Want to end the GFC? Put debt to good use

The Global Financial Crisis should be called the Global Debt Crisis. Too much debt has been created and there is not enough productive capacity to pay the interest on the debt, let alone repay the loans.

This was not meant to happen. The banking system is meant to restrict the amount of debt created by requiring loans to be secured against existing assets or future income.

In 2008, US households had debt equal to three times GDP. Today, Australian household debt is 1.6 times GDP. The total debt in the world is many times the productive assets available to generate the income to repay the debts. Even with low interest rates the amount of debt is difficult to service let alone repay.

To understand how we can remove the debt burden in an orderly way, we need to understand how the system has been able to create so much debt.

With that understanding, we can introduce additional mechanisms into our monetary and financial systems to reduce debt and reduce the likelihood of it happening again.

Making money

Most debt is created by banks providing credit. Banks do this by creating new money secured against assets or income streams.

This would appear to set an upper limit to the amount of debt created because, at first sight, there appears to be a finite value to monetisable assets, and hence a limit on the amount of debt. Unfortunately, there is no limit to the value of monetisable assets.

The financial system allows debt to be treated as an asset, with the aim of spreading risk. Every day, banks borrow from each other so that they can balance their books. When banks make loans to each other they typically create new money rather than lend existing money.

If they lent existing money, then they would indeed be spreading the risk. But by creating extra money, they in fact increase the systematic risk.

This is because the money supply is increased without the backing of tangible assets to repay the debt. Banks are driven to do this because they make profits from giving loans and not from the creation of profitable assets.

For as long as the financial system continues to profit immediately from the creation of new money, the system will tend to generate too much debt.

Sufficient control?

The Reserve Bank of Australia (RBA) attempts to control the domestic system by changing the rate at which it will lend to other banks.

If the RBA thinks there is too much debt, it increases its lending interest rate which in turn is meant to discourage banks from borrowing from each other.

This, reduces the appetite for banks to lend, and in the process, reduces demand. Unfortunately, this approach results in recessions and depressions because a reduction in demand when debt is high reduces liquidity. This leads to a contraction of the economy and a reduction in the ability to repay debt.

This process is then accelerated by countries introducing austerity measures that reduce demand further, and with it, demand for debt. The increase in the money supply increases financial profits without any increase in productive capacity because interest is paid on newly created money.

Hard cash

We need to change this situation so that newly created money has to be invested in profitable assets before a profit is realised.

We can stop this cycle of boom and bust if we can build mechanisms so that an increase in the money supply is guaranteed to build new productive assets.

Banks will still lend to each other, but they will use existing money to make their loans. They will do this because existing money carries less lower risk than newly created money.

Because an increase in the money supply also causes an increase in productive assets, the amount of debt and money in circulation will remain below the value of productive assets in any country that adopts this approach.

We can encourage asset creation by making loans to create new productive assets interest free. At the moment banks don’t do this because building new productive assets is higher risk than buying existing assets.

Banks could give interest free loans for new assets, if the government guaranteed the loans. To be politically acceptable the loans could be for community infrastructure projects and the loans could be widely distributed throughout the community.

It has worked before

This has many historical precedents. The Commonwealth Bank under its first governor, Sir Dennison Miller, created money and lent it at low interest rates to governments for port, road and rail infrastructure as well as financing the Australian involvement in World War I.

The approach has been critical to China’s rapid progress, with banks being encouraged to lend for productive infrastructure at low interest rates. Japan and the Asian Tigers export industries were built on low cost finance.

Australia has been giving inflation-linked interest free loans for student tuition through HELP (previously called HECS) for the past 20 years.

When it is tried, interest free loans used for productive purposes almost always increases wealth without inflation.

Australia has many ways it can increase productive capacity with interest-free loans. Communications and information systems technology enable us to build systems to ensure that interest-free loans are distributed fairly to Australian citizens and that the funds are invested for the purposes they are given.

The National Broadband Network (NBN) could be financed through low-interest loans given to people who sign up to use the service.

The money from loans could be invested in the NBN as investment bonds and the loans repaid from interest on the bonds. The interest on the bonds would come from the payments borrowers make for the NBN services.

This approach would fund the NBN for no cost to the government, as the government would simply guarantee the new money the banks create for the loans.

The loans are certain to be repaid because borrowers agree to use the NBN. Once the loans are repaid, the borrowers are left with interest bearing bonds which they can use for their own purposes.

Renewable energy projects could be financed through interest-free loans distributed to consumers who agree to purchase green energy. The money from loans would be invested in private companies that must build new renewable energy productive capacity.

The loans would be repaid from the distribution of profits of the companies. The size of the loans could be inversely related to the amount of mains energy consumed by a person so encouraging lower energy consumption.

This approach will encourage savings investment in renewables because, by reducing finance costs, almost all renewable energy production is profitable at today’s prices. This approach would reduce emissions without any increase in the price of energy.

The loans are certain to be paid because the borrowers have agreed to purchase energy from the renewable energy companies they have financed. After the loans are repaid the borrowers are left with ownership of income generating assets.

Any form of community infrastructure can be financed this way. Public transport, water supply systems, toll roads, ports, education and even health.

The system can be introduced incrementally with no change to the current financial or monetary system. The RBA will still control the money supply but has a new tool.

It will advise governments how much money they can allow to be created through interest free loans for specific infrastructure purposes.

Overseas borrowings will be reduced and there will be a lower debt burden which translates into higher incomes for the population. Ownership of infrastructure will be distributed to the population. Accumulated over a lifetime this ownership will provide a retirement income.

Shifting debt

Observant readers will notice this proposal will result in a change in the distribution of credit in the population. Today, the banks rarely give loans to build new assets without another asset available to secure it.

Today almost all loans result in the creation of new money to buy existing assets. Those with more wealth can get more credit while the poor have difficulty.

The wide distribution of interest-free credit throughout the community, will result in those with less wealth getting credit provided it is used to create productive assets. This is fair and politically achievable because it does not redistribute existing wealth only future wealth.

Adopting this approach will mean that most new money will result in the creation of new assets and existing money will be used for the transfer of asset ownership through loans.

History shows us that if a profit is made from the creation of new money with an interest coupon attached then the financial system always creates too much debt.

Targeted systems must be put in place so that profits are made after new money has been invested and not before.

If this is done well, the controllers of the money supply will have additional ways to increase the money supply, the current debt overhang will reduce in an orderly fashion and debt explosions will not occur.