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Modern Monetary System, Banks, Money Supply, Recessions and Depressions

Economics / Elliott Wave Theory Jun 07, 2010 - 03:12 AM GMT

By: Mansoor_H_Khan


Best Financial Markets Analysis ArticleModern monetary theory seems almost too good be true.  It seems as if "one is getting something for nothing".  Too many people who understand and write about modern monetary systems are very professor-ish and don't really answer the basic question:  How can one get something for nothing?

I believe in a sense we do get something (actually a lot) for very little effort.   How?

All goods and services (i.e., wealth) creation involves not only production (the engineering part) which is easy to see but also exchange (i.e., trading of one’s produced output for produced output of another person).  The exchange part is hard to see unless one is involved in barter.  Getting money for one’s produced output and buying other people's produced output with that money is just an extremely efficient form of barter.  Therefore, going through this thing called "money" makes barter (trading) extremely efficient.  So, there you have it.  One is getting something (one becomes extremely efficient at barter) by using fiat money that is very cheap to produce.

Of course, the producer (the seller) must trust that the money received will retain its value over time to a sufficient degree.  This is the main challenge of all currency management by governments or anyone else:  Maintain the trust. 

Currency failure occurs when this trust is compromised (actual rampant inflation or an expectation of rampant inflation).

But we have major problem with fiat money:  Who gets to create it? How much should be created or destroyed and when? And once created how should it be introduced into circulation? And if some money needs to be destroyed, whose money should be destroyed?

Once one realizes that 97% of economic exchanges (trade) is done using bank deposits (yes, bank deposit=modern money) then one will begin to see why banks are so important because they create (and destroy) and distribute (by lending) this so important commodity.  It is a common misconception that governments create money (yes, they create some, called base money or cash - coins, paper bills, reserves at the central bank) but most of it is created (or destroyed) by private banks as they are able to leverage (pyramid) up to 20 or more times the government created money or deleverage and destroy money.

It is this private banking industry’s money creation or money destruction that enables booms (more money creation via more lending) or recessions (less money creation via lending less) or a deflationary depression (credit crunch--very little lending).  One way to counter a recession or a credit crunch is for the government itself to create money (or borrow) and spend it (fiscal stimulus or even bailouts or purchases of crap assets by the central bank, etc). This is an attempt to counter the money destruction (money is destroyed as loans are paid back by borrowers and new loans don't entirely replace the destroyed money).   This is what Japan (since 1990) and U.S. (since 2008) have been doing. 

Both governments are waiting for the credit crunch to go away and more normal private (bank) money creation (i.e, lending) to resume.  Which many people think will not resume until bad debts are wrung out of the world economy (i.e, take the hit of a worldwide deflationary depression).  A worldwide deflationary depression (I think) will lead to much, much chaos and probably wars and extreme poverty.

But I think that there is another way.  We need to modify the process of money creation and distribution itself so the real economy (trade) is not so severely impacted (one major reason for extreme booms and depressions is severe changes in money supply that occur due to too much lending or too little lending). 
  1. Money is extremely useful because it greatly facilitates trade.
  2. Fiat money can be created very cheaply and there is no problem keeping up with demand for money.
  3. Most money creation (by far) is performed by private banks.
  4. Decline in the supply of money (electronic scrip=bank deposits) in the economy greatly hampers trade.

Here is my proposal:

  1. Remove government bank deposit protection insurance schemes (e.g., FDIC deposit insurance) and allow “Free Banking”.  Allow banks to fail.  This will greatly reduce the ability of banks to create bank deposit private money. 
  2. Give the public the option to “store” money electronically risk-free in a government owned bank which can only “store” electronic money and clear checks but not lend it out.  100% reserve credit risk-free money storage for a small fee.
  3. Allow new money creation in all forms (coins, paper bills or bank deposits) by the treasury department.
  4. The new money should be put into circulation by spending it on legislature approved government expenses and projects.
  5. The object of the government will be no deflation and no inflation (stable purchasing power).  I realize purchasing power is hard to measure and the process can be gamed by the government but benefits are so great that this risk should be taken and managed. 
  6. If inflation ensues the government can tax and destroy the money. 
  7. If deflation ensues then the government can create new money and spend it on legislature approved government expenses and projects.

Mansoor H. Khan

About the author: I am an Electrical Engineer by training (Bachelor of Engineering from Stevens Institute of Technology). I also have a Masters of Business Admnistration degree (MBA) from the University of Virginia.

© 2009 Copyright Mansoor H. Khan - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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