Thirdly, we must examine the legality of interest charged on the loan. Is not interest charged on something created out of nothing an attempt to defraud the borrower? What legal right does the bank have to receive interest on something created out of nothing? What consideration has it given to deserve this interest? The payment of interest in a loan contract is justified because the holder of the money is giving up the current use of the money. With bank loans under a fractional reserve banking system, as the money did not exist prior to the loan contract, the bank had no money to use, and as such, the bank has not given up the use of any money. Any claim to interest then must be an attempt to defraud the borrower.

Fourthly, we must examine the fractional reserve banking system as being a large pyramid scheme, which by their very nature are illegal. In a fractional reserve banking system, money is created when loans are created, and money is destroyed with the payment of principle or interest. Since loans are repaid with money, and the amount of money created (through loans) is always less than the amount of money required to repay the loans (principle plus interest), it then follows that it is impossible to repay the loans. By the simple fact that money is destroyed by both interest payments and principle payments, there can never be enough money created by loans to repay these same loans created by the banking system. Moreover, should the creation of new loans stop, even if no principle loan payments were made, the entire money supply would soon disappear. At a 10% interest rate, this would happen in less than 10 years. back to Table of Contents

By a further example, should we wish to keep the money supply constant, then loans must grow by the amount of interest paid. Over time this leads to a continual increase in loans for the same money supply, also demonstrating that loans can never be repaid.

Bankers attempt to maintain their pyramid scheme by ever increasing amounts of loans. However, these loans are neither self-sustaining nor repayable, and the system must eventually collapse. This is part of the deceit of fractional reserve banking, the granting of loans that can never be repaid.

Separately, but with keeping with the same ideas, we must examine the legality of government income taxes, and ask if these taxes are not an attempt to defraud taxpayers.  The main issue centers around government debt, and the collection of taxes to pay either interest or principle on this debt. The financing of government deficits could be accomplished with either the printing of new government notes (in a simple case, the government would print up bank notes, deposit these notes to their bank account, and write cheques on the amount deposited), or by borrowing money created out of nothing by the banks (either by direct loans or by the purchase of government bonds by the banks). In both cases, the government is spending money that did not exist before. However, by borrowing from the banks, the government is deliberately creating a future tax liability when it was not necessary to do so. These loans then become a

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fraudulent transfer of wealth from taxpayers to bankers. Moreover, as we will examine, governments can immediately repay all loans at no cost to the taxpayers, and at the same time improve the stability of the
financial system. That they fail to do so, clearly shows their intention to continue to defraud taxpayers.

Considering these legal issues, in Canada, I refer to the Bank Act, Chapter B1 311.(1)  back to Table of Contents
“Every bank or other person who issues or reissues, makes, draws or endorses any bill, bond, note, cheque, or other instrument, intended to circulate as money, or to be used ebts of other European nations. ..If it seems incredible that a single person should actually manage to gain funds in excess of the money stock of an entire country, it should be remembered that the national debt at this time stood in the region of £850 million.  Rothschild and others built up financial empires of colossal power; empires that persist to this day.”  Michael Rowbotham, The Grip of Death. Jon Carpenter. 1998 (pp. 199).

The Bank of England’s original charter stated “The bank hath benefit on the interest on all monies which it creates out of nothing.”  Note that the Bank of England was and still is a private company.

The American constitution states ‘Only Congress shall have the power to coin money, regulate the value thereof…’

back to Table of Contents
A Tribute to Frederick Soddy; Nobel Laureate and Monetary Reformer

Frederick Soddy was one of the first generation of English atomic scientists, working with Rutherford on the initial discoveries about atomic disintegration, and received the Nobel Prize in 1921 for his research on isotopes.

Writing in 1926, he said;

“It was natural to consider what sort of a world it would be if atomic energy ever became available. To compare such a world to that of today, it was necessary to contrast the latter with the world before the dawn of history and the art of kindling a fire. Just as the savage died of cold on the site of what now are coal-mines, and perished with hunger on corn fields now energized with fertilizers produced at Niagara, so, it seemed, we were leading a pettifogging existence, fighting one another like wild beasts for a share of the supplies of energy somewhat niggardly vouchsafed by nature, whilst all round us existed the potentialities of a civilization such as the world had not then ever imagined possible…back to Table of Contents

The whole of the achievements of our civilization – in which it is differentiated from the slow, uncertain progress recorded by history—appeared as due to the mastery over the energy of fire reached with the steam engine. If, therefore, there is at hand not merely in the remote stars, but at our feet, an unlimited source of energy of the order of a million times more powerful than any known, what tremendous social consequences await the discovery of artificial transmutation.

Yet how far is human society from being safely entrusted with such powers? If the discovery were made tomorrow, there is not a nation that would not throw itself heart and soul into the task of applying it to war, just as they are now doing in the case of the newly developed chemical weapons of poison gas warfare.”

Seeing that our world contained unlimited potential, yet in which poverty and want abounded, his sites turned to economics. We too must ask why what is physically possible, is prevented from actually happening. Using his analytical skills that earned him a Nobel Prize, he got inside the money matrix. He knew the genetic code, the DNA of money, and understood that unless our financial system was changed, that no significant change of any social consequence could happen. He understood what money was, and how it controlled and enslaved every person in society.

Yet it appears that he was unable to convince any significant following of people of his views. This is the question that I now ask myself, for my views on money, obtained in a completely independent manner, are idea for idea, concept for concept, almost identical. What Frederick Soddy did, was to undertake a micro economic analysis of money, what it was, how and why it was created and destroyed, and the effect that this bsp;                             35
Government bonds      5
Buildings                      1
Equity                                                                           2

Total                            37                                            37

Loans and assets have remained constant, while deposits have decreased and the bank’s equity has increased. Thus, the payment of interest has decreased total money supply by the interest paid. I should stress here, that it is because the payment of interest destroys money, that a fractional reserve banking system is an unstable financial pyramid. While this will be expanded upon shortly, I know of no other economic text or paper that has described the payment of interest on bank loans as destroying total bank deposits. However, this fact is so important to understanding how economies work, that the reader must ensure that there is a full understanding of this concept.  Now, consider the effect of the bank selling $3 in government bonds. The purchaser of the bonds will have its account debited to purchase the bonds, with the net affect as follows. back to Table of Contents

                           Assets                              Liabilities

Loans                          31
Deposits                                                                     32
Government bonds      2
Buildings                      1
Equity                                                                           2

Total                &np of the country.”  C.H. Douglas
“If you want to be slaves of the bankers, and pay the costs of your own slavery, then let the banks create money.”

“The modern banking system manufactures money out of nothing.  The process is perhaps the most astounding piece of slight of hand that has ever been invented.  Banking was conceived in iniquity and born in sin.  Bankers own the earth; take it away from them, but leave them with the power to create credit, and with the stroke of a pen they will create enough money to buy it back again. … If you want to be slaves of the bankers, and pay the costs of your own slavery, then let the banks create money.”  Lord Josiah Stamp, former director of the Bank of England.
“If the American people ever allow the banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers occupied.  The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs.  I sincerely believe the banking institutions having the power of money are more dangerous to liberty than standing armies.”
Thomas Jefferson, former U.S. President

[note: In June 1963 President John F. Kennedy implemented Executive Order 11110 in an apparent attempt to restore power to Congress over money creation from the Federal Reserve by issuing $2 and $5 “Treasury notes.”  Only a few thousand notes were ever issued and ceased following his assassination.]
“An uncovered note of a bank or of the government, or an uncovered bank check, is therefore plainly falsehood in the cash account; it is a matter of credit, an evidence of debt, under false pretenses and in the wrong place…debt was being converted into currency…..  back to Table of Contents

The depression (of 1879) ..is a cause within a cause; it is itself a consequence of inflation with false money… it is but the revolt of commerce against the violation of its laws.   Commerce requires money… as the equivalent of other commodities, and we feed the money channel with debt, the equivalent of nothing, and the very opposite of money….

‘The banks of the city of New York control the currency and commerce of this country: when they expand, all other banks expand, and when they contract, al others contract or fail.  They are the financial directors of the creditor city of the country and thus of the whole country.” Charles Holt Carroll, author of The Organization of Debt into Currency. 1964.
In monetizing the real wealth of Australia (that is, creating its monetary equivalent) the banks have issued the money as a debt and so acquired assets equal to about one third of the entire wealth of Australia….Does it not strike you as preposterous that an institution that produces nothing more than figures in books, can acquire the ownership of assets more vast than our greatest industries which employ thousands of people in all states, and upon whose physical production the entire economy of Australia depends?” The Money Trick, The Australian Institute of Economic Democracy. 1989.
“During the early nineteenth century (in England) Nathan Rothschild built up his vast fortune.  Rothschild claimed to have multiplied his initial £20,000 capital, no less than 2,500 times over in the course of just five years, to a total fortune of £50,000,000 – vastly in excess of the entire money stock of Britain!  Rothschild achieved this by buying up many of the British government loans of this period, and also dealing in the public dbsp;  30
Deposits                                                               30
Buildings                  1
Equity                                                                     1
Total                         31                                        31

Assume that a person borrows $3, which the bank deposits into his account. In the bank, the loan clerk completes two bookkeeping entries. The loan clerk credits the borrows account by $3 and debits the banks general ledger loan account by $3.

                           Assets                            Liabilities

Loans                         33
Deposits                                                                  33
Buildings                    1
Equity                                                                       1

Total                          34                                          34

Total loans and total deposits have increased by $3. The borrower, now having an extra $3, can write a cheque against his account. However, this will have no net affect on the banks balance sheet, as another depositors account is increased by an equal amount. Since we are dealing with bookkeeping entries with no physical limit, it then follows that there is no limit to the amount of loans and deposits that can be created. Now governments can place artificial limits to loan gro The Nature of Money

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The Nature of Money, John Kutyn, March 5, 2000, (with editorial comments by Mark Anielski)

“The central error of all present economic thought, is its failure to understand money from its microeconomic foundation”, John Kutyn, johnkutyn@connect.ab.ca

The following has been reformatted slightly and a table of contents has been added to make it easier to read.  No words have been changed.  If you want to alter the font size, press     <crt + ]> once for each increase desired and <ctrl + [ > for each decrease.  If you choose to print the entire text, it will take about 32 pages. In case  you would like to print only portions of the article we have added a horizontal line and the notation <x pages> at the approximate end of the  5th,10th, 15th, 20th, 25th, and 30th pages to aid your interpolation.

Table of Contents

Main Article

    • Great Quotations on Money
    • Introduction and tribute to Frederick Soddy
    • The Financial System as an Illusion
    • Wealth Transfer
    • Understanding the Financial System
        • Understanding the Financial System ... start
        • Consider a cash-less society
        • when the bank purchases an asset
        • repaying loans
        • paying interest
        • when the bank sellbsp; 39

          Again, these transactions involve only simple bookkeeping entries, and in the absence of artificial restraints, can be created in unlimited amounts.
          Bank deposits are destroyed whenever a loan payment is made, an interest payment is made, or a bank sells an asset, as shown by the effect that these transactions have on the bank’s balance sheet.

          In the above example, let us consider what happens to the banks balance sheet when a $2 principle loan payment is made. In the bank, the loan clerk again completes two bookkeeping entries. The loan clerk debits the depositors account by $2 and credits the bank’s general ledger loan account by $2. back to Table of Contents

                                     Assets                              Liabilities

          Loans                          31
          Deposits                                                                     36
          Government bonds      5
          Buildings                      1
          Equity                                                                           1

          Total                            37                                           37

          Loans and deposits have both decreased by $2. Now, consider the effect of a $1 interest payment. The bank completes two bookkeeping entries, a depositors account is debited by $1, with the banks equity account being credited by $1. The balance sheet adjusts as follows. back to Table of Contents

                                     Assets                              Liabilities

          Loans                          31
          Deposits                                       &nwth, such as restricting total loans to a total dollar figure, restricting total loans to a certain multiple of total Gov. Notes, restricting total loans to a certain multiple of owner equity, or some other factor. However, this not change the fact (and I stress the word fact), that in a fractional reserve banking system, deposits and loans are created through simple accounting entries (hence the concept of money out of nothing), that in the absence of artificial restraints can increase without limit, so long as banks are willing to lend, and people are willing to borrow. In many countries, loans are no longer restricted to a multiple of Gov. Notes. While loans may be restricted to a percentage of owner’s equity, in reality this has little effect. Banks can always increase their equity through the issuance of new shares, even if a small percentage of newly created money must be allotted to purchase these shares.
           In the absence of artificial restraints, the increase of both loans and deposits can grow without limit, as they only represent bookkeeping entries.

          Similarly, consider the effects of the purchase of an asset by the bank, in this case being a government bond. back to Table of Contents

                                    Assets                            Liabilities

          Loans                         33
          Deposits                                                                  33
          Buildings                     1
          Equity                                                                        1

          Total                          34                                          34

          Now, the bank will purchase a government bond for $5. The initial transactions are for the bank to issue a bank cheque to the government for $5. The balance sheet adjusts as follows:

                                    Assets                            Liabilities

          Loans                         33
          Deposits      st be made clear, is that before an economist can provide an analysis of an economy, this person must first understand the financial system. Otherwise, all analysis becomes meaningless, because different financial systems affect the economy in different ways. Moreover, if we do not understand the basics of our financial system, then this leads us only into logical contradictions and errors. The essential elements of money, is that it is a means of exchange, a unit of account, and a store of value. Today, economists have several definitions of what money is,(M1,M2,M3, etc.), but do not appear to understand what these definitions mean.

          Consider the words of Allan Greenspan during testimony at the Humphrey-Hawkins hearings of February 17, 2000.
          Mr. Greenspan: “Let me suggest to you that the monetary aggregates as we measure them are getting increasingly complex and difficult to integrate into a set of forecasts. The problem that we have is not that money is unimportant, but how we define it.  By definition, all prices are indeed the “ratio of an exchange of a good for money.” And what we seek is what that is. Our problem is we used M-1 at one point as the proxy of money, and it turned out to be a very difficult indicator of any financial state. We then went to M-2 and had the similar problem. We have never done M-3 per se because it largely reflects the extent of expansion of the banking industry. And when in effect banks expand, in and of itself, it doesn’t tell you terribly much about what the real money is.  So our problem is not that we do not believe in sound money. We do. We very much believe that, if you have a debased currency, that you will have a debased economy. The difficulty is in defining what part of our liquidity structure is truly money. We have had trouble ferreting out proxies for that for a number of years. And the standard we employed is whether it gives us a good forward indicator of the direction of finance and the economy. back to Table of Contents

          Regrettably, none of those which have been able to develop, including MZM – has not done that. That does not mean that we think that money is irrelevant. It means that we think our measures of money have been inadequate. And, as a consequence of that, we, as I have mentioned previously, have downgraded the use of the monetary aggregates for monetary policy purposes, until we are able to find a more stable proxy for what we believe is the underlying money in the economy.”

          Dr. Paul: “So it’s hard to manage something you can’t define?”

          Mr. Greenspan: “It is not possible to manage something you can’t define.”

          Alan Greenspan, Humphrey-Hawkins testimony, February 17,2000

          We will consider money to consist of deposit accounts in banks or similar institutions, and government bank notes. Of these two, deposit accounts make up almost 99% of all money. In the world today, most exchanges between people or firms occur in only three ways, barter, an exchange in government notes, or an exchange of bank deposits. With government notes and bank deposits being the only universal forms of exchange, they will be considered to be money. All other financial assets, while being sometimes highly liquid, must be first exchanged for a bank deposit, before the owner can purchase some other asset, good, or service, and are clearly not money. As such, money consists of two distinct and separate things, sort of two financial systems co-existing. As we will examine, the creation or destruction of government bank notes is a very different process from the creation or destruction of bank deposits, each of which will have a very different affect on the economy.

           Banks offer different types of deposit accounts, from chequing accounts, which can be transferred immediately, to term deposits, which may restrict the transfer of funds until ats accruing to those that partake in this process.

          We will examine different financial systems, how the creation of money differs in different financial systems, and how this leads to different effects on the real economy. In examining the dominate financial system in the world today, fractional reserve banking, we will show that such a system is the greatest fraud

          <5 pages>
          in history, a classic financial pyramid. We will show that because of the manner in which it both creates and destroys money, a massive fraudulent transfer of wealth occurs, while at the same time creating a financial system that is mathematically unstable and will collapse. The physical economy, being controlled by this mathematical construct, is thus subject to the same distortions, creating poverty amongst plenty, and enslavement to all those who exist within the system.

          We will reexamine some of the economic theories of the Keynesians and Monetarists, and show that because they failed to understand the microeconomic foundation of money, that many of their ideas and concepts were seriously flawed.

Wealth Transfer
Frederick Soddy noted:

“Psychologically, the economic aim of the individual is, always has been, and probably always will be to secure a permanent revenue independent of further effort… Economic and social history is the conflict of this human aspiration with the laws of physics, which make such a per-petuum mobile impossible, and reduces the problem merely to the method by which one individual may get another individual or the community into its debt and prevent repayment, so that the individual or community must share the produce of their efforts with their creditor.”

“Unlike wealth, which is subject to the laws of thermodynamics, debts do not rot with old age and are not consumed in the process of living… For sufficient reason, the process of compound interest is physically impossible, though the process of compound decrement is physically common enough. Because the former leads with passage of time ever more and more rapidly to infinity, which, like minus one, is not a physical, but a mathematical quantity, whereas the latter leads always more slowly towards zero, which is, as we have seen, the lower limit of physical quantities.”

This concept of compound interest is very interesting. It sends both the deposits of the creditor, and the loans of the debtor towards infinity, which while mathematically possible, is physically impossible in the sense that money is a claim on the real assets of the community. Now, let us consider the wealth transfer process. Interest on bank loans is paid to the bank, which increases its equity.

Now let us assume that all bank profits are paid as dividends into the accounts of the shareholders, and these funds are not spent, but grow due to compound interest. This causes the money supply that is used in the transactions economy to be governed by the equation Mey2=Mey1+NL-PP-IP. The net result, is that while the economy is constant or growing, both the loans of the debtors and the deposits of the shareholders will both be approaching infinity. Once IP exceed NL (assuming no principle payments), the Me money supply will begin to implode, causing income to fall with loans continuing to rise.(The deposits of the bank shareholders also continue to rise.) Eventually, the economy collapses, loans are defaulted, and the bank shareholders use their deposits to effect a major wealth transfer.

Understanding the Financial System
What mu                                                            33
Suspense Account      5
Bank cheque account                                              5
Buildings                     1
Equity                                                                        1

Total                          39                                          39

The bank now purchases the $5 government bond, with the government depositing the cheque in its bank account.

                                 Assets                            Liabilities

Loans                               33
Deposits                                                                      38
Government bonds          5
Buildings                            1
Equity                                                                            1
Total                                  39                                      &ns a bond

  • The Equity Position of Banks
  • Legal Issues
  • How Money Creation and Destruction Affects the Economy
  • Impact of Loans on Productive Capacity
  • Impact of Speculative Debt on the Economy and Financial System
  • Impact of Repayment of Loans
  • Is There a Maximum Level of Debt?
  • Summary of Concerns with Fractional Reserve Banking
  • Conclusions
  • Ancillary Topics Great Quotations on Money:
    “(the process of money creation is as) a method so simple the mind is repelled.”
    John Kenneth Galbraith, author of the book Money.
    “Today’s money system boils down to institutionalized theft”
    Ed Mayo, Executive Director, New Economics Foundation (UK)
    “Each and every time a bank makes a loan, new bank credit is created – new deposits – brand new money.”
    Graham Towers, former Governor of the Central Bank of Canada
    “As a result of fractional reserve banking over 90% of our money supply is loaned into existence by commercial banks and thus must grow by enough to at least pay the interest on the loan by which it was created.  This gives a basic growth bias to the economy.  Fractional reserve banking also transfer from private hands the state’s traditional right to issue money, and does so in a way that increases the cyclical instability of the economy.  The corrective call for 100% reserve requirements has been made periodically not only by so-called ‘monetary cranks’ (Frederick Soddy), but also by economists of impeccable reputation such as Frank Knight and Irving Fisher.”  Prof. Herman Daly, co-author of For the Common Good
    “I am afraid that the ordinary citizen would not like to be told that banks or the Bank of England, can create and destroy money.  The amount of money in existence varies only with the action of the banks in increasing and decreasing deposits and bank purchases.  Every loan, overdraft or bank purchase creates a deposit and every repayment of a loan, overdraft or bank sale destroys a deposit.”  Rt. Hon. Reginald McKenna, former Chancellor of the Exchequer and former chairman of the Midland Bank.
    “Taking the banking-system as a whole, the act of lending creates, as a direct consequence, deposits exactly equal to the amount of lending undertaken.  Provided, therefore, banks all move forward in step, there appears to be no limit to the amount of bank money they can create.  Even more than this, there would appear to be a basic instability in the banking system.” Andrew Crocket, author of Money  back to Table of Contents
    “This is a staggering thought.  We are completely dependent upon the commercial banks.  Someone has to borrow every dollar we have in circulation, cash or credit.  If the banks create ample synthetic money, we are prosperous, if not, we starve.  We are absolutely without a permanent monetary system.”
    Robert Hemphill, eminent banker.
    “The essence of the fraud is the claim that the money they (banks) create is their own money, and the fraud differs in no respect in quality but only in its far greater magnitude, from the fraud of counterfeiting…  May I make this point clear beyond all doubt?  It is the claim to the ownership of money which is the core of the matter.  Any person or organization who can create practically at will, sums of money equivalent to the price values of the goods produced by the community is the virtual owner of these goods, and, therefore, the claim of the banking system to the ownership of the money which it creates is a claim to the ownershi process had on the human and natural capital that determines our personal and economic wellbeing.
    It is an analysis of a virtual system of abstract mathematics, subject to no physical laws, which influences and controls the real world of production and consumption.

    Frederick Soddy saw, that as long as money was used as the accounting and distributing mechanism, it would enable generalized and social production, combing the advantages of human association and division of labor with the distribution of the product for individual and personal use and consumption. However, when money was issued as a source of revenue to the issuer, whether the issuer was the State, the bank, or the counterfeiter, it then became the most disintegrating and dangerous power ever invented by man.

    “The essential rule is that whoever, in the way of business, receives wealth for money – itself now intrinsically valueless – must give up the equivalent, and this is simply secured by his having in the preceding transaction given up for the intrinsically worthless money the equivalent in wealth. But it is not and cannot be observed with credit – money, falsely so called, in the first issue of money, and as a result the whole scientific civilization has been brought about as near to ruin as it is possible to go. It is only in regard to its first issue (and final destruction, if it is ever destroyed) that modern money is the least difficult to see through. In the first exchange of new money for wealth, the issuer, whoever he is gets something for nothing, and cannot help getting something for nothing… But when it comes to the money created to lend and destroyed when the money is repaid, the users of it neither know who created it nor how it was created. It differs from all the rest only in the first transaction in which it exchanges for wealth, and the last in which it is decreated and indeed, what does “all the rest” now amount to?” Frederick Soddy  back to Table of Contents

    This is the main problem with modern money, it is issued as a source of revenue, and not as an accounting and distributing mechanism, and in so doing distorts and enslaves the whole of production. It does not matter who owns the banks, who are the creators of modern money. If all banks were nationalized, and all profits given to the poor, it would in no way affect on the destructive effect that modern money has on our social and economic well-being.

    Soddy considered the views of other monetary reformers, and saw that they were “not complementary but mutually exclusive, and any attempt to compromise and combine parts of them would almost certainly result in disaster”. Thus, he was against the policies of reformers like Douglas, who while well meaning, would of only masked, and not solved the problem because they did not address the fundamental problems created by a fractional reserve banking system.

    Today the same problem exists. Some believe that the “price system” is the problem, and so call for the linking of money to some natural capital. In Soddy’s time they called it “energy certificates”, though today they can be more inventive with what it is called. There are also many who follow the thoughts of Douglas, that it is the “wage system” that is the problem, which will be solved only with the issue of “Social Credit”.
    I am not sure what it will take to convince people that it is the “Financial System” that is the problem. I seem to be of a similar view to Soddy, that a legal challenge is what is required. I hope that you find this interesting.

    The Financial System as an Illusion
    A financial system is not a natural system. It is a creation of bsp;           34                                            34

    The Equity Position of Banks
    It is useful to reflect on how the banks equity position affects the banks ability to make loans or purchase assets. Does the increase in equity through profits or share offerings affect the banks ability to create loans or purchase assets? While it may be useful that a banks equity be at a certain level to satisfy some outside financial regulator, technically, it has no bearing on the creation of loans or the purchase of assets. Since each time a bank purchases an asset or creates a loan, an equal and offsetting deposit is created, these transactions can continue to occur regardless of the equity level of the bank. In the granting of a loan, it is also wrong to think of a bank re-lending money (as some conventional economic theory teaches), for this is not what happens. In the process of giving a loan, the bank both creates the loan and the deposit, both being balancing entries on it’s balance sheet. This really has nothing to do with the existing assets or liabilities of the bank. In a fractional reserve banking system, debt is first created, and then used to create money. We must contrast these loans with loans where money first exists, and then it’s ownership is transferred by a loan contract. These are very different contracts, with totally different effects on the economy.

    Legal Issues
    Before proceeding, I believe that it is important to consider the legality of these transactions. While this ultimately will be decided in the courts, I raise the following questions.

    It is my contention that bank loans do not constitute a legal contract, that they represent an attempt to defraud, and that they represent part of a large pyramid scheme, which by their very nature are illegal.
    My rational is as follows. In a borrowing contract, the borrowers account is credited with the amount of the loan, for which the borrower agrees to repay the amount borrowed plus interest. In examining the legality of this contract, we must first examine the source of the borrowed money.

    It is commonly believed that the borrower is borrowing money that the owners of the bank have invested in the bank, or from a pool of funds that depositors have entrusted to the bank.  However, it is not, and herein lies the deceit and fraud of the bank. When a bank gives a loan, the bank completes two bookkeeping entries. The bank credits the borrowers account with the amount of the loan and debits a general ledger loan account by an equal amount. The banks deposits (liabilities) and loans (assets) have increased by an equal amount. What has happened is that the bank has created money out of nothing, and this money, created out of nothing is what they lend the borrower. The creation of the loan must proceed the creation of the deposit, and is the very instrument that creates the deposit. It should be pointed out that loans created outside of the fractional reserve banking system are very different. Here money or the deposit already exists, and the ownership of the money or deposit is transferred in exchange for the loan contract.

    Questions to be asked, are first, can banks legally create money out of nothing? Secondly, in contract law, is something created out of nothing valid consideration for a contract?back to Table of Contents

    The borrower has increased the amount of money he has, while the money held by all other persons has remained the same. An economist must understand this before anything else, and failure to understand this will only lead to an illusion of reality. Next, an economist must understand how the creation of a loan affects the economy. When a loan is created, this allows the borrower to increase expenditure,(generally all loans are given to finance some sort of purchase) which will affect GDP (Gross Domestic Product), since expenditures make up GDP. Secondly, the creation of a loan also results in the borrower having to make payments of interest and principle. Loan payments of principle or interest reduce the disposable income of a person or firm (Here consider a person earning $1000 per month. If the person has no loan payments, then the whole $1000 is available to consume or invest. If the person has loan payments of $200 per month, then only $800 is available to consume or invest) which causes expenditures to be reduced, which again affects GDP. The payment of either principle or interest will reduce the amount of money held by the borrower, and since the amount of money held by all other people has not changed, this must reduce the amount of money. In addition, money is also created whenever a bank purchases an asset, or is destroyed whenever a bank sells an asset. To confirm and clarify these points, we will examine the effect of these transactions on the banks balance sheet.

    I must state here in no uncertain terms, that the key to understanding all economics is understanding the following balance sheets, and the effects these have on the economy. If these balance sheets are substantially incorrect, then my analysis is flawed. However, if these are correct, then all economic analysis up to this point in history is flawed. The reader must be assured of the accuracy of these balance sheets. Thus begins our microeconomic analysis of money.

    For simplicity, we assume that there is only one bank, which is the same as considering the banking system as a whole

    Consider a cash-less society in which all financial transactions are handled by cheque, and assume the initial bank balance sheet. back to Table of Contents

                            Assets                            Liabilities

    Loans                    &nas a substitute for money, is guilty of an offence against this Act.”

    There can be no doubt, that a bank deposit, which is used as the means to faccilitate 99% of all financial transactions is money, or at least a substitute for money. Every time a bank creates a loan, purchases a government bond, or purchases an asset, creates or issues a new deposit intended to be used as money, in contravention to the Bank Act, which is a criminal offence under section C-46 121(1) of the criminal code.

    As Soddy explained; “For a loan, if it is a genuine loan, does not make a deposit, because what the borrower gets the lender gives up, and there is no increase in the quantity of money, but only an alteration in the identity of the individual owners of it. But if the lender gives up nothing at all what the borrower receives is a new issue of money and the quantity is proportionately increased.”

    The loan contracts of banks would also appear to be illegal under contract law in Canada. From “The Law of Contract”, by G.H.Treitel 10th edition:

    Page 76, “The rule that consideration must ‘move from the promisee’ means that a person to whom a promise was made can enforce it only if he himself provided the consideration.”

    Page 79, “A promise may appear to be made for some consideration which is illusory and which must therefore be disregarded.”

    As I have shown, in a loan contract, the bank has provided no consideration, it has created out of nothing an accounting entrée, but demands that the borrower surrenders real assets as security, and repay far more than is borrowed. back to Table of Contents

    Page 395, “A contract is illegal where its object is the deliberate commission of a civil wrong. Thus contracts to assault or defraud a third party are illegal”

    Prior to the completion of the loan contract, neither the borrower or the bank could purchase a product or service. However, the creation of a loan, creating a new deposit, now allows the borrower to have a claim on the goods of the community, which did not exist prior to the loan, effectively defrauding the community.
    Soddy saw “the issue of any form of credit money is a forced levy or tax on the goods and services of the community which it is impossible for the community to resist or escape. Parliament alone has the right to authorize and impose taxation, and this Act enables the whole constitutional position to be challenged…For surely, even in law, it is not possible to maintain that a tax is only a tax when the levy is paid in money tokens, and that a levy paid directly in valuables is not a tax.”

    Page 402, “A contract which does not involve the commission of a legal wrong may prove illegal because its tendency is to bring about a state of affairs of which the law disapproves on the grounds of public policy. A contract is illegal for this reason only if its harmful tendency is clear, that is, if injury to the public is its probable and not merely its possible consequence.”

    As I have, and will continue to show, loan contracts that create deposits, result in a financial system that is unstable, and will eventually provide tremendous destruction to the economic well being of the community.
    Again I refer to Frederick Soddy; back to Table of Contents

    “Why is it so vital to the security of the realm that money, and particularly credit money, should be the prerogative of the Crown, as a central authority representing the whole nation?…A new currency has been created by the banks through people engaged in industry incurring debts to the banks which cannot be repaid except by destroying that currency, for there is nothing else to repay it with…Clearly long before any great portion could be repaid there must arise a shortage of money and all the remaining debtors would be physically unable to obtain the money, that is to sell their produce or manufactures at ant price.
    From that invention dates the modern era of the banker as ruler…Industry and agriculture, the producers of the positive wealth by virtue of which communities live, can only expand by getting deeper and deeper into debts to the banks.”

    Page 474, “Failure to comply with the statue makes the contract void if the requirement is obligatory”
    As I have shown, loan contracts contravene the Bank Act which would make them illegal.”

    This is the first problem with letting banks create money, the fraudulent transfer of wealth. The second problem is the amount of money that is created, and how this money is used, both of which fall under the control of bankers. This allows them to control or fuel economic expansions, and create financial bubbles in specific areas. This gives them the knowledge to speculate at the right time in the right investments.

    How Money Creation and Destruction Affects the Economy
    We must remember that the key to controlling the world is the creation and control of economic contractions. It is here that the majority of wealth is transferred to the money people. Moreover, it is at these times that these same people bring about political change. As bad as the banks ability to create money is, it is their ability to destroy money that is even more frightening. We will now consider how a fractional reserve banking system affects the economy.

    When we discuss money, it is important to remember that money is used both as a store of value as well as a medium of exchange. That is, some people hold money as a preference to holding some tangible asset such as real estate. Money is also used as a medium of exchange; it is used as a means of payment for goods or services. The total amount of money therefore consists of the total amount of money used as a store of value plus the total amount of money used as a medium of exchange. It is useful to think of the money supply as consisting of two separate money supplies. First there is a supply of money used to exchange currently produced goods and services. Secondly, there is a money supply that people hold in lieu of holding either real or financial assets. Neither money supply is static. People are continuously exchanging currently produced goods and services for money. In addition, people are continually exchanging real and financial assets for the money that makes up this second money supply. Most importantly, there are flows between these two money supplies, depending if people are saving or dissaving. As we will explore, when money changes from one use to the other, it will have a direct effect on the economy, as well as on the prices or tangible or financial assets.

    When we discuss economic growth, we must distinguish between the nominal or dollar valuation of an economy, and the real number of goods or services produced. This is governed by the equation; back to Table of Contents
    GDP = (# units produced) * (price/unit) where GDP is the Gross Domestic Product of an economy.
    Thus, it is possible that GDP could remain the same when the number of units produced increases, if the price/unit decreases. What is important to remember is that two factors determine nominal GDP, both the number of units produced and the price/unit.

    The other equation that must be considered is;
    GDP = (amount of money) * (velocity of money)
    Here, when we talk of “amount of money”, we are referring to the amount of money used as a medium of exchange. Some may prefer to consider the “amount of money” as the total combined amount of money, and so a smaller velocity of money would be shown. I have chosen to separate the amount of money as to it’s uses, as this is more precise, as well as to show the effects of the changes between the different uses of money. Put Mathematically, to consider the relationship between these velocities;
    MT = Total money supply
    ME = money supply circulating in the business economy
    MI  = money held as an alternative to existing assets
    V = velocity of money where VME would be the velocity of money circulating in the business economy back to Table of Contents

    VME = VMT(1+MV/ME)

    In most of our discussion, we will assume that the velocity of money remains constant in order to consider the relationship between the other variables. Moreover, unless we can show that the velocity of money is affected by either the amount of money, or the number of units produced, or the price/unit, it is the only logical assumption that we can make. This is further supported by the restraint placed on the spending of money, in that economic units are generally restricted to spending what they earn or borrow. This thus gives us the equation;

    (amount of money) * (velocity of money) = ( # units produced) * (price/unit)

    This represents the Quantity Theory of money, which basically says that economic activity is an exchange of money for goods and services and that the two sides of the equation must at all times be equal. back to Table of Contents

    With the amount of money remaining constant, an increase in the number of units produced will not effect nominal GDP; it will only decrease the price per unit. This follows with conventional economic thought that says when supply increases, prices will fall. An increase in production will lead to a fall in price/unit, and with costs remaining constant, will see profit margins decrease. Since the greater the increase in production, the greater the fall in price, an economy that continually increases production will eventually see the price/unit fall to or below the cost/unit, making production uneconomic and leading to production shut downs. If however, the money supply was increased at the same rate as the increase in production, the price/unit would remain constant and the profit margins would not be affected. This clearly points how the manipulation of the money supply will affect profitability and ultimately production.  The above analysis is true of all financial systems, though effects will be very different in different systems. back to Table of Contents

    In discussing the effects of loans on GDP, I will consider three types of loan growth, for they all impact the economy in different ways. Specifically, we will consider loans that increase expenditures, loans that increase production capacity, and loans that are used to purchase existing assets. I might add here, that the effect of loans on the economy has been largely ignored by the economic community. This follows from the belief that “for the community as a whole the increase or decrease of the aggregate creditor position is always equal to the increase or decrease of the aggregate debtor position” (p.75, The General Theory of Employment, Interest, and Money, John Maynard Keynes). While this statement is true in a 100% reserve banking system, it is totally untrue in a fractional reserve banking system (though even in a 100% reserve banking system, different loans will affect the economy in different ways). In a 100% reserve banking system, loans represent a transfer of purchasing power (money) from one person to another. In a fractional reserve banking system, increasing bank loans represent an increase in purchasing power (money), while decreasing bank loans represent a decrease in purchasing power (money). Moreover, conventional analysis has failed to understand how different types of loans will have different effects on the economy.

    First, let us consider a fractional reserve banking system when loans are used to finance expenditures. This new debt is spent and increases GDP by the amount of the increase in debt multiplied by the velocity of money.  The next year, new loans must increase by interest costs plus principle loan payments just to maintain GDP at last years levels (this maintains a constant money supply). Put mathematically;

    If "new loans" = NL; "interest payments" = IP; "principle payments" =
    PP;and "r" = interest rate; MS= “amount of money”; and VL= “velocity of money”, then we have the following nominal values for

    GDP (Again, we will assume that the velocity of money remains constant)

    GDPy1= MSy1 * VLy1
    GDPy2= MSy2 * VLy2
    GDPy2= (Msy1+NLy2-Ipy2-PPY2) * Vly2
    GDPy2= (MSY1*VLY2) + ((NLY2-IPY2-PPY2)*VLY2)
    GDPY2= GDPY1 + ((NLY2-IPY2-PPY2)*VLY2)

    If we consider a financial system where loans are first introduced in Year 2, then we have the following; back to Table of Contents

    GDPy2 = GDPy1 + (NLy2*VL)
    GDPy3 = GDPY2 + ((NLy3 -(r*NLy2) -PPy3)*VL)
    GDPy4 = GDPY3 + ((NLy4 -(r*(NLy3+NLy2-PPy3)-PPy4)*VL)
    GDPyn = GDPym + ((NLyn -(r*(sum(NLYm:NLy2)-sum(PPym:PPy3))-Ppyn)*VL)

    For simplicity, if we assume that no principle payments are ever made, then;

    GDPyn = GDPym+ (NLyn -(r*(sum(NLym:NLy2))))*VL
    Thus, for GDP to remain constant, loan growth in Yn must equal the total amount of interest paid. For GDP to increase, loan growth must increase at an even faster rate.

    If NL is constant for all years, once NLyn = r*(sum(NLym:NLy2)) then economic growth will stop, and in subsequent years will decrease at an accelerating rate. At this point GDP is contracting, even as loans continue to grow. Thus, for GDP to continue to grow, loan growth must exceed interest payments(assuming no principle payments).

    These relationships are also shown in the equation;
    GDP = (amount of money) * (velocity of money) = (# units produced) * (price/unit)
    Where (amount of money )yn = (amount of money)ym +NLynIPynPpyn

    An increase in the amount of money will increase nominal GDP, which will increase the number of units produced or the price/unit or both. Should an economy be operating below its productive capacity, then it is likely that most of the increase in the amount of money will result in higher production. If the economy is operating near it’s productive capacity, then most of the increase in money will result in higher unit costs.
    back to Table of Contents

    Considering the above analysis, it might be useful to reflect on the thoughts of C.H. Douglas and his views on monetary reform. Douglas thought in terms of “lack of purchasing power”, that because industry  incurred debt in any expansion, and had to include the expense of repaying this debt in the pricing of it’s products, that the wages generated in actually producing the products would not be sufficient to actually buy all the products produced because of this additional expense (hence lack of purchasing power).

    Due to this lack of purchasing power, unless new firms were expanding, and thus increasing purchasing power prior to actual production, the economy would slump, with the business cycle attributed to these timing differences. In order to address the problem of always needing new investment to keep adding purchasing power, Douglas proposed that the government issue to each person, sufficient debt free money to cover the “lack of purchasing power”. back to Table of Contents

    In a classical sense, Douglas was wrong in his concept of “lack of purchasing power”, and those that concur with “Say’s Law”, which states that the process of producing goods automatically distributes sufficient purchasing power to buy all the goods produced are correct. In the context of Douglas’s example, it is true that wages alone would be insufficient to purchase all the goods produced because of the need to increase prices to cover debt repayments. However, the interest and principle payments distributed by industry also become purchasing power, and would equal any funding gap Having said this, I would have to agree with Douglas in a certain sense, that is, while no funding gap would be created in a 100% reserve banking system, in a fractional reserve banking system, it would be created (though not for the reasons given by Douglas). This is because in a fractional reserve banking system, payments of principle and interest are not distributed to anyone (they provide no purchasing power), but simply cause money (and hence purchasing power) to disappear. (In making a loan payment, the borrowers purchasing power is reduced by the amount of the payment, and since no one else’s purchasing power is increased by the payment, this brings about a reduction in total purchasing power.) This can be compared to a 100% reserve banking system where payments of principle or interest are distributed, can be used as purchasing power, with no money being destroyed.  In this regard, Douglas’s proposal to distribute debt free money must be seen in a positive light, for it would have replaced the money lost due to principle and interest payments, and thus helped maintain the stability of the system.

    While Douglas appeared to intuitively know that there was something wrong with the financial system , and attempted an explanation of what it was, it appears that he did not fully understand the consequences of allowing banks to create money. More importantly, it appears that he totally failed to understand the ability of banks to destroy money. It is this ability to destroy money a creates economic contractions, and not some “timing differences”.

    Impact of Loans on Productive Capacity
    Now, let us consider a fractional reserve banking system when loans are given to increase production capacity. This will increase the number of units produced (which will act to lower the price/unit) as well as increase the amount of money (which will act to increase both price/unit, and the number of units produced). The change in the price/unit will be dependent on relative change in these variables. In subsequent years, the amount of increase in the amount of money will be the difference between new loans to increase production less any payments on principle and interest on previous loans. Even if initially, the percentage increase in the price level is greater than the percentage increase in the amount of production, in subsequent years, the increase in the amount of money must continually fall, even as the increase in the amount of production continues at a set rate, by virtue of ever increasing principle and interest payments acting to decrease the amount of money. Thus, over time, the price/unit must fall and will eventually fall below costs, which will lead to closing of production. Should no new loans be given, this process will only accelerate, as the continual decrease in the amount of money due to principle and interest payments, will decrease the price level below cost at an even faster rate. Put mathematically, we have the following equations;

    Let Z be the increase in production for every $1 increase in new loans (NL)
    Let UP be the number of units produced
    Let P/U be the price per unit

    GDPyn =GDPym +(NLyn –PPyn- Ipyn)*VL
    UPyn*P/Uyn = UPym*P/Uym +( NLyn- PPyn- Ipyn)*VL
    Since UPyn = UPym+(NLyn*Z)
    P/Uyn = P/Uym(UPym/(UPym+NLyn*Z) + (NLyn-PPyn-IPyn)*VL/(UPym+NLyn*Z)

    The price level (P/Uyn<P/Uym) will turn negative prior to the money supply turning negative (NLyn<PPyn+IPyn). As we have already described, for any constant NL, PP+IP will eventually exceed NL even if PP=0. back to Table of Contents

    In an economy operating below it’s productive capacity, it should be expected that the initial loan will result in more production, and will have only a limited effect on the price level. Once the new capacity is in operation, this will lower the price level. Thus, we would expect these loans to have only a minimal initial increase on the price level, soon to be reversed by a downward trend. Are there negative effects to a fall in prices? As a society, are we not more concerned about the number of units produced, and not the relative level of the price level? This question can only be answered by examining how rigid costs are compared to prices. If in response to falling prices, costs, at least in the short term do not fall, then prices will eventually fall below costs resulting in business closures. More importantly, payments of principle and interest are in nominal terms and can not fall. Thus, even if all other costs freely fall with prices, a falling price level will severely impact the financial viability of a business. This may also be a factor in the ability of different costs to fall in response to a fall in prices. Rent costs may not be able to be lowered due to the level of mortgage payments on the building. Workers may not survive a fall in wages due to high personal loan payments.

    A point should also be made that any effects of technological growth are reflected in this financial model by a change in the “# of units produced”. With money remaining constant, an increase in production through technical advancement will see prices fall.  Money is created or destroyed through loan growth or repayment regardless of technological advancement. . Perhaps it is important to touch on a point not well understood. People believe that there must be economic growth to earn money to repay loans. This is the same as saying that we get money from economic activity, which can then be used to repay loans. These statements are false. No economic activity has ever created any money. Money is only created by within the banking system by a new loan. Thus to generate money to repay loans, a new loan must be created creating a circular impossibility. Moreover, since the payment of interest reduces the amount of money without reducing loans, this only adds to the problem of not having enough money to repay loans..  By way of comparison, consider the following statement by Irving Fisher:

    "For, under the 10% system it is true, as we have seen, that an increase in business, by increasing commercial bank loans, and so increasing the circulating medium, tends to raise the price level. And, as soon as the price level rises, profits are increased and so business is expanded further. Thus comes a vicious circle in which business expansion and price expansion act each to boost the other- making a "boom" . Reversly if business recedes, loans and prices also recede, which reduces profits and so reduces business volume- again causing a vicious circle, making a "depression". But take away the 10% system and you take away these unfortunate associations between business and the price level." (p.164 100% Money)  back to Table of Contents

    Irving Fisher felt that the expansion of bank lending would lead to booms, and the contraction of bank lending lead to depressions, mainly due to the change of the price level as a result of lending activities. He thus desired to move away from a financial system where the level of money was determined by the amount of bank loans which he saw as being unstable (though he felt that the 10% system( fractional reserve banking) combined with a stabilization plan would work better than an unmanaged 100% system).

    Strictly speaking, the above statement by Irving Fisher, while containing elements of truth is incorrect. It does not consider that the economy may be operating below capacity, with some expansion possible without affecting the price level. It does not consider what affect that the extra production will have on the price level (lowering it), and it does not consider the effects of interest payments on the price level (through the reduction in the money supply). If we consider the equation:

    (amount of money)*(velocity of money) = (# units produced)*(price/unit)

    it is only considering how the (amount of money) is influenced by changes in commercial loans, and not by the payment of interest. It does not consider that an increase in (amount of money) may lead only to an increase in (# units produced), nor does it consider how an increase in ( # units produced) due to an increase in productive capacity will affect the price level for any given money supply. This shows the error of those that take the view that price fluctuations are the cause of the business cycle.
    back to Table of Contents

    As I have shown, over time, loans that increase productive capacity must eventually be deflationary as the inflationary effects of creating money through new loans are counterbalanced by the deflationary effects of the destruction of money through increasing interest payments as well as increases in the (# units produced). Continual business expansion will lead to eventual bankruptcy as business incomes fall below costs. Should business stop expanding, then new loans stop, and with interest payments continuing, money supply will continue to contract, with the same result, a continual drop in the price level, and income falling below costs. Due to interest destroying money, such a system is not self-sustaining.

    A financial system with money based on debt will be unstable and eventually implode, regardless of how efficient or technologically advanced an economy is.

    Impact of Speculative Debt on the Economy and Financial System
    Let us now consider the effects on both GDP and the financial system as a result of this investment or speculative debt.   To begin with, let us consider a closed system consisting of 10 units of money, 10 units of loans, and 10 units of land.  An equilibrium exists where people are equally happy to hold either 1 unit of land or 1 unit of money, and thus the value of one unit of land is one unit of money.  Some people wish to 
    <15 pages>
    purchase some of the land, and  through the banking system, 10 units of money and 10 units of loans are created.  We now have a closed system of 10 units of land, 20 units of money, and 20 units of loans. The equilibrium value of 1 unit of land would be 2 units of money. Assume now that the creation of new loans stop and repayments begin to repay loans over a 5 year period or 4 units per year plus interest. Assuming a 10% interest rate, we have the following table.

               Money (start)  Loans(start)  Money(end)  Loans(end) Landvalue(start) Landvalue(end)

    Year 1     10.00              10                  10.00            10                   1/unit                    1/unit
    Year 2     20.00              20                  14.00             16                  2/unit                 1.40/unit
    Year 3     14.00               16                  8.40             12                   1.40unit               .84/unit
    Year 4      8.40                12                   3.20             8                   .84/unit                 .32/unit

    After reaching a high of 20, the money supply has fallen to 3.20, which has reduced the price of land from 2/unit to .32/unit back to Table of Contents

    The next points to consider  the effects of these loans within an open economy. In our previous examples, we have assumed that money was either only used as a medium of exchange in economic production or consumption, or as a medium of exchange in purchasing existing assets. Since money is used for both of these, we will show the interaction between both of these systems.

    Consider an open economy that has 10 units of land, 50 units of money, 50 units of loans, and an equilibrium price of land at 1 unit of land = 1 unit of money. Here it is assumed that people are equally happy owning 1 unit of money or 1 unit of land, and that 40 units of money circulate within the economy.  Again, assume that 10 units of money and 10 units of loans are created in which to purchase land.   What is the effect on the economy and land prices?  The answer is that it all depends.  Should people decide that they wish to maintain the same number of units of land that they own, the price of land will rise to $2 per unit.  Should the people who sell land decide not to own land at all, the price will not change.  Generally, the net result will be somewhere between these extremes.  What is the effect on the economy?  Again, if the price of land rose to $2/unit, there would be no immediate effect on the economy.  However, if the price of land did not increase, an extra 10 units of money would be spent on the economy.  People who sell land have an option of using the money to finance expenditures (increase GDP) or holding on to the money.  Should they decide not to spend this money, then as in the first example, the amount of money relative to the units of land will increase and the price of land will increase.  Should this money be spent, the GDP will increase by the amount of money spent. If the price of land increased to $1.50/unit, an extra 5 units of money would be spent in the economy.  We thus see that the results of investment borrowing will increase GDP by the difference between loans created and the increased value of land.

    While this may be a theoretical truism, in a world that is constantly changing, with peoples perceptions of value subject to change and manipulation, over a certain period of time what we can observe is something quite different.  Price changes occur at the margin, generally representing a small percentage of the whole yet affecting the perceived value of the whole. back to Table of Contents

    In our above example, should only 4 units (of the 10) of land be available for sale, and the holders of the new 10 units of money wish to exchange this for land, the value of the land would need to increase to more than 1 unit of land = 2`  units of money.  Carrying on with this example, over the short term, expectations of price movements tend to be based more on historical trends than on economic fundamentals.  Perhaps this is based on the human tendency to view what is observable and not search for the forces and actions creating our perceived reality.

    In any case, in most cases, the following generalities will be observed.
    When new loans (and money) are created to purchase existing assets
    - prices of the asset class will increase
    - some of the newly created money will be spent in the general economy, thus increasing GDP
    - there is an equilibrium price between money and the asset class, though in the short term, these may be a substantial distortion between the market price and equilibrium price.
    Mathematically, we are again seeing the following equation

    GDP = (amount of money)*(velocity of money) = (# units produced)*(price per unit)

    When the amount of money is increased to purchase existing assets, if the velocity of money decreases (people decide to hold on to the money from the sale of their asset), then GDP will remain constant. However, if people decide to spend the money from the sale of assets (velocity of money remains constant), then GDP will increase. It is important to reflect on factors that effect the velocity of money and the effect on GDP. When earnings are spent to purchase existing assets, and not expenditures, then GDP will fall which is reflected in a decline in the velocity of money. When people receive money from the sale of assets, if they spend this money on expenditures, then GDP will increase which is reflected in an increase in the velocity of money. If people receiving money from the sale of assets decide also to purchase assets with this money, then GDP is unaffected. Put differently, it is best to think of

    MT=ME+MI, where;

    MT= total money supply
    ME = money used in business economy
    MI = money held as an alternative to existing assets
    And  GDP= ME*VME

    Should people or firms spend less than they earn, then there is a transfer of the use of money from ME to MI, thus reducing GDP and increasing asset prices. Conversely, if people or firms spend the money that they were holding as an investment, ME increases, MI decreases, with GDP increasing and asset prices falling. A shift to ME to MI will raise income while lowering asset prices. The combination of a lower price and greater income will increase investment returns, and encourage money to flow back from ME to MI, and so we see a natural equilibrium between these two supplies of money. Similarly, a movement to MI from ME will lower GDP while raising asset prices, thus reducing investment returns. This will encourage money to flow back to ME, thus maintaining a natural equilibrium. back to Table of Contents

    If we consider an increase in MI,(say from loans to purchase real estate), this will increase the price of assets while leaving GDP unchanged, thus reducing investment returns. This will encourage money to flow from MI to ME, thus increasing income (GDP), and reducing asset prices until an equilibrium is reached. Similarly, an increase in ME,(say from new loans to purchase automobiles), will increase income without changing asset prices. This will increase investment returns, and money will flow from ME to MI until the equilibrium is reestablished. The reverse of these flows is also true, when money is reduced from payments of principle or interest.

    The above analysis can be used to provide a greater understanding of the factors affecting the U.S. stock market. This market has increased due to a large amount of money flowing into the market. If this money had come from reducing expenditures, this would produce a negative effect on GDP. If this money was created through new loans, then this would not affect GDP. If people decide to sell some assets to increase expenditures, this will increase GDP and reduce the value of these assets. If people decide to borrow against the value of these assets to finance expenditures, this will increase GDP while maintaining the value of the assets.

    Impact of Repayment of Loans
    Now let us consider the effects when new loan creation stops, and repayment begins.  The first point to remember is that new money is created by the amount of new loans created.  However, money is destroyed by the amount of loans repaid plus the amount of interest paid.  That is, even if the total amount of loans outstanding remained the same, each year money would be destroyed by the amount of interest paid.   Thus, over time, in a system where money is created through debt, if new debt creation stops, all money will eventually be destroyed (even if no loans are repaid) as a result of interest payments.

    There are two sources of repayment of loans. Either money circulating in the economy can be reduced, or some money held in lieu of property can be reduced, or some combination of both. In the first case, GDP will fall as the money circulating in the economy falls. In the second case, the price of land will fall, as there is now less money held in lieu of land. In reality, some combination of these two is likely to occur. This will change the rising price trend to a falling one and will alter future expectations.  Should market values have risen substantially above any equilibrium price, they will now start to fall towards the equilibrium price, mindful that the equilibrium price is also falling as the money supply is falling.  The effect on GDP is to decrease GDP by the amount of principle and interest paid as a result of reducing expenditures multiplied by the velocity of money.

    A point should be made here about the stability of the banking system.  Loans are generally secured by collateral (land) and repaid by income.  As the granting of loans will increase both land values, and GDP, this will have a positive effect on both collateral values, and income repayment ability.  However, once credit creation stops, both collateral values and income will fall.  A relatively large credit expansion will increase GDP while increasing land values substantially above equilibrium values.  When such an expansion stops, and land values fall back to equilibrium values, many loans will be left unpayable, especially those made in the latter days of the credit expansion.  As banks are highly leveraged businesses, this could easily lead to significant bankruptcies in the banking industry. back to Table of Contents

    If we consider debt that is created to purchase existing assets, the creation of this debt is likely to partially increase GDP and partially increase asset prices, though the creation of debt is likely to have a much smaller impact on GDP than debt created to fund expenditures.  Repayment of this debt can come from the sale of assets purchased, or by reducing expenditures in the economy.  Should none of the existing assets be sold to repay debt, then all of the payments of principle and interest must be made by reducing expenditures, which will reduce GDP, by the amount of principle and interest payments multiplied by the velocity of money.

    In this way, the creation of a credit asset bubble can have a very negative effect on GDP.  In this case, ever increasing amounts of debt will cause a substantial increase in asset prices.  This propels prices of these assets far above the real value and we generally see the interest costs on these loans far exceed investment returns.  Once credit expansion stops, asset prices will fall to a fair value, which will leave loan balances far above asset prices.  New loans cannot be repaid at all from the sale of assets, and can only be repaid from a reduction of expenditures, which will reduce GDP, by the amount of payments of principles and interest.

    The collapse of the Japanese real estate market in the 1990’s or the asset bubble in SouthEast Asia in 1997 provides a good example of this phenomenon.  Observing what will happen to the holders of margin debt in the U.S stock markets will provide a further opportunity to observe this relationship. back to Table of Contents

    Again, to emphasis the mathematics of these three loan types:
    1) Loans to purchase existing assets will increase these asset prices in a model where the newly created money is not spent in the productive economy. As the prices of these assets rise, the value of investment returns fall given that the investment return has remained constant. In extreme cases, loan growth and asset valuations will be such that loan payments far exceed investment returns. When such a credit expansion stops, asset values will fall to a level that reflects their investment return. Loan values will then be far in excess of asset values and loans can not be repaid from the sale of assets or from investment income.
    2) Loans to finance expenditures will result in loans increasing at a much faster rate than income. When such a credit expansion stops, the resulting decrease in expenditures will significantly decrease GDP, which will decrease incomes, which will further decrease GDP, creating a downward spiral. With loans and debt  repayment remaining constant, and income falling, loan repayment is impossible.
    3) Loans to finance increased production will lead to falling unit prices, which will decrease investment returns. Thus, the greater the increase in loans, the greater is the fall in unit prices and the ability to repay these loans. When such a credit expansion stops, the absence of new loans as well as loan payments will decrease GDP. This will further reduce either the number of units produced or the price/unit of both, further reducing the ability of business to repay loans. Again, once the credit expansion stops, loan repayments are impossible.

    In any economy, all three types of loans will have a cumulative effect, and in the short term this effect will appear to be positive. Credit growth that finances both increased expenditures (either by consumers or governments) as well as business investment will both increase GDP. In addition, the deflationary effects of the business expansion will provide a balance to any inflationary effects of expenditure expansions. Credit growth that finances existing assets will increase asset values. As asset prices rise, they will provide security for increased borrowing while providing the justification for lowering the savings rate. back to Table of Contents
    However, once credit expansion stops, the financial system will implode. When the productive economy is intimately connected to the financial system, the effects will be most traumatic.

    One of the policy points in this exercise of examining a debt-money based economy, is that it is deflation, not inflation, that is the cause for concern. It would also appear that a deflationary spiral would be difficult to stop. In an economy financing the increase in productive capacity, prices will turn negative while loan growth and money supply growth are still positive. This will lead to a contraction in demand for loans to increase production, which further reduces prices, and so a downward spiral is created.   A decrease in interest rates will reduce the total interest paid, which will have a positive affect on the money supply and the price level. However, this is only temporary, as for any given interest rate, the total interest paid will again start to increase over time.

    What is evident from a debt-money based economy, is whenever debt stops increasing, the economy will enter a downward spiral. Thus, the only way for such an economy to continue operating is an ever-increasing level of debt.

    Is There a Maximum Level of Debt?
    The question must now be asked if there is a maximum level of debt, and what factors could influence future debt increases. Since the creation of debt (and money) is a simple bookkeeping entry, these can be increased without limit, and so there is no maximum level of debt. However, with each type of debt creation, there are factors that will tend to restrict new debt (unless these factors are ignored). For debt created to increase expenditures, loan growth will exceed any income growth. It then follows that the value of loan payments will increase faster than income, and at some future date, loan payments will exceed what can be repaid from income. Even here, people can continue to borrow, and banks continue to lend, if they ignore the repayment of loans.

    For debt created to finance production increases, the continual increase in production will eventually lead to falling prices. This will continually reduce profit margins and eventually make the business unprofitable. Here again, it is still possible for banks to continue to finance losses, and even increase production further.
    For loans to purchase existing assets, this will lead to rising prices for these assets. This will lead to lower investment returns for these assets. Eventually, interest costs will exceed investment returns, but even here this does not mean that loans will stop, with new loans to pay interest expense and further purchase of assets. People paying 8% on loans to purchase stocks paying dividends of 1% is a good example of this.

    In order for the economy to function, loans must continue to grow. As we have shown, there must come a time when new loans do not make logical sense if we consider that loans have a  requirement to be repaid. When something happens that causes people to stop borrowing, or stops banks from lending, then the economy will begin to implode. The greater the extremes of credit creation, the more powerful will be the implosion. There is another factor that must be maintained for this system to continue to operate. Not only must people continue to borrow, or bankers continue to lend, but also depositors must leave their deposits within the banks, even knowing that the loans securing these deposits can never be repaid. This can hardly be considered to be a stable financial system.

    Moreover, a fractional reserve banking system is not self-stabilizing. People and firms tend to borrow in good economic periods when profits and incomes are strong, and not to borrow in poor economic times when profits and incomes are weak. In poor economic periods, there are not as many profitable areas to invest in, and in fact many businesses may be losing money. In poor economic times, since their incomes are reduced, people see themselves as unable to repay new debt. This leads to a rising money supply in good economic periods, and a falling money supply in poor economic periods, which is the exact opposite of what is required in order to have stable economic growth. back to Table of Contents

    “All that is necessary is to have a system of creating new money if the price-level tends to fall and unsaleable goods to stack up, and to destroy it if they get scarcer and prices tend to rise. This is quite impossible under the existing banking system, but quite possible under a rational, scientific, and national system, designed in accordance with the physical realities to which production and consumption of wealth must conform. To imagine otherwise is to attempt to preserve a system in which money is issued not to distribute wealth, but as a source of revenue. If there is one lesson that the history of money enforces, it is that when its issue is used as a means of enriching the issuer, whether the issuer be the State, the bank or the counterfeiter, it is the most disintegrating and dangerous power ever created by man.” Frederick Soddy

    Money is the lifeblood of our financial system, and in order for economies to continue to expand, the money supply must continue to grow. The major problem with an economy based on a debt-money system is that such a system both creates money as well as destroys money. What is required is a financial system where money can not be destroyed, but grows at the same rate as the productive economy. We must move away from a system where growth can not occur without the increase of debt. In the words of Frederick Soddy;

    “The invention of a new currency, as a debt to the issuing bank which could never after be repaid, because repayment destroyed the currency and the means of payment, put the whole wealth-producing system of the world in pawn to the banker. Ever after the world was in his absolute power… It is bad enough to be put in the grip of the money-lender who does lend money, but it is a million times worse to be in the grip of the pretend money-lender who does not lend his own money but creates it to lend and destroys the means of repayment just as fast as the debtors succeed in repaying it. This is a surrender of the powers of life and death over the nation’s economic life into the hands of irresponsible imposters.” back to Table of Contents

    A fractional reserve banking system also gives bankers the capacity to create severe financial distortions. At the heart of today’s bubble is a massive credit expansion within America. As noted, increasing loans increases spending which increases incomes, profits, and government tax revenues, all of which have a positive effect on GDP. However, with a creation of such a bubble, there are forces that tend to counterbalance this bubble. In a consumer driven economic bubble such as we find in America, increases in consumer demand will lead to an increase in imports. This in turn leads to a decrease in the exchange rate, which in turn leads to higher inflation. Generally speaking, this increase in inflation in an economy experiencing a credit expansion will lead to higher interest rates which will tend to decrease demand and counterbalance the expansion. Should central banks attempt to keep interest rates low, thus creating an environment of low or negative real interest rates, capital will begin to flow out of the economy, again limiting the credit expansion.

    Thus, in order for the bubble to intensify, measures must be developed to counter the effects of an increasing trade imbalance. This has been accomplished through what is called the “Yen Carry Trade”. The “yen carry trade” is a series of paper financial transactions within the Japanese banking system that has not only allowed the American financial bubble to be created, but has added greatly to it’s rise. Within the Japanese banks, offsetting bookkeeping entries have created vast amounts of new loans and new Yen. This new Yen has been sold for U.S. dollars in sufficient quantity to not only offset the effects of a trade imbalance, but significantly increase the value of the U.S. dollar. This Japanese created liquidity has had a significant effect on America, providing funds not only to finance the trade imbalance, but also funds for the purchase of U.S. government bonds (thus holding down long term interest rates) and investments in the U.S. stock markets (thus helping to fuel the speculative fever). The combination of a rising U.S. dollar, and higher investment returns in America have allowed investors in the Yen carry trade to show significant paper profits. It must be stressed that the creation of such a large financial bubble in America would not be possible without the “Yen Carry Trade”. It truly attests to the power given to bankers to manipulate the world economy through the creation of money from nothing, even to the point of creating money in one country to control the economy of another. back to Table of Contents

    For the purpose of this article, I will discuss the events that will occur, should the loans involved in the “Yen Carry Trade” be repaid. The United States trade deficit is now approaching $250-300 billion. In addition, as the worlds largest debtor nation, there is a significant capital account deficit. Offsetting these outflows has been large capital inflows into the U.S., such as the “Yen carry trade”. As these capital inflows slow, due to the large current account deficit, we will notice a fall in the value of the U.S. dollar. As the dollar continues to fall, there will be pressure on many of the investors in the “Yen carry trade” to sell their U.S. assets and repay their Yen loans. This will first involve a major sell off on the U.S. bond and stock markets to convert to U.S. dollars. Then, this massive sale of U.S. dollars at a time when the trade deficit is about $250-$300 billion/year will accelerate the decline in the value of the U.S. dollar. This will add greatly to future inflation expectations, further accelerating the sell-off of the bond and stock markets. Consumers, seeing the value of their savings fall, will further accelerate the fall as they sell to meet margin calls or salvage their savings before further falls. More importantly, there will be a major reduction in consumption due to rising interest rates, a falling dollar and stock market, all creating a negative wealth effect. In effect, what we will observe is a severe contraction in credit growth. This will put the economy into a major downward spiral with falling employment, profits, and government tax revenue further diminishing demand. It is important to note that a major source of government tax revenue is due to capital gains income, and that once taxpayers start claiming capital losses, the change in tax revenue will be severe. The banks will now be re-evaluating how new loans are given, paying greater attention to the ability of the consumer to repay loans from income. Due to the fall off of income and the major credit expansion over the last few years, very few new loans will be given. In addition, it will be much more difficult to use stock margin accounts to fund consumer purchases.

    Without new loans to help repay old ones and finance consumption, consumers will now face a major decline in consumption. For example, if loan payments equal 16% of current income, in the absence of new loans, consumption will decrease by over 16%(with a negative savings rate). back to Table of Contents

    Corporations, facing rising interest costs and collapsing demand, will see profits greatly diminished. This will be another factor driving down the stock market. Layoffs and insolvency’s will be common place as corporations attempt to deal with falling demand, tightening profit margins (as over capacity leads to more competitive pricing), and rising interest costs.

    Without elaborating further on events occurring in such a nightmare scenario, it must be understood that when a credit contraction does occur, based on logical reasoning, the above events will happen.  It must be also be understood, that the solution to the financial Armageddon described above lies first in understanding how our present financial structure operates, and finding the political will to alter this structure.

    To stop financial Armageddon, the negative effects of present loans must be neutralized, and bankers must be prevented from creating money from nothing.  Neutralization would come from replacing all bank loans with government notes.  For example, the government bonds held by the banks would be replaced with government notes.  This would be non-inflationary, as no “new” money would be created.  The only effect would be to replace government bonds with government notes as bank assets.  Should depositors wish their money, the bank would have the notes to go with them.

    The only difference is that while government bonds pay interest and have to be repaid, government notes do not.  Thus, the taxes collected to pay the interest and principle on the bonds could be eliminated.  In a similar manner, all bank loans could be replaced with bank notes.  This could destroy the ability of banks to collect vast sums of money as well as manipulate the economy. It must be emphasized that banks have already created vast sums of money. What must not be allowed to happen is for this money to be destroyed, either through repayment or default, as this will have a major negative effect on world economies.  As a special case, all debts to the third world country’s can be eliminated at no cost to Western governments and taxpayers, while improving the financial soundness of the worlds financial system. Most Third World debts are structured as follows.  back to Table of Contents

    Debts are owed to commercial banks, or to organizations like the IMF and World Bank which obtain much of their funds from loans from commercial banks (often with a government guarantee), or to Western governments which again obtain their funds from commercial banks.

    For debts owed directly to commercial banks, Western governments would print up bank notes totaling the loans outstanding. These would be deposited with the commercial banks as repayment for the Third World debt held. Essentially, the balance sheets of the commercial banks would be strengthened, for instead of having loans that could not be repaid as assets, these would be replaced with government notes. Depositors will be more confident in their financial system, knowing that if they wish the return of their money, that the banks will have government notes to give them, and not have their money invested in bad loans to Third World countries.

    For Third World loans to organizations like the IMF and World Bank, governments would print up government notes as repayment for the Third World Debts. The IMF and World Bank could then deposit these notes in commercial banks in repayment of their loans with commercial banks. back to Table of Contents

    For Third World loans directly to Western governments, Western governments would cancel these loans

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    whiles printing up an equal amount of government notes.  These notes would then be deposited in the commercial banks as repayment of government loans (the purchase of government bonds held by commercial banks).

    Thus, for the cost of printing government notes, the entire debt burden of the Third World would be eliminated while improving the financial soundness of the worlds financial system. It is important to note that this printing of government notes is not inflationary and will not increase the money supply. No new money is created with no one having any additional “ money “.  All that has happened is that banks have substituted assets, replacing loans with government notes. Commercial banks, and their international organizations, the IMF and World Bank, would no longer be able to steal from the poor, and would no longer be able to control and manipulate these people.

    Put differently, consider the balance sheet of the bank, one side consisting of assets (loans, bonds etc.), and the other side the banks liabilities (deposits). To convert from a fractional reserve banking system to a 100% reserve banking system, the government would print up bank notes totaling the assets of the bank (these notes can be purely digital), which it would use to purchase the assets of the bank. Deposits are now backed by an equal amount of bank notes, and financial transactions will continue as before, except that the creation of additional bank deposits will no longer be tied to loan creation. The government, now owing all the debts of the nation, could cancel all debt, could cancel all interest payments, or could require all payments be made to the government. In the first case, government taxes would fall by the amount of interest previously paid on the national debt, and peoples disposable income would increase by the elimination of all loan payments plus reduced taxation. In the second case, government taxes would fall by the amount of interest previously paid on the national debt plus the amount of principle payments paid on all non government debt. In the third case, government taxes would fall by the amount of interest previously paid on the national debt plus principle and interest payments paid on non government debt.

    “The proposal, therefore, is that the Government should issue the necessary money to the banks in exchange for the borrowers collateral, so that henceforth these borrowers owe, not the banks, but the nation which, not the banks, has supplied the goods.” Frederick Soddy  back to Table of Contents

    Summary of Concerns with Fractional Reserve Banking
    In summary, the major concerns with a fractional reserve banking system are;
    1) Banks are able to create loans and deposits by means of bookkeeping entries, and by charging interest on these loans( that they have created virtually out of nothing), they are able to transfer significant amounts of real wealth into their hands.
    2) Banks, by being able to create loans and deposits at will, can create severe financial distortions as they direct this newly created money into specific areas. The “Yen-carry trade” is a good example of this.
    3) As banks create loans and deposits, this will be seen to have a positive effect on GDP. However, as loan growth stops, this will lead to a contraction of GDP. By being able to create and control periods of economic expansion as well as economic contraction, bankers are able to effectively speculate in the economy, further concentrating wealth and power within their control.
    4) It is a classic pyramid scheme. It is based on fraud and deceit, is not self-sustainable, and will implode. The amount of money created ( by new loans ), is always less than the amount of money that will be destroyed in the repayment of loans( principle plus interest), it then follows that it is impossible to repay loans. As bankers attempt to maintain their pyramid scheme by ever increasing amounts of loans, as previously shown, financial distortions are created that will eventually implode the financial system.

    In examining the problems with a fractional reserve banking system, I have shown how all of these can be eliminated by changing to a 100% reserve banking system, which we will discuss in more detail. In this case, when a loan is created, the lender must transfer money to the borrower. No money has been created, only ownership has changed (the lender now has less money while the borrower now has more money). In a 100% bank reserve system, the bank must hold a dollar in government notes for each dollar on deposit. As such, no deposits are available to lend. In order for banks to lend in such a financial system, they would first have to borrow money from depositors, and then re-lend it at a profit. What we would observe is for every loan transaction, one persons deposit value would increase, with another persons deposit balance decreasing by an equal amount. The ability of the borrower to increase expenditures is offset by a reduction in the ability of the lender for expenditures, and thus it tends to have a neutral effect on GDP. When the borrower makes a payment of principle or interest, his reduction in money is offset by an equal increase in money by the lender. Again, the amount of money does not change with the repayment of loans. Again, when a borrower makes a payment of either principle or interest, this will reduce his capacity to spend while increasing the capacity of the lender to spend by an equal amount. This will tend to have a neutral effect on GDP. back to Table of Contents

    While borrowing and lending will tend to have a neutral effect on GDP, it is important to understand how each will affect demand and hence GDP as neutrality is not guaranteed. Savings represent a withdrawal from economic activity, and hence a reduction in GDP. Loans represent an increase of money for economic activity and an increase in GDP. Savings and loans are not necessarily equal, and this points to the need of efficient financial markets to distribute savings back into the economy. Interest and principle payments, by taking money out of economic activity, will reduce GDP. Dis-savings will put money into economic activity and increase GDP. Simply put, savings , as well as interest and principle payments will reduce demand (GDP) in an economy, while loans and dissavings will increase demand (GDP).  Money would no longer tied to debt, which would make the system self-sustaining. The government could create additional money each year, that would maximize economic output, and distribute the benefits of this new money in an equitable manner. Government notes would function as a bookkeeping entry, more than a means of exchange, with most financial transactions being conducted as they presently are. In fact, these notes could be purely digital.

    We should think of money as a community utility, a utility that will be used to enhance the well-being of every person, especially the most marginalized. As an economist, we would determine the optimun level of money in an economy, and the level of annual increase in money that would most benefit the economy. As a policy maker, we would have to consider who should benefit from the annual increase in the money supply. A centralist would have all the benefits remain with the government, which would distribute at according to it’s policy’s. A decentralist, would have an annual payment made to all citizens.

    Now I do not recommend replacing banking, or even the form of exchange. Indeed, our present form of exchange would appear to be quite efficient. The real question is how is money created, and who benefits from its creation. At present, money is created when banks give a new loan. The real question we must ask, is this the best way of creating money, and what other alternatives are available.

    The key point that I am making, is that what money is, and how it is created, will create very different economic effects. In today’s financial system, money is either created through the printing of Government Notes, or in the banking system by increasing loans or purchasing assets. With Government Notes making up just over 1% of bank assets, most money is created through new loans. While we consider both Government Notes and bank deposits to both be money, we must understand that they are very different, and it is in understanding how they are different that we are able to more fully understand how our economic structures operate.

    A point should be made about other models of the business cycle. Real-business cycle models omit monetary disturbances as a source of the business cycle. Thus, the inability of a person to get a new car loan should not affect consumption, or having to make loan payments should not affect the ability of a person to consume the whole of his earnings. Such models are not true on a microeconomic level, and by expansion on a macro-economic level. back to Table of Contents

    Keynsian theory also lacks microeconomic foundations. It gives current income an important role in determining consumption, yet does not consider how consumption is affected by new loans (increasing it) or by loan payments (decreasing it). Nominal money supply is considered set by the government, totally ignoring the role of banks in creating money. The role of money in determining interest rates is seen as affecting investment, but the effects of creating money on the economy are ignored.

    By comparison, this economic model has started with the basic truism of the Quantity Theory of money. It has considered how new loans as well as debt repayments affect this equation. It has looked at two types of loan creation and shown how these will have very different affects on the economy. Specifically, it has shown that if the debt is first created, and then used to create money( as in a fractional reserve banking system), that this will have a very different effect then when money first exists, and then is loaned, as in a 100% reserve banking system. back to Table of Contents

    I have considered the views of other monetary reformers such as Douglas or Fisher, and have shown that while they attempted to bring monetary considerations in their understanding of the business cycle, that their ideas, while presenting worthwhile alternatives, fell short of a complete understanding.

    As I mentioned at the start of this article, the understanding of our present financial system is crucial in economic analysis. While some have understood that the creation of bank loans also creates money, and the repayment of bank loans destroys money, none have applied this understanding to the Quantity Theory of money. Most importantly, it does not appear that others have understood that the payment of bank loan interest also destroys money, and that this has a most profound and major affect on the business cycle. It is this fact alone that ensures a total economic collapse under a fractional reserve banking system.

    After reflecting on the above analysis, it is useful to consider the status of the United States stock market.  When the S & P 500 hit it’s high in July 99, the average Price/ Earnings ratio was 37/1.  Assuming an 8 % interest rate, the Net Present Value (NPV) of earning $1 per year is about $12, valuing the S&P 500 at 308% of its NPV.  Not only is the S&P 500 index overvalued by over 300% based on present fundamentals, future adjustment of NPV are very much likely to be to the downside.  Firstly, we are nearing the end of a massive credit induced grow cycle which has increased business profits.  When credit expansion stops or contracts GDP and profits will fall. Secondly, current risks are currently for a rise in interest rates, which will only increase once the U.S. dollar begins to fall.  Moreover, these adjustments are likely to be much greater than many anticipate. It is also important to note, that the value of current earnings may be substantially overvalued. . Specifically, in that the credit expansion within America and Japan (financing the Yen Carry Trade) has lead to an increase in American economic activity, this has been supportive of American profitability. Secondly, with a rising stock market, the defined pension plans of many companies have risen in value to such an extent that no company contributions are now required, inflating company profits by the savings of pension contributions. back to Table of Contents

    Thirdly, an era of share buy-backs has been used to increase earnings per share. For the most part, these buy-backs are financed through loans, and not profits. For example, since 1995, IBM has reduced the number of shares outstanding by 22%, while it’s debt has increased from $22.6 billion to $30 billion. According to the Federal Reserves flow of funds data, for non-financial corporations, in 1994 a net $44.9 billion in stocks were retired while corporate borrowings showed a net increase of $51.3 billion. In 1998, a net $262.8 billion in stocks was retired while net borrowings increased by $342.9 billion. We must ask why U.S. companies are buying back their stocks on credit, which not only leverages their earnings, but also further fuels an overvalued stock market.

    Fourthly, the use of stock options, particularly by technology firms, has significantly understated compensation paid to employees, and thus significantly overstated profits. For example, Microsoft, with a market value approaching ½ trillion dollars is valued at over 20 times sales. By some estimates, if the value of stock options given were shown as an employment expense, the company would not be profitable. back to Table of Contents

    On August 16,1999, Morgan Stanley issued a report titled, “U.S. Fears of a Consumer Debt Squeeze are Overblown”. They note that the decade long consumer borrowing and spending binge has left households with record debt levels, now totaling 101 percent of disposable income. The concern is that rising interest rates will cause consumers to spend less due to higher debt costs. However, Morgan Stanley argue that with rising incomes and falling interest costs over the last year, scheduled payments of principle and interest have fallen to near 16 percent of disposable income over the last year, and that consumers are somewhat insulated from rising interest costs due to fixed rates on part of their loans.  Accordingly, they do not expect a significant impact on consumer spending. However, what Morgan Stanley has completely ignored, is the level of the national savings rate in assessing the ability of the consumer to continue on its spending binge. While making debt payments of 16% of disposable income is not a concern when the savings rate is 20%, it is quite another matter when the savings rate is the current –1.2 percent. Simply put, with a savings rate of 20%, consumers still have the capacity to increase expenditures even if debt service costs increase slightly. However, with a savings rate of –1.2 percent, consumers must already borrow 17.2 percent of disposable income just to make present loan payments and personal expenditures, and rising interest rates will only magnify this distortion.
    To look at the effects of the level of debt payments on future consumption without considering the present savings rate presents a totally flawed analysis. It either represents a case of the blind leading the blind, or a deliberate attempt to present a false theory to manipulate opinion.  The reality is that Americans must obtain new loans totaling 17 percent of disposable income just to fund present expenditures. This is in no way sustainable, and either from the withdrawal of bank credit or voluntarily stopping going further into debt, one day it will stop.  When Americans reduce expenditures by this 17 percent of disposable income, it will have a very negative effect on GDP and thus corporate profitability. This will only increase current price/earnings ratios, and further distort the value between the S&P 500 and it’s Net Present Value. It is my opinion that should Americans decrease expenditures by 17 percent, that profitability would fall by over 50 percent which would place the value of the S&P 500 at over 600 percent above it’s Net Present Value. Moreover, as discussed previously, a fall in expenditures of 17% is likely to cause a fall in employment, which will further decrease expenditures and so a downward spiral is created.   According to the economic model that has been developed, new loans with interest costs of 8-9% and used to purchase stocks paying dividends of 1% that are presently valued at 308% of Net Present Value will one day have a very negative effect on the economy. back to Table of Contents

    On August 18,1999, China’s State Economic and Trade Commission announced a ban on all new projects involving a broad range of consumer investment. After many years of over investment, deflationary pressures are resulting in most companies now making little or loosing money. Beijing has already attempted to slow the deflationary pressure by imposing price floors. China is also stopping the construction of luxury apartments, hotels, department stores, and office buildings. With office vacancy rates in Shanghai now up to 70%, China has now entered into a major deflationary spiral. This will only accelerate as investment spending slows. Given that China is in a major deflation, with insolent companies, an insolvent banking system, bloated inventories, and soon to be contracting investment, those economists that have pointed to rising GDP as a sign of strength may have missed the dynamics underlying what really happens in an economy.

    Today, we tend only to look at the surface, and not understand the forces that control and manipulate our economies. A report has been written by the Federal Reserve Bank of Cleveland called; “Beyond Price Stability: A Reconsideration of Monetary Policy in a Period of Low Inflation”, and is available at
    Error! Bookmark not defined.. I quote part of this report;

    “As we entered 1999, the pace of real economic activity once again exceeded market expectations of substainable growth by a wide margin. Consumers continued to aquire houses and durable goods at a fast clip, and financial institutions provided the credit necessary to support a prodigious rate of national spending. The United States is borrowing from abroad to consume far more than it produces and, at the same time, through Social Security, it is transfering resources from future generations to bolster the consumption of current retirees. This spending frenzy finds additional support from equity markets, where price levels and earnings multiples continue to set records.

    The experiences of the 1920s and 1930s provide a perspective from which to think about today’s monetary policy. Real growth may indeed reflect the transition to a permanently higher level of material well-being, ushered in by the information technology revolution that began 20 years ago. Current spending patterns may indeed be a justified response by current generations to the prospect of permanently greater wealth for themselves and future generations.  But exceptional demand conditions in the United States have also been accompanied by torrid monetary expansion. M2 growth has been accelerating for the past five years, reaching a nearly 9 percent rate last year. Its growth rate exceeds what would normally be seen in an economy with 5 percent to 6 percent nominal growth and relatively stable interest rates. back to Table of Contents

    Surprisingly, consumer price inflation registers only between one and two percent. The conventional explanation for reconciling strength in economic activity and monetary growth with the benign inflation rate is a shift in the demand for money. A surge in money demand means that people have decided to hold more of their wealth in the form of money balances. This could happen if the cost of holding money relative to other assets has declined, or if people desire more liquidity. If money demand surges along with an expansion of money supply, harmful inflationary developments or other types of market instability might be considered unlikely.

    There is, however, a significantly more troubling interpretation of events, a view grounded in historical precedent. Suppose that people have been overestimating the size of the productivity gain and confounding asset price valuations. These mistakes may have converted a real burst of productivity-driven output and wealth gains into speculative excess. In this view, asset prices do not accurately reflect projections of the future earnings streams. Instead, they reflect a situation in which earnings are overvalued and supported by excess liquidity. Conventional consumer price inflation, then, becomes only one concern. back to Table of Contents

    Even worse is the possibility that when the speculative excess ends, it will bring with it the type of real dislocation that has surfaced in the past and has recently plagued Japan and other countries. Similar signs were present in those economies- fast money growth accompanied by stable prices but soaring asset prices. The warning signs were neglected, and those economies paid for that neglect.

    A particular problem arises when the absence of overt inflation acceleration leads analysts, producers, and consumers to underestimate the corrosive influence that easy monetary policy can accommodate in the economy. Do these corrosive influences now exist in the U.S. economy? Households may feel wealthier, but the most significant portion of that wealth now consists of equities, not their homes. Consumer spending has been brisk lately, but its pace has been achieved through declining savings rates and increased debt-to-equity ratios. Consumers appear to be relying heavily on their equity holdings as a financial cushion.

    For their part, banks find it increasingly difficult to fund commercial loan growth without purchasing funds in money markets. Banks’ balance sheets show that securities share of total assets has been dwindling, reflecting reduced liquidity. Consequently, the economy could be vulnerable to a sharp downward revaluation of stock prices, because consumer spending could fall off and because equity finance has become a vital source of corporate financing. back to Table of Contents

    Does this explanation of recent events require irrational exuberance to hold it together? Yes and no. It certainly requires that mistakes are made, but it does not necessarily imply that a chain of negative consequences can occur only in the presence of widespread irrationality. Ordinarily, economists would expect market forces to correct mistakes in judgment about equity valuations and bond prices as more information becomes available about the underlying strength of corporate profits and monetary policy. But suppose that financial market participants think that monetary policy will respond to unsettled market conditions by injecting more liquidity. The results of such actions could short-circuit the normal forces that would generate market corrections, at least for a little while. For its part, the monetary authority could find itself in a sort of “expectations trap.” The best choice of action at each decision point may seem to be one that validates private expectations and calms roiled markets, despite the fact that excess liquidity conditions would still prevail.”

    I would suggest that those economists that are presently looking at only inflation and GDP growth as a sign of a healthy economy are creating a dangerous illusion. While I would not expect the Federal Reserve Bank of Cleveland to provide a truthful analysis of our fractional reserve banking system, in their own way, they have provided a definite warning of future events, a view that is most consistent with what I have presented. back to Table of Contents

    This paper represents an economic viewpoint that may be unique in it’s understanding, and is certainly directly opposite conventional economic thought.  The question that one must ask is what is the truth? Is not every work subject to the criticism of those who are unable to commit themselves to understanding it in depth?  In my writings, I have argued that mankind seems to have lost the ability to distinguish reality from illusion, mainly because he has lost his ability to distinguish good from evil.  He has lost the ability to trust his reason to know the truth and is so swayed into various false doctrines. Those same people, who do not take into account decisive arguments in favor of the truth, will latter follow doctrines and opinions without foundation. Indeed, it is our failure to understand sound economic doctrine that ultimately will lead to our enslavement.

    We are about to leave a century where many have identified it according to their personal point of view. International capitalism has been pitted against materialistic socialism, with few people having the understanding that both are controlled by the same forces, who respect no frontiers and play equally well on both sides. Both powers pretend to give people a total solution to their problems while enclosing them in their nets. back to Table of Contents

    The ultimate test of any theory is its ability to predict and explain actual events.  My writings, using logical arguments and sound mathematics have shown that unless we change our financial system, and eliminate our fractional reserve banking systems, that we will see the collapse of world stock markets, bond markets, currency’s and economies. Mankind must once again seek the truth, and once found live by this truth.  The consequences of living a lie will be most traumatic under the light of revealed truth.

    John Kutyn; johnkutyn@connect.ab.ca
    March 5, 2000
    Edmonton, Alberta, Canada
    Alternative email:

    Keynes and the Classics, a criticism
    “The central error of all present economic thought, is its failure to understand money from its microeconomic foundation”

    A few points should be made about the two major present economic camps, the Keynesians and the Monetarists. In these comments, it is assumed that we are operating under a fractional reserve banking system.

    First we will consider Keynesian views starting with the Aggregate Demand (AD) and Aggregate Supply (AS) curves. Aggregate Demand represents what all the entities in the economy would buy at different price levels assuming that all other factors affecting aggregate demand remain constant. It is assumed to be downward sloping with demand rising as prices fall. The basic problem with this concept is that price is not an independent variable, that a change in price will change other factors, or will be caused by a change in other factors. To talk about price changing while other factors remain constant then presents itself as a logical contradiction. For example, consider the equation:

    GDP=( # units produced)*(price/unit) = (amount of money)*velocity

    A rise in the price level, with money remaining constant, will reduce the # units produced. Alternatively, if we assume that real production remains constant (as Keynes would suggest), then money supply must increase in order for prices to rise. Under a fractional reserve banking system, money is only increased when loans increase, and since under a fractional reserve banking system these loans are a source of demand that increases income; it becomes totally illogical to say that all things are remaining constant. back to Table of Contents
    Another problem with AD curves, and in fact with most graphs used in the Keynesian presentation is that they are never strictly definable. In addition, they make an assumption of how people or firms will act, and when people or firms act in a different manner than this assumption, the whole model breaks down.

    The AD and AS curves are treated as independent, with a change or a shifting out of the AS curve having no effect on the AD curve. A shifting out of the AS curve will increase production and hence employment income at any given price level. Keynesian analysis assumes that this increase in income will not affect demand, that demand is determined by price and not income. In truth, demand is not determined by price, but by purchasing power. Demand is a function of what is earned plus what is borrowed less loan payments less savings plus dissavings.

    The Aggregate Supply curve (AS) represents the quantity of goods and services that businesses are willing to produce and sell at any given price level and again assumes that other determinates of aggregate supply are held constant. It is upward sloping indicating that as prices fall, production will decrease, and with prices rising, production will increase. The use of the AS curve presents the same logical contradictions as using the AD curve, namely that price is not an independent variable, and a changing price level will be caused by other factors changing or will cause other factors to change.

    <25 pages>
    It assumes that firms will act in some specified manner and when they do not, the model breaks down. For example, a government may encourage production regardless of profitability, with firms financing losses through borrowing. back to Table of Contents

    Now let us consider the LM and IS curves used in Keynesian presentations.
    The “LM curve” is a representation of the monetary equilibrium condition and specifies the level of income, which, for different rates of interest makes the demand for money equal to the supply of money. The money supply consists of demand (chequeing) accounts at banks and government notes and is considered constant. The demand for money is considered a combination of the transaction demand and the speculative or liquidity demand. It is assumed that with higher rates of interest, that their will be less demand for speculative money, thus increasing the money available for transactions, which will then support a larger volume of transactions (a higher level of GDP). Lower interest rates will increase the liquidity or speculative demand for money, decreasing the money available for transactions, thus supporting a lower level of transactions (a lower GDP).

    The first problem is that the whole question of analyzing money from its micro-economic foundations is ignored. Today, virtually all transactions are handled through the banking system and it is this system that we must understand in order to evaluate the “LM curve”. Transactions are completed through an exchange of deposits, one deposit is credited, and another debited. Total deposits are increased whenever a new loan is given. Total deposits are reduced with the payment of either principle or interest on a loan. Banks create different deposit types and may restrict the liquidity or use of some deposits. By this we mean the ability to transfer funds from one account to another. For example, funds in a term deposit may not be available to be transferred until a certain date. Deposits are used for a wide variety of purposes; to buy currently produced goods and services, to buy existing real assets such as real estate, to buy financial assets, and to act as a store of value or savings. back to Table of Contents

    The Keynesian “LM curve” fails because it considers only one type of deposit, assumes its value does not change, and assumes it is only used to purchase currently produced goods and services or as a store of value. While the concept of liquidity preference makes some sense, one must ask if liquidity preference is not met by the various choices of the deposits offered. After all, all deposits could be placed in chequing accounts, and the fact that they are not must indicate some sort of liquidity preference is involved. Liquidity preference is determined by a substitution of deposit accounts, and not a crowding out of the transaction use of money. What the Keynesian theory is saying, is that because interest rates are low, I am going to want to hold onto the money in my chequing account and will therefore reduce my consumption. Such a statement is so illogical that I doubt that you will find one person who will adhere to it. In fact, it is the opposite that will happen. With higher interest rates, future consumption will be more valuable, so I will be inclined to transfer money from a chequing account into a savings account, reduce my current consumption in return for a greater future consumption. This will reduce the transaction demand for money.

    The “IS curve” is a representation of the product market equilibrium condition, and it shows the level of income that will yield equality of intended investment and savings at different possible interest rates. It assumes that a fall in the rate of interest will imply a higher level of investment and therefore greater income (GDP). back to Table of Contents

    The model assumes that investment is dependant on the interest rate, that Investment = Savings, that there is a definite relationship between savings and income, and that if we know the savings rate, we can determine the equilibrium income. There are several problems with this approach. Firstly, savings are not equal to investment. If we consider savings to be that part of earnings that is not spent on current consumption, then what a person saves he has available to invest. If he chooses not to invest, then these funds are withdrawn from the transaction use of money and become part of the speculative component. Should a person borrow to finance investment, then new deposits are created, with these deposits increasing the transaction component of money. These are totally independent events. Should all savings be used for investment, then investment will exceed savings by the amount of any borrowings. Even the definition of savings may not be correct. If a person is making loan payments, then savings would equal earnings less current consumption less loan payments.

    One of the most important relationships in Keynsian theory is the consumption function, which shows the level of consumption expenditures and the level of disposable income. It is based on the hypothesis that there is a stable empirical relationship between consumption and income. It infers that as income rises, that consumption will rise but at a smaller amount. While economists can plot historical relationships between income and consumption, this does not imply an empirical relationship. While there is a definite relationship between income and consumption, consumption is also positively affected by new loans, and negatively affected by loan payments. Both of these are excluded in Keynesian thought, which makes income the sole factor determining consumption. Moreover, the claim of an empirical relationship between consumption and income is not strictly definable, nor is it supported at all times by what is actually observed. For example, the U.S. population, currently earning more income than any people in history has a negative savings rate. On the other hand, the Chinese people, with a fraction of the income, have a much higher savings rate. The Keynsian model relies on people acting on how Keynes thought that they should act, and when they act in a different manner, the models totally break down. back to Table of Contents

    Keynesian theory assumes that altering the money supply has no direct effect on current income, that there is only an indirect effect, with changes in money supply affecting interest rates, which influence investment. It is felt that the transaction motive is relatively insensitive to changes in the rate of interest, so that the effect of changes in the quantity of money upon the speculative motive is the major basis upon which monetary management rests its case for control of interest rates. Since the money supply is only increased when new loans are given, and since the proceeds of these loans are generally spent on consumption or investment (though they can be spent to purchase financial assets or existing real assets in which case they have no direct effect on income), these loans have a direct effect on income, again contradicting Keynesian thought. Money supply is decreased through interest or principle payments, and since these payments reduce the funds available for consumption or investment, the decrease in the money supply will also affect income.

    While we have already discussed the errors of Keynesian thought regarding the speculative or liquidity demand for money, we should discuss those factors affecting the demand and supply of money. The demand for bank deposits and the supply of bank deposits do not have a direct relationship, so it is inappropriate to think of a pricing mechanism such as interest rate that will equate the demand and supply. Deposits are increased whenever loans are increased, and decreased whenever payments of principle or interest are made. The demand for deposits is a result of the transactions demand (which is affected by the overall level of economic activity) as well as deposits held as a store of value (the speculative or liquidity demand). However, an increased demand for deposits will not affect the supply. Should loans stop growing, deposits will contract and approach zero by virtue of interest paid on loans. Alternatively, a continual acceleration of loan growth will continually expand deposits. Severe distortions between the demand for and supply of deposits can be created, and no pricing mechanism will be able to correct these imbalances. If interest rates are not set by the demand or supply of deposits, what then affects interest rates? Here I would suggest that the bond market or central bank policy would be the major determining factors.
    back to Table of Contents

    This is not meant to be an exhaustive criticism of Keynesian thought, but is sufficient to totally discredit a theory so full of logical contradictions, errors, and over simplifications that we must wonder how it was ever taken seriously. What Keynesian thought did do, was to provide the theoretical justification for massive increases in government spending, thereby increasing government control over individuals and the economy. The massive increases in government debt, both in the third world and industrialized nations have enslaved billions of people, and delivered them into the hands of the banking community.

    Classical economists hold that “supply creates its own demand”, that money makes no difference than frictionally, and that consumption is limited to production.
    Milton Friedman argued that nominal variables such as money supply or inflation could not permanently affect real variables such as output or employment. Real variables were determined by real forces.

    Say’s law has been stated as follows;
    1) supply creates its own demand
    2) since goods are exchanged against goods, money is but a veil, and plays no independent role
    3) in the case of partial overproduction, which necessarily implies a balancing underproduction elsewhere, equilibrium is restored by competition, that is, by the price mechanism and the mobility of capital.
    4) Because aggregate demand and supply are necessarily equal, and because of the equilibrating mechanism, output can be increased indefinitely and the accumulation of capital proceed without limit. back to Table of Contents

    Keynes is said to have refuted Say’s law, while Douglas has said that it is wrong because prices must be raised to cover loan payments, and thus demand is insufficient. To understand the forces that shape demand, we must understand the cash flow statement for a company.

    Less  Funds paid to other firms
    Less  wages
    Less  principle loan payments
    Less  interest loan payments
    Equal funds available to owners

    When we consider the economy as a whole, that is the sum of all firms, “funds paid to other firms” becomes nil, so we have;

    Less  wages
    Less  principle loan payments
    Less  interest loan payments
    Equal funds available to owners

    We are dealing with a simple equation, a truism, that states the following:
    Sales distribute sufficient purchasing power, such that, if wages, principle loan payments received, interest loan payments received, and funds available to owners are spent, then supply and demand are equal.
    Sales = wages + principle loan payments +interest loan payments +owners funds received

    What this equation does not tell us, is if there are other sources of demand, and if wages, loan payments received, and funds available to owners will actually be spent. That is, it does not give us a complete model of demand. We will now examine each component. back to Table of Contents

    Does wages received = money spent by wage earners?
    Personal expenditures are governed by the following equation;
    Wages received + new loans = money spent on consumption or investment + loan payments + increase(decrease) in bank deposits(savings)

    We see that “money spent on consumption or investment” or demand, is dependant on four factors, of which “wages received” is only one factor. Particularly, in a fractional reserve banking system, where new loans are not the result of savings, but new money creation, they are an important source of demand. As loan payments are not distributed to anyone, but simply cause money to disappear, they are a significant cause of a deficit in demand. Personal savings result in wage income not being redistributed (lowering demand), while dissavings results in demand greater than wage income.

    Does “loan payments received” = money spent by those receiving loan payments?  This depends on the type of loans involved. Drawing on the above comments, the payments on bank loans in a fractional reserve banking system will not redistribute money, but simply cause money to disappear. This is a significant cause of deficit demand. Other loans, or bank loans in a 100% reserve banking system will redistribute money (money does not disappear or change), but this could still cause some deficit demand if those receiving the loan payments do not spend it. back to Table of Contents

    Does owners funds received = money spent by owners?
    Again, this is governed by the following equation; Owners funds received + new loans = personal spending by owners + investment + increase (decrease) in bank deposits.

    Considering demand (personal spending by owners + investment), it is affected by three separate items, of which “owners funds received” is only one. Again, in a fractional reserve banking system, where new loans are not a result of savings, but of money creation, they are a significant factor in demand. This again demonstrates, that in a fractional reserve banking system, unless new loans are greater than or equal to principle plus interest loan payments, that this will cause a significant deficit in demand.

    With deficit demand being the primary cause of business downturns, and surplus demand being the primary cause of business expansions, this analysis, by focusing on the factors affecting demand, also provides a greater understanding of the factors involved in the business cycle. It is important to note that most of these are financial factors (new loans, loan payments, savings), and that financial factors will have different affects, depending on the financial system (fractional reserve banking or 100% reserve banking). back to Table of Contents

    The above analysis shows the effects of financial factors on demand assuming the firms continue to exist. Should financial factors affect profitability so that firms cease to exist, then the results will be more traumatic. On a microeconomic level, this analysis has also failed to examine the overall balance of loans in anyone firm, and this can also have a significant affect on production. For example, a firm may have too much short term debt, and too little long term debt, which will restrict working capital and the firms ability to produce. The microeconomic analysis of firms and debt, (both to the structuring of this debt, as well as amount required), and the effects that this will have on overall production, is presently lacking within the economic community.

    It is hoped that this analysis will show the errors of Classical or Monetarist economists, who failed to understand the microeconomic foundations of money

    John Kutyn
    February 4, 2000

    Monetary Aggregates
    Governments and economists have several different monetary aggregates. For example, in Canada, the composition of these may include the following: currency outside banks, demand deposits at banks, notice deposits at banks, demand and notice deposits at near banks (Credit Unions, Trust Companies), Money Market Mutual Funds (MMMF), T-Bills, Provincial Savings Bonds, Canada Savings Bonds, Annuities of Life Insurance Companies, Mutual Funds, 1-3 year Government Bonds, Mortgage Backed Securities, Bankers Acceptance, Commercial Paper.

    Money is considered as a means of exchange, a unit of account, and a store of value. All of the above financial assets could be considered a store of value. However, in our present economy, almost all transactions are the result of a transfer of government notes (currency held outside banks or near banks), or deposits held at banks or near banks. As such, only these financial assets could be considered to be money. One question that arises is if notice or term deposits at banks or near banks would fit this definition of money, since the ability to transfer these deposit balances may be limited to some future period. Notice or term deposits could be demand deposits, with the holder of these deposits giving up this liquidity in exchange for a higher rate of interest. Since these deposits are not currently required for any transactions, it can be argued that these deposits represent money used as a store of value. In time, all deposits can become demand deposits. This is not true of any other financial asset. Deposits, whether demand, notice, or term, are all created as a result of new loans, and are all destroyed as a result of interest or principle loan payments.
    back to Table of Contents

    As such, it is argued that all deposits at banks or near banks are money, and that the separation between demand deposits and notice or term deposits, is only the result of liquidity preference and the particular way in which different deposits satisfy different uses of money (deposits not required for immediate transactions will accept lower liquidity for a higher rate of interest).

    It is also important to contrast how other financial assets are created or destroyed in order to further clarify the difference between these assets and our definition of money.

    The creation of financial assets involves the transfer of bank deposits, but does not change the overall level of bank deposits (the exception being when banks or near banks purchase financial assets). An investor invests in a Money Market Mutual Fund (MMMF) by transferring a portion of his or her deposit account to the deposit account of the MMMF. The MMMF may purchase a newly issued corporate bond by then transferring a portion of its deposit account to the corporation’s deposit account. In these transactions, financial assets (liabilities) have increased while total deposits have remained constant. Since this process can be continually repeated, there is no theoretical limit to the creation of these financial assets (liabilities). The creation of these financial assets does not affect the overall purchasing ability in the economy, since purchasing ability is transferred from one party to another. One deposit account is decreasing while another one is increasing. By way of further example, consider the case of a MMMF that lends $100,000 to a Mortgage Company, which then gives an Investor a $100,000 equity loan to invest in a MMMF. Funds first move from the deposit account of the MMMF into the deposit account of the Mortgage Company. Funds then flow from the deposit account of the Mortgage Company into the deposit account of the Investor. Finally, funds move from the deposit account of the Investor into the deposit account of the MMMF. back to Table of Contents

    In these transactions, the assets and liabilities of the MMMF, the Mortgage Company, and the Investor have all increased by $100,000. This process can be continually repeated, and will not affect total deposits or overall purchasing ability.

    However, this may not represent the complete picture. The MMMF, having increased its assets by $100,000, may arrange a new bank loan for $100,000, using the note from the Mortgage Company for security. The Investor, having increased his or her assets by $100,000, may also arrange a new bank loan for $100,000, using his or her MMMF investment as security. Thus, we have the creation of $200,000 in new deposits, and hence new purchasing ability, as an indirect result of the creation of these financial assets (liabilities).  The Mortgage Company may also borrow $100,000 from a bank, using its new mortgage as security, and so a total of $300,000 in new deposits could be created.

    The repayment (destruction) of these financial assets will not affect or change the overall level of deposits in banks or near banks. In our above example, should the Investor decide to repay his or her mortgage, transactions will occur as follows. The MMMF will transfer funds from its deposit account into the investor’s deposit account as consideration for the redemption by the Investor of his or her MMMF. The Investor will then transfer funds from his or her deposit account into the deposit account with the Mortgage Company in repayment of the mortgage. The Mortgage Company will then transfer funds from its deposit account into the deposit account of the MMMF in repayment of its note to the MMMF. In all of these transactions, total deposits with banks or near banks have remained constant. back to Table of Contents

    We should also reflect on the erroneous thought that banks or near banks are competing with other financial institutions for deposits. Banks or near banks do not loose deposits to other financial institutions (MMMF, Mutual Funds, Insurance Companies, etc.). When a person invests in one of these financial companies, the person’s deposit account is decreased while the deposit account of the financial company is increased. Total deposits are not changed. Total deposits are only increased when new bank or near bank loans are given, and decreased when payments of principle or interest on these loans are made.

    The Dynamics of Banking on Money
    The dynamics of banking on money go beyond what we have discussed so far, and can be best understood by examining the balance sheet of a bank, and the affect that financial transactions will have on this balance sheet. Typically, some of the assets of the bank will consist of loans, bonds, government notes, deposits held at the central bank, other securities, and capital assets (land, buildings etc.). Some of the liabilities will consist of deposits, loans (borrowings by the bank), and owners equity.

                            Assets                                                             Liabilities

                              Loans                                                               Deposits
                              Bonds                                                               Borrowings by Bank
                              Government Notes
                              Deposits at Central Bank
                              Other Securities
                              Capital Assets                                                  Owners Equity
                              ______________                                              _______________
                            Total                                     =                         Total

    Any financial transaction will affect any two items on the Balance Sheet, and when these financial transactions affect “deposits”, this by definition must affect the money supply.
    Some financial transactions that reduce deposits are as follows:

    1) In the payment of bank service charges or fees, the customers deposit account is debited (reduced), while the banks equity account is credited (increased).
    2) In the payment of interest on loans, the customers deposit account is debited (reduced) while the banks equity account is credited (increased).
    3) In the purchase of newly issued bank shares, the customers deposit account is debited (reduced), while the banks equity account is credited (increased)
    4) In the principle payment of a loan, the customers deposit account is debited (reduced), while the banks loan account is credited (reduced).
    5) In the sale of a bond to a non-bank entity, the customers account is debited (reduced), while the bond account is credited (reduced).
    6) In the sale of capital assets, the customers account is debited (reduced), while the capital account is credited (reduced) back to Table of Contents

    Some financial transactions that will increase deposits are as follows:

    1) In the payment of bank operating expenses including wages, the banks equity account is debited (reduced), while customer deposit accounts are credited (increased).
    2) In the payment of interest on deposit accounts, the banks equity account is debited (reduced), while customers deposit accounts are credited (increased).
    3) In the payment of a dividend to the shareholders of a bank, the banks equity account is debited (reduced), while customers deposit accounts are credited (increased).
    4) In the creation of a new loan, the banks loan account is debited (increased), while the customers deposit accounts are credited (increased).
    5) In the purchase of a bond, the banks bond account is debited (increased), while customers deposit accounts are credited (increased).
    6) In the purchase of capital assets, the banks capital asset account is debited (increased), while the customers deposit account is credited (increased).

    Some financial transactions that will not affect deposits are as follows:

    1) In the write off of bad loans, the banks loan account is credited (reduced), while the banks equity account is debited (reduced).
    2) In the sale of a bond to a central bank, the banks deposit at the central bank increases, while the bonds held decreases. back to Table of Contents

    There are several financial transactions that will affect the total level of bank deposits, and whether bank deposits are increasing or decreasing will depend on the sum total of all of these financial transactions. Normally, the creation or repayment of loans, as well as the payment of loan interest, will tend to have the largest affect on the total amount of deposits.

    We can also identify the financial audit trail whereby vast sums of money can be transferred to the shareholders of a bank. Loans, being simple financial transactions without physical limit are created in vast amounts with a corresponding increase in deposits. Interest payments on these loans reduce the deposit accounts of the borrowers while increasing the equity of the bank. Dividends are then paid to shareholders, decreasing the equity of the bank and increasing the deposit accounts of the shareholders.

    The Role of Reserve and Equity Requirements in Fractional Reserve Lending
    Reserve requirements are generally viewed as having a major role in the process of money creation. A typical example has a deposit of $1000 in government notes being made, which increases reserves by $1000. With a 10% reserve requirement, the bank, now having excess reserves, will lend out $900 of these excess reserves, which on being deposited, allows another loan to be given, and so on until $9000 in new loans are created. Such an example is technically incorrect.

    <30 pages>
    What happens is that the initial deposit of $1000 in government notes increases both deposits (liabilities), and government notes held (assets) of the bank by $1000. There is no extra money, as assets continue to equal liabilities, having increased by equal amounts. With the bank paying interest on deposits, this will result in expenses increasing with revenues remaining constant. Bank reserves (government notes held) have increased which will allow the bank to technically increase total assets. The bank then creates new loans totaling $9000, which also results in deposits increasing by $9000. The net result is that assets increase by $10,000 ($9000 in loans and $1000 in government notes), and liabilities increase by $10,000 ($10,000 increase in deposits). To earn a profit, interest income on loans of $9000 must exceed interest expense on deposits of $10,000. back to Table of Contents

    The same is true when banks increase reserves by increasing deposits with the central bank. In this case, the bank sells the central bank a government bond for $1000. The banks assets and liabilities remain constant, with the bank substituting one asset (a government bond), for another (a deposit at the central bank). This results in the income of the bank decreasing, as deposits at the central bank do not pay interest. However, since reserves are now increased, the bank can create new loans of $1000 which will also increase deposits by $10,000. To earn a profit, the interest earned on $10,000 in loans less the interest lost due to the $1000 sale of government bonds must exceed the interest paid on $10,000 in deposits.

    To the banks, since reserves do not pay interest, this results in a loss of profit, and so they seek to have reserve requirements decreased. This has occurred in many countries, and in some like Canada, there are no longer any reserve requirements. The claim that reserve requirements provide a restriction on total bank lending is more illusionary than real. For example, a bank can purchase a government bond which increases both deposits and bonds. The government bond is then sold to the central bank, which increases the banks deposits held at the central bank (its reserves), which then allows it to multiply lending. This process can be repeated whenever the bank gets close to its reserve requirement. Of course, with reserve requirements of 0%, even this accounting step is unnecessary for the creation of additional loans. The claim that reserve requirements affect or restrain total lending is thus shown to be false, as banks can always increase reserves by simply expanding their balance sheet.

    Capital adequacy requirements of the banks have no direct affect on bank lending. The creation of a loan creates an equal deposit, which can occur regardless of the level (positive or negative) of the equity of the bank. The only time when a banks equity will affect lending, is when an outside regulator forbids any new loans due to the banks lack of capital. Should outside regulators ignore any capital adequacy requirements, then insolvent banks can continue to create loans and deposits (as they are continuing to do in China). back to Table of Contents

    Even where regulators carefully monitor the capital of banks, their skill with creative bookkeeping allows them to increase equity in order to maintain credit expansion. By earning vast profits on loans created out of nothing, banks equity is increased allowing the bank to further expand assets. Should this prove insufficient, banks will issue new shares (resulting in deposits decreasing and equity increasing), again allowing for a further expansion in assets.

    Even when their financial pyramid has started to collapse, banks will increase equity through creative bookkeeping , as shown by recent events in Japan. Here, an insolvent government issues new bonds that are purchased by the banks. This increases the banks assets (government bonds), and liabilities (deposits).
    The government then uses the money they received for the bonds to purchase bank equity. This results in deposits decreasing and equity increasing. The net result is that assets have increased by the amount of the bonds purchased, and liabilities have increased by the increase in equity.

    The concept of inflation and it’s causes continue to be a mystery that is not well understood. Central banks often have an inflation target, without any defined concept as to exactly why this is important. In this analysis, I will consider inflation to represent a rise in prices, and deflation to represent a fall in prices. We must remember that money can be used to purchase either newly produced goods and services, or existing assets, so it is important to consider what prices that we want to measure, and the interrelationship between these two areas.

    Let us first consider newly produced goods and services. These are governed by the equation:

    GDP = (# units produced) * (price/unit) = (amount of money)*(velocity of money)

    From this equation, we see that several factors are involved in determining the price/unit, and in any economy , it is the cumulative effect of these factors that will determine any change in the price/unit. For example, new loans(which increase the amount of money) used to increase the amount of production, will be both increasing price/unit due to an increase in the money supply, and decreasing the price/unit due to increasing the # of units produced. As I have previously explained, over time, these types of loans must have a deflationary effect, with an increase in the amount of money in fact leading to a deflation( as has happened in Japan and S.E. Aisa).
    Even if we consider new government or consumer loans, it is not necessary that even these will lead to an increase in the price/unit, if instead they result in an increase in the # units produced in an economy operating below its capacity. back to Table of Contents

    Inflation can also occur due to factors not related to a change in the money supply. Commonly called cost-push inflation, prices can rise as a result of monopoly pricing in either the product or labor markets. Oil prices tripling within a short period of time would be a good example. A rise in the price/unit with money supply constant will reduce the # units produced. The correct policy to such an event would be to expand the money supply to restore real production. Attempting to control inflation by reducing the money supply will only contract real production further. An increase in the money supply will increase prices or # units or both, and since in a fractional reserve banking system money supply is increased only through loan growth, there is a direct relationship between debt and the price level.

    Now let us consider the prices of existing assets, say real estate or company stocks. At any time there is an equalibriun between people owning money, or people owning existing assets. In a closed system, a loan(which increases the money supply) , will increase the price of existing assets. As I have explained, while in the long term, we would expect to see a porportinate increase in the price of existing assets relative to the increase in the money supply, this may not necessarily happen in the short term.

    Now, let us consider the interrelationship between these two systems. It may be best to think of two different money supply’s, money that is held in lieu of existing assets, and money used to transact business, with the total money supply being the total of these two. First, let us consider the interrelationship between these two systems. If people take some of the money that has been circulating in the business economy, and use it to purchase existing assets, this will lead to an increase in the price of existing assets. The decrease in the amount of money in the business economy will result in a decrease in the price/unit, a decrease in the # units produced, or some combination of both. Should people decide that they no longer wish to own existing assets, then this will cause a fall in their prices while increasing the money in the business economy, resulting in either an increase in the price/unit or the # units produced or some combination of both. Thus we see that new loans to purchase existing assets will increase the value of existing assets, but will only affect prices in the business economy if there is a flow of money out of existing assets and into the business economy( and here again, only if the # units produced remains constant). back to Table of Contents

    Thus we see a very complicated relationship, and unless we know how the new money (loans) is being spent, how this will affect production, and how this will affect peoples attitudes towards owning existing assets, we are unable to predict how an increase in the money supply will affect prices. Equally important, is defining which prices we will use in determining the amount of inflation.

    It becomes apparent, that inflation targeting any specific group of prices is quite meaningless.