Not so long ago American commentators were talking of paying off the US National Debt and the British Chancellor was trumpeting the "end of boom and bust". Now the Americans are becoming more concerned by the day about the ballooning budget deficit and the British are in the middle of another unsustainable housing bubble.

The explanation of this relentless economic cycle lies within commercial banking practices that began hundreds of years ago. Following its foundation in 1694, the Bank of England would print pieces of paper that bore upon them the promise to repay the holder with gold coins "on demand". Depositors of coins in the Bank would receive such a piece of paper in evidence of their deposit. Any individual bearing the paper to the Bank could then reclaim the underlying gold on any business day. With its reputation assured by government charter, people came to trust the Bank of England's paper receipts. Soon they began to use them not just as receipts for money deposited in the bank, but as money itself. At this point the Bank could print large amounts of paper money at next to no cost and lend it at interest. A big profit resulted, as indeed it would for any person who obtained a "license to print money". Bank charters soon became highly sought after things. Government and people soon found themselves heavily in debt to the banks.

Today, modern money is created out of nothing by the banking system in a more sophisticated way, but the principles are the same and the most essential flaw in the system remains. When the banks create money they do not create sufficient of it to repay the interest on the loan which created that money in the first place. For example, if the banking system in aggregate creates 100 of money today and lends it at 10% annual interest, then 110 will have to be repaid by borrowers next year. But where will the extra 10 come from? The answer, under the modern banking system, is that repayment of the aggregate of bank loans plus the interest charges on them requires new amounts of money to be created. This is a big problem, because in all developed countries today it is the banking system that creates the majority of new money. Since banks create new money by lending it into existence, yet more debt results and so the cycle goes on. More and more money floating around, leading to higher and higher prices, and a debt pile that never seems to shrink.

When the banking system is producing more money than is needed to repay past debts, then society enjoys a boom. Government tax receipts increase and the government budget goes into surplus. Asset prices begin to rise, commentators herald the "new economy" and politicians take credit for their wonderful economic management. But then the banks become nervous of lending more, or society becomes nervous of borrowing more, and thus in due course bank lending begins to slow down. Soon existing debtors are finding that they do not have enough money to repay their old debts. Business conditions worsen, government tax receipts fall, and the government budget goes into deficit. By this stage in the process, everyone realises how foolish it was ever to have believed the "new economy" story.

During the early years of the Bank of England, the limiting factor in the Bank's creation of money was the possibility that people would come to the bank with paper receipts and ask that the Bank fulfilled its promise to pay out gold in return. So the Bank carefully calculated what amount of receipts would on average be presented at the Bank each day for repayment in gold, and what amount of gold would be deposited in the Bank each day in return for paper receipts. The calculation was vital, because it determined the proportion of reserves that had to be held against the outstanding paper issue. The amount of this reserve ratio was, of course, less than 100%. For example, with 100 pounds worth of its own gold coins in the vault and a 50% reserve ratio, the Bank could create and issue as much as 200 worth of paper receipts for lending at interest. If the bank were to decide that a reserve ratio of 25% could safely be adopted then, with 100 pounds worth of gold coins in the vault, as much as 400 worth of paper receipts could be created for lending at interest.

Obviously then, it was in the commercial interests of a bank to adopt a lower reserve ratio. Too low a ratio however, and the bank might run out of gold coins and not be able to meet requests for redemption of paper notes. This would be the occasion of much distress, because the bank would be forced to close its doors and endure a possibly catastrophic loss of confidence in its operations. So the principle was established at this time that the lower the reserve ratio, the higher the risk but the more profit that could be made. This maxim remains with us today in all 'good' financial textbooks which proclaim the relationship between risk and reward. It is an entirely artificial maxim, built upon the activities of the early bankers.

If people could be encouraged to use the bankers' paper money in their daily transactions, instead of going to the bank to collect the underlying gold coins, then there would be fewer requests for redemption at the bank counter. A bank could then adopt a lower reserve ratio and manufacture more paper receipts for every unit of gold coin reserves. Bank money is nowadays created using such instruments as cheque books and direct debits, and the state creates not gold coins but paper notes. But even now people are encouraged to use bank-created money, not state-created money, in their transactions. The strategic reason behind the commercial banks' promotion of bank money becomes clear when we bear in mind the importance, from their point of view, of reducing reserve ratios.

Long ago the results of allowing such a monetary system to develop were recognised:
If the American people ever allow the banks to control the issuance of their currency, first by inflation then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers occupied. The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs. I sincerely believe that banking institutions are more dangerous than standing armies.
Thomas Jefferson, the Writings of Jefferson, vol. 7, "Autobiography, Correspondence, Reports, Messages, Addresses and other Writings", Committee of Congress: Washington D.C., 1861, page 685

Several different measures now exist in bank management to describe the key reserve relationships. One such ratio is the capital ratio which measures the amount of capital against the "risk-weighted assets" of a given bank. It provides a measure of how much loss in asset value the bank can support from its own resources before reaching the position where liabilities to depositors exceed the bank's assets. The larger the capital ratio, the larger the cushion of comfort for the bank. In order to produce a risk-weighted value for each of a bank's assets, the bank's management will assess the risk of that asset according to set guidelines. For example, a short term dollar government bill would be assumed to have no risk because the US government is assumed never to default on its own currency obligations. Cash would also have a zero risk-weighting. Meanwhile, a loan against a property mortgage might be given a 50% risk weighting. Hence, if a bank has 200 of assets comprising 100 in cash and 100 in loans against property mortages, then the risk weighted-assets in this simple example would total 50. [150?] So if our hypothetical bank wished to keep a 10% capital adequacy ratio against risk-weighted assets, then it should maintain at least 5 of its own funds as equity on the bank's balance sheet.

Guidelines set under the 1988 Basle Capital Accord basically followed the above methodology, proposing a minimum "Tier 1" capital set at 4% of risk-weighted assets and a minimum total capital set at 8% of risk-weighted assets. Tier 1 capital includes the book value of a bank's stock plus retained earnings whilst "Tier 2" capital includes loan-loss reserves and subordinated debt. Total Capital is approximately equivalent to the sum of Tier 1 and Tier 2 capital. It should be obvious that total capital ratios are higher than Tier 1 capital ratios. For example, on 31 December 1997, HSBC Group's total assets were £286,391 million, Tier 1 capital was £16,564 million (total shareholders funds reported on the balance sheet were £16,442 million), and Tier 2 capital was £9,772 milion. After risk-weighting of assets, HSBC's Tier 1 capital ratio was 9.3% and its total capital ratio was 14.2%. (In June 1999 the Basle Committee on Banking Supervision issued a proposal for a new capital adequacy framework for internationally active banks, often referred to as "Basle 2", the guidelines of which aim to be more in keeping with modern banking practices.)

A capital ratio is of course very different from a liqudity ratio. The liquidity ratio measures the amount of liquid assets against deposit liabilities. The higher the liquidity ratio, the less the chance that the bank will fail to meet depositors' requests for repayment due to the fact that assets cannot be liquidated quickly enough. In other words, liquidity problems are not related to instances where the bank has insufficient assets to honour depositors requests for withdrawal, but rather where the bank has assets in the wrong form (property instead of cash, for example).

As with capital ratios, there are several types of liquidity ratio. For example, a broad liquidity ratio measures the ratio of cash plus short-term marketable securities to deposit liabilities. There is also a narrower liquidity ratio, the cash reserve ratio, which measures the ratio of cash held by a bank in relation to its deposit liabilities. Of course cash no longer takes the form of gold coins and deposit liabilities for commercial banks are no longer issued in the form of paper receipts. Instead, the cash reserve ratio compares the stock of state created money (base money or "M0" as it is called) held by a bank against the value of deposits made by customers. Commercial banks are usually subject to a minimum required level of cash reserves under audit of the central bank or other relevant authority.

In the UK, the cash reserve ratio has fallen over time and this history of decline has been repeated to some degree in other developed countries. From 1971 onwards a cash reserve ratio of 10% applied to specified banking institutions and these were also required to hold a minimum of 1.5% of the value of their "eligible liabilities" (a defined sub-set of total deposit liabilities) with the Bank of England in a non-interest-bearing account. The Bank of England could invest the balances in these non-interest-bearing accounts onto the money market at interest and thus generate profits with which to finance its own operations.

In 1981, the situation changed. Under new monetary arrangements, the commercial banks were required to hold 0.5% of their eligible liabilities with the Bank of England in non-interest-bearing accounts, and additionally maintain an average of 6% of their eligible liabilities as liquidity reserves in the form of short-term money market instruments. By the time the Bank of England Act was passed in June 1998 the non-interest-bearing balance had been reduced to a ratio of 0.15% (the intermediate steps being 1986: 0.45%; 1991: 0.4%; 1992: 0.35%; and April 1998: 0.25%) and the requirement for a minimum liquidity reserve had been abolished entirely.

We should note the difference between a statutory or required cash reserve ratio (which is imposed by government and / or the central bank), and a voluntary cash reserve ratio which banks themselves choose to hold. On 31 December 1997, HSBC Group held monetary base balances of £1,798 million against liabilities to repay customers' sight deposits of £81,960 million and further liabilities to redeem customers' term deposits within 3 months or less in the amount of £85,172 million. This indicates that the HSBC Group chose to hold slightly less than a 2.2% cash reserve ratio against the sight deposits, and less than a 1.1% cash reserve ratio against the sight plus term deposits.

The above ratios are of the same order of magnitude that is observed for the whole UK economy. Bank of England figures as of 1997 show that the UK government had produced some £27.80 billion of state money whilst the commercial banking system had created and loaned up to £721.16 billion (this the "M4" definition of money supply). On this basis, the average actual cash reserve ratio across the entire UK banking system stood at 3.8%.

Under Article 19.1 of the Statute of the European System of Central Banks (the ESCB), the European Central Bank (the ECB) determined in October 1998 that commercial banks operating in the Euro-zone would be required to keep at the ECB a minimum reserve of 2% of their deposits. Unlike in the United Kingdom however, these reserves would pay interest (at a near market rate) and hence be competitive with the lower (but non-interest bearing) reserve requirements in other jurisdictions.

Reductions in required reserve ratios are often announced in the quietest of fashions for such important changes. With each successive drop in the ratio, the theoretical limit on the amount of money that the bankers can create is relaxed. It is no surprise therefore to find that following each relaxation of the required reserve ratio, the rate of bank money creation in due course tends to increase and an economic bubble soon develops. But of course this is only one side of the story because even if reserve ratios do not fall, the amount of state money supply can increase thus allowing the upper limit on total bank money supply to rise.

Where increases in bank money and state money supply are both gradual and approximately related to the level of prevailing interest rates and real economic growth, then it is possible that such a state of affairs can coincide with economic stability for many years. This is a rare scenario of course (which country hasn't experienced a boom and bust cycle in the last twenty years?) and it changes nothing in regard to the unrepayability of debt, with all of the political and commercial pressures that this inflicts upon society.

* 1997 data
source: IMF Financial Statistic Yearbook 1998 and 2001

% Ratios of M0 to M2 (IMF definitions)
various countries
 

I believe that the general trend to lower actual and required cash reserve ratios will continue because it is in the interests of the commercial banks that it does so. At the end of this road lies one of the ultimate objectives for the international banking lobby, and that is to create a cashless society in which the use of bank created money is the only option. State created money would then cease to be of relevance to the commercial operations of the banking system. Such a system would be a disaster for every nation, because by this means the opportunity to issue interest-free money would be lost and a major break acting upon the creation of interest-based money by the banks would be removed. When it comes, the move will probably be dressed up in appropriately innocent language, something to do with "the need to increase efficiency" or an end to "old-fashioned bits of paper" I expect. The result will be the placement of even greater financial power in the lap of banks (and credit rating agencies) and the digital recording of every financial transaction entered into by every person. What a nightmare.

One of the clearest signs of this process is contained within clause 104 of the Maastricht Treaty. In a speech delivered on the 13 May 1997 at the Oesterreichische Nationalbank in Vienna, Alexandre Lamfalussy, President of the European Monetary Institute states:
"Already since the start of Stage Two [of Monetary Union], Member States have no longer been allowed to engage in monetary financing of budget deficits (Article 104). Correspondingly, for Stage Three, it is explicitly forbidden for the ESCB [the European System of Central Banks] to supply credit facilities to government bodies, or to buy government debt instruments in the primary market. In addition, financial institutions are not allowed to grant credit to public authorities under preferential conditions (Article 104a). Furthermore, a bail-out of one Member State with financial problems by another country is strictly excluded (Article 104b). Finally, the Treaty obliges EU countries participating in the single currency to avoid excessive budget deficits (Article 104c). Compliance with this obligation will be assessed in the context of an elaborate procedure which will ultimately lead to the imposition of sanctions if no effective action is taken to correct an excessive deficit. The preventive nature and effectiveness of this procedure has recently been strengthened by the adoption of a Stability and Growth Pact, which specifies both the time limits for the consecutive steps in the procedure and the size of sanctions. Moreover, it commits each Member State to target a budgetary position that is close to balance or in surplus over the medium term."

What this means is that governments of the member states within the European Monetary Union can no longer create their own interest-free money. Instead, only commercial banks are allowed to create money out of nothing, money that governments must subsequently pay interest for the privelege of borrowing (article 104a). The speaker recognises that a member state may borrow too much from the banking system, causing inflation or higher interest rates or an unstable economic boom. Article 104c and the subsequent "Growth and Stability Pact" among member states addresses this problem. Article 104b is self-explanatory. We are constantly informed by media commentators that governments are wreckless when entrused with the monetary printing press, but this argument ignores completely the ability of the commercial banks to create money for the sake of their own profit. It also ignores the fact that commercial banks can be equally wreckless when doing so.

The requirement for member states to target an approximately balanced budget over the long term is a fundamental error of policy under the current monetary system. A balanced budget has never been achieved in modern European history, indeed it is impossible because of the simple fact that debt created by the banking system is unrepayable in aggregate. The requirement for budget balance will therefore be conveniently forgotten, or there will be a dogmatic attempt to stick to it in which case major political or economic turmoil will ensue.

The theory of money that is related above has been promoted by many men over the centuries since fractional reserve banking began. It predicts the monetary events that happen, explains how they happen, and why they happen. The theory also explains why debt and money supply are growing in every developed economy and why, no matter how hard we try otherwise, the debts of society only ever seem to grow. Basically sound theories are simple to understand, easy to evidence, and often highly intuitive. Professional economists may mock, but they have yet to produce a similar alternative.

The bankers meanwhile present themselves as intermediaries ("we only lend you other people's money") when in fact they are creators of money out of nothing. They do their best to ignore their critics, which for the most part has been a successful strategy, and systematically promote their opinions through schools, universities and the media. The American Federal Reserve spends millions on promoting friendly economic research each year. The Bank of England too. And this from the 1997 HSBC Group annual report:
"The HSBC Money Gallery at the British Museum attracted millions of visitors after its formal opening in 1997. A 'Resource Pack for Teachers' was created to help teach the history and value of money to students; and, to facilitate distance learning for those unable to visit the gallery, a CD-ROM, The World of Money, will be released in June 1998. The book, Money: a History, will soon be available in Korean, Japanese, French and German, and the children's book, The Story of Money, is being reissued in paperback and in Danish."

Propagandise all you like, men of the Money Power. To every oppression there comes an end.

Tarek El Diwany May 2002