Notes for the reader
This is a
revised version of the text "Financial Crisis Explained by the Theory of
Free Money." Not much new has been added. Some graphics have been updated,
the English has been improved using a translation program, and the text has
been made more neutral (de-ideologized). I also created a German version on
this occasion. However, there is a great deal of German-language literature on
this topic, so it is of little interest to German readers. I refer, for
example, to writings by Bernd Senf and Helmut Creutz, as well as to the
Natürliche Wirtschaftsordnung e. V. (INWO).
Abstract
Economics is a science of
perspectives. It requires an understanding of the different interests of buyers
and sellers, creditors and debtors, supply and demand, and so on. It is thus a
dialectical system in which science seeks synthesis, for example, in the form
of equilibrium theories of price formation.
One of the many perspectives is the
critique of interest rates. It is an important component of interest rate
theory. It addresses the negative aspects of interest rates. However, the
discourse is predominantly conducted outside of economics. It is well suited to
characterizing the challenges of our existing monetary system and facilitates
the description of the processes that lead to deflationary economic crises. It
enables the introduction of concepts such as inequality, crises, and limits to
growth and improves the possibilities of prediction.
This article examines our monetary
system macroeconomically using aggregate values, taking a time and interest
rate perspective. The common equilibrium theories are only briefly discussed
and classified.
1 The nature and creation of money
Money plays an important role in our daily
life. It is an accomplishment of the society which renders division of labour
feasible and is therewith absolutely essential for modern life.
·
It is a mean of payment and
makes direct exchange of goods unnecessary.
·
It is a medium of exchange,
allows the setting of prices and let compare the value of different goods
·
It is conditional a store of
value and allows to do the exchange later at a more favourable time.
From a materialistic perspective, we depend
on the resources available to us through our existence on this earth. From the
perspective of the human collective, these resources must get to where they are
needed to ensure our survival. From a macroeconomic market perspective, the
functions of money described above are our preferred instrument for
distributing these resources.
From a particular or microeconomic
perspective, it is a negotiation between actors to accept money in exchange for
goods and services. Anyone who sells goods or services can be confident of
being able to exchange the money received for goods or services that meet their
own needs or desires. In this perspective, however, money can also be
understood as a claim. The provider or seller offers goods or services to
society and, through the money earned, receives the right to demand goods or
services of comparable value from society. Commodities such as gold or other
goods that were traded like money in the early history of money are also
considered claims.
The value of money in this particular
or microeconomic view is a claim.
For example, describing the value of money
as a commodity or as a claim is one of these typical possibilities of different
economic perspectives. Different perspectives or different definitions of the
economic system, such as the microeconomic or macroeconomic view, lead to
different characterizations. While these do not necessarily lead to
contradictions, they often lead to different interpretations of events. Taken
individually, these perspectives are all correct, but they always only offer
part of the reality. This also means, however, that the economic debate would
gain in value if the perspective or definition of economic structures were
considered more frequently.
Economics is always a question of
distribution. Scientific discourse is guided by two opposing tenets that can be
summarized with the terms profit and utility.
The rules of profit optimization apply in
the capital markets. The goal is to achieve the highest possible profit and
acquire as many resources as possible. Profit can be easily represented as a
monetary value. This tenet is easy to understand and anchored in our basic
instincts. In orthodox economics, this is elevated to a law.
However, if utility is something other than
maximum profit, then the goal is to make the best possible use of available
resources and to deploy them where they are needed with the least possible
effort. This utility is difficult to describe in monetary terms and is anchored
as a tenet in our cultural development.
Justice is the central concept. Taking income
and labor as an example, it is important to distribute it fairly. The better
the work is distributed among many shoulders, the lower the effort for everyone.
Optimizing the division of labor would be the economic term for this goal.
Just as economics is a question of
distribution, opinions about distribution differ depending on who you ask.
1.1 Money creation
If we consider money as claim, then we can
also consider bank notes as a kind of promissory notes. It is not inevitable
necessary that the tangible value of these notes must be equal to the numbers
which are printed onto these notes. Cashless payments are intangible numbers in
the computer network of the bank system. And as most amounts of payment in many
countries will be done cashless, we could assert that money is almost
intangible.
But
we should not deceive ourselves. Money will still be considered as commodity
and real asset which is in narrowest woven to reality by the function to be a claim.
It crucial influences nearly all decisions of our life at all levels.
If money is narrow, it must be borrowed at
the bank. The modern system of banks and central banks are the mean for supply
and demand of money which keep savings in circulation and regulate the demand
for new money through loans.
Banks can create new money by fractional
reserve banking if the need for money is higher than the lendable savings.
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Parts of the savings must be kept as reserves while the other parts can be lent out. The lent-out money flows back into the bank system and increases the primary savings. This is a very brief description of an abstract macroeconomic model of money creation. It is something that cannot be recognized as fractional-reserve banking in the continuous and individual transactions between banks and central banks. If the primary reserves were held constant, money supply growth would lead to a finite increase.
The ratio between reserves and savings is
the leverage. The higher the legal reserves, the lower the leverage, the
smaller the clearance for credits and money creation.
From a microeconomic view or rather view of
private sector debts disappear if the last rate is paid. From a macroeconomic
view or rather to recognize money as a scheme the process of borrowing and lending
keeps money in circulation. It is a process without a beginning or an end.
Debts will never disappear. It is an unavoidable part of our monetary system.
But money creation is not a circuit, it
is a growing helix
From a macroeconomic or aggregate perspective, this means that the borrowed money is not only repaid but also increased through interest repayment, as this also increases loanable reserves. This, too, is an abstract model that is not visible in everyday business transactions.
Due to interest repayment, the demand for
money is always higher than available and loanable savings. Orthodox Economists
describe this with the theorem that money is always a narrow good. This leads
to the so-called helix of monetary growth.
2 monetary time beam and interest criticism
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Money supply grows exponential in an interest based monetary system caused by interest compound. In times of non-crisis most of the capital will be lent out so that the total debts will grow equivalent to the money assets also in an exponential way and as a mirror image.
The debt or liability side is also called
the productivity side, since debtors must be productive to repay their debts.
This obligation to repay gives money its value. The surplus or backflow of
interest seen as aggregate in the helix of money growth leads to a continually
demand for new money and continually increase of money supply.
It also leads to permanent growth in gross
domestic product, which can be represented on the asset side of the monetary
time axis. Regardless of whether nominal or real GDP is represented, this
underscores the different paths of GDP and money supply and shows that there is
no direct relationship between these two curves, especially when the majority
of an economy's GDP is based on the production of real goods and services
rather than financial transactions. But must it show this correlation, if we
consider the model of a closed economy? How to link the world of money with the
real economy of goods and services is still an enduring contention in economic
science. But two aspects are probably confident.
It is self-evident that money is linked to
material goods and services through price. Money serves as a unit of account.
Price formation, on the other hand, is well developed in economics as a central
object of the equilibrium model.
The second aspect of connecting money with
the real economy is that money assets will be backed by receivables and
collaterals and the continuous demand of debtors for new money keeps money
always narrow which correspond with the economic theorem that money is always a
narrow good. It keeps money in circulation and ensures the value of money.
As already mentioned, the economy is a
system of perspectives. If the demand is for a sustainable and long-term
monetary system rather than for maximum returns on capital, an interest-based
system raises several critical problems.
The critical problem is not the exponential
growth of the system. If money were neutral, not only money and prices but also
income would grow evenly. Purchasing power and wealth distribution would remain
constant for everyone. The worst consequence is that rising prices lead to
rising numbers, and over time, the decimal point must be shifted in a currency
reforms.
The critical problems are caused by
compound interest and are described in interest criticism, which lists three
main points.
2.1 mass gravity behaviour of interest-based money
Financial investors will have millions or billions at their disposal. The small saver has significantly less money for savings at likely lower interest rates and, unlike the large saver, is forced to consume some or all their earnings and savings. Typically, the small saver cannot hold on to their savings long enough to become a wealthy owner. Economy is a system of antagonism, means that the investments or savings need the counterpart of debtors. As the savings increase also the debts will increase. Subsequently not only the savings of little savers will not grow also the debts distribute themselves into the society and grow like the big investments. This is an automatic process determined by the mathematical law of compound interest.
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Without counter measures leads it inevitably to strong inequality of wealth. European history is a succession of wars, civil wars and revolutions. Investigation of causes for these outbreaks of violence would lead always to causal chains where at the beginning can be found receivables, liabilities, someone who want to have or don’t want to repay something or will be excluded from wealth or even from the means to survive.
It is obvious that a concentration of money capital subsequently leads to an accelerated concentration of productive capital. Business cycles are increasingly shifting from local to global dimensions, and local business cycles are being eliminated. These changes can be clearly observed today. From the perspective of entrepreneurs, the concentration of means of production is being driven by cost reductions through automation. The increase of productivity based on technological progress replaces handwork which leads to an oversupply of manpower. This oversupply brings down the income of workers and makes workers increasingly unnecessary. No one would want to miss technological progress, but social progress cannot follow, as unemployment is a growing phenomenon of modern times and of global proportions. Unemployment or low incomes exclude people from prosperity and can be viewed as a modern form of exploitation that simultaneously accelerates the concentration of wealth.
2.2 Coercion of growth
As already mentioned, the demand for credit
or new money, from an aggregate perspective, is always higher than the
available and loanable savings. This leads to a never-ending demand for new
credit and a never-ending growth of the helix of money. Borrowers must be
productive to generate income to repay their debts. This transfers the growth
imperative to the real economy. With neutral money, only prices change, not
productivity. Productivity remains constant. However, if money is not neutral,
productivity must increase.
Rich money owner must spend only a small
part of their money for consumption. Parts of the money remain in the
speculative space. Speculative space means the trading of proprietary rights
with less to no impact onto the demand of tangible goods and services. In
former times of the theory of “Freigeld”
2.2 Coercion of capitalization
Making a profit now is better than in the
future, as the money earned generates additional profit in the meantime through
interest. This leads to more short-term thinking and action, as we can clearly
observe in the behavior of the financial markets. The focus is shifting from
the utility of real goods and services to short-term profit. This is
significantly influencing economic and political decisions toward more growth
to accelerate all types of business and transactions.
From the viewpoint of a peaceful
respectively sustainable society is interest a strong burden. From the
viewpoint of return on investments they are an inviolable sanctuary. It is
almost impossible to call interest into question, because it is taken for
granted in almost all societies. On the other hand, it would be a missed
opportunity to bypass thoughts on the issue of interest.
If we better understand the system's
challenges, we may be able to improve it or at least better predict its
negative impacts. Apart from the question of justice, which would go beyond the
scope of this essay [1] and for
which this monetary system seems completely unsuitable, deflationary crisis are
an integral part of the system and that deserves closer examination. Some
economists refer to them as market adjustment mechanisms or creative
destruction
3 The nature of financial crisis
3.1 The Limits of money supply growth
Figure 8 shows the money supply of aggregate M3 of the euro currency. The solid line shows the recorded money supply, while the dotted line represents a hypothetical exponential curve with 7% growth per year. The euro money supply also grew exponentially until the last crisis in 2008, then declined slightly and rose again two years later with lower growth of approximately 3% (dashed line).
3.1.1 Representation of relative vs. absolute money supply growth
There are various ways to represent money supply growth. Relative money supply growth indicates growth in percent. This is the standard representation in economics. It allows for a quick response to changes in money supply growth Interest rates and intervention limits can be simply represented by horizontal lines.
For this essay, however, I prefer absolute
money supply growth. It illustrates the geometric growth of the system and
corresponds to the asset side of the monetary time beam. This representation is
more suitable for describing the system, its macroeconomic interrelationships,
and long-term forecasts, and is the preferred representation in interest rate
criticism. In this representation, interest rates must be extrapolated using
compound interest, and the corresponding starting point must be found (see f.
e. 3% interest rate curve in fig 8).
3.1.2 Upper limit of money supply growth
The graphs of the absolute money supply
(M3) of the US dollar and the euro show an exponential trend, as expected. In
non-crisis times, the curve growth is surprisingly close to 7 percent. This is
the average interest rate yield on all credit transactions in a year. It
appears to be the maximum return that these developed economies like USA and
Western Europe can achieve without risking collapse. In interest rate
criticism, this limit is referred to as the natural interest rate. However, the
horizontal steps in these curves confirm that this monetary system is not
completely stable and can lead to serious events on the monetary timeline.
Deflationary crises are the cause of these steps, because during these crises,
money supply growth stagnates.
The principle of profit maximization
applies in the financial markets. It is the continuous attempt to push the
boundaries of the system toward higher profits and thus also exceed the limits
of the natural interest rate. Occasionally, this succeeds, as we saw in the
last crisis. The increased borrowing or money creation leads to the debtor side
experiencing payment difficulties over time. As soon as this becomes visible, a
downward helix begins. The creditor side stops lending to avoid losses. From
this point on, the supply of capital becomes scarce. The first debtors, usually
companies, file for bankruptcy. Workers are laid off. A portion of the
population loses income. Purchasing power declines. Declining purchasing power
means declining demand, and declining demand leads to declining prices.
Aggregate demand collapses. The increase in bankruptcies leads to an oversupply
of assets from the bankruptcy estate. This leads to a decline in asset prices.
In anticipation of falling prices, further purchasing reluctance sets in. This
increases the deflationary effects. Ultimately, the price decline enables
creditors to acquire productive capital cheaply. This typically leads to
further capital concentration and profit maximization among a few, but
financially powerful, market participants.
The steps in the monetary timeline are easy
to explain: In times of uncertain returns, creditors do not lend. However, once
they stop lending, they can no longer earn money through interest, and money
supply growth must tend toward zero. Contrary to the claim of many orthodox
economists, low interest rates do not necessarily lead to higher money demand
or an increase in the money supply. This statement does not hold in times of a
deflationary crisis, at least not for the M3 money supply.
3.1.3 Lower limit of money supply growth
3.1.4 The Control Options of a Central Bank
Central banks must ensure a stable monetary
cycle. In an interest-based system, they attempt to keep monetary growth within
the range of interest rate ceiling and interest
rate floor. Short-term excursions above or below the interest rate bounds are
irrelevant. However, in the long term, monetary growth should remain within the
range of interest rate ceiling and interest rate floor. The interest rate bounds
depend on long-term economic developments and can be different for each
currency area, which raises interesting questions. Exceeding the upper bound of
the interest rate represents monetary expansion through fractional reserve
banking. In this case, the central bank raises the key interest rate.
Exceeding the lower bound of the interest
rate represents stagnation of the monetary cycle. In this case, the central
bank lowers the key interest rate. In the case of very persistent stagnation,
the key interest rate can even become negative. Central banks have learned from
the last financial crisis. Perhaps there were too many losses, so the market is
currently self-regulating. After all, the last deflationary crisis was 17 years
ago. But the system is and remains geared toward profit. Stabilization and control
therefore remain a difficult issue.
3.1.5 Hyperinflation
3.2 Debt in general and government debt in particular
Total debts consist of public debts and
debts of the private sector. Private sector is distinguished in debts of
enterprises and debts of private persons. All money with interest must be lent to
get returns. The return must be paid back by the debtors, which have to work
for it, described with the idiom “money must work”. Thus, the growth of money
supply and the growth of debts are directly connected together. As money supply
growths in an exponential shape also the aggregate of total debts must follow
inevitable this growth and shape.
In this context public debts have an
exceptional position. For centuries, it has been common practice to replace
maturing liabilities with new debt. This leads to a visible exponential growth
of public debts. In contrast, debt in the private sector is perceived as the
creation and disappearance of one’s own debts. This obscures the fact that the
aggregate value of private sector debt grows exponentially, like public debt.
The current mainstream discusses paradoxically only public debts. Theoretically, it is possible to separate government debt from total debt in order to reduce public debt. But if the majority wants capital growth, which means profits, parts of the government debt must be overtaken by the private sector, since money supply growth is inextricably linked to debt growth.
In an interest-based monetary system, debt
growth is inevitable. We cannot reduce overall debt. The system doesn't allow
it. The question is therefore who should take on the debt, the public or the
private sector. Dependent from the grade of public evolution, rather for a high
sophisticated and democratic controlled administration than for a corrupt
administration of undemocratic character, the public sector will try to return
all revenues of taxes and indebtedness into public services which support the
efforts to keep the social classes in equilibrium of prosperity.
From the perspective of a highly developed
public administration, debt within an interest-based monetary system is an
important component of public revenue. A reduction of public debts leads to a
reduction of public services. Consequently, two options are given: Either parts
of public services are foregone, or the private sector must overtake the debt.
But for sure, private sector will only overtake in cases of profitability. This
can significantly increase the costs of public services and infrastructure. Unprofitable
services must be provided through volunteerism and charity, as is common in
informal or non-profit economies. For example, non-profit behavior ensures the
survival of large segments of the population in severely underdeveloped
economies. Underdeveloped economies can also be considered the equivalent of
underdeveloped public administrations. Corruption is the application of market
economy principles in the public sector by exploiting a state monopoly. In
corrupt societies, public services are better substituted in the private sector.
There, the thesis is appropriate that the market should regulate itself.
The transfer of public debt to the private
sector is privatization. Not only public services, but also infrastructure and
land are transferred into private ownership. Financial markets are keen on the
profits that can be achieved through this privatization. However, the public
should be aware that even when transferred to private ownership structures, the
debt must be repaid. This refunding happens through payment of the particular
use of now private services. In practice, for example, we are observing sharply
rising rents.
One advantage of refinancing public debt
through new borrowing on the financial markets is that it represents an
investment by money owners in their own returns. The
advantage for investors is that they invest their money in safe bonds. They
thus benefit directly and indirectly from the advantages of a functioning or
improved public infrastructure. In addition to the improved public
infrastructure, the advantage for the public is that some of the speculative
money temporarily flows back into the real economy. If we assume that large
financial assets are taxed little or not at all (a taboo subject in public),
then government bonds could be described as the rich man's tax.
It is cost-neutral for the public if the
growth of new public debt equals or exceeds the aggregate interest rates on
maturing public debt. In contrast, reducing public debt means shifting debt to
the private sector, which will ultimately have to be repaid. Only the
distribution of payments is different and likely more unfair.
If the growth in new public borrowing
corresponds to the aggregate interest rates on maturing government debt, considering
monetary growth including the inflation rate, the money supply is neutral,
means it is neutral for the stability of the currency. The growth in new public
borrowing corresponds to the growth of the money supply. In a stable economy,
the interest rate on new government debt should be aligned with monetary
growth. In times of economic overheating, new public borrowing should be below
the interest rate for monetary growth. In times of recession, it can or should
exceed monetary growth. A temporary increase in new public borrowing above
monetary growth does not endanger monetary stability. However, a permanent
increase in government debt would inevitably lead to hyperinflation.
Large economies can borrow in their own
currency. This allows them to hedge their currencies, within the limits
described, through their own central banks. This offers them somewhat better
protection against speculation in the financial markets. They can borrow not
only too much, but also too little. In principle, it would be the duty of
strong economies, with the help of their government bonds, to stabilize the
global economy during a recession through appropriate economic stimulus
programs and to mitigate the negative consequences of speculative bubbles. Smaller
economies must borrow in foreign currencies. This leaves them with few
opportunities for investment or, sooner or later, they fall into a debt trap.
3.3 The German debt brake and its
effect
The German words for "debt" and "to be guilty" have very similar meanings. Germany had very bad experiences with the hyperinflation of 1924 and the Great Depression of 1929, although in public perception, a sharp distinction is not made between the two events and their causes. Sometimes this period is viewed as a time of hyperinflation, thus triggering great fear of inflation. Excessive government debt is often cited as the cause of inflation. After World War II, it was common practice for almost all German politicians to promise to reduce national debt. It is therefore unlikely that the German public and government would accept the irresponsible issuance of government bonds. From this perspective and given the growth of German national debt since the beginning of recorded history in figure 10), all German governments would have failed.
However, if we also consider the dashed
line in figure 10), which represents a hypothetical curve with 7% growth and a
jump during reunification, and assume that it corresponds to the average
monetary growth rate during this period, German government debt correctly grew
along the neutral line, where debt and money supply grow at a comparable rate.
This means that the cost of debt is neutral, and revenues remain constant.
The German Bundestag has incorporated a law
(Article 109, Paragraph 3 of the Basic Law) into the constitution, the
so-called debt brake. This essentially represents a commitment to reduce new
indebtedness. It is intended to limit structural budget deficits at the federal
level and restrict the issuance of government bonds. The rule limits annual
structural deficits to 0.35% of GDP
Figure 11) shows what would happen if the German government were to abandon the neutral debt curve as part of the debt brake. As already described, a gap in the monetary policy schedule would arise on the debt side, which would have to be closed through privatizations. The experience of the last financial crisis suggests that the private sector is unable to maintain the balance of payments between creditors and debtors in the long term. The reason for the decline in private business activity is the decline in money circulation due to declining confidence in the market's solvency. This disrupts the continuity of lending and borrowing, which forms the basis of market solvency.
In the end, the public sector must support the private sector to avoid a chain reaction of bankruptcies. The public sector must replace dwindling private demand and declining interbank transactions. This requires private money, which subsequently leads to new debt. This gives two possibilities: either the public sector can attempt to maintain the neutral debt growth, which would lead to high levels of debt, or it can attempt to avoid new public debt, which would lead to loss of public wealth. But in the end with the same level of public debt.
3.4 Government measures
Countercyclical support through public demand and the provision of money for interbank transactions is the measure used to revive the monetary and credit cycle in stagnation and deflationary crisis. In an environment of deregulated financial markets, it appears to be the only measure capable of stabilizing the system or keeping it stable. If the revival of financial transactions fails, it will lead to the destruction of parts of the economic and social order. It is generally considered a significant historical event.
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