Future Proof Kilkenny » Blog Archive » Our shrinking money supply

Our shrinking money supply

We use it every day but rarely think about where it comes from. Now our money supply is shrinking in a deflationary spiral with no end in sight. Where is it all going? The simple answer is that it is being paid back to the people we borrowed it from. For apart from the 2% of actual notes and coins money is created as debt. This mean that if you are fortunate to have money in your account it is only because someone else somewhere has borrowed it. This applies to businesses, corporations and governments as well as ordinary individuals. Prepare to be confused, puzzled and amazed with a brief (attempted) explanation of our bizarre debt based money system.

When we think of money being created the image of notes and coins being minted by the government comes to mind but this is not the full story. Today 98% of money is electronic and is created by banks whenever a person takes out a loan and spends it into the economy. For example when an individual borrows to purchase a house or car, when a business borrows to purchase machinery or materials or when a government borrows to fund new infrastructure or pay civil servants.

Contrary to popular belief, however, a bank does not lend out the money it has on deposit but creates it out of thin air on the basis of the borrowers promise to repay. A double entry book-keeping technique is used placing the value of the collateral on one side of the balance sheet and the value of the debt to the bank on the other. From the point of view of the bank money wasn’t created since the two amounts cancel each other out but this misses the fact that the loan cheque has been spent and new money, that previously did not exist, has entered the economy.

Now, since the money in circulation is borrowed money it must be repaid to the banks. Consequently, as it is repaid, unless new loans are taken out the amount of money in circulation will shrink. It is hard to believe, but if no new loans are taken out money would simply disappear as all existing debts are paid off. Our money supply is therefore constantly circulating through the banking system as old loans are paid off and new loans are taken out. Money and debt are two sides of the same coin.

Confused? Prepare to get more so.

Banks charge interest on their loans which means that more money must be repaid than was originally borrowed. Since virtually all money is borrowed this means that at any one time the total amount of debt in society (principal + interest) is always greater than the total amount of money. In order to repay the debt, the money supply must therefore expand. This requirement can only be met if the economy grows each year thereby creating the demand for new additional borrowings to fund new purchases, business expansions and so on.

As the money supply grows so to does the debt. Since interest is compounding the rate of growth is exponential (a 3% growth rate equals a doubling every 22 years, a 10% growth rate equals a doubling every 7 years). Today’s monetary system, rather than simply facilitating economic activity, requires economic activity to grow exponentially year after year in order to keep functioning. The monetary system, as it is presently construed, literally traps us in a growth paradigm.

At the heart of our monetary system, therefore, is the need for the economy to grow forever. But what happens if the economy cant grow forever? Say for example resources start running out, or the population decreases or we simply decide we have had enough, are content and don’t want to buy more stuff. What then?

As people cut back in their spending retail suffers and profits go down. Consequently businesses scale back and people are let go. The need for borrowing is reduced. Now less new money is being created and as the previous loans are repaid the total amount of money in circulation starts to shrink. With less money available to purchase goods and pay employees prices drop, wages are cut, more jobs are lost and banks restrict lending. All this leads to further reductions in borrowings and further contraction in the money supply.

Left unattended, all money would eventually be extinguished in a self-reinforcing deflationary spiral. This is every governments worst nightmare and this is what is happening in Ireland today. Central Statistics Office figures for last year confirm a sharp contraction in the amount of money in circulation from 91 billion in January to 78 billion in November. With government cutbacks and mounting job losses this looks set to continue throughout 2009 and 2010.

The standard approach to tackling deflation is to inject money into the system through more government borrowings. This re-inflates the money supply allowing banks to restart lending and allowing businesses and consumers to restart spending. Although the process piles up more debt for future tax payers it works so long as there is more growth in the future to create the new money to pay back the old loans.

We live, however, on a finite spherical planet with finite natural resources. Growth cannot go on forever. Many believe we are now reaching what the Club of Rome’s 1972 study called “The Limits to Growth”, especially with regard to fossil fuels, our most important resource. Writing in the New Scientists October issue under the title “The Folly of Growth” Herman Daly put it this way:

“The scale of the global economy is approaching the limits of what our planet can cope with. As the oceans are emptied of fish, forests shrink from logging and levels of pollutants and green house gases in the atmosphere rise, the environment and social costs of further growth are likely to intensify. Resources are running out and waste sinks are becoming full. The remaining natural world can no longer support the existing economy, much less one that continues to expand.”

Can our financial system keep functioning if we can no longer grow our economies? Will it collapse in a deflationary spiral? Should we start looking at alternatives such as local currencies and barter systems? Undoubtedly we will have the answer to these question in the not so distant future.

In the presentation below, Ellen Brown, author of Web of Debt, gives a fascinating historical overview of how our debt-based money system developed. She then outlines how the collapse in the financial industry occurred and what communities and states should do to take control of their future.