The shortcomings of today’s financial system

Before treating a patient, a doctor will first make a diagnosis to ensure the correct remedy is applied. The same applies to economics. Before he devised the remedy of Economic Democracy, Scottish engineer Clifford Hugh Douglas studied and diagnosed the current financial system. He determined that not only is money created in the form of debt, leading to unpayable debts, but that there is a chronic lack of purchasing power. His analysis concluded that consumers can never have enough money to buy available production.

One of the first questions to ask is where does money come from. One might answer that if you want money, get a job. But where did your employer get his money? Others might answer that the government makes the money, since we have banknotes issued by the country's central bank, such as the Bank of Canada.

But the reality is that paper money, known as cash, represents less than 5% of all money in the country. The other kind of money is credit loaned by private banks. This electronic money exists only in the form of accounting entries in bank computers and in the chip of a bank card, but it is accepted and circulates everywhere as if it were paper money.

Note that even to obtain paper money, it must be borrowed from the bank, at interest. So you could say that all the money in existence comes from a bank loan, which has to be repaid with interest. Every time a loan is repaid that sum of money ceases to exist and is withdrawn from circulation.

Money is created as a debt

A fundamental flaw in this system is that when banks create new money in the form of loans, they require borrowers to return more money to the bank than was created. This is because banks create the capital they lend, but not the interest they demand. It is impossible to repay money that doesn't exist. The only solution is to borrow again in order to pay this interest, and hence unpayable debts accumulate. This is what Louis Even explained in The Money Myth Exploded. In this fable, only $1,000 existed, but the banker demanded repayment of $1,080 ($1,000 lent at 8% interest).

Another shortcoming of bank money creation is that it is not permanent, nor does it remain in circulation indefinitely. It must be returned to the bank when the loan matures and must be repaid. The money lent is then canceled and disappears. The bank retains only the interest for itself. So, just to keep the same amount of money in circulation, there must be continuous borrowing. To those who say that if you don't want to go into debt, just don't borrow, we have to reply that if no governments, companies or individuals borrowed from the bank there would be no money in circulation at all. In the current system, the choice is either go into debt or starve.

How is it that banks can create a substitute for paper money in the form of bookkeeping entries? See the true story of the goldsmiths who became bankers described in Economics courses and explained by Louis Even in In this Age of Plenty.

The goldmsith who became a banker

If we go back to the Middle Ages, money only existed in the form of precious metals such as gold and silver. Gold owners, for fear of thieves, entrusted the safekeeping of their gold to goldsmiths (manufacturers of gold or silver objects) who, because of the precious material they worked with, had well-protected vaults. The goldsmith received the gold and issued a receipt to the person who had deposited it with him. The goldsmith protected the asset in return for a premium for the service. The owner could reclaim all or part of it whenever he wished.

Merchants who left Paris for Marseille or Amsterdam could take gold with them to make their purchases. But here again, there was a danger of attack en route, so the merchant persuaded his seller in Marseille or Amsterdam to accept, instead of metal, a signed right to part of the treasure on deposit with the Paris goldsmith. The goldsmith's receipt testified to the reality of the asset. And similarly, the supplier in Amsterdam, or elsewhere, was able to get his own correspondent in London or Genoa to accept, in return for transport services, the receipts issued by the goldsmith which he had received from his French buyer. In short, little by little, merchants came to pass on these receipts to each other instead of the gold itself. Instead of gold, the goldsmith's receipts changed hands.

But the goldsmith learned from experience that almost all the gold entrusted to him remained intact in his vault. As the owners of their gold used its receipts in their trade, hardly one in ten came to the goldsmith to collect it. This is the origin of today's banking system, which allows banks to lend out several times the amount of their deposits in cash and to lend money they don't have in their vaults, but which they create when they grant a loan. This is the origin of the practice known as fractional reserve banking, which means banks must hold only a fraction of their deposits in cash available for lending.

In the 1940s, banks lent out on average 10 times more money than they had in reserves. This proportion has since changed. In 1980, the Canadian Banking Act allowed chartered banks to create 20 times the amount of their reserves in banknotes and coins. However, in 1994, the percentage of cash banks were required to hold was reduced to zero!! By 1995, Canadian banks had lent out more than 70 times their reserves. By 1997, this figure had risen to 100 times. In the USA, the cash requirement was reduced to zero in 2020.

In other words, there are no longer any prescribed limits on loan creation. The only limit to the creation of money by banks is that individuals still wish to be paid in paper money, which obliges the bank to keep a certain quantity of it on their premises. Also, there is always a risk that too many of the bank's customers will show up at the same time demanding to be paid in paper money.

It is understandable that banks will do everything they can to eliminate the use of paper money, by encouraging the use of debit cards, direct payment, etc., so that eventually cash will be altogether eliminated. Everyone knows the appeal of Central Bank Digital Currency (CBDC) for the banker! While paper money allows anonymity and freedom, CBDC's will enable banks and governments to know everything you buy, facilitating virtually total control of the population.

Chronic shortage of purchasing power

Today, products are offered for sale at a price point. This allows people with money to choose the products that suit them. But what happens to those who have no money at all? Mr. Even explained that money distributed in the form of salaries, profits and industrial dividends constitute purchasing power for those who receive it. But:

1. industry does not distribute purchasing power at the same rate as it sets its prices; and

2. production does not distribute purchasing power to everyone. It only distributes it to workers.

Even if banks did not charge interest on the money they lend out, there would still be a shortage of purchasing power, because money paid out in wages can never buy all production, which includes other elements in its prices. Scottish engineer Clifford Hugh Douglas was the first to demonstrate this chronic lack of purchasing power, and to provide a scientific solution to it, known as Economic Democracy.

Douglas explained this lack of purchasing power in the A + B theorem. Producers must include all their production costs in their prices to stay solvent. Wages paid to employees - known as "A payments" - are only part of the cost of production. The producer also has other costs that are not distributed in wages, but which he must include in his prices, such as payments for materials, taxes, bank charges, machine maintenance and replacement, etc. Douglas called these payments for other costs, "B payments".

The selling price of an item must include all costs: wages (A) and other payments (B). The product's selling price will therefore be A + B. Clearly, then, wages (A) cannot buy the sum of all costs (A + B). There is therefore a chronic lack of purchasing power in the system.

Even if we try to raise wages to catch up with prices, the wage increase will automatically be included in prices, and nothing will be resolved. To be able to purchase all of production, therefore, we need additional income outside wages, at least equal to B.

Another problem is that production only distributes purchasing power to those who are working. Today, production is a factor of automation more than it is the product of human labor, and this fact will continue to impact the number of workers over time. There is conflict between progress, which eliminates the need for labor, and yoking purchasing power to paid work yet everyone has the right to live and to the necessities of life. The earth's goods were created for all men, not just the employable. That's what Economic Democracy would correct, as we will see in another article.

                                                       Alain Pilote