The existing banking system seems to be sound yet we have a banking crisis that does not seem to be going away.

The banking system works in the following way.

Each day a bank makes loans and receives repayments.  It only makes loans if it can find a borrower who has assets that can be used as collateral for the loan.  At the end of the day it taillies up its loans and repayments and if it has more loans than repayments it goes to another bank and gets a loan that is backed by its loan portfolio.

This all makes perfect sense.  The amount of money increases – or decreases – depending on the demand for loans.

What can possibly go wrong?

Well something goes wrong because there is now many times more loans in existence than there are assets to back the loans. How can that be?

It comes back to what happens at the end of the day and the cumulative effect of doing this for many years.   When a loan is made that is backed by another loan then money is created that does not have a real asset backing it.  The asset backing has already been used to back the original loans so we have loans being created without the backing of real assets.  Again this would not matter if there was only a small amount of extra money in the system but over the years we have increased the amount of money so that it is now many times the value of existing assets.

The real problem becomes how to get rid of these excess loans.  Governments have run up huge deficits and governments take on the job of servicing those loans.  The way we try to get rid of the loans is to inflate the currencies of the world or to make the loans so that they do not matter. They become interest free or they are written off.

In a global economy writing off government deficits means transferring wealth from one country to another and this is what the IMF tries to do with some countries.  It says to a country like Ireland.  “You have to repay your debts and the way to do that is for you to reduce your spending and sell off the assets of your country to repay your debts”.

This appeared to work when the countries “going broke” were small but it is not working when the country “going broke” is the USA.

But countries don’t go broke.  It is all monetary mirage.  The loans should not have been created in the first place but because of the way the system works it is inevitable that this will happen.  The assets of the country still exist – it is just that there are too many loans written against them.

There is a solution and that is to stop the way this extra money is introduced into the system and to replace it with a different method.

Instead of banks getting an interest bearing loan from another bank if it has shortfall the bank could give interest free loans to its depositors.  These interest free loans would create interest free deposits and the bank would require that the loans be invested to create new productive assets.

However, this mechanism would be cumbersome and too open to abuse. Rather let us have Public Banks whose job it is, is to increase the money supply with interest free loans to the general population to satisfy the monetary needs of the other banks.  If Public Banks took on this role then it would supply the money needed for the rest of the system.  It has created extra money – not as a loan on top of another loan – but as a loan against a future asset.

If this was done then the banking system would get rid of the excess loans as it is too expensive to create extra money as interest bearing money when the money can be created as interest free money.  This means that as existing loans get repaid then we would not get new money being created with interest bearing money but we would get new money created with the cheaper money.

The system will rapidly return to equilibrium.

The good thing about this approach is that individual countries can do it with or without a public bank.  All it requires is a government willing to give interest free loans to its citizens – if they will invest the money to build public infrastructure.  Most citizens in most countries would be only too willing to take up the challenge.

One thought on “Why we have a Dysfunctional Banking System and What to do About it

  1. You actually make it seem so easy with your presentation but I find this matter to be really something which I think I would never understand. It seems too complex and very broad for me. I’m looking forward for your next post, I will try to get the hang of it!


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