zero inflation and eliminate financial booms and busts. It will stop the Australian Economy being held to ransom by the world’s financial markets.

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