Steven Lords Website

Ever thought about how money works or what it is ? £ – “Pound Sterling” – it used to be a pound of sterling silver and you could have gone to a bank and asked for your silver. You may remember or been taught about the Gold Standard and how this was abandoned.

In order to fully understand the crisis humanity is facing it’s critical to understand how money works. I’ve long had an interest in economics, I have an economics a-level, a maths degree, qualified as an accountant and spent 15 years working in an investment bank in Interest Rate Derivatives and still the way money works sometimes messes with my mind. So here’s an attempt at explaining how money works.

There are three major features of our money are:

• Fractional Reserve Banking;
• Compound Interest; and
• Fiat currency

To explore the implications of money I spent a lot of time thinking through a scenario which I called “Lordy World”. I originally included it in this post but my sister felt it got a little complicated so I’ve separated it out. I will provide links to it rather than include directly here.

LORDY WORLD – introduction

Fractional Reserve Banking

When banks take a deposit they only have to keep so much of it (the reserve amount) the rest can be leant out. So say you deposit £100 with your bank they can lend out £90 (given a reserve requirement of 10%). They are reliant on all depositors not wanting their money back at the same time as they will only ever have about 10% of total deposit available. This is how runs on banks happen – if depositors start to worry about the solvency of a bank they may start withdrawing money. After a certain length of time the cash deposits at branches will be gone further fuelling the panic and more people will try and get money out. The bank will get more cash but at some point they will run out of reserves and not be able to pay any more.

The full implications of Fractional Reserve Banking are not immediately obvious. Say Bank A gets a deposit of £100 and lends out £90 keeping £10 in reserve. The person borrowing the money is clearly going to spend it (why else borrow) so the money ends up in someone else’s hands and ultimately as a deposit in a bank, say Bank B. Now Bank B has got £90 so they loan out £81 and keep £9 in reserves. Now note that there is still only £100 total money but Bank A has £100 deposit and Bank B has £90 deposit. The owners of deposits have £100 and £90 each. If they both go to withdraw that money from their banks there is clearly a problem – they demand £190 in cash but only £100 exists in total. This table above illustrates how this works.

Given £100 pound initial deposit and a 10% reserve requirement (I believe this is approximately what most western economies require) this can result in £1,000 of deposits existing via this process. Crazy stuff right !

Note that this can be backed out if a nice orderly repayment of loans happens. There is enough money in the system for all this to work.

Imagine what this means for our banking system as a whole. Imagine what happens if even a small proportion of total deposits are demanded in short order (say more than 10%). One way to tackle this comes as a result of moving to FIAT currency, which we will come to later, but that has it’s own set of implications.

This is already pretty scary before I even add in Compound Interest.

Back to “Lordy World”

Compound Interest

This is something we’re all brought up with and just take for granted. Logically you would think you would pay a bank to safeguard your money. In the times of gold (no paper currency) you can imagine that would be reasonable – pay a bank a monthly fee to protect your money. Once you introduce FIAT currency (see below) and fractional reserve banking it becomes a little less important, in fact if a bank is only holding 10% of your money most of it isn’t available to steal. In todays world where it’s just a bit on a computer even less so. With Fractional Reserve Banking you can see why you get interest – the bank is paying you because they can then lend your money out. They lend it out and earn interest meaning those borrowing must make a profit (either through a business venture or working to pay off the loan plus interest). Hopefully you see that implicit in this is the need for growth. Perhaps they also paying you to take the risk that your money won’t be available when you want it, though this is certainly not made clear to the average depositor.

I want to make this clear. Once you charge interest that is creating money and at any one time there isn’t enough money to pay it all back. Look back at Fractional reserve banking – £100 deposit with 10% reserve could create £1,000 of loans. Say interest is 5% (lets ignore compounding – it just makes it worse anyway) which means £50 of interest. Now without interest all those loans can be repaid with only £100 money in circulation but where will the £50 comes from – we need continued growth for this to work.

Think about it you deposit money and it just keeps creating more money. Money grows infinitely. Whats even better everytime a borrower pays interest the bank can lend 90% of it out and via fractional reserve banking the increase in money is 10 times the interest.

For example if we deposit (of course it works just the same for a loan it’s just banks unlike depositors won’t just wait and let it accumulate without getting some of it paid) £1 at 2% interest:

• After 1 year we have £1.02
• After 10 years we have £1.22
• After 100 years we have £7.24
• After 1,000 years we have £398,264,652

And after 10,000 years we have about £100 Sextillion Vigintillion (thats 100 with a further 84 zeros).

There’s that crazy exponential growth again. You may say well thats daft you won’t keep it deposited for that long. If you think I won’t then why wouldn’t I ? Or are you thinking well the banks won’t be around that long. If so I agree … but if you think that do you assume it will happen in some far distant future and not tomorrow?

If we think back to when money had some physical meaning to it (say gold) then compound interest would mean depositing gold created gold ! Well, at least from the depositors perspective. Whats happening in the background is that the bank loans it out and charges interest (ie more gold) so it’s all reliant on the borrower producing something that will result in more gold to pay back the loan plus interest or gold would have to increase in value.

Back to “Lordy World”

FIAT CURRENCY

The best definition I can come up with is “money without intrinsic value”. Though the pound in your pocket may have historically represented a pound of sterling silver and you could have gone to a bank and redeemed it for the silver that is no longer the case. The £1 in your pocket represents nothing other than a promise that you can exchange it for some good or service. The value of money is completely based on trust. There’s trust that at the time you chose to spend it that the seller will accept it. This trust can fade or disappear. Take countries that experience hyperinflation – the value of the money in your pocket decreases rapidly, people lose faith in it and fewer and fewer people accept it reverting to barter or other currencies.

The key thing with FIAT currency is that without any link to something physical there is, in theory, no limit to the amount of money that can be printed. In fact, economists that believe in infinite growth (which really is all you hear in the mainstream media since every expert tells us we need to have economic growth) are reliant on being able to have as much money as required. It’s also one of the reasons government debt is so secure because they could just print money to pay it off. Heard of “Quantative Easing” ? Well, thats printing money which is used to pay off govt debt. By buying back govt bonds from banks they inject more money in to circulation as it allows banks to lend out. The problem here is that printing more money has not increased wealth at all, it’s merely devalued all money – it is inflationary.

Back to “Lordy World”Back to “Lordy World”

Now lets put this all together. We have individuals, businesses and governments borrowing money. Due to compound interest they all have to add value to pay back the interest. This requires an ever expanding economy. On top of this we have Fractional Reserve Banking – it means any interest paid on loans is multiplied up to create even more money to loan out and charge interest on. For this to keep working economies have to keep growing. If you’ve ever heard of banking as a huge Ponzi (pyramid) scheme you can now perhaps see why. What happens if individuals can’t pay their interest or debt ? Or governments for that matter. What could cause that ? Lack of economic growth over an extended period ? Whats happening now ?

Growth is something I will blog about shortly but for now just look at those numbers above which demonstrate how growth progresses at 2%. I picked that percentage because thats the target growth rate regularly touted by economists and politicians. Surely I don’t need to site Peak Oil for you to realise growth cannot go on endlessly. Anything in nature has a period of growth and then becomes stable. Why do we not believe this is the case with economic growth. IT MUST STOP. Unfortunately the way money currently works has endless growth as implicit within it. Conventional economic thought believes this can continue due to efficiency & substitution which means they believe we will get ever more efficient in our use of resources (The Faith In Technology) and also as something gets more expensive we will find or make a substitute. Unless the substitute is sustainable it will, of course, also have a limit.

This post hopefully gives you something to think about in terms of what will happen to our current financial system when it growth does stop. Think about the current EURO crisis. Don’t observe that and think ah poor them. We (UK) are in no better state, neither is the US or China (who Europe are turning to to bail us out!)

The bankers notices that as the economy has evolved absolutely no one ever comes and redeems PHLs. There no longer seems any point since they can just deposit them and earn interest. PHLs have been so successful people are no longer viewing them as worthless paper but as valuable in and of themselves.

They take the final step and say that you cannot redeem them for hours, they are now FIAT. Their value is based on trust and the backing of the community through the Central Bank.

For the bankers this removes the final bind. They are now free to print more money and leave it in circulation as there is no connection with anything physical. As the economy grows there is need for infrastructure to be built for all. A government is formed to co-ordinate this and given rights to raise taxes to pay for the work. For big big projects they go and borrow from the bank and pay interest from their tax revenues.

Please observe

• Growth is even more inherent in this system now as the government is paying it’s interest charge out of Tax revenues so it needs those revenues to increase
• Money can now be quite literally printed. This is what makes government debt so safe, they can always print money to pay it.

This brings me to Quantative Easing which is a posh name for printing new money and injecting it in the economy somehow. I want to illustrate this in two ways – an unrealistic way (perhaps) which should illustrate it’s effect and how it is being done currently.

Scenario One – The central bank prints a load of new money and distributes it equally to everyone. Potentially it has no impact, everyone buys the same things and ends up with surplus cash and deposits it. Alternatively (more likely) people can now afford products they didn’t used to, or can afford more resulting in shortages which pushes up the prices which can be paid as everyone has more cash. We have inflation.

Quantative Easing is inflationary.

Also note that a large proportion of this new cash ends up deposited at the bank which can then leverage it up by lending it out using Fractional Reserve Banking. Thus the total increase in money is much greater than that printed.

Scenario Two – the Central Bank prints money and buys back some of the government debt from the Bank. This means the bank has increased reserves, reduced it’s lending and thus credit availability increases. He can lend out more allowing more people to borrow to produce things or buy things. Thus increasing money in the economy. This still increases money in circulation running the risk of inflation. Of course if there is general inflation this reduces the real cost of all debt thus making it easier for the government to pay back it’s debt.

With time our Bankers notice that often loans aren’t paid back on time. They decide to reflect the different times taken to repay they should charge interest rather than a fixed fee. The depositors hearing of this move demand a cut of the interest. The bankers now make their money from a difference in the rates they charge vs what they pay.

Now merely owning money can create wealth. Slowly many people decide to pursue amassing money as a goal in itself as that money can earn them more money reducing their need to work. Some observers say that greed has entered the system.

Some observations

• Even more money is now being created out of thin air. The interest on deposits can be just created provided the bank has enough reserves. Note this is now compounding and thus infinite. Anyone just leaving their money there will have it increase in size exponentially.
• For the bank to indefinitely continue to pay these ever increasing deposits they will need two things – ever increasing lending and ever increasing money supply
• Increasing money supply requires either reducing reserve requirements (which is ever more risky) or increased availability of the underlying (ie growing population). It should be noted that every bit of interest paid by a borrower is extra PHLs that can be leant out. With the 25% reserve this means every PHL paid in interest increases available credit by three times that amount. The ability to increase the money supply make cease as you can’t force people to deposit time and though in theory you could take the reserve to zero (infinite credit) it clearly wouldn’t work. The only possible solution would be to devalue the PHL ie 1 PHL now represents just 30 minutes. This leads us to the final piece – FIAT currency
• This requires continued growth to be viable
• Unravelling this as we did in the previous case is vastly more complicated.
• Growing population is OK to a point but this community can only support so much population and thus there is a strict limit to growth.

It’s interesting to think how this world would approach it’s limit, what would happen and how they could adjust to it. I am not planning to explore that here.

PHLs prove a great success. Most people deposit their week of time and the money supply stabilises. Few see any need to redeem PHLs, instead they work for someone else to earn PHLs or have a business that sells something for PHLs. People tend to hold on to a few PHLs just in case. In time the idea of a PHL bank is put forward for the safe keeping of PHLs. The community feels it best for this to be separate from the Bank so they rename that the Central Bank and a new Peoples Bank is opened to take there deposits. Again the person running the bank is paid a salary by depositors for the safeguarding of their PHL deposits.

The owner of the peoples bank notices that most deposits remain untouched and comes up with a cunning idea. Rather than the depositors paying him to safeguard them he will instead safeguard them in return for being allowed to lend their money out. He earns by charging a fixed fee (say 1%) for lending out money. He agrees that a certain amount needs to be kept at the bank in case someone wants their PHLs. He calls this his ‘Reserve’ and decides to set it at 50%.

He lends out 50% of the deposits which gets spent and re-deposited with him. He can lend out 50% of this new deposit. Before long he’s lent out ever smaller amounts and hits the limit of his lending having more or less doubled the level of deposits. (see the table left that illustrates how this works). This means the people as a whole feel they have double the amount of money but in fact there is only the same number of PHLs (ie actual hours deposited). It means that if all of them tried to remove their money at the same time the bank has a big problem. Before I address this specific problem I’d like to illustrate how, in theory, this could unwind itself:

Looking at the chart all the borrowers could sell there products (which they borrowed to produce) for phl 100 to D1 (who removes his deposit to pay them – strictly speaking at this point the bank has broken it’s reserve requirement as all it’s reserves are gone but lets assume all the transaction happen in short order) allowing them to pay phl 1 to the banker (his fee), pay off all debts and make phl 5 profit. D1 would have zero deposit. There would be no debt. Leaving phl 94 deposits, phl 1 with banker and phl 5 with borrowers, totally phl 100 which is what we started with.

This shows how it can work, allowing people to get access to PHLs as they require. Soon, our, now two, bankers, realise that they could increase money circulation if they reduce the reserve requirement however the more they do this the more they run the risk of demands for deposits exceeding the reserves which could result in a run on the bank (loss of confidence) and in turn could bring down the whole system. The Bank can’t print money to address this BUT the Central Bank could especially as he’s realised that PHLs are hardly ever redeemed. He could help the Bank overcome any short term liquidity problems he has by simply printing more PHLs. He could work with a reserve he has to keep against redemptions. Provided this reserve is prudent enough he should be OK (say 50%). Lets walk through how this would work.

The Bank goes to 25% reserve which means he can lend out 3x the deposits he has which he does increasing the money supply to 400% of it’s original. He then finds that 30% of the deposits are demanded so he goes to the Central Bank who prints the extra 5%. Now there are more PHLs in circulation than hours deposited but as long as everyone doesn’t decide to redeem at once it’s ok. In short order the liquidity problem at the bank passes (eg deposits made, debt repaid, fees paid) and he can repay the money to the Central Bank plus his fee.

Again lets make some observations

• We now have hours somehow creating more hours. Since the bank lends out PHLs and gets those back plus a fixed fee. Where are those extra PHLs (hours) coming from ? The banker has done nothing of intrinsic value. He’s reliant on the borrower using the money to produce something she can sell for more PHLs than she borrowed.
• Growth is now needed by this system to pay of the debts. In this scenario have we had growth ? Here I mean in a more general sense (rather than increase in GDP). Say the borrower made something, for example a chair. At the end of the scenario there is still the same money in existence plus a chair which has some worth – hence the economy grew.
• Growth is limited provided it’s assessed as growth in overall wealth. Given the chair example once everyone has enough chairs thats it. If you measure growth based around money changing hands (as our financial system does) then if someone chucks out their chair and buys a new one that could contribute growth.
• Increased money supply is based on creation of credit. Lowering the Banks reserve requirement increases the amount of money available. Adjusting the fixed fee charged for credit can influence how much available credit is taken up.

Despite believing I had a good understanding of money this exercise took far longer than I expected largely because I tried to think it through with a simpler case “Lordy World” but as I explored the implications of the features of money it just kept messing with my mind. “How can this really work?” There appeared to be flaws all over the place. With this in mind I hope Lordy World will really make you think. The fundamental features are correct but you will see that the implications are mind boggling.

[ASIDE: I spent a lot of time thinking about what was a good currency for this, looking for something everyone could get and could split in to small parts whilst being limited in availability. You may think an idea is original but it rarely is. Also, today at the cinema I saw a trailer for “In Time” which looks to be based on this kind of idea]

Imagine a small area of land surrounding a market town such that everyone can get to the town and back to exchange goods. There is no contact with other communities everything consumed and produced is done so within this land and done sustainably. The land has rich soils and extensive forests. People meet everyday to exchange goods by barter. Some people produce goods others work for people in exchange for goods. The main form of energy is human work and sunlight.

It is noted that the barter system makes getting what you need in exchange for what you have oftentimes hard, convoluted and sometimes impossible. A bright spark in the community comes up with this idea of a medium of exchange. He decides, for good reasons, to have the medium of exchange related to human work so he thus introduces the “Person Hour Lordy” – each note represents an hour of human labour. If needs be smaller coins will be produced representing a man minute. Though not strictly fungible (ie an hour of person As labour is not the same as an hour of person Bs) they more or less are and if there is a problem they can work on standardisation (eg we have a standard person hour and each person will have an equivalent – eg for person A 45 minutes is equivalent to a Person Hour Lordy, person B is 1h15. Periodically these factors could be reviewed) [for my illustration this fact is not that important] He decides to call this idea “money”

How does money get in to circulation ? They set up a central body which he calls the Bank. From here you can deposit your time and get fungible Person Hour Lordys (quickly abbreviated to PHLs). Rules are in place so you couldn’t deposit more hours than could be redeemed in a certain time frame (eg a 35 hour work week). The Bank would keep accounts so they knew who had deposited hours of labour and handled any redemption of hours. The guy running the bank is paid in PHLs by the producers since his services are helping facilitate the trade in their products.

If you have PHLs there are three things you can do

1. Hang on to them to buy products later
2. Redeem them at the bank. This means you get hours of someones labour it could be your own if you deposited hours or someone elses

It’s important to note some features of this system:

• money is linked to something of intrinsic value and of limited supply.
• the money in circulation is limited by the population and the maximum number of hours you can deposit.
• the banker cannot arbitrarily increase the money in circulation. He could increase the limit on time deposits which increases the maximum but it would still require people depositing time to increase the money supply.
• given the closed system we have and the limit on money supply general inflation cannot occur. If some products went up in price others would be cheaper or unsold since  there’s only so much money. So much like a barter system prices will fluctuate based on relative availability but there can’t be a general rise in prices. (NB – for years and years nations for all intents and purposes were not in a closed system with the mass of the world to expand in to and lots of room for population growth. However, the World is a closed system and with globalisation and population growth we are now starting to hit the limits of this closed system)