Money in law is a form of debt
Lawyers are not much concerned about, and economists have never really known, what money actually is. In microeconomics the issue of money does not appear at all: indeed, mainstream microeconomics has eliminated money entirely from the supply-demand market model, with the argument that money is just a neutral means of exchange without any effects on the market. In this way one can avoid addressing economically and politically relevant points.
Money is a form of legally recognised and legally enforced debt; in fact, it is the nature of being a debt and its the enforceability by the law which creates the money. Money is a debt represented by socially recognised reifiers (coin, banknote, accounting entries, …) which the law orders to be accepted as payment and extinction of another debt, for example arising from a contract of sale. Thus money is entirely a creature of the law.
If we first look at cash, banknotes have no intrinsic value, and yet people have to accept them as legal tender in satisfaction of the debt of £10 to him which a £10 banknote embodies, and they are also forced to accept the (entirely valueless) banknote as payment and extinction of the debt. This so-called fiat money or compulsory tender is an order by law according to which banknotes and coins without intrinsic value have to be accepted as satisfaction of debts. Bank money (accounting entries) is as yet not legal tender, but accepted payment as recognised by law.
Since money is itself a debt (for the payment of another debt), it follows that there must be debtors and creditors as a result of the debt that money is, not of the debt that money pays in satisfaction of this other debt. If there is no debt, then there is no money, and a modern economy would be impossible. It follows further that sovereign debt is not necessarily bad; it depends on what the debt is for and why it has been created. Thus the usual terminology ‘sovereign debt crisis’ presupposes certain value judgments which are not necessarily accurate. Furthermore, one needs to address the question whether money must necessarily be created in form of a debt and who should have the authority to create money.
For this question we must look at the modern money creation process first. Today we have a two-tier system of money creation. The first form of money creation is by the Central Banks (such as the Bank of England) which appears most prominently because of the visible reifiers of the money-debt, the bank notes, but is very marginal in the modern economy, being at most about 5% of the money in the economy. The second and economically really important form of money creation is through commercial banks, which comprises over 95% of all money.1
(1) Money creation by Central Banks: The Central Bank is the ‘bankers’ bank’, in that commercial banks settle their debts between one another via the Central Bank, and in that commercial banks have their deposits with the Central Bank. This means, their cash in form of deposits is a liability of the Central Bank against them. The Central Bank is also the bank of the Government, in that it can increase its assets by, for example, buying Government bonds and so lending money to the Government, or it can increase its liabilities by issuing promises to pay (e.g. banknotes) and acquiring assets. Increase of the Central Bank’s assets and liabilities increases the money supply of a country which the Central Bank can determine, theoretically at will and with no limitations, but practically subject to macroeconomic and financial considerations: the most typical danger of an unlimited supply of money (if it does not stay within the banks) is that of hyperinflation, as for example in Germany in 1923.
(2) Money creation by commercial banks: This is done through granting loans. When a commercial bank grants a loan of £ 10,000 to a customer, this customer obtains £ 10,000 which he transfers to a seller of, say, a car, who in turn deposits these £ 10,000 in an account with the same or another bank (so it appears in the other account as a debt owed by the bank to the car seller). The £ 10,000 are bank money, so money that exists in the accounts of the bank only – nowadays as a figure typed into the bank computer. The bank money can be converted into cash (banknotes), as the customer (as well as the third party, the seller) can at some point require a pay-out of some or all of the amount in cash. The bank will have obtained this cash which it pays out now by having reduced its credit (deposit) with the Central Bank before. (This is one reason why cash is not too popular with banks.)
The debt of the bank of £ 10,000 to the customer is money created ‘out of nothing’, by way of a loan for £ 10,000 given to the customer as recorded in the accounts of the bank. Thus when a bank grants a loan to its customer it credits itself with the amount of the loan the customer owes (on the assets side of the bank’s balance sheet) and at the same time debits itself with the loan amount as deposit of the customer owed to him by the bank (on the liabilities side of the bank’s balance sheet), because the loan money has been paid into the customer’s account and is a deposit, thus newly created money. It is a curious accounting entry, compared to usual book-keeping, because it creates a liability or debt of a bank which consists exclusively of a debt to that very bank. The bank’s asset is the debtor’s liability to the bank itself, created by the bank as a bank’s liability to the bank’s debtor.
The grant of the loan happens in principle independently of the amount of deposits a bank has obtained from customers’ savings, contrary to the erroneous belief that credits supposedly come out of existing, previously collected, deposits. In addition, banks can then multiply the money, because the £ 10,000 which were given as a loan are used for payment and paid into another account of another bank (or into another account of the same bank). The other bank can use the money to give credit of £ 10,000 to another customer. Hence there is really money creation, not just money supply, and there is almost no limit to this possibility to create, except by the existing fractional-reserve banking system: the law requires banks to maintain reserves equal to a small fraction of their deposits, usually less than 10%. Even these less than 10% are not necessarily backed by tangible scarce assets since the abolition of the gold standard. Reserves in excess of this amount may be used to increase earning assets (loans/deposits and investments). They are not backed by anything of value at all. If a non-bank did something equivalent, it could attract criminal liability.
Why is it possible that banks can create money by way of lending while anybody else who lends money cannot? The reason is that a non-bank which lends money reduces the funds from elsewhere in the firm to disburse the loan, while banks only effectively re-label their liabilities: before the loan it is ‘accounts payable’, after the loan it is ‘customer deposit’. This is possible because the banks are exempt from the normal client money rules which require that client money must be kept in separate accounts, well segregated from the firm’s own money (e.g. solicitor’s accounts).2 In this difference lies the privilege of the banks which confers far-reaching economic and political powers on them.
The inevitability of ‘debt’, whether sovereign or private debt
As demonstrated, money is debt, and so there are necessarily debtors and creditors; if there is no debt, then there is no money and no economy. This is a finding arising from basic book-keeping, but does not seem to be realised much: If I own a £ 10 banknote, then I am creditor to the amount of £ 10, and somebody else must be debtor of these £ 10 plus, importantly, interest and compound interest, because loans are never given interest-free, although this would be legally possible. The major difference between the ordinary debt created in private law (for example payment under a contract of sale) and a money-debt is that the correlation between a determinable creditor and a determinable debtor cannot be ascertained: I as the owner of the £ 10 banknote cannot define who exactly ‘my debtor’ is, because the debt relationship is mediatised by the banks (Central Banks as well as commercial banks). We have seen that the creation of the money-debt is through a loan. If I save money, then somebody else must become indebted, if the state saves money, for example by reducing its sovereign debt, then either its citizens, its enterprises or its foreign economies as trade partners must become indebted. This can become dangerous for the ‘rich’ creditor state in the long run, because either the businesses and/or the individuals as debtors become insolvent or lose their employment which reduces tax income for the state and shrinks the domestic economy, or the foreign economies can no longer repay the debts to the state or stop importing the state’s goods because they are increasingly unable to afford this. Germany currently faces this problem within the EU.
The state could issue banknotes of its own accord, without having a debt created against itself. One could think of replacing debt-money by state-issued money that is not the creation of a debt, or if it is to be a debt, then it should be one which does not attract any interest at all. This also means that commercial banks should be barred from money creation at all (as everyone else is), or, if loans are granted and the money is provided in form of bank money, not cash, such a loan should not be able to attract interest. But such a reform is obviously not likely to happen.
Thus ‘austerity measures’ which are so popular in current politics these days are meaningless in the present monetary system: if the states repaid their debts (which they theoretically could, and fairly easily by raising taxes, a remedy not open to any private person or entity), they would either destroy money at a large scale (extinction of assets of creditors). They would also provoke a breakdown of the economy, or non-state entities, individuals or enterprises, would have to get indebted much more. Thus sovereign debt, if one accepts the present system of money as a form of debt at all, is not necessarily objectionable. However, as debts do not only trigger the duty to repay the capital of the debt, but also the interest and compound interest – and compound interest does not grow in a linear, but in an exponential way3 – the spiral of the indebtedness would increase to astronomic proportions far beyond the present (already high) level of state debts, and individual and corporate indebtedness. But the monetary system aims at exactly that.
The enforcement and maintenance of the debt relationship
The reason why this method of money creation is that this system creates and maintains an enormous power over people and whole economies, states and political systems.
First, the idea of debt also involves the idea of guilt and can be used for emotional blackmail: he who is indebted must repay his debts if he wants to remain an honourable person. For example, in the debate of the European Parliament of 8 July 2015, the leader of the European Christian Democrats, Michael Weber, pointed out reproachfully to the Prime Minister of Greece Alexis Tsipras (who was present) that a haircut of Greek public debts will have to be paid by the people of (poorer) countries in Europe, not by financial institutions.4
Secondly, one can convince easily in the prevailing neo-liberal political debate with the simple argument that if the debts are too high it is necessary to save money. In this way the cut of expenses in politically undesired areas, such as health, education, public transport can be justified effortlessly. Among German politicians, this purely microeconomic perspective is referred to prominently as the argument of the ‘Swabian housewife’ who also understands perfectly well that she will have to make savings if she has less money. One major flaw of this analogy, among others, is that banks, and indirectly the state, can and do create new money, while a Swabian housewife in need of money cannot. To continue with this pre-feminist metaphor, her saving may rather put her breadwinning husband out of employment or business.
Thirdly, across a country’s economy it is impossible to repay money debts because of the exponential growth of the interest which accrues with the debts. The impossibility is systematic, not accidental. Some individuals can repay, but never all debtors in a whole economy. If the debtor cannot meet the payments, the debt plus interest will be enforced by the law, through the usual enforcement methods: sale, auction etc. It is in this moment, and in this moment only, when money genuinely transfers real value and not just an expectation to value, to be realised at some later point in time. If there is a large number of insolvent debtors which may endanger the liquidity of banks and it is felt that a collapse of banks may lead to a systemic failure of the banking system, political representatives are now prompted to rescue banks with taxpayer’s money to keep the banks afloat, as has happened from the financial crisis of 2008 onwards. The result is a shift of banks’ debts to public debts (‘sovereign debts’), to be serviced by tax payers. The creditors of these public debts are again, banks, which, in turn, can enforce these monetary debts against all their customers and states as debtors, and everything starts again. In this way private enterprises, with governments as their agents, can blackmail and intimidate whole countries. This has been demonstrated impressively in the case of Greece during the seventeen-hour bail-out negotiations with EU representatives from the 12th to the 13th July 2015.5 It is quite possible that this coercion of one EU Member State (with no future chance of economic improvement) is the beginning of the demise of the EU itself, because the peoples of Europe may increasingly see the European Union as a threat to their national democratic systems. Euro-sceptic and extremist parties exploit this sentiment for their political ends with growing success.
Thus ultimately the monetary system is an expropriation device, and the present construction of money as debt continues to be maintained for the preservation of this power of the richer over the poorer. Whether that debt is a public/sovereign or a private debt is a secondary point. What matters is that any reforms, economic or social, do not touch the fundamental principle of money supply through debt creation, and political parties of all colours seem to abide by this unwritten rule.6 The purpose of mainstream economics is then to clothe this system with an unassailable scientific garb.
Andreas Rahmatian is Senior Lecturer in Commercial Law at the University of Glasgow.
- For the following brief outline, see in more detail e.g., Federal Reserve Bank of Chicago, Modern Money Mechanics (Chicago, Il., 1994 version), 7-10; Bank of England: Michael McLeay, Amar Radia and Ryland Thomas, ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin, No. 1 (2014), available at: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf (visited on 11 Nov 2015); Deutsche Bundesbank, Geld und Geldpolitik (Frankfurt am Main: Deutsche Bundesbank, 2008 edition), 59–63. ↩
- Werner, Richard A. (2014), ‘How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking’, 36 International Review of Financial Analysis, 71–77, at 74–75. ↩
- This is according to the formula M = P×(1+i)n, whereby M is the final amount, P the principal sum, i is the interest rate per year and n the number of years. So the principal sum of 100 invested for 10 years with 5% interest will be the final amount of 100×(1+0.05)10 = 162.89, thus almost an increase of 63%. ↩
- Conclusions of the European Council (25-26 June 2015) and of the Euro Summit (7 July 2015) and the current situation in Greece (debate): http://www.europarl.europa.eu/sides/getDoc.do?type=CRE&reference=20150708&secondRef=ITEM-003&language=EN ↩
- The coercive aspect of this deal was generally noticed, see e.g. ‘Tsipras faces clash with Syriza radicals opposed to Eurozone bailout for Greece’, Phillip Inman and Jennifer Rankin, The Guardian, 13 July 2015, available at: http://www.theguardian.com/business/2015/jul/13/athens-and-eurozone-agree-bailout-deal-for-greece (visited 11 Nov. 2015). See also Paul Krugman, 12 July 2015, ‘Killing the European Project’, The New York Times available at: http://krugman.blogs.nytimes.com/2015/07/12/killing-the-european-project/ (visited 11 Nov. 2015). ↩
- However, the problem of money creation was debated critically and illuminatingly in the British Parliament from all sides of the political spectrum: Money Creation and Society (backbench business), Hansard, 20 Nov. 2014: Columns 434ff., available at: http://www.publications.parliament.uk/pa/cm201415/cmhansrd/cm141120/debtext/141120-0001.htm#14112048000001 (visited 15 Nov. 2015). ↩