BANKING
SYSTEM
ANOMALY

We are currently living in an era where there is a lot of attention to address the problems of financial systems, moreso than in any time since the Great Depression. The general public assumption is that commercial banks are collecting deposit and using that deposit to finance loans based on the public demand. People rightfully expect to be able to gain revenue through interest in return for banks using their deposited money. The reality however is quite the opposite.

The key function of banks today is money creation and not intermediation. Banks do not intermediate pre-existing savings. They do not wait for people to enter the bank and deposit money so that they can lend it to somebody else.

Nearly zero percent of bank business is of that nature. Instead what banks do is, they create new money ex nihilo in the act of lending. So what that means is that banks can very easily start a lending boom, by simply growing both sides of their balance sheet. There is no real limitation on how much loans bank can issue, it is fundamentally based on the bank’s perspective of the economical situation. The only constrain that banks face when they do that is precisely their own expectations of how profitable the loan will be, and whether it might endanger their solvency. In two-tier banking systems central banks act as an independent authority that manage money supply and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank is owned by the state, and usually also prints the national currency, which usually serves as the state’s legal tender. Central banks also act as a “lender of last resort” to the banking sector during times of financial crisis.

Essentially banks decide to create money, that always comes first then comes the refinance from the central bank. From the commercial bank’s perspective handling deposits is a byproduct of their primary activity, because deposited money already exists, there is no new money entering the system. That is not the primary goal of banks.

 

CHICAGO PLAN RELOADED

At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan:

  1. Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money.
  2. Complete elimination of bank runs.
  3. Dramatic reduction of the (net) public debt.
  4. Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation.

The decade following the onset of the Great Depression was a time of great intellectual debates in economics, as the leading thinkers of the time tried to understand the apparent failures of the existing economic system. This intellectual struggle extended to many domains, but arguably the most important was the field of monetary economics, given the key roles of private bank behavior and of central bank policies in triggering and prolonging the crisis. During this time a large number of leading U.S. macroeconomists supported a fundamental proposal for monetary reform that later became known as the Chicago Plan, after its strongest proponent, professor Henry Simons of the University of Chicago.

It was also supported, and brilliantly summarized, by Irving Fisher of Yale University, in Fisher (1936). The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks.

Fisher (1936) claimed four major advantages for this plan. First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations. Second, 100% reserve backing would completely eliminate bank runs. Third, allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt. Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

We take it as self-evident that if these claims can be verified, the Chicago Plan would indeed represent a highly desirable policy. Profound thinkers like Fisher, and many of his most illustrious peers, based their insights on historical experience and common sense, and were hardly deterred by the fact that they might not have had complete economic models that could formally derive the welfare gains of avoiding credit-driven boom-bust cycles, bank runs, and high debt levels.

We do in fact believe that this made them better, not worse, thinkers about issues of the greatest importance for the common good. But we can say more than this. The recent empirical evidence of Reinhart and Rogoff (2009) documents the high costs of boom-bust credit cycles and bank runs throughout history. And the recent empirical evidence of Schularick and Taylor (2012) is supportive of Fisher’s view that high debt levels are a very important predictor of major crises. The latter finding is also consistent with the theoretical work of Kumhof and Rancière (2010), who show how very high debt levels, such as those observed just prior to the Great Depression and the Great Recession, can lead to a higher probability of financial and real crises.”

Benes, J. and Kumhof M. (2012) The Chicago Plan Revisited

 

NEED TO GROW FOREVER

How do we define Capitalism or market economy? Based on empirical observation there is an agreement that it is based on:

  1. private ownership. That is, with the property everyone does what he wants, provided he does not violate others in his right.
  2. Decentralized, which means in this sense that any individual is able to act without any knowledge about the actions of the rest of the individuals.

The dominant economics theories use these two criteria to identify capitalist economies. They built their general equilibrium theory based on these 2 statements. The observation made by Aristotle is entirely incidental to the fact that merchant societies are characterized by the fact that there are actors who spend money to ultimately get more money than the amount of money originally spent. Aristotle called these characters as chrematistic actors. Marx raised the attention to this important observation. Marx regards the economy as a product transformation process, where goods are produced, sold, then purchase other goods, then produce again and so on. In this sense the economy flow can be displayed as Product-Money-Product-Money. However, in trading societies this basic unit changed to: (Money – Product – Money). Such a transformation process obviously only makes sense, if the initial and final amount of money is not the same. We think companies and banks are behaving like this in today’s economies, so we assume that in today’s modern economies there are:

  1. chrematistic actors. That is, there are some entities who spend money in order to get rich. In other words, when a chrematistic actor spends money to earn more; at the end of the cycle there is extra money left which the chrematistic actor is able to spend.

There were a number of money systems throughout history. The money system of today’s economies:

  1. are based on private-credit money. That is, private banks are able to create money by lending.

According to these empirical observations our capitalist society can be defined: an economy based on private ownership, decentralized, chrematistic, fueled by private-credit money – which we will refer to as modern market economy.

Inserting chrematistic actors in the standard model has another consequence – as mentioned before the economic logic changes completely: the starting point is not the existence of goods (P-M-P) as the first element of the transformation process, but it all starts with money (M-P-M). Money no logner plays a secondary role in making substitutions, but through it’s settlement unit function it plays a primary role in the model. “Money-of-Account, namely that in which Debts and Prices and General Purchasing Power are expressed, is the primary concept of a Theory of Money. (Keynes 1930, A Treatiseon Money first sentence of the first chapter!)

The Rosier model mathematically proven the following statements:
In the modern market economy, if the total loans amount does not grow faster than than the monetary stock, then the economy does not function properly from the banks perspective – there is a banking crisis in the economy. The alternative of growth is not balance, it is banking crisis.

One more important note: in modern financial economies, exchanges are made with money. If there were no money available in the economy, the actors could not make the planned exchanges. Therefore, an individual would be willing to borrow from the bank under the burden of paying interest simply to be able to make the planned transactions. In fact, some of the money in the economy is only needed to make the planned exchanges, but there is a loan behind this money. Therefore, if money creation was not a credit operation, the loan portfolio would be smaller: it would only be enough to get money through credit to those who would like to invest (investment loan) or to make premature consumption (consumer credit).

This money creating practice is only viable in a growing economic scenario, and it does not only effect banks, this effect of need to go forever is putting a great pressure to the economy as a whole. That is exactly the reason that companies around the globe push for growth each year compared to the previous. They can never be satisfied with the similar level of of performance – not unless their business is loan-free. It is important to note, that companies can only grow constantly, if there is always a significant demand for their products – no wonder they there is a phenomenon as planned obsolescence. If the majority of consumer goods were to last as long as they did 40 years ago companies would lose demand and could not keep on growing their indicators.

 

MOTIVATION

In 2009 a new cryptocurrency and worldwide payment system was born. It is the first decentralized peer to peer payment system, as the system works without a central bank or single administrator. The network is peer-to-peer and transactions take place between its users directly, without any intermediary. These transactions are verified by network nodes through the use of cryptography and recorded in a public distributed ledger called a blockchain. It was invented by an unknown person or group of people under the name Satoshi Nakamoto and released as open-source software that we know today as Bitcoin. People are able to transact without intermediaries around the Globe. However Bitcoin does not solve the problem of lending. Lending plays an exceptionally important part to every economy, that is the generator of economic development.

Although the Chicago Plan was never implemented in the real-world economy, the reasoning behind is based on empirical observations and its conclusions are fundamentally valid to this day. When we designed our lending platform we wittingly focused on making a lending product that contributes to the stability of the global financing system. As in our system, behind every loan there is coverage presented by the borrower, he is extra-motivated to indeed pay the loan back, thus our business model contributes to mitigate the effect of negative events of the world economy.

Our goal is to connect the people who have already owned cryptocurrencies, but have been unable to effectively utilize them, to those who want to benefit from the profit generated by cryptocurrencies, while avoiding the high risk that often describes the crypto-markets.