The problem with debt-based money

Can our broken monetary system be fixed?

Debt-based money

Credit: Pixabay

A debt-based monetary system is a money system which allows banks to create most of the money in circulation through loans (debt), following the ‘fractional-reserve banking’ practice. The global economy is running on it.

The problem with this money system is that it requires constant economic growth, which is practically impossible. Furthermore, the average growth rate it requires is unsustainable. This results in booms and busts, and man-made climate change.

Banks print most of the money in circulation in the world today (also referred as broad money). Every time a bank lends money to somebody, it credits the client’s account with a deposit of the size of the loan. It enters numbers in its computer system. It “prints” digital money.

However, the lending capacity of banks is constrained by capital requirements. The way regulators control the fraction of “non-debt based money” reserves banks must hold. This, in theory, ensures that the overall amount of money in the economy is right for the expected growth.

Debt and growth

Debt (Credit) theories of money try to explain the relationship between debt and money. Some argue that money and debt are the same thing, when money is not backed by gold or another commodity. Some argue that the two are the same, even when money is not backed by anything. The latter view is the one supporting the current debt-based money system.

Debt means somebody owes money to somebody else. It usually carries interest. People, businesses, or countries who borrow money need to use the money in a productive way so that they can pay back capital and interest, within agreed timelines.

This translates into a system where overall economic activity must keep growing so that debt can be serviced. Otherwise, an economic crisis is triggered.

Last time I checked, most economists seemed to agree that developed countries can expect an average growth of 3% to be sustainable (developing countries can expect more). However, they used mathematical models which did not seem to factor in the finite planet resources.

(Meanwhile, some scientists considered a growth rate sustainable for the planet to be around 1%.)

The rates set by central banks, banks and others, based on such expectations, are never right. At times too high, so debtors cannot keep up with payments, go busts. At times too low, so people, businesses, governments borrow too much in boom times and then end up in trouble when inevitable busts follow.

Solutions

We can hope that the stringent capital requirements enforced by regulators around the world, after the Credit Crunch (2007/2008) will work. We can also hope that in the future there will be more lending for green infrastructure projects. Or we can try new, possibly better money systems.

Fintech companies are working hard on, among other things, fresh ideas which could lead to money systems working better than the current debt-based money system. Things like Cryptocurrencies, Distributed Ledgers and Initial Coin Offerings (ICOs). Some ideas sound crazy, but who knows. 

The key may be to take a ‘portfolio management’ approach. That is to have a series of alternative systems implemented alongside the current debt-based money one. Not only to see which ones work better over time, but also to ensure that we are not all dependent on the same system at any one time.

Everybody has a role to play here. Governments, regulators, financial services companies, businesses and people. I include banks in financial services companies. However, they may need to reinvent what they do and how they do it in fundamental ways.

For more on the debt-based money system, see the Bank of England’s paper Money creation in the modern economy on the BOE website. See also Positive Money’s blog articles for interesting views with good visuals on the topic.