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Monday, April 05, 2010

The Ecology Of Money (FULL TEXT)

BOX 1: How the Bank of England controls the money supply

The explanation of the way banks create money makes it appear that the amount of notes and coins in circulation, coupled with the reserve ratio the banks set themselves, determine the extent of a country's money supply. Actually, this is not quite the case. In most countries, the central bank does not attempt to control the total value of the notes and coins in circulation. In Britain, for example, the Bank of England (BoE) will sell as many notes and coins to the commercial banks as they wish. It simply debits the accounts these banks operate with it by the appropriate amount. So the cash base of the British monetary system is not just the notes and coins that the banks have in their branches, but whatever money they have in their accounts with the BoE as well.

Another minor difference is that it is not the commercial banks themselves that decide the reserve ratio they want to follow, but the central bank to which they report. For example, in Britain until 1981, the BoE specified the total amount of notes and coins a bank must have available at its branches, plus the amount on deposit with it, in relation to the amount of money the bank had created by granting its customers overdrafts and other loans. This meant that if at any time the BoE felt that the amount of money in circulation was too high and was causing inflation, it could force banks to reduce their lending by requiring them to deposit more funds in their accounts. A reduction in the reserve ratio from 20:1 to 10:1 would have halved the total of the amount of money that banks could create.

That system still applies but in a less rigid form. Responding to pressure from the commercial banks (who argued that they would otherwise lose overseas business to foreign banks), the BoE abolished its minimum reserve ratio in 1981. It now agrees a reserve requirement individually with each bank. This reflects both the level of competition the bank is experiencing from its foreign rivals, and the lending and other risks that it is perceived to be running. This change has weakened the BoE's ability to control the money supply by varying the reserve ratio.

The second way that the BoE can control the money supply is by 'open market operations'. These involve the BoE in buying, or selling, interest-bearing bonds. If it sells bonds, the purchasers (financial institutions or members of the public), pay for them by writing out cheques drawn on their commercial bank accounts in favour of the BoE. Subsequently, the BoE debits the accounts that the commercial banks operate with it by the relevant amounts. Unless the commercial banks make up these debits in some way, the volume of lending they are able to make (and thus the amount of money in circulation), has to be reduced by a figure set by whatever the reserve ratio they had agreed with the central bank. If the ratio were 20:1, their lending would have to be reduced by twenty times the amount of bonds that the BoE had sold.

If the reserve requirement is increased, or the amount in its account with the BoE falls, a bank could maintain its lending by raising more capital and depositing this with the central bank. The new capital could come from selling more shares, or from making a trading profit and paying that to the BoE (rather than distributing it to shareholders as a dividend). For many years the Irish commercial banks attempted to justify their huge profits with the argument that they were necessary to enable the banks to lend enough money to finance a rapid expansion of business activity. Profits made by the UK's twelve banks and former building societies quoted on the Stock Exchange are high too. In 1998/9 they totalled £22bn, around £400 for every man, woman and child in the country.

If the BoE wants to increase the amount of money in circulation, it can do so by buying up bonds that it, or perhaps a local council, had issued previously. In fact, a possible way that Begg's hypothetical customer obtained the £100 to deposit with their bank was by selling some government stock (perhaps Consuls or War Bonds that they had inherited). Alternatively, their lodgement could have been a payment from overseas.

The third way in which the BoE can control the national money supply is to alter the interest rate at which it lends funds to banks that fail to keep positive balances in their accounts with it. According to an official BoE statement,
9 this is the main way that the money supply is controlled at present. The technique involves keeping the banking system short of money and then lending the banks the money they need at an interest rate that the BoE decides. The BoE statement explains, "If, on a particular day, more funds move from the private sector [i.e., non-government accounts held in the commercial banks], to the Government's accounts than vice versa, for example because banks' customers are paying their taxes, then the banking system will be short of the funds needed [by the commercial] banks to maintain positive balances on their accounts at the Bank." Alternatively, if the government is spending more than it is collecting, the BoE can create a shortage by selling bonds itself. The Bank then lends the banks the funds they need to keep their accounts with it in credit at a rate of interest that sets the rates at which the banks lend to each other, and to their customers. And that rate of interest, of course, determines how much the banks' customers borrow, and hence the national money supply.

BOX 2: Why does our present money system lead to a long-term misuse of resources?

The prices set by the market at any given moment have nothing to do with long-run values because of the type of money we use at present. As a result, they are entirely inadequate for determining the development path that we should select. The problem arises because the market is a human construct that works according to rules people have devised for it. Currently, those rules prevent millions of people without money from affecting the price levels in the market. The needs of the unborn cannot be reflected in market prices either. Consequently, the prices that emerge from the market merely reflect the immediate wants of that fraction of the world's present population fortunate enough to have the money to be able to express them.

The ideal use of resources over the years can only be assessed in terms of one's objectives. At present, the system's objective is simply to minimise costs from moment to moment in terms of market prices that are largely determined largely by the current pattern of income distribution. This inevitably leads to a gross misallocation of resources in favour of the present. A key step toward sustainability is therefore to establish a unit-of-account currency that represents absolute amounts of something important to the whole world's population, present and future, rather than current transitory price levels determined by a temporary minority.

Box 3: Businesses organise their own currency to overcome money drought

One way that businesses can continue to make profits in periods in which the supply of national currency is inadequate is to allow each other credit. As discussed in Chapter One, the credit-control measures that most firms use to protect themselves whenever trading becomes difficult actually make matters worse. While it would obviously be a mistake for firms to have no credit control at all, what businesses need when national currency becomes scarce is a properly regulated system of mutual credit so that they can use much less normal money when they trade amongst themselves. The Swiss Wirtschaftsring (Economic Circle) co-operative (WIR) is such a system. It was launched in 1934 by a group of businesspeople to overcome the currency shortages of the time and has since grown into a massive organisation. In 1993, its 60,000 account holders turned over 2,521 million Swiss francs (£1,200 million).

The founders' idea was simply that traders who knew and trusted each other would extend credit for purchases within their group, cutting down their need to borrow from banks. According to report on the system in 1971: "they thought they could transact business among themselves with a system of chits similar to IOUs that would cover at least part of the price of any transaction, the balance being settled in the conventional way. (However) it was soon found that in order to bring about wider acceptance of these chits, and also to comply with existing banking laws and avoid financial losses, collateral was essential."

This insistence on collateral might partially explain why WIR has survived and similar systems established at the same time in other countries have disappeared without trace. However, an official history of WIR
18 produced for its 50th anniversary suggests that WIR is the sole survivor because the other systems did not realise the significance of what they were doing and closed down after the financial crisis was past. But opposition from vested interests played a part in some cases too. The founders visited circles in Norway and Denmark before starting WIR and when they returned to Denmark for a second visit, they found that the government had closed the circle there after pressure from the banks.

Essentially, WIR is an independent currency system for small and medium-sized businesses. A company wishing to join contacts a WIR office and sets up a meeting at which the firm's credit requirements and the collateral it is able to offer are discussed. As first mortgages in Switzerland do not usually exceed 60% of the purchase price of a property, the collateral most frequently offered is a second mortgage on a house or business premises (in recent years, over 80% of WIR's loans have been secured this way). A loan application is then sent to the WIR credit approval committee that checks the security and obtains a report on the applicant from a credit-checking agency. If the report and the security are in order, the new participant is given a WIR chequebook, a plastic charge card and a large catalogue listing other participants with whom the loan can be spent.

Although the sums in WIR accounts are denominated in Swiss francs they cannot be turned into normal currency, paid into ordinary banks or given to non-members. Even when someone wishes to leave the organisation, they cannot exchange the system's units (Wir) for national currency. As a result, the purchasing power created when the credit committee authorises a loan remains entirely within the 'ring', generating increased business for all participants. Secured loans of this type are cheap. In 1994, Wir mortgages carried a service charge of 1.75% and relatively long repayment terms could be negotiated; the charge for ordinary current-account loans was 2.5%.

In order to maintain the Wir's value, the credit committee restricts the total value of the loans to one-third of the system's annual turnover. All repayments are made in Wir (earned by selling goods and services to other members). Only service charges have to be paid in Swiss francs, since the co-op itself cannot function without some national currency. Its other charges, the cost of the WIR magazine and catalogue and a levy of 0.6% of the value of each cheque lodged to a participant's account, are all in Wir.

Almost every conceivable product and service was listed in WIR's summer 1994 catalogue, including 167 lawyers, 16 undertakers, 1,853 architects and 18 chimney sweeps. Not all suppliers take 100% payment in Wir, but with several sources listed for most products and services, it is generally possible to find at least one who will (especially at slack times of year or during sales). Prices and payment terms for Wir transactions are just the same as they would be for cash. And since the beginning of 1995, it has been possible to make combined payments of cash and Wir using a single plastic charge card.

The percentage of the Swiss franc price of the goods and services that participants will supply for Wir is discussed with each member when they join. The service charges mentioned so far only apply to 'official' members who have agreed to guarantee to accept at least 30% of the payment in the system's unit. Members unable to give such an undertaking are called 'unofficial' and pay higher charges. Income earned in Wir is, of course, taxable, and has to be paid in Swiss francs.

Overall, the Wir avoids the two main defects of national currencies: it should never be in short supply, and because no interest is charged for its use it does not create the growth compulsion. In addition, it does not have to be earned or borrowed from outsiders before it can be used. Its main drawback seems to be due to the way the WIR is run, rather than any design defect in the currency. The WIR is often regarded as a way of financing the working capital requirements of businesses, rather than purely of facilitating trade between them. As a result, too many long-term loans are issued and some members earn so many units that they become reluctant to take any more. The availability of mortgages has obviously compounded this problem.


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