Money tokens can be exchanged for goods and services.  These money tokens can be physical (coins, notes) or they can be electronic. When we accumulate tokens we can either spend them or we can lend them to someone else.

Banks are places where we can put money tokens and the bank lends them for us to others. Banks takes a commission on the loan interest for arranging the loans.

If someone comes to a bank and wants a loan and the bank does not have enough existing deposits to make a loan it is permitted to create new tokens and lend them out.

This system means that money can be created to match the demand for loans.

This system works well but it suffers from the problem of regulating how much money is created for loans.  If there was no limit on the banks then banks would simple create money and lend it.  This would clearly not work very well because banks would create much more money than was needed and we would get inflation.

Banks are limited and constrained in how much money they can create. The first limit is that they must have more money on deposit than they have loans outstanding. This is called the fractional reserve.

The second limit is that banks are not permitted to make a loan unless the borrower can put up some collateral that can be sold if the borrower is unable to repay the loan.  Collateral is normally in the form of assets that can be sold.

Thus theoretically the number of loans outstanding should be less than the total assets.  However, people with assets may not wish to borrow money against those assets. They might prefer to keep the assets unencumbered by debt.  This is particularly the case when the returns on the assets are not sufficient to meet the cost of the loans.

What happens in real economies is that the controller of the currency solves the problem of not enough money tokens or not enough loans by lending to itself.  Governments increased the money supply by borrowing money secured against future taxes. These borrowings are called bonds.

Banks are also given the privilege of lending to each other where the money created is backed by loans of the borrowing bank.

What this means is that even if there are not enough money earning assets to secure the loans then the banks can create extra money by getting a loan from another bank but securing the loan with its loan portfolio and/or deposits.

A loan backed by another loan is called a derivative. It is the backing of loans by other loans that has caused the explosion of debt and the creation of many times more loans than there are physical money earning assets.  The problem has been compounded by the use of other derivatives or “financial instruments” that permit the creation of loans without the backing of money earning assets.

The problem of the explosion of debt is caused by financial institutions being able to increase the money supply through any form of derivative.

The solution to the problem is simple.  Instead of increasing the money supply through the creation of interest bearing loans we can increase the money supply through the creation of interest free loans.  It is cheaper and less expensive to increase the money supply with interest free rather than interest bearing loans.  This means the use of derivatives to increase the money supply will fall into disfavour.  Derivatives and other financial instruments will still exist but they will tend to use existing money not create extra money.

The problem now becomes how to distribute interest free loans and for what purpose.  A solution to this problem is to be found in using the loans for projects that increase the wealth of the community but which are often deemed “uneconomic” because the returns cannot cover both the repayments and interest charges.  Such projects are any long term, long lasting investments where the returns comes over many years.  These projects are typically called infrastructure investments and include.

  • Education investment where the returns are over the life of the person receiving the education.
  • Roads, Rail, Ports, Public Transport and other physical transport infrastructure.
  • Power generation and distribution.
  • Power saving investments
  • Health investment particularly for young people.
  • Communications infrastructure such as broadband services.
  • Long term housing where the buildings will last decades.
  • Water distribution, water saving and water storage systems.

Areas where we should not use interest free loans are for consumables like clothes, food, vacations, cosmetic surgery, palliative care, entertainment, insurance, finance costs, administrative costs, or for any investments where we have enough supply to meet demand.

Interest free loans should be distributed widely throughout the community and there should be an incentive to encourage behavioural change to the granting of the loans.  Examples are

  • education loans to students who have achieved grades that show they can take advantage of an education experience.
  • loans for water saving purposes to people who already consume little water.
  • loans for energy generation and energy savings to people who consume little energy.
  • loans for broadband to people who agree to use the broadband when it comes past their home.
  • loans for housing to people who do not have the financial resources to borrow money at interest for their own home
  • loans for medical purposes to people who promise to repay either through future earnings when healthy or through their estates if they die.

How many interest free loans a community can distribute is determined by the interest rate on savings.  If the interest rate is too low then people will not save. If the interest rate is too high people will not borrow because the financial returns cannot cover the interest payments.

This approach to increasing the money supply enables governments, who can direct the areas for the creation of interest free loans, to increase the wealth of the community in ways that shares the wealth across the whole community and to do it with an inflation resistant currency.

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