The inherent instability of banking and the markets

Between 1970 and 2010 the International Monetary Fund (IMF) counted 425 banking, sovereign debt and monetary crises.  


Economic theory vs. the real world and our understanding of it

Adam Smith the 18th century scholar the father of modern economics authored "The Wealth of Nations", it ensures that private undertakings benefit society as a whole when three conditions are met. First, economic actors, meaning people, must always make economically rational decisions. Second, people must be fully informed: they must have all knowledge relevant for making a decision. And third, there must be perfect competition – meaning an infinite number of producers and consumers. In the real world, and especially in financial markets, none of these conditions are met. People do not act in an economically rational manner: social, psychological, biological and cultural factors also influence behaviour. 

Also, the banking sector is not particularly competitive: in many countries there are only a limited number of players, big banks that hold a large part of the market. And it may be difficult to prove, but it often appears that there are tacit agreements to limit competition – for example, by not competing too aggressively on the interest rate paid on savings or the interest charged on loans. The most important inhibiting factor for markets “doing their work” is that many operators, from small consumers to governments, lack information. Most people not only have no idea of how our monetary system works but also lack understanding of all kinds of financial products. Many even have trouble understanding their own financial situation. For example, a study estimated four out of five people in the Netherlands were unable to judge the benefits and risks of financial products and that was the best score among the 13 countries surveyed.(1)

In short, the basic conditions for the proper functioning of markets,

established by economic science itself, are not met for financial

markets.Yet the belief prevails that the

market, in the form of a system of profit-oriented private banks, is

the best way to control money creation and allocation.

(1) Study discussed in the Dutch newspaper De Volkskrant, December 23, 2009


Are financial markets good for the economy?

Because there are limits to how much money a bank can create it is assumed they cannot cause an explosion in the money supply. That’s true only in part, since the 1990s banks have created huge amounts of virtual money that ended up largely in financial markets. These form a kind of virtual economy with few ties to the "real" economy of the production and consumption of goods and services. Much of the money thus created ended up in complex financial products famously called "financial weapons of mass-destruction" by American billionaire and "super-investor" Warren Buffett. These products were the basis for the 2008 financial crisis. Post- crisis, after a brief downturn, growth in this speculative financial system has resumed as before, leading to an ever growing risk of a new crisis.

Monetary expert Bernard Lietaer estimated for 2010 that of the 4 trillion dollar traded daily in currency transactions only 2% was of significance for the "real" economy, e.g. for importing or exporting goods and services; the other 98% was used purely for speculation. 

So where has our current monetary system brought us? The effects of the crisis are still with us, Governments are deeply in debt and disposable income is declining. Entitlements are reduced, costs for basic services such as education and health care are on the rise. In many countries the national infrastructure is in poor shape, even crumbling, as there is little or no money for maintenance, let alone improvement. And there is barely money for investment for the future, such as reducing greenhouse gas emissions through energy efficiency and the switch to renewable energy.

Many economists believe that these problems can be controlled by regulation. Over the past centuries that assumption has been made time and again, after which yet again things went wrong and the next crisis was born. It therefore appears that even with regulation the system is inherently unstable


Privatizing profits and socializing losses

Another disadvantage of the current banking system is that if things go wrong the government must intervene: the banks must be saved. This applies especially to the so-called “too big to fail” banks, of which it is feared that should they fail they’d take down the entire financial system and thereby, the economy. To prevent this from happening the government spends huge sums of money on nationalizing or supporting banks that are about to fail. And since the government is funded through taxation it’s the taxpayer who foots the bill. At the same time the national debt increases due to the many billions of dollars spent on the bail-outs. The loans for doing so are partly provided by the same banks that caused the crisis, meaning new money is created that is lent to the government at an interest rate that gives the banks a tidy profit. The money for repaying the loan plus interest must, once more, be raised by taxpayers. Indirectly, the taxpayer also pays a price: to reduce the deficits created by the bank bail-outs the government has to reduce spending, as a result of which services are cut or become more expensive.

In summary: if all goes well with the banks the (ample) profits are

for the shareholders, managers and financial traders, in the form of

dividends, exorbitant salaries and bonuses. If things go wrong the

losses are passed on to ordinary citizens. This has been described as

privatizing profits and socializing losses, or socialism for the rich.


What has money creation got to do with the business cycle?

The current monetary system leads to an economic see-saw with high peaks and deep troughs in economic performance, or, as economists call it, the business cycle. The variations are aggravated

by private banks because in good economic times they give more loans, as they see more opportunities for profit. This boosts the economy further, at some point leading to economic overheating, asset bubbles and a new crisis. Then, in times of economic contraction, banks are hesitant to lend money, meaning less money is created precisely at a time when more is needed for economic recovery. This behaviour of banks makes sense from a business point of view and is, therefore, in line with the logic of private banking. But it is contrary to the public interest, because the economy as a whole gets the opposite of what is needed.


A small group benefits from banking

The privilege of creating money benefits a small group of people: bankers, traders, and bank shareholders.  However, there is no reason to continue extending this privilege of money creation to a few privileged companies, executives and shareholders. We’ve already done so for the past two centuries, so why continue to provide a small elite with this boon? It would be much more logical and equitable to have the profits of that privilege benefit society as a whole, by bringing the right to create money back to where it belongs, a government that represents our best interests.


What happens if your bank fails?

If you are a saver a major drawback of the present system is that it exposes you to the risk of losing all your money with the exception of $100,000.00 which is covered by the Canadian Deposit Insurance Corporation.


Higher debt is the inevitable result of our current system

Another problem associated with money creation by private banks is that it’s inextricably linked to profit-oriented lending and thus, to debt and interest. Lending takes place only if the bank is convinced that in the future the borrower will be able to repay the borrowed capital plus interest. Therefore borrowing is possible only with an increase in profits (for companies), income (for consumers), and tax revenues (for government). More profit, earnings and tax revenues are inextricably linked to economic growth. Without growth there is no increase in company profits, consumer incomes and government revenues, and loans plus accumulated interest cannot be repaid and this leads to the growth imparative. There is no or very little growth during an economic downturn, leading to many people, companies, and even countries no longer being able to meet their payment obligations. That can lead to a debt crisis, which is sometimes delayed by further borrowing. But this only increases the debts and thereby the problem. In consequence, without strong growth a new and possibly even graver crisis becomes almost inevitable. Many experts believe that, in the aftermath of the 2008 crisis, with many households, companies and countries still deep in debt, another major crisis is looming.


Where will the growth imperative lead us?

Lending by privately owned commercial banks is tied to growth: growth is indispensable to repay debts plus interest. Besides growing indebtedness this causes another major problem: continuing growth can not be reconciled with the finite nature of our natural resources. The money supply can, in principle, grow indefinitely but our stocks of raw materials, fresh water, land, and natural ecosystems are finite. Economic growth is putting ever greater demands on those resources, in an unsustainable manner. Meaning that, if we continue present ways, we ourselves or future generations will face major shortfalls and run out of essential resources such as fresh water, agricultural land, metals, and fuel. This will cause huge problems especially for the have-nots in our world. The rich will be able to handle the price increases resulting from the shortages initially, but they too will ultimately suffer, especially if the deficits lead to popular uprisings 


The growth imperative and our environment

The growth imperative and thereby, the unsustainable use of finite resources is inextricably linked to private money creation. In other words, the current monetary system will, sooner or later, cause shortages of finite resources. That in itself is enough reason to convert to another monetary system. Besides the growth imperative there is another reason why the current monetary system is incompatible with the sustainable use of resources. The main objective and in many cases, the sole purpose of private banks is to maximize profits and not, as should be the case from a public interest point of view, to provide society with the money supply needed for an optimally functioning economy. Functioning optimally does not mean maximum wealth creation through maximum efficiency – the implicit and sometimes explicit purpose of mainstream economics. From a public interest perspective functioning optimally means achieving public goals as effectively and efficiently as possible. Goals such as providing for everyone’s basic needs, the right to clean air, water, and creating equal opportunities for all


Profit comes first all other considerations are secondary

In the current monetary system commercial banks only create loans for profitable activities. From a public interest perspective it may be very important for government to invest in, for example, better education, a healthier environment, good quality health care and disease prevention, and the development and application of renewable energy. But if such investments are not profitable no money is created for it. Instead the state has to raise money by taxing or borrowing. It can do so only to a limited extent because it has to service its debt and other expenses.


Are there advantages to the current system?

The first argument that its defenders will raise is the assumption that with money creation by private banks and the market mechanism will ensure the right amount of money is created. We’ve already seen that this is little more than a belief. The fact that banks only lend if they think the loan can be repaid along with capital adequacy ratios forms a brake on money creation. However, it’s a brake does that not work well and is limited mainly to the real economy. Things are different in the financial or virtual economy. In financial markets there are almost unlimited possibilities of creating money for all sorts of speculation in financial products. Proof of this are the enormous quantities of money currently circulating in the financial markets. Defenders of the current system will also argue that private banking has contributed to huge prosperity growth. This also is doubtful. 

First, both prosperity growth and well-being could have been much greater with the alternative to money creation by private banks, that is to say, with public money creation. Second, much of the wealth created through private banking is unsustainable because it derives from speculation. Such prosperity can indeed grow rapidly until the next crisis occurs.  Proponents of private money creation and private enterprise in general will emphasize that only competition between multiple providers creates wealth creating innovation. However, it was such innovative financial products that caused the crisis, showing that the results of this kind of innovation, even if highly profitable to those creating and selling the products, are rarely in line with the public interest. It is also a misconception that innovation is limited to the private sector. If that was so then why do so many companies cooperate with public universities and research institutes, and contract them to do their research?


Defenders of the current system

Our present monetary system has many disadvantages and no clear advantages, except of course for bankers, traders, consultants, lobbyists, and private bank shareholders. Yet the system is firmly ingrained primarily because the general public, the media, politicians, administrators and economists accept the current situation as an immutable given. Some of this influence can be credited to mainstream economics, given that it is a social science it would be expected to engage in unbiased analysis and debate. However, very few economists seem to be interested in putting our monetary system up for discussion and thus support the status quo. If the topic is brought up at all it is not so much to analyze in an objective manner the advantages and disadvantages of different monetary systems in support of political decision making. Instead it is attempted to stifle debate in the bud with the selective use of examples and unsound arguments. Alternative systems, in particular money creation by and for the government, are rejected out of hand with the argument that money creation by government will lead to financial and economic disaster. The favourite bogeyman is hyperinflation; the best known example is the hyperinflation in Germany in the 1920s. Ironically, sound historical research has led to the conclusion that although the German government was complicit the hyperinflation was caused mainly by private banks and war time reparations to the allied countries. Hyperinflation could be prevented  by giving the monetary authority (Bank of Canada) the status of an independent entity that cannot be subjected to political pressure. Thus decision making on the money supply would be based only on technical criteria and remain in line with the authority’s mandate.

Much of the content on this page has been inspired by a document produced by Frans Doorman in 2015 entitled "Our Money - Towards a new monetary system ". Some of the content has been copied verbatim while other content has been modified.



Should we have the Bank of Canada responsible for all money creation in our country? How would that work?