# Change how our money works

LARA IRIARTE
Last updated 05:00 22/10/2012

## Change how our money works

FIGURE 1: Interest does interesting things.

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The reason our economy and economies in Europe and the US are broken is structural.

This boom/bust cycle has been seen before - the depressions of the 1870's and the 1930's the biggest examples. It's cyclical. It will keep happening until we change the underlying structure of our economic system.

I used to think that our money supply had something to do with our productivity. If we were a more efficient nation and produced more goods and services then we would have more money in our economy. However, this is not true.

Our monetary system is the structure which underlies our economic system. Money makes our world go around.

In our system new money is created by debt. At its simplest, this can be explained using an example of how the fractional reserve system works.

Banks need to keep a fraction of deposits on reserve to have funds available should depositors wish to withdraw it. This does not prevent a 'run on the banks', which is when depositors demand to withdraw more funds than the bank holds in reserve; this can still happen, and in fact sometimes does.

Currently in the US the fraction required in reserve is 10 per cent. I am unsure of what it is in New Zealand.

If I deposit \$100 in my bank they must keep \$10 in reserve. They may loan out the remaining \$90. This is given to the borrower, or whomever they give it to to purchase something who may then deposit it into their bank.

This second bank (which may also be the same, for this example it doesn't matter) now has a deposit of \$80. It must hold \$8 in reserve and may loan out \$72. Which gets deposited in another bank or account leading to a new loan of \$64.80, which leads to a new loan of \$58.32 and so on. After 10 such cycles the initial \$100 creates total loans of \$357.05, which now circulates in the economy.

This is the multiplier effect. Because of the fractional reserve ratio essentially new money is created by banks as interest bearing debt.

However, from what I can tell it may actually be worse than that. The procedure that banks undergo may not follow the steps outlined above. What they may be doing is creating the loans first and after that balancing their books with funding from the Reserve Bank. Which means new money is created as interest bearing debt first and the reserve requirements of the banks are met by wholesale loans from RBNZ at the wholesale interest rate. Which means the amount of money circulating is dependent upon whether or not private banks wish to make loans.

Economists like to identify different types of money. M1, M2 and M3 according to how it was created. However, when it is being used in the real world by real people it really does not matter. We still spend it, leave it in our bank accounts and pass it on to each other in exactly the same way.

The biggest problem, and one economists seem to have the hardest time understanding, is that if our money is created as interest-bearing debt then because the interest is charged at a percentage rate this requires our money supply to grow at an exponential rate. Anything which has growth at any percentage rate mathematically has an exponential growth rate.

Even a nice low growth rate of 2 per cent will have a doubling time of only 35 years. It is mathematically impossible to have perpetual growth in a finite space. No economist will ever be able to tell you how to do this, and so the underlying premise of our system is structurally flawed. And they simply ignore this simple math.

If new money is created as interest bearing debt then the interest on the debt must be repaid, which means that someone else somewhere in the system must take out a new loan for the money in circulation to increase. This means more interest must be paid, which means more loans ... it's a vicious cycle.

When the population is so saturated with debt, just like a sponge saturated with water, it just cannot take another drop, that is when the system crashes. This is why each great crash is at its heart a debt bubble which burst. When no new loans are being created the interest payments cannot be met and defaults and bankruptcies occur.

Interest does another interesting thing. It makes the rich get richer and the poor get poorer. If you have more money than you need it will grow. If you don't have enough for your needs you will pay interest. This is the biggest cause of the wealth gap. Figure 1 illustrates this idea.

That is an outline of the basic problem. The solution is remarkably simple, and has historical precedent which occurred for thousands of years and worked pretty well indeed.

We must change to an interest free system. There is a reason why interest is termed 'ursuary' with all it's negative implications.

We need to get back to the original purpose of money, which is to facilitate the exchange of goods and services to overcome the limitations of a barter economy. Money has become the end not the means, we need to take it back to the means.

I would propose a new monetary system with the following attributes:

1. No interest. This eliminates the need for an exponential growth curve.

2. New money is created by our RBNZ for productive purposes on instruction by the Government.

3. A regular demurrage is charged.

A demurrage is a fee for holding on to money. This encourages money to circulate which encourages a flourishing economy which can lead to full employment (and did in historical examples). Demurrage would be charged on all money sitting in a savings account and would require a stamp scrip to be affixed to all cash in circulation. The amount needs to be capped at no more than about 15 per cent per annum to stop governments using it as a tax.

Demurrage could be charged quarterly at, for example, 3 per cent. Which means if you have \$100 in your pocket today and the demurrage comes into effect tomorrow then if you still hold your \$100 it would be only worth \$97.

Demurrage does three interesting things:

1. It encourages money to flow in the economy. People would spend their money to avoid the demurrage. This encourages more business activity and employment.

2. It reintroduces the incentive to loan that removing interest took away. To avoid demurrage someone with money could loan their money to someone willing to borrow it. The lender avoids the demurrage and the borrower pays the loan principal back at an agreed rate without interest.

3. It keeps the money supply in circulation stable. Government creates new money for productive purposes, and uses demurrage to reduce the money supply back to a stable level. This amount would have to be calculated according to how many people are present in NZ, and would be about \$24,000 for each resident.

One interesting historical example occurred in Worgl, Austria in 1932. In the middle of the Great Depression this small town had a very high unemployment rate. It used an interest free demurrage local currency with a monthly demurrage of 1 per cent. In one year the interest free schilling circulated 463 times, compared to only 12 times for the national interest bearing currency. Unemployment was reduced by 25 per cent in one year.

Europe in the Middle Ages prior to the 1280s abounds with examples of successful interest free currencies. Egypt in its golden age also used an interest free currency which had a natural demurrage as it was based upon grain.

A demurrage currency encourages an economy to grow initially strongly up to its carrying capacity. Thereafter growth stops and the economy is stable. This is more like a natural growth curve, which is what we need to aspire to if we are to exist in perpetuity and leave a decent plant for our grandchildren and successive generations. Figure 2 illustrates different growth curves.

Once one understands the problem and this simple solution the next question is why has this not been done? The answer is simple. Ask yourself, who stands to lose the most from this change? It is the banks.

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