New Money for a New World

by Bernard Lietaer

It is common to think of money in terms of its material representations. Down through the ages, money has appeared to be a thing—in fact, an incredible variety of things. Monetary historian Glyn Davies created a complete alphabet with a selection of objects that have represented money in the past, starting with amber, beads, and cowries, and ending with wampum, yarns, and zappozats (decorated axes).66

  A simple thought experiment, however, helps distinguish money from other things. Assume you are stranded alone on a deserted island. If you had a thing, say a knife, it is still useful as a knife. Yet, if you had a million dollars in whatever form—cash, gold coins, credit cards, or even zappozats—it becomes merely paper, metal, plastic, or whatever. It no longer functions as money.

  Events in recent decades have made further evident the nonmaterial nature of money. In 1971, the United States ceased to define the value of the dollar in relation to the value of gold. Since then, the dollar has represented a promise from the U.S. government to redeem the dollar—but with what? Another dollar! At least when the dollar was backed with gold, it could more easily be assumed to have some material value.

  Money often appears to possess magical properties. Consider, for instance, that no self-respecting magician’s routine is complete without a decent disappearing act, a feat that money performs in a rather spectacular fashion, especially of late! Once upon a time, when money was mostly gold and silver coins, banks started issuing pieces of paper. These papers were simply receipts indicating how much of the precious metal was being stored, and where. The disappearing act has since become increasingly more sophisticated as paper money rapidly dematerializes into binary bits in the computers of bankers, brokers, and financial institutions. There is now serious talk that it could all soon disappear into the virtual world. Perhaps when the last dollar, euro, or yen has evaporated into the electronic ethers, the nonmaterial nature of money will be understood.

  In short, although money has taken many material forms throughout history, money is not a thing.

  What, then, is money?

  Money may be defined as an agreement, within a community, to use some standardized item as a medium of exchange.67

  As an agreement, money inhabits the same space as other social constructs, like marriage or lease agreements. These constructs are real, even if they exist only in people’s minds. A monetary agreement can be made formally or informally, freely or by coercion, consciously or unconsciously. Most people do not consciously agree to use dollars or pesos, nor do we consider their nature. We just use them and in so doing, automatically enter into an unspoken agreement with all others with whom we conduct business.

  A monetary agreement is only valid within a given community. Some monetary agreements are operational among only small groups of friends like chips used in card games, or within a larger community like the citizens of a particular nation, or for restricted periods of time like the cigarette medium of exchange among frontline soldiers during World War II. A community can be geographically disparate, such as Internet users, and can include large segments of the globe, as with the case of the U.S. dollar in its role as an international reference currency.

  The key function that transforms a chosen object into money is its role as a medium of exchange for the trade of goods and services. Other functions of money include its role as a unit of account, that is, a standard numerical unit capable of measuring the value of goods and services; a store of value that can be reliably saved, stored, and retrieved; and finally, especially of late, as a tool for speculation. Not all currencies, however, necessarily serve all of these features.68

  In summary, the magic of money is bestowed on something when a given community agrees to use it as a medium of exchange. Conventional money and the monetary system are therefore not de facto realities like air or water, but are choices like social contracts or business agreements. As such, they are subject to review and amendment.

  Another long-standing mystery is how and where our money is made.

  MONEY CREATION

  When asked why he robbed banks, American criminal-celebrity Willie Sutton’s reputed reply was, “Because that’s where the money is.” To better appreciate our agreements about money, it is first necessary to understand the banking system, not because that is where money is kept, but rather because it is where money is actually created.

  Origins of the Western Banking System

  During the Late Middle Ages, gold and silver coins were established forms of money. Those most qualified to check the purity of these coins were the goldsmiths, who, coincidentally, also owned strongboxes to protect against thieves. It thus became a prudent practice to give one’s excess coins to the goldsmith for safekeeping, who would issue a receipt for the coins and charge a small fee for the service.

  When money was needed, owners could cash in the receipt, and the goldsmith would pay out the coins. It soon became more convenient to settle an account by paying with the receipt instead. If the goldsmith was known to be a trustworthy fellow, why risk moving the coins physically? The goldsmith’s receipts thus became a promise of payment. Anyone who accepted such a receipt was implicitly entering into an agreement with the goldsmith. This was the origin of modern-day paper money.

  In time, a few enterprising goldsmiths observed that the bulk of the coins stayed put in their strong boxes. Depositors would rarely if ever retrieve all their coins at the same time. The goldsmiths could thus issue receipts in excess of the gold coins stored on behalf of clients, and increase their income by lending out money without having to increase actual reserves.

  Hence, there was a gradual shift from money based on commodities such as gold or silver to money based on credit or loans in the form of paper receipts. The same basic arrangement exists to this day, with one major difference being that banks replaced the goldsmiths. Our lexicon reminds us of this link. The transactions between goldsmiths and their clients took place on Italian benches, or bancos, the origin of the word “bank.”69

  European banking and the credit-based monetary system were thus simultaneously born in 13th-century Italy. Many of the key ingredients were already in place: paper money as the counterparty’s liability, the importance of a good reputation for that counterparty, and the ability of the bankers to create more money than the deposits they held in reserve. Today this latter process is called the “fractional reserve system.”

  The remaining elements of today’s banking system would be established several centuries later in pre-Victorian England.

  Our Monetary Agreements

  The late 1600s saw the dawn of the Industrial Revolution and the creation of modern-day nation states. These developments required substantial resources, including more sophisticated types of investments and monetary agreements. Thus, in exchange for a commitment to provide loans whenever governments needed money, banks secured the exclusive right to create paper money as “legal tender,” that is, as the currency accepted by government in payment for taxes.70

  The longest surviving agreement of this kind originated in 1668 with the license of the “Bank of the Estates of the Realm,” Sweden’s central bank (now known as the Riksbank). Two decades later, the Bank of England was founded on a similar model, “from where it spread around the world.”71 According to economist John Kenneth Galbraith, the Bank of England is “in all respects to money as St. Peter’s is to the Faith. And the reputation is deserved, for most of the art as well as much of the mystery associated with the management of money originated there.”72

  The deal struck between the banks and government, in effect to this day, entitles banks to create new money for the deposits they receive. The new money is generated in the form of a loan to customers of up to 90 percent (a fraction) of the value of the deposit (held in reserve); hence the name “fractional reserve system.”73 That new loan—say, a mortgage to buy a house—usually results another deposit somewhere in the banking system, in this case by the seller of the house. The bank receiving that next deposit is, in turn, entitled
to create a new loan for yet another 90 percent of that deposit, and the cascade continues from deposit to loan to deposit again and again throughout the banking system. This “money alchemy” is one of the most arcane secrets of our monetary system (see insert).

  Money Alchemy

  Modern money alchemy is officially called the “fractional reserve multiplier.” It starts with the injection of say, 100 million units of “high-powered money” into the banking system by the central bank of a nation, which issues a loan to pay for government bills for said amount. These funds are then deposited in the banking system by the recipient, which enables the receiving bank to lend out 90 million units (90 percent of the original 100 million units), while the other 10 million remain on deposit as “sterile reserves”).

  The new loan for 90 million units will, in turn, lead to another deposit for that amount somewhere else, enabling the next receiving bank to provide another loan for 81 million (which again represents 90 percent of the deposit), and so forth. This is how the original 100 million units will, after many iterations, generate 900 million units of additional “credit money” as it flows through the banking system.

  This convoluted mechanism is the end result of the deal struck between banks and governments. It is the reason why money ultimately involves the entire banking system, and helps explain how money and debt are literally two sides of the same coin.

  Note that this entire money-creation process hinges upon loans. If all debts were repaid, bank money would simply disappear! This is so because the entire process of money creation, as illustrated above, would reverse itself. This process of paying off all loans (on the left side of figure 4.1) would automatically use up all of the deposits (on the right side). Even the central bank’s high-powered money would evaporate if the government were able to repay its debts.

  This money-creation process is one of the more significant yet least understood aspects of the current monetary paradigm. With our money set up as loans, we are all debtors, indebted to those who create and loan us money—the banking system. The implications of this money-creation scheme are profound and far-reaching, as is examined in the next chapter.

  CLOSING THOUGHTS

  Magic and mystery have surrounded money throughout its long evolution. Given money’s key role in society today, it is vitally important that we become as familiar as possible with this all-important human creation. The first step is to understand that money is an agreement, and as such is open to amendment.

  The current agreements we have regarding our monetary and banking systems were made in late 16th-century England. The banks were given the right to create new money from the deposits they received, which is now commonly known as the fractional reserve system. In this money-creation process, almost all of our money is debt money, derived from loans made by our banking system. This arrangement, this agreement, was made centuries ago in a very different place and time and under very different conditions. Is it possible that there are other types of money better suited to manage today’s challenges?

  CHAPTER FIVE - Money Is Not Value Neutral

  The most powerful force in the universe is compound interest.

  ~ATTRIBUTED TO ALBERT EINSTEIN

  There is a long-held assumption in economics that money is “value neutral,” that is, money is simply a passive medium of exchange that affects neither the transaction nor the nature of the relationships among its users. This assumption is closely related to another traditional notion,“economic man,” which claims that people invariably act with perfect rationality regarding economic decision-making in such a way that maximizes their personal utility or wellbeing.

  It should be noted, however, that these notions date back to the 18th century, before the advent of discoveries regarding the human unconscious, and much of our current understanding regarding behavioral and social sciences. These assumptions are rooted in a worldview that sought to fashion economics and much of society along the lines of Newtonian physics, and which held that the same order and predictability that defined plantary orbits would explain human behavior and investment patterns.

  We now know that attempts to understand money and other complex socioeconomic phenomena through a mechanistic, value-neutral lens are inherently misguided. The countless instances of “irrational exuberance” and the boom-and-bust manias that have plagued our economies for centuries contradict the very idea of economic man. Likewise, money’s supposed value neutrality is challenged by ample evidence showing that different types of monetary systems promote distinctly different values and have uniquely influenced societal behavior throughout history.

  One of the key assertions of this work is that our money is value-nonneutral.

  Money is a major determinant in the nature of our exchanges and the relationships among currency’s users. Each of money’s constituent parts, from the manner by which money is created, to whether or not a currency bears interest, strongly influences our behavior patterns and plays a determinant role in shaping the kind of economy and society in which we live.

  All national currencies have the following key characteristics that persist as unquestioned features of conventional money:

  geographical attachment to a nation-state;

  creation out of nothing—fiat money;

  issuance through bank debt

  incurrence of interest.

  Below, we examine how these seemingly innocuous components of our monetary system wields a profound influence upon each and every one of us and on society at large.

  NATIONAL CURRENCIES

  National currencies have proven to be a highly effective means of strengthening national identity, as they facilitate economic interactions with fellow citizens rather than with foreigners. Economist Charles Handy explains money’s impact on identification within a given community: “A common currency translates into a common information system, so that its inputs and outputs can be measured and compared across the parts.”74 Money draws an “information border” between “us” and “them,” making tangible boundaries that would otherwise be visible only in an atlas, reinforcing unity within the confines of a nation-state.

  During the breakup of the Soviet Union, for example, one of the first acts by each of the newly independent republics was the issuance of their own national currency. The euro, the single currency that officially replaced a dozen national European currencies, had as one of its principal aims the creation of a European supranational consciousness and unity.

  While it might be difficult today to imagine any currency other than those issued on a national or supranational level, the vast majority of historical currencies were actually privately issued by local rulers.

  FIAT MONEY AND BANK DEBT

  The word fiat is found in the Latin version of the Bible. According to Genesis, “Fiat Lux”(Let Light Be) were the first words pronounced by God. The next sentence states, “And light was, and He saw it was good.” Fiat implies the godlike ability to create something out of nothing (ex nihilo), through the power of the Word.

  All conventional national currencies in the world today are fiat currencies. They are created by an authority that declares a particular medium of exchange as acceptable in payment of taxes—that is, as valid legal tender. As we have seen, these fiat currencies are created as bank debt, under the hierarchical authority of a national central bank.75

  The convoluted bank-debt, money-creation process described earlier resolves the apparent contradiction between two principal goals of pre-Victorian England: creating and supporting the nation-state on the one hand, while relying on private initiative and competition on the other. The monetary system provides a smooth way to privatize the creation of a national currency—theoretically a public function—via the private banking system, while simultaneously maintaining pressure on individual banks to compete for deposits.

  Economists John Jackson and Campbell R. McConnell summarize an important aspect of bank debt and fiat monetary systems: “Debt-money derives its valu
e from its scarcity relative to its usefulness.”76 In other words, money must be kept artificially in shorter supply than the need for it. It is this built-in scarcity that keeps everyone doing what they must to obtain this vitally important commodity. From a banking perspective, failure to maintain this scarcity results in inflation and even hyperinflation, and erodes a currency’s value.

  The necessity of managing scarcity is one reason why today’s monetary system is not self-regulating, but instead requires central banks’ supervision. Central banks also compete among themselves to keep their own currencies in short supply, so that the relative value and scarcity of their currencies are maintained internationally. They accomplish this by raising interest rates whenever they need to tighten the money supply, thereby making it more expensive to borrow.

  Among its many profound impacts upon society, this artificially-maintained scarcity creates strong incentives to compete rather than cooperate.

  INTEREST

  Though loans and interest likely date to pre-urban societies, the first written evidence of interest goes back to ancient Sumer where it was known as más, which also meant “a lamb.” This followed from the practice by which, in return for permitting a flock of sheep to graze on one’s property, the landowner had the right to choose a lamb born from that flock. This denotes the original relationship between loans, interest, and rural produce.77 According to Stephen Zarlenga, Director of the American Monetary Institute, “loans were made in seed grains, animals, and tools to farmers. Since one grain of seed could generate a plant with over 100 new grain seeds, after the harvest farmers could easily repay the grain with ‘interest’ in grain.”78