14 Aug 2012

Why the Eurozone should take the plunge

In my "Eureka" post yesterday, I argued that the first currency block to take the plunge, ban creation of the currency by commercial banks, and funnel all money creation by the central bank though the elected governments on a pro rata basis, using just the size of the population as the criterion, would have a major advantage over other systems.

The more I think about it, the better it seems.

Here's why. The fundamental difference is that when the money supply is created by commercial banks, they charge interest. When they lend to governments, they typically charge 5-6%, although if they don't like your politics, they can impose the 25.82% that Greece is currently having to pay. And of course, if the government does what the markets tell them and block financial reform, they get super low rates like the 1.24% that Germany currently gets charged. Note that even that super discount rate is substantially more than the ECB charges the banks. That's just government debt. What about the interest that gets charged for creating money and lending to consumers and companies. I have been unable to find any overall figures, but just note that credit card companies and loan companies will happily charge you 15-20% (I won't even mention the 14,368% charged by the payday loan sharks in the UK, because that particular English Disease seems not to be present in the Eurozone).

Since essentially all the money is produced as interest bearing debt, it follows that you need to have inflation. Central banks such as the ECB and the Bank of England aim to have inflation at 2%. Why? Because you need to have price inflation to be able to pay the interest charges. To see why, imagine an island with a bank that lends out 1 million currency units to people to spend, but requires them to pay back the money with compound interest at 2%. After 35 years, the people on the island would have paid 999,890 of the currency units to the bank in interest charges.

There are various scenarios possible. One is that the bank keeps all the interest for itself. It could, for example, move all those interest charges to another island (let's call it the Caymans). If they did, there would be just 110 units of money in circulation (999,890 is 2% of a million, compounded over 35 years).  Maybe people would object a bit.

A second option is that the bank could be nice and put the money gained in interest charges back into circulation. One way to do this would be by paying its directors and traders massive bonuses. In that case, you would have an island where 99% of the population was living and poverty, and 1% (those who were in the banking system) living the life of kings and driving around in Ferrari's paid for with this years bonus. Sounds rather familiar to me.

Actually, there's a third way, which goes some way to masking the level of the scam. And that is to pump more money (i.e. debt) into the system every year. To provide enough money to pay the 2% interest charges, you would need to pump at least 2% extra every year to keep people reasonably happy. By getting them to take on more debt, they would be able to buy those flat screen TVs and have the impression that they were reasonably well off.  After 35 years, the bankers would now have half the money in the system, and the people would have the other half. That's pretty much the situation we have now.
The one obvious drawback (apart from the fact that it is outrageously unfair) is that there is now twice as much money around (the original 1 million, plus the 1 million that was gotten by the banks in interest charges). And with twice as much money around, there has to be inflation at about 2%. Everything will  go up in price every year by about 2%.

In other words, the 2% inflation target is the price we all have to pay to allow a system to operate in which the money supply is provided by commercial banks who charge interest.

OK. End of explanation.

Now what is the relevance for the idea of the Eurozone switching from money creation as interest-bearing debt by commercial banks, to debt-free public money creation by central banks? Well, the fact is that in the new Eurozone, there is no need to pay the interest charges to the banks. And because there are no charges, you don't need to pump extra money into the system just to keep the system running. And that means that you could have a currency zone where there was no inbuilt need for inflation.  If 10,000 euros is enough to buy a Eurozone-constructed car in 2012, there is every reason to believe that you could get something equivalent in 2022 for the same amount of money.

So, let's suppose that you have a million dollars and you want to put the money in a safe place for your retirement. You have a choice of leaving the money as dollars, or alternatively, you could trade your dollars for euros. What should you do?

Well, unless I'm horribly mistaken, you would be well advised to choose to convert to euros. Why? Because in the dollar zone you will be living in a world where commercial banks are pumping hundreds of billions of credit into the economy every year and requiring that people find the money to pay the interest. And that means one thing. Inflation. Your $1 million might buy you a lot today, but in a few years time, you are almost guaranteed to have lost out unless you are clever and find a way to make more money.

In contrast, if you change to Euros, you can be much more confident that your savings will still be worth something when you get to retire. As a consequence, I would predict that as soon as the Eurozone countries make the shift to debt free public money creation, everyone will be tempted to convert their money into Euros. In turn, this means that there will be a lot of demand for Euros, and the ECB would be able to open the taps for creating more Euros. That money would be given directly to the 17 eurozone governments who would be able to spend the money directly into their local economies - building efficient transport systems, renewable energy, schools, hospitals, universities, research, social services etc etc... whatever their citizens want.

Is this too good to be true? Well, I'm having a bit of difficulty myself in grasping just how revolutionary this would be. Certainly, I am not aware of any economists who have seriously modeled this key issue of how a mixed world where the money creation mechanisms for dollars, pounds and euros  is so radically different. If there are any economists reading this who would be prepared to help analyse the situation, please do get in contact.

In the meantime, I am feeling absurdly optimistic.


  1.  "As a consequence, I would predict that as soon as the Eurozone countries make the shift to debt free public money creation, everyone will be tempted to convert their money into Euros."Hmm, methinks the dollar folk have already cottoned on to that one and are just waiting for the Eurozone to fizzle out because of it.

  2.  Do you really think so? I've actually not seen any discussion of this rather interesting question of what would happen if one currency group decided to abolish money creation by commercial banks and do everything debt free by the central banks. What would be the effect on other currencies that are being continuously devalued by have debt-bearing money creation going on?

    I rather doubt that many dollar people have got that far yet - the idea that the ECB could take over the money creation activities of Europe's commercial banks is so far off mainstream thinking that I am pretty confident that if a mass movement were to call for such a change, the bankers would be completely floored.

    Hopefully, we may have an opportunity to find out!