Curing the credit cancer

Stephen Zarlenga of the American Monetary Institute invited me to speak at the 2010 conference in Chicago, which I did on the topic of "why a credit money system doesn't have to crash, and why it always does".

I was pleased to be invited, since this indicated a very open-minded approach by the AMI. They are campaigning to have the American Monetary Act passed to establish a 100 per cent reserve monetary system, which is a measure that I have expressed ambivalence about in the past.

The proposal itself is functional. It would convert our current banks into institutions like building societies, which when they lend money to a borrower, have to decrement an account they hold at a bank so that no new money is created by the loan. Under the AMI's plan, banks would have accounts with the federal government (the Federal Reserve, which is currently privately-owned, would be incorporated into the US Treasury), and could only lend what was in those accounts. Money creation would then be exclusively the province of the government via deficit spending.

I don't oppose this plan, but I think it directs attention at the wrong problem. The issue to me is not how money is created, but how it is used. If it's used to finance productive investment, then generally speaking all will be well; but if it's used to finance speculation on asset prices, then it will lead to financial crises (though not necessarily as severe as the one we're experiencing now).

My reform proposals are therefore directed not at how money is created, but at how it can be used. Briefly, I argue that banks are always going to want to create as much debt as they can (under whatever system of money creation we have), so if we're going to stop the use of money for speculative purposes, our reforms have to affect the willingness of borrowers to borrow, rather than expending energy on ultimately futile attempts to limit bank lending directly.

Bankers especially might not like this analogy, but it's apt: banks are effectively debt pushers, and trying to control bank lending at the source is like trying to control the spread of illegal drugs by directly controlling the drug pushers. If there are drug users who want the drugs, then there'll be a profit to be made by selling drugs, and drug pushers will always find ways around direct controls.

So if you want to stop the spread of drugs, it's far more effective – if it's at all possible – to reduce the desirability of the drugs to end-users. This was the basis of the very successful "Kiss a non-smoker: enjoy the difference" anti-smoking campaign run in the 1980s.

We need something like that in finance to counter the successful campaigns that bankers have run to give debt as 'sexy' an image as tobacco companies once gave cigarettes, even though – in another apt analogy – it causes financial cancer. The uncontrollable growth of debt is very much akin to the exponential growth of a tumour that ultimately kills its host.

The metaphor is not perfect of course, since a certain minimal level of debt is a good thing in a capitalist society. Productive debt both gives firms working capital, and finances the activities of entrepreneurs who need purchasing power before they have goods to sell.

But debt that funds simply speculation on asset prices is very much akin to a cancer. And like the cigarettes that cause lung cancer, growing unproductive debt gives a 'hit' that makes the borrower addicted to more debt.

When debt is growing, the debtor and society in general feel better. It enables the borrower to make profits from speculating on asset prices, since the rising debt drives up asset prices; and the spending this capital gain allows spreads into the wider economy, creating a genuine but ultimately terminal boom. The boom can only continue if debt continues to grow faster than income, but at some point this guarantees that the debt-servicing costs will exceed society's capacity to pay, and the cessation of debt growth causes a crisis like the one we are in now.

My two 'Kiss a non-debtor' proposals to make debt far less attractive to borrowers are:

– To redefine shares so that, if purchased from a company directly, they last forever (as all shares do now), but once these shares are sold by the original owner, they last another 50 years before they expire; and

– To limit the debt that can be secured against a property to 10 times the annual rental of that property.

The objective in both cases is to make unproductive debt much less attractive to borrowers.

Almost all trading on the stock market involves speculators selling pre-existing shares to other speculators. This trading adds zip to the productive capacity of society, while promoting bubbles in stock prices because leverage drives up prices, encouraging more leverage, leading to a crash when price to earnings ratios reach levels even the Greater Fool regards as ridiculous. Then shares crash, but the debt that drove them up remains.

If instead shares on the secondary market lasted only 50 years, then even the Greater Fool couldn't be enticed to buy them with borrowed money – since their terminal value would be zero. Instead, a buyer would only purchase a share in order to secure a flow of dividends for 50 years (or less). One of the two great sources of rising unproductive debt would be eliminated.

I have to thank one of the participants at the AMI conference for inspiring a name for this proposal: Jubilee shares, after the Biblical practice of abolishing debt every 50 years. There's a twist to my proposal of course. It wouldn't be a liability that was abolished but an asset, but the intent is to stop the liability of debt ever rising to the level where it would be a problem. So I suggest calling shares that last forever Jubilee shares, while those that are on the secondary market are just ordinary shares that expire after 50 years.

Jubilee shares could be introduced very easily, if the political will existed – something that is still years away in practice. All existing shares could be grandfathered on one date, so that they were all Jubilee shares; but as soon as they were sold, they'd become ordinary shares with an expiry date of 50 years from the date of first sale.

The feedback loop created between bubbling asset prices and debt in the economy would be broken. Next week I will outline a similar plan to keep a lid of property prices.