Tuesday, 30 September 2008

UK Libertarian Party Publish Economic Reform Document.

Libertarian Party
LPUK Policy: Monetary Reform

The monetary reform proposals of the Libertarian Party consist of three central planks. However, and before we can talk about what we'd like to change, we need to take a brief look at how the current banking system works, and expose the flaws that our policies seek to address.

Most people think that the government creates all of our money by printing banknotes, and minting coins. But that is not the case. Let's start by looking at where the government gets its income from.
Government Income
Banknotes are printed by the Bank of England (BoE) on behalf of the government. The BoE then sell those notes at face value to commercial banks, who use them to fill their cash machines and to hand over to us when we withdraw money from our bank accounts. The profits from the sale of these notes by the BoE (known technically as seigniorage) is passed straight back to the government, and netted the Treasury the sum of £2.3 billion in the tax year 2007/081.

The second source of government income is well known and hated by us all—taxes.

Finally, the government gains income through borrowing. If insufficient funds have been brought in through seigniorage and taxation to meet the government's spending commitments, it sells bonds. Bonds are the equivalent of a government IOU, and promise the holder that the government will buy them back at a future date for the value of the bond plus some predetermined interest.

Raising money through selling bonds has a huge downside, though. It means that the government incurs debt. And, like the rest of us with debts (on a credit card, for example), the government ends up paying a sum of money each year simply to service those debts. Government estimates for 2007/08 put the figure that it will have spent on servicing its own debts last year at a staggering £30 billion2—over 20% of the total amount of income tax that we all paid!3

Money From Thin Air
Currently, around 97% of the 'money' in our economy isn't in the form of notes that you can fold, or change that weighs down your pockets—it's in the form of credit (or debt, depending upon which side of the transaction you are standing). So the real question to be asking if we want to understand where our money comes from is how all of this debt appears?

Our commercial banks create money as debt, effectively from 'thin air'.

Imagine a person paying, to keep the example straightforward, £100 in notes or coins into their bank account. Now, bankers know that most of the time, most people leave their money in their bank accounts; we tend to pay for goods with our debit cards, or by writing cheques to one another. Consequently, if a bank has just received £100 in cash it knows that there is little chance that the depositor is going to come along and ask for it back at any moment.

Knowing this, banks only keep on hand a certain proportion of deposited funds; the amount that they reasonably expect they will need to cover any requests for withdrawals. The amount is termed the reserve ratio, and for any funds deposited, a bank will solely keep the amount of the reserve ratio on hand, and lend out the remainder. The whole process is known as fractional reserve banking (FRB).

So, to carry on our example, if the bank that person paid his £100 into maintained a reserve ratio of 10%, the bank would accept the £100 deposit, keep £10 on hand, and lend out the remaining £90.

But what happens to that £90 loan? The individual or business who takes it from the bank will probably not just spend it straight away, but deposit it into their bank account. If they do so in cash, the whole process can start again. Assuming that their bank also maintains a 10% reserve ratio, the bank will accept the £90 deposit, keep £9 on hand, and lend out the remaining £81.

And so the process continues. In fact, if fully worked through the system, that original £100 deposit will end up having 'created' a total of £1,000 that can be spent in the real economy.

In accounting terms, no money is actually created. If each borrower were to pay back their loan in sequence, the debts would unwind until we were left with our original £100 deposit at the first bank. This is why those who defend the existing system will tell you that no new money is really created.

What these folks conveniently overlook, however, is that in real terms, as opposed to accounting niceties, new money has appeared—it's in your hands, and you can spend it. And as long as new bank deposits are being made, the process above can continue.

Keeping The Merry-go-round Turning
And what allows the entire process to continue is our central bank—the Bank of England. Remember the bonds that the government sells to raise additional funds, the Treasury IOUs? Well the BoE will, from time to time, buy bonds in the market. To pay for its purchases, the BoE genuinely does create money from thin air, and credits the seller's account with money that it has just decreed should exist.

This process injects new money into the economy, which spreads about and ensures that the fractional reserve system described above never grinds to a halt.

If it wishes to, the BoE can use the same process in reverse; selling Treasury securities and destroying the money the purchaser pays. In this manner, the BoE has a crude control mechanism available for determining how much money exists in our economy at any one time.

The BoE also sells money to the commercial banks. These banks buy money at one rate, then loan it out to their customers at a higher rate, pocketing the difference.

The above is, of necessity, a simplified explanation of how FRB operates, and the role played by the central bank. The Bank of England do not appear to have ever produced a layman's guide to these processes, but the US Federal Reserve has. Although several years old now, this document is still a good guide to the operation of a fractional reserve system, and largely applicable to the regime in the UK as well as the US. If you wish to look at the technical detail for the UK system, the Bank of England's Handbooks In Central Banking series of publications, and in particular Handbook #24 (Monetary Operations), is a good place to start.

And whilst the above is a simplistic version of the processes at work, remember that much of the complex language and obscure practice of the banking industry is designed to mask its operations from public scrutiny. At its heart, it is a simple fraud: central banks genuinely creating money from thin air, and commercial banks lending money that's not rightfully theirs to loan. As the famous economist JK Galbraith once noted: "The process by which banks create money is so simple that the mind is repelled."

The short answer is because bankers profit from it!

Remember the seigniorage that the government receives from the printing of banknotes by the Bank of England? That brought £2.3 billion into the Treasury last year. Estimates by Huber and Robertson back in 2000 suggested that the loss in seigniorage to the government by allowing commercial banks to create money was in the order of £49 billion per annum4. And, of course, the more money there exists within the economy, the greater this loss is to the government.

The big driver for commercial banks is the interest that they charge on loans. Obviously, the more loans that they have on their books, the greater the potential amount of interest that they can earn. Simply by being able to loan (effectively) the same money over and over again, they are able to develop multiple interest income streams from a single deposit. Banks also profit from the business of actually arranging loans. Most will charge a small percentage of a loan's value simply for allowing you to enter into the loan contract with them.

We've enjoyed this system—largely unchanged—since the Bank of England was first established in 1694. Seeing the obvious benefits to themselves, bankers around the world have, over the centuries, embraced a model first imposed upon the people of our nation.

But it's a flawed model. It's one built to serve the interests of the few, not the many. It's one that results in the scourge of inflation. It's one whose time has long passed.

To build a strong bridge from our unfair and failed banking system to an honest and prosperous future one requires some sturdy materials. The Libertarian Party's monetary reform proposals consist of three central planks.

Plank One: Sterling — A National Currency That Belongs To The Nation
Our first key proposal is to wrest the privilege of creating money from the private banking industry, and to return it to where it rightfully belongs: the Crown.

Where an increase in the money supply is required to maintain monetary value—because of a growth in the underlying economy—government will spend the newly created debt-free money into the economy in the form of financing capital works, paying the salaries of public sector workers and so on.

This money will be the money that we are all familiar with: pounds Sterling. Our national currency, it will once again become the property of the nation. Out of control inflation caused by feckless bank lending will become a thing of the past, as we will demand that all Sterling be 100% reserved. All income from seigniorage will end up in the public purse, to provide funds for necessary government activities.

Should a particular government abuse its position and create more money than the economy requires, all of us—as the electorate—will have the opportunity to do something about the situation at the ballot box. This is in stark contrast to the current position, where inflationary pressures are created by unelected private bankers; people who actually have a vested interest in causing such pressures in the first place—the more money that they create, the greater their profits.

Nobel Prize winning economist Milton Friedman once said: "Money is too important to be left to central bankers". This is a position that we wholeheartedly endorse. The private banking industry needs to be removed from involvement in the creation of our national currency and, as US President Thomas Jefferson remarked over 200 years ago: "The issuing power should be taken from the banks and restored to the people to whom it properly belongs"; to the government of the nation, on behalf of the entire nation.

How To Prevent The Fractional Reserving Of Sterling?
A key point of these proposals is to prevent the fractional reserving of pounds Sterling in the future. As banks must be allowed to continue taking deposits and making loans in Sterling, this raises a potential problem.

To illustrate the problem, cast your mind back to the person depositing £100 in cash into his bank in our example above. Currently, the bank taking that deposit has no way of knowing if the money is government produced (debt-free) money, or if the person depositing it has acquired it via a loan. Without being able to distinguish between debt-free and debt-laden money, the bank cannot determine whether it should be allowed to re-lend that money.

In the days before computerisation of the banking system, this issue would have been easily dealt with. When there was a direct one-to-one relationship between money and the physical representation of it (the banknote), everybody knew where they were. However, it would be totally absurd in this day and age to return to the historic system of having fleets of security vans ferrying physical banknotes around the country between branches and different banks.

Various solutions to this problem have been mooted by different experts. Fortunately, the very technology that has largely rendered banknotes obsolete—computers, with vast amounts of cheap data storage—offer us the potential for tracking money through the banking system, to ensure that is only capable of being on loan to any one person at any time.

Those who run the banking computer systems have not had cause to give much thought to these issues to date, as they don't currently require this functionality. As a responsible political party, we intend to fully consult with private banking institutions to develop a future system that is both effective and transparent.

No matter that any such system would mean changes in the way that banks do business, we need to remember that what we are talking about here are solely implementation issues. Whether hard or simple for banks to adapt to, such mere procedural issues must not be seen as a barrier to prevent the much needed structural change from occurring. No government fails to attempt to apprehend criminals simply because it would be easier to allow them to roam free; and no government should shy away from monetary reform simply because the changes required might be arduous for the private banks to implement.

Plank Two: Pounds Sovereign — A 'Hard' Currency
In addition to reforming how pounds Sterling are created and handled, the Libertarian Party is proposing the introduction of an additional, parallel, currency: pounds Sovereign.

What gives our money today the value that it has is simply our trust that the government, and the banks, will honour it. There is no physical commodity backing Sterling: it is what is known as a fiat currency.

Our money was not always like this. In the past, precious metals such as gold and silver (the origin of our pounds Sterling) were kept by banks, and banknotes issued in relation to the amount of precious metals on hand. Such hard currencies proved remarkably resilient over the centuries, and really only died off during the 20th century with the explosion in fractional reserve banking.

Precious metals like gold have held their value—their real purchasing power—remarkably over the ages. Back in Roman times, an ounce of gold would have bought you a good quality toga, belt and sandals. Today, that same ounce of gold would pay for a quality suit, belt and a pair of shoes.

Metals, and particularly gold, are still of great value in the world economy. This is never more true than during times of economic trouble, such as that which we are facing right now. Whilst fiat money may be refused as a means for financing foreign trade, gold never is.

Back in 1999, Gordon Brown decided to sell off over half of the UK's gold reserves via auction—an act described by Peter Fava, then head of precious metal dealing at HSBC, as "a disastrous decision"5. Not only was the decision to sell the wrong one, but trailing it in advance guaranteed that prices would be depressed prior to the auction. As Martin Stokes, former vice-president at JPMorgan, said: "I was surprised they had chosen the auction method. It indicated they did not have a real understanding of the gold market"5.

Gold is still key to the operations of most central banks around the world. At the end of the financial year in March 2007, the United States held 8,133 tons of gold, Germany had 2,422 tons and France had 2,710 tons. Britain, currently the fifth largest economic power in the world, at least on paper, had a pitiful 315 tons5.

The Libertarian Party is proposing to reintroduce a hard currency, one backed by gold: pounds Sovereign. Although we would expect it to be initially used largely to fulfil international trade obligations, such a currency would have the added advantage of attracting foreign investors into the UK, as it would provide a secure harbour for their money in a turbulent world market. Over time, and if both the amount of gold held by the Treasury and the demand from the public was great enough, pounds Sovereign could become a commonly used currency in all our daily lives.

Plank Three: Free Banking
Another approach to banking reform that is advocated by some is the concept of free banking. Within a free banking system, there is no government control over currency or banking whatsoever—market forces determine everything. A free bank would be able to create its own currency, and make its own decisions as to how it would operate—choosing to embrace FRB if it wished.

The idea is that you—the customer—would make your own decisions as to which banking institutions and currencies to use; with pure market forces determining which survived and prospered, and which fell by the wayside.

The Libertarian Party is committed to allowing a plurality of choice in as many situations as possible for the citizens of the UK. Consequently, allowing a free banking regime to be instituted is the third plank of our portfolio of monetary reform proposals.

If the adherents of the free banking model are proved right, and such a system is embraced by the consumers of banking services, then over time free banks will become predominant in our economic system. If, on the other hand, the system isn't well received by the public, few, if any, free banks will come into existence or survive.

That's the real beauty of a truly free market: what is ultimately available to the consumer are the products and services that consumers create and sustain a demand for.

Money has to come from somewhere. Currently, money is created by the banking industry and, with the exception of the seigniorage on physical banknotes which returns to the Treasury, the profits from creating money stays within this private industry.

Our proposals for monetary reform address the issues raised above in three ways. Firstly, we will return the sovereignty of our national currency—pounds Sterling—to the Crown, with new Sterling being created, debt-free, by the government, and thence spent into the broader economy. The amount of Sterling in circulation will be prevented from being expanded through FRB, stopping bank generated inflationary spirals developing, and keeping the value of your savings safe.

Secondly, we will create a new currency, pounds Sovereign, to be 100% backed by gold. Still vital for international trade, a gold-backed currency will be immensely strong, and help protect the UK from the storms and squalls that sometimes rip through international markets. In providing a safe haven, this currency will attract investment from many overseas into the UK.

Thirdly, we will legislate to allow for the creation of free banks. If these prove popular with the market—the citizens of our nation—they will grow and prosper, with their currencies likely supplanting Sterling as the primary means of exchange on a day-to-day basis. However, and should they fail, such failure will not impact on anyone who chooses to keep their banking facilities purely denominated in pounds Sterling. In this way a genuine free market in banking will be able to be tried, without the risks being spread over the general population.

We believe that the proposals outlined above are sound and necessary. Our existing banking system has been creaking from one crisis to the next over many years, and has only remained unchallenged because of the enormous influence that those who most benefit from it—the private bankers—wield over our elected politicians.

It's a broken system. And, uniquely amongst the UK's political parties, the Libertarian Party is ready to fix it.

Removal of all legal tender legislation except in [9] below
Removal of all additional (VAT etc.) taxes on precious metals
Allow free banks to operate how they like with their own currencies (enabled by [1])
Only the Government shall be permitted to perform fiat issuance of pounds Sterling. Banks must either use foreign currencies or issue their own Bank Money
Sterling held in on-demand deposit accounts to be 100% reserved by any bank handling it. Banks have always been free to create investment accounts to enable on-lending
New pounds Sovereign currency to be introduced, 100% backed by gold
Sovereign to incrementally replace Sterling as gold reserves allow
Payments to government (taxes) and payments by Government to be in pounds Sterling or pounds Sovereign
Only pounds Sterling and pounds Sovereign will be "legal tender" in regards to the obligation to accept as payment for debts
Existing pounds Sterling fiat debt to be reduced systematically within the first parliament
The various Bank Money, pounds Sterling and pounds Sovereign shall float against each other
The true value of pounds Sterling will no longer be affected by private lending operations. A "safe haven" of a 100% gold backed currency, pounds Sovereign, will be provided. Pounds Sovereign will not initially to be issued in note form. All deposits of pounds Sovereign must be recorded by the Bank of England to ensure that no fraud occurs (totals should always be as expected by the BoE). Banks will be free to continue FRB operations using their own Bank Money or foreign currencies. We expect pounds Sterling to be the main currency in day to day life.
1 Bank of England Annual Report & Accounts 2008
2 Debt servicing from table 1.15, HM Treasury Public Expenditure Statistical Analyses 2008
3 Income tax revenue from table T1.2, HM Revenue & Customs Annual Receipts
4 Huber & Robertson, Creating New Money
5 The Sunday Times, April 15 2007

I think the bottom line, is the current system of allowing unelected banking elites, decide how our economy is going to go, by creating money out of nothing, is a one way road to disaster (where we are heading now).

I personally favour a number of competing methods of currency. The one I would choose, is the one that provably has value. That means being backed by real wealth or commodities. That doesn't just mean gold for me (as I personally don't value gold as much as some). Other commodities could be used though and even the fiat system, as long as people are willing to trust the people running it.