Monday, March 2, 2009

Monetary Cause of Poverty

While poverty may be due to reasons most of which are already known in

economics and sociology, it can also be looked at from another viewpoint, namely from the monetary viewpoint. Looked at from this angle, poverty may be significantly due to the structure of the global monetary system itself, particularly the fractional reserve banking system that is practiced worldwide.

The word ‘fractional reserve’ refers to the fraction from total deposits that banks

must keep as reserve. This reserve ratio is determined and used by the central bank as

one tool of monetary policy for controlling the money supply in the economy. The Bank Negara Malaysia, for example, imposes this reserve requirement on commercial banks as the Statutory Reserve Requirement (SRR). This reserve requirement determines the amount of money that commercial banks can create (The total = deposit ÷ SRR). The smaller the reserve requirement is, the more the money that can be created. For example, if the SRR is 4 percent, a RM1 million cash deposit can support a total deposit of RM25 million. The additional RM24 million can be introduced into the economy by the banking system in the form of loans. Opposed to currencies and coins in circulation, the money created by commercial banks takes the form of numerical or accounting money, circulated as cheques, credit card payments, electronic transfers, and the like. In other words, it is money created by means of mere accounting entries. The benefit of new money creation, known as seigniorage (the value given to money over and above its cost of production), accrues to the bank that lends it out at interest. The fractional reserve banking and its accruing seigniorage have implications for asset ownership through their distributional effects, including the creation of poverty. Since fiat money is easy to create, most economies create too much of it relative to their ability to produce goods and services. This results in the growth in money supply that exceeds the growth of the real GDP, thereby causing inflation to reel (The table below, extracted from the writer’s book entitled The Theft of Nations, provides the statistics for some selected countries. The reader can easily guess which countries are likely to experience hyperinflation and hence socio-economic problems). The socio-economic implications of this inflation arise from the fact that the newly created money does not accrue in the hands of every individual ‘evenly’. If the money or income of the people were to grow as the inflation rate does, then their real income would be intact and inflation would not be a problem. But true to the contrary, the new money created in the form of loans would instead go to corporations and individuals who are already relatively ‘well-off’ as only they are capable of depicting better credit-worthiness. A host of socio-economic problems would naturally result as a significant portion of the population does not experience income growth that would match the growth in money supply and the henceforth inflation rate. This group would find its real income being gradually eroded by the annual growth in money supply, and hence the possibility of running into poverty. This increase in money supply can be aptly described as ‘inflation tax’, a tax on every individual in the economy that accrues to the one who creates and owns the money.

To illustrate the point, when a commercial bank extends a loan of RM300,000 for

the purchase of an existing house, all individuals in the economy are actually financing the transfer of ownership of the house to the bank by means of inflation. This is because when the bank creates the additional RM300,000 through fractional reserve banking, there would now be more money in the economy relative to the real things and inflation would naturally come about. Initially, the bank neither had the RM300,000 nor the house. However, a mere accounting entry immediately places the ownership of the house with the bank. The implication of this is that the transfer of ownership is actually paid for by the entire economy through inflation. As a result, the seigniorage of the principal amount and interest accrues to the bank, all by means of mere numerical accounting only.

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