WHY DO GOVERNMENTS LET BANKS CREATE MONEY?

Did President Kennedy's decision that the US government should issue its own notes like this one lead to his assasination? Some conspiracy theorists think so.

One of the most perplexing problems future economic historians will face will be that of explaining why almost every 19th and 20th Century government allowed private banks to create almost all the money their citizens used even to the extent of requiring their state treasuries to pay interest for the loan of money private banks had created merely by making entries in their account books when the governments could have created an equivalent amount of currency the same way themselves and financed, interest-free, whatever they wished to do. At the very least, the practice constituted - and constitutes - a massive subsidy to the banking sector and to the wealthiest groups in society.

According to the late John Hotson, who retired as Professor of Economics at the University of Waterloo in Canada in 1992, roughly 95% of a typical industrial nation's currency is created by privately-owned banking organisations granting loans to their customers ²⁷. One of the few occasions on which governments put interest-free money into circulation is when their central banks decide they need new premises and simply issue the currency to pay for their construction.

At almost all other times, governments feel constrained to borrow all the funds they need and therefore pay interest on money the private banks have created. Quite why governments feel unable to create money for, say, public capital projects apart from central bank buildings and have run up massive National Debts in their determination not to do so has never been adequately explained, although bigots with hypotheses abound. For example, neo-Fascists claim it is due to a Jewish conspiracy and sell books about it through badly-printed mail-order catalogues alongside works which claim that the Holocaust never happened. An equally silly, but perhaps less dangerous theory comes from the Order of St. Michael in Canada, where Social Credit (the idea that a society should create its own purchasing power) was a powerful political force in the 1930s. The Order's members, who call themselves 'slaves of Mary' and 'Catholic Patriots' working 'to deliver nations from Communism and the banking dictatorship', hold the Freemasons responsible but, like the Fascists, fail to produce a shred of evidence.

Three extremely serious consequences flow from allowing banks to create almost all a country's money by issuing loans for which they charge interest. The most pernicious is that the need to pay this interest creates the capitalist system's constant need for economic growth and thus makes it unsustainable in a finite world. We will be discussing this more fully in the next chapter when we consider how interest should be managed in a local economy.

The second consequence of their delegating the power to create money is that governments have too little control over the amount put into circulation. For example, if the banks issue so many loans that the economy overheats and the inflation rate rises, one of the few ways governments can respond is to raise interest rates by selling government stocks to mop up the excess funds - in other words, by borrowing some of the excess money themselves. This can seriously distort the distribution of national income because if the interest rate rises above the percentage rate at which the gross domestic product is growing in money terms, the wealth of lenders begins to increase faster than that of borrowers and the total debt owed to financial institutions by everyone in the country, including companies and the state itself, grows in relation to GDP. This is exactly what happened in Britain in the 1980s: because inflation was suppressed by raising interest rates and real growth rates were low, the proportion of national income going to moneylenders significantly increased as we noted in Chapter One.

The third consequence of not issuing money is that governments cannot do what Paul Glover has done with his Ithaca Hours and the Westport LET system with its Reeks - pay to get things done without incurring a debt on which interest must be paid indefinitely. Only two places in the world have issued their currencies on a non-debt, non-interest basis - Jersey and Guernsey - and the results have been remarkable.

The Guernsey system dates back to the period just after the Napoleonic Wars which had seriously damaged the island's economy because they prevented smuggling, the people's most important income source. As a result, according to Olive and Jan Grubiak's 1960 pamphlet, The Guernsey Experiment ²⁸, the island was in a distressed state: "The deep roads ... in wet weather became muddy rivers between steep banks. The town was ill-paved and unattractive, and there was not a vehicle for hire of any kind on the island. There was no trade, nor hope of employment for the poor. Worst of all, the sea was encroaching the land, and washing away large tracts of it, thanks to the sorry state of the dykes."

There seemed little possibility that the island's government would be able to erect the necessary sea defences, which were expected to cost £10,000, since the £2,390 interest bill on Guernsey's public debt of £19,137 (equivalent to approximately thirty times that amount today) absorbed all but £600 of its annual income and, in view of the people's poverty, there was no scope for further taxation. However, a committee was set up to see how money could be raised for a smaller project - the erection of a covered market. This reported back in 1816 with the proposal that the cost of the market and various other public works be met by issuing 6,000 States Notes, each with a face value of £1, to circulate alongside the £50,000-worth of banknotes then in use on the island. The idea was accepted although notes worth only £4,000-worth were initially issued, and since it was proposed to redeem them with British money in stages, the arrangement amounted to little more than an ingenious interest-free way of borrowing the funds to finance the island's capital works programme. However, other tasks including the sea defences and the construction of schools were taken on, and further note issues made, so that by 1829, States Notes worth £48,000 were in circulation.

In 1826 a complaint was made to the Privy Council in London that the States (as the Guernsey Parliament is called) had no right to issue currency without royal consent. The States submitted a lengthy report to the Privy Council on the ways in which the local currency had been spent which demonstrated that the income from the projects it had financed was more than enough to redeem the notes issued. Satisfied, London took no action. The complaint was probably instigated by the promoters of the Old Bank which set up in Guernsey the following year. A second private bank, the Commercial, opened in 1830 and the two 'flooded the island with paper money.' The States held discussions with both banks and, as a result, withdrew £15,000-worth of its own notes from circulation and agreed to keep the total issue of States notes below £40,000. This agreement remained in force until 1914.

During the World War I, the local banks were prohibited from increasing their note issue while the States was under no such restriction and issued a further £100,000-worth of its currency to meet the demand. Since then, the two local banks have become part of British high-street banking chains and have ceased to issue currency - instead, British notes circulate in Guernsey alongside the island's own.

Today, if someone uses a bank on the island to cash a cheque or draws money from an automatic teller with a plastic card, they will receive Guernsey currency which the banks obtained from the States' Treasury in exchange for a sterling cheque for the same amount. The treasury then returns the sterling cheque to the bank which issued it to be lodged in a deposit account in the States' name. Each Guernsey note in circulation is therefore backed one-to-one by its British equivalent.

"We've got about £14m.-worth of notes and coin in circulation at the moment" Michael Browne, the States' Supervisor told me in early 1994. "It fluctuates a little with the seasons. It constitutes a £14m. interest-free loan for us - in fact, it's a loan we collect interest on. The payments we get on it from the banks make a small but useful contribution to the island's budget" ²⁹.

Although Browne says it would be possible for the States to spend the sterling it receives from the banks in payment for its currency, it no longer does so. "Our policy on this island is, if we can't afford a new school building or something like that, we don't borrow, but wait until we can pay for it before we put it up. As a result, we have almost no public debt, apart from some money owed by the state trading boards which run the telephone and electricity systems. Even that is covered by sinking funds" he explains.

According to Browne, Guernsey's absence of debt is as a result of its conservative financial policies and the main reason why the island's income tax rate is only 20%. He regards the States' refusal to spend the funds obtained as a result of its currency issue simply as prudent book-keeping and suggests that the success of the 'Guernsey experiment' is largely a myth.

With the presumption of an outsider, I suggest he is mistaken. There are two ways in which Guernsey could handle the sterling it receives from the sale of its currency. One would be to spend a high proportion of the £14m. it has already collected on capital works immediately, leaving just enough on deposit in the banks to ensure that a Guernsey pound can always be exchanged for a British one. But if this course was followed, the amount of capital spending the currency issue made possible in future would fluctuate wildly from year to year as it could never be more than a prudent proportion of whatever amount of additional island currency had entered circulation during the previous twelve months. In some years, there might be no increase. In others, the amount of local currency in circulation might even decline because of a fall in economic activity, requiring the island not only to halt its capital programme but, in the event that the Guernsey pound's fractional sterling backing proved inadequate to cover the withdrawals, to use some of its tax revenue to pay interest on British pounds borrowed to ensure the exchange rate was maintained. In other words, basing the island's capital spending on how much more local currency went into circulation in a particular year would prove highly destabilising: the States would spend more when the island was booming and have to cancel its capital programme and slash its current spending when it went into decline.

The second way open to the island is to do exactly what it does - to limit itself to spending the interest on the capital sum that issuing its own currency creates. This avoids the destabilisation entailed by the first course and ensures that a relatively steady amount of capital spending can be undertaken annually. After all, if the States are able get 7% interest on their £14m. sterling deposit, this will earn them enough to cover a third of its £3m. capital budget year after year.

Jersey issues its currency in the same way. Could counties and towns elsewhere follow suit and enjoy similar benefits? There seems no reason why not because the Guernsey arrangement suits both the island and the banks. Lending is any bank's most important source of income and whenever a bank hands currency notes over to a customer, both its assets and its liabilities are reduced, cutting its capacity to make revenue-earning loans. When it hands out Guernsey currency, however, the sterling it used to buy them is deposited in another of its accounts, so there is no fall in the bank's assets and hence in its capacity to make loans. Guernsey, as we have seen, benefits too. Someone appears to be getting something for nothing - how do the benefits arise? The answer is that they come from the creation of £14m. which would otherwise have not existed by essentially the same process that banks use to create money when they grant a loan facility on which the customer writes cheques. So, given that both sides benefit, the only obstacle likely to arise would be if central banks objected to county councils convincing their residents that it was in their interests to insist on getting county currency whenever they withdrew cash from their banks.

Alternatively, county or town councils could create their own money by following the Wörgl model almost exactly: working in close collaboration with local businesses, as local authorities did whenever scrip was issued in 1930s America, they could arrange loans from their local credit unions and leave them on deposit so that anyone who wished to exchange their local money for national currency could do so on payment of a small fee. Wörgl's monthly revalidation stamping system could also be adopted to ensure that the local money was always spent in preference to that from outside.

The benefits to any council adopting either approach are clear: no longer would it have to depend almost entirely on central government or on bank borrowings to finance low-income housing, industrial starter-units, a library building or a better swimming pool. Local builders would get more work - indeed, if the council was wise, it would only embark on a big spending programme when there was spare capacity in the local construction trade. Even the national government would be better off as a result of increased tax revenues and lower social welfare claims. But would these gains be sufficient to enable it to ignore dire warnings about inflation which would undoubtedly come from its central bank or treasury department upset by the loss of some of its powers?.

John Hotson was associated with the Committee on Monetary and Economic Reform, COMER, which describes itself as ’composed of economists and non economists, both academic and non-academic, whose goal is a sustainable financial system in a sustainable world economic/ecologic/social system.’ COMER's website, at www.comer.org, contains many interesting articles. E-mails can be sent to comerpub@comer.org.The street address for COMER is: COMER Publications, 245 Carlaw Ave. Suite 107, Toronto, Ont. CANADA M4M 2S6. Membership costs US$45 per year for non-Canadians.

COMER is one of the few groups in the English-speaking world doing serious work on monetary reform. It has links with Economic Reform Australia which is working on similar lines. Economic Reform Australia's street address is P.O. Box 505, Modbury, SA 5042, and Frances Milne, co-editor of the newsletter, can be reached at +61 29 810 7812. An unsurpassed source of historic material on microfiche on free money and free banking is the Libertarian Microfiche Publishing Company, 35, Oxley Street or P.O. Box 52, Berrima, NSW 2577. Another good source is The Monetary Freedom Network (website in German), c/o Siegfried H. Schwenke, Wissmannstrasse 15, D-12049 Berlin. Tel. 030 6213861.