Monopoly Money 2: Don’t Blame The Capitalists

This is the second post in a three part series on money. The first part can be read here. 

The recent Occupy protests have mainly targeted the banking sector. Demonstrators have held signs saying everything from: “Capitalism in cancer,” to “You got bailed out, we got sold out,” to “No bears, no bulls, just pigs,” get it?

Protesters have camped outside Wall St. and the London Stock Exchange etc, where many of the wrongdoers can be found. However, this isn’t where the root of the problem is. The protesters should really be outside the Federal Reserve or the Houses of Parliament and the Bank of England.

The blame for the economic instability and unfairness that people resent is being laid on capitalism, and when people think capitalism, they think banks. Although capitalism does of course create inequalities and embraces greed as a positive driver of prosperity, it is not the enemy. Capitalism creates the wealth and jobs that we all want to see. It is the government’s involvement in the banking system that has entwined banking and politics and sown the seeds for yet another credit driven recession. 

In the first post we talked about how the central bank creates money through ‘quantitative easing’ and the reasons it gives for doing so. We asserted that inflation = people getting poorer, and I stand by this generalisation as being true for the vast majority. 


However, there are some groups of people who stand to benefit from the government’s money creation activity. In this post I talk about who these people are, how the government’s policies are designed to benefit them and hence why we are the 99%. 

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To begin, here is a short comedy sketch from the Australian duo Clarke and Dawe: 

So who benefits from inflation? 

- Bankers: As put by John Clarke in the sketch, economists advise governments to prepare their printers to fire off loads of new money out the window, alert the banking sector and then 'let 'em rip.' OK, a bit of an exagerration, but that is pretty much how it works.

The government’s policies to "stimulate" the economy, are extremely biased towards the banking sector. The government and the bankers are all buddies in the 1% club.

The banks are the primary recipients of money created by the central bank. By the time ordinary people see this money, prices have risen and it is too late to take advantage of it. Banks benefit from more money in the economy as it allows them to create more loans and credit and, as they are also borrowers, it reduces the size of their interest payments, as explained below. 

- Borrowers: When the value of a currency is steadily decreasing, the longer in the future you wait, the cheaper (less valuable) the money becomes, and the less borrowers have to repay in real terms. A government, for example, that owes lots of money and must make regular interest payments to its creditors, benefits from inflation, as each future interest payment is worth less than the previous one. The government can literally ‘inflate away’ its debts. The same applies to all people/organisations who owe more than they are owed. Inflation hurts the prudent and rewards the indebted. 

- Rich people and owners of big corporations: Inflation is good for big business - it makes the stock market go up. Big corporations, that borrow money to finance their investments, benefit from more liquid bond markets (i.e. cheap and available credit). As the prices of energy and consumer goods go up, the big companies that sell these things make more money.

Chief executives own most of their wealth in stocks and many are even remunerated with stocks. The losses that they may suffer due to the rise in prices for consumption goods like food, TVs and cars etc, is insignificant compared to the gains they make in the stock market. 

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So inflation doesn’t hurt everyone, it is actually good for some people.

It transfers money from savers to borrowers, from the poor to the rich, from the general population to the government and their cosy club of banks and favoured borrowers.

It is a form of wealth redistribution; a tax. 

Of course, it is not just the Bank of England that creates money. All the banks do. When you deposit money into the bank, you give up the ownership of the money in exchange for a bank balance which gives you access to the money when you need it.

The money doesn’t just sit in the bank, it is lent out to other people, who then deposit the money in their bank, which lends it out again, and so forth. Each bank is required by law only to keep a fraction of its deposits as cash on reserve in the bank. This is called fractional reserve banking. 

Nowadays it is all electronic, but in order to illustrate how the system came about, imagine the days of the very first banks. When wealthy individuals deposited real gold at the bank,  they would get a ticket, a paper guarantee of their deposit, that they could take back to the bank in order to redeem their gold. As the paper ticket is a claim on real gold, it is essentially worth its denomination in gold and can be exchanged as if it were gold. As paper is much more portable and practical than metal, it would soon become less important to redeem the actual gold, so long as everyone had confidence in the system and recognised the paper tickets for what they were worth. The bank could therefore, if the law allowed them to do so, use the gold for other means, or at least some of it, thereby rendering some of the paper tickets in circulation irredeemable. However, so long as everyone did not try to redeem their gold at the same time, no-one would be unhappy. There would therefore be more paper tickets (claims on gold) than there was gold in the bank. This is a simplified example of how banking still works today. So long as everyone retains confidence in the system, and doesn’t demand cash from the bank at the same time, each bank is able to hold only a fraction of its assets as liquid assets (cash) and the rest as receivables (loans). In the UK this reserve amount is typically under 10%. The banks therefore loan out money that doesn’t exist. They create money. 

Banks make money not just on the initial deposit that you put in the bank, but on nine times the initial deposit. A deposit of £10, where banks are required to keep only 10% of reserves (a reserve ratio of 10%), means that the bank can create £90 of loans, so long as the £10 of cash is left in the bank to cover the £90 of money that has been created. This practice of fractional reserve banking is, of course, profitable for the banks. Banks make money by lending money out at a higher rate than the rate they pay to whom they borrowed it from. So if they are willing to lower their reserve ratio, they can create money, lower their interest rates to entice people to borrow it, and then they can make even more money.

The incentive for banks to create money is therefore mainly for profit, so the banks cannot be fully absolved of all blame for the financial crisis, but the ability to create money exists only because the government has granted the banks these powers and encouraged their use.

The government has, over time, created a financial and regulatory framework whereby the Bank of England acts as the lender of last resort to the other banks, meaning that if their reserves get low, and they are short of cash, the Bank of England can print more money and help them out. Banking services are so commercialised these days that ordinary depositors like you and I do not even think to compare banks on their riskiness (by examining their reserves and leveraging) because their worthiness is guaranteed by the Bank of England. 


There is also the continued support for the use of bailouts, as expressed in a previous article, which means that when banks become too dependent on debt and illiquid investments, the government can provide liquidity by loaning them ‘emergency’ funds. If the banks were truly independent, they would be limited in their fractional reserve banking activities by the genuine risk of bankruptcy, the risk that people might lose confidence in the bank and withdraw their money and then a lack of reserves might trigger a bank run (such as seen with Northern Rock in 2007, where depositors raced to withdraw all their funds from the bank because they had reason to believe that they may not be able to get it back). 


If the government and the banks were totally separate, then banks that got into trouble would be left to fend for themselves and would not be able to rely on the government to bail them out. Of course when we say the government, we actually mean the people, either through the Bank of England, taxing the people with inflation, or the Treasury, taxing the people with actual taxes and using this money in a bailout.

The bank’s ability to create money is like an extension of the government's money monopoly licence. Whereas capitalism is supposed to engender free privately owned enterprises taking on their own risks and their own profits and losses, the banking sector has become an extension of the government. In a ‘true’ capitalist society, businesses would still be able to take on big risks and flourish, like banks have done. But if they then take on too much risk and fail, which has also happened, they would then be forced to pay for their own follies and the businesses would go bankrupt, instead of the government intervention of bailouts and emergency loans that has saved these wealthy people from the consequences of their own mistakes. The government and the central bankers have turned capitalism from a system of profit and loss, into a system of private profits and socialised losses.

In the next post we talk about why this monopoly power lies with the state and the banks, and how we might begin to solve this problem.

Below is a video of one of the Occupy protesters who seems to have right idea. It is from an American perspective, but he’s got it spot on.

Read on » Monopoly Money part 3