1. Intrinsically Bad Money System
The money system in the neoliberal economy is intrinsically sick. The crucial flaw lies in the ability of private banks to create virtually unlimited money. The private banks create money “out of thin air” by incurring debts in the form of loans to individuals, companies and governments. Private banks are bound by the rules of the central banks. The debt of the Netherlands is currently about 400% of GNP, about 2380 billion euros. The amount of debt determines the amount of money in circulation. Debts must be repaid with interest. As a result, the economy must grow and inflation must be 2%. Monetary policy is aimed at that. The central banks have two instruments: interest rate policy and influencing the money supply.
Private banks only need to keep a small percentage of their liquid assets (cash + the balance of the central bank) to be able to lend, and thus create, a multiple of this. Banks benefit from privatized money creation and run little risk. If the banks fail, i.e. lend too much money, they get in trouble, but they don’t go bankrupt, because the government saves them with public money (through taxes), as we saw during the financial crisis in the late 10's.
This money system in the neoliberal economy poses serious problems. Governments, companies and private individuals must pay interest to the private banks on the debts, which must of course also be repaid. However, the money to pay the interest, also a form of debt, was never created. As a result, there is always more debt in society than there is money. Governments, companies and individuals can only repay borrowed money and interest if they manage to make it their own at the expense of others, which increases inequality in society. Then there is skewed growth in the economy. Even today, the increase in inequality in society continues. Economic growth is high (4%) and purchasing power is increasing by 0%. There is only a small group that is making progress.
Another possibility is that new debts are created, with which the old debts are paid off and the interest is paid. This is only possible if the economy grows. If there is no economic growth, the accumulated debts will hit disproportionately hard for the coming generations. Economic growth is therefore a policy of governments and central banks in the Western world. However, in a finite world this is not sustainable. High economic growth has many drawbacks. This leads to excessive consumption of fossil fuels and depletion of natural resources. We are already seeing the disadvantages of this in the form of environmental and climate crises and depletion of the earth.
2. Relationship between interest, inflation and economic growth
Fisher’s equation of exchange is widely used in monetary economics. This equation shows the relationship between the money supply, inflation and the size of the economy:
Mv = pT,
where M is money in circulation (money supply), v is the transaction velocity of money, p is the price level and T is the total goods and services transacted (the national income).
The central bank tries to influence inflation by increasing or decreasing M. Then, if v and T remain the same, an increase in M will lead to an increase in p, ie to inflation.
Now there is also a relationship between the money supply and the interest rate. Low-interest rates make it easier for private banks to borrow money, what they can lend again afterwards, because debt is incurred in the economy. This increases the money supply and increases inflation. There is also an effect on the currency rate. The demand for the currency with the lowest interest decreases and so does the exchange rate (= price) of that currency, with the result that imports become more expensive, and inflation increases as a result. Conversely, as interest rates rise, more is saved and less money is put into circulation, and inflation falls. At a higher interest rate, the demand for that currency increases and so does the exchange rate (= price) of that currency, with the result that imports become cheaper, and inflation decreases as a result. So the Fisher equation basically shows the relationship between interest rates, inflation, and economic growth.
Central banks use both interest rates and the money supply to influence inflation and economic growth.
Influence through interest rates: If a bank wants to lend money, it must first get it from somewhere, and this is often done by borrowing it from the central bank. If the central bank raises interest rates, it becomes more expensive for the banks to borrow money from the central bank. With an interest rate increase, the banks will borrow less money from the central bank and therefore be able to lend less, which reduces the money supply. Conversely, with a interest rate cut, banks will borrow more money from the central bank and pump more money into the economy, increasing the money supply. By cutting interest rates, the central bank can therefore encourage consumption, which will increase economic growth and/or inflation.
Influence through the money supply: In ‘quantitative easing’, the central bank directly increases the money supply in an attempt to stimulate the economy. This is done by buying securities with money created especially for that purpose. Although this can lead to extra spending, there is also the risk of inflation. The purpose of this is to increase aggregate demand/production T by increasing the money supply M. This only works if v and p remain constant. If the velocity v remains constant, inflation p will be able to rise. However, if the velocity drops, nothing needs to happen in the economy. This is called the “liquidity trap”. In a liquidity trap, people do not use the money that is pumped into the economy to spend it but, for example, to save it. The velocity of money is then lower: money is not spent.
3. Analysis
Interest rates have a major impact on inflation. But inflation is also influenced by other factors, such as the prices of raw materials and, above all, oil and oil-products). There is a strong relationship between inflation and oil prices. Looking at the year on year changes, at first glance there seems to be little connection. The correlation coefficient between these two series (mutations for the period 1970–2020 of the Dutch CPI and oil prices in US dollars per barrel of Dubai 1970 t/m 1975 en Brent 1976 t/m 2020) is therefore low: 0.39. The pass-through of oil prices to the rest of the economy will take some time. If we take into account a delay of 1 year, we see that the correlation coefficient increases to 0.54. We see an even better correlation when we look at the levels: the correlation coefficient between the oil price and the consumption price index is: 0.77. This means that the influence of the oil price on the consumer price index over this long period is substantial.
The oil price is the result of supply and demand. Since 2009, the global demand for oil has steadily increased. The price of oil has also continued to rise since 2009, with the exception of the price decreases in 2009/2010, 2014/2015 and 2020. The price level has been significantly higher since 2009 than in the period before 2009. The price decrease in 2009/2010 is related to the financial crisis of 2007/2009. The global economy collapsed as speculative bubbles burst in the housing and stock markets as a result of increased savings and inadequate regulation and supervision of the banking system. The 2014/2015 price drop is related to the increased supply of oil, partly due to the strong increase in American shale oil production. This subsequently led to an increase in oil production in the Middle East in order to lower the oil price , and thereby price shale oil, which has a high production cost, out of the market. The result was a sharp fall in oil prices in 2014/2015. This strategy was not working and oil prices started to rise again. The fall in oil prices in 2020 is related to the growing economic impact of the coronavirus and a concomitant reduction in oil demand. Negotiations between OPEC and Russia over production restrictions broke down, after which Saudi Arabia started a price war by offering the oil at a lower price. Production was reduced and investment in new and maintenance of existing oil fields was halted. OPEC maintained restrictions on production and allows only minor production increases.
When considering future oil prices, a factor that plays a role is that after the low point of the corona crisis, the demand for energy will increase again. The trend towards cleaner energy means that we use less coal. Because the development of alternative energy sources is slow, this will result in an additional increase in demand for oil and with it the price. The price of gas has also risen a lot and is leading to a switch to oil. Although OPEC does not expect oil prices to rise much further and that supply and demand are in balance, these developments make it likely that the oil price will continue to rise.
Notwithstanding the high oil prices since 2009, with the exception of the aforementioned declines, and despite the declining trend in interest rates since 1980, inflation has also remained low, at around 2%. Central banks cut interest rates to increase the money supply and boost the economy. Despite the high money supply and low interest rates, inflation remained limited.
Despite the corona crisis, economic growth also remained stable, with the exception of the corona year 2020. However, the extra money is not spent (low velocity), but is saved and does not contribute to spending, and therefore inflation is not affected. In other words, the liquidity trap has become a reality.
The Dutch Central Planning Bureau (CPB) calls the current low interest rates a structural and global phenomenon and does not want to deal with its causes, but only with its consequences. However, the interest rate is not a natural phenomenon, but is set by central banks. Central banks can therefore also change the interest rate. Normally, low interest rates put upward pressure on the economy and inflation. The CPB indicates that the low interest rates are an expression of large worldwide savings surpluses. As indicated above, this relationship is rather reversed. The savings surpluses reduce the velocity of money, which means that the effect of interest rate cuts on the economy and inflation no longer works.
4. Consequences of monetary policy
In recent years, low interest rates went together with increasing money supply. This financial policy has not achieved its goal, it has mainly negative consequences.
High(er) inflation is very likely. Since mid-2021, the oil price has risen sharply. It can be expected that this will have an effect on the economy and that prices will therefore also rise in the long term. Wage demands and wages will rise as a result of these price increases. Businesses are faced with rising costs, especially as higher oil and gas prices feed through to the economy. With prices rising again since mid-2021, you would expect the central bank to raise interest rates in order to slow down the money supply. However, that doesn’t happen. The central bank assumes that the rise in inflation is temporary. She bases this on her own inflation expectations. Building policy on inflation expectations is dangerous. Another reason why inflation would be temporarily high is because commodity prices are rising on the supply side and not on the demand side. However, it is highly questionable whether inflation is temporary. Rather, we will see higher inflation and rising interest rates in the future very likely. In addition, if the velocity of money starts to increase again, due to more (catch-up) spending by private individuals, inflation will be fueled again. Also the USA the $1400 that the American citizen has received from the government stimulates the consumer drive.
Monetary policy remains focused on supporting economic growth. However, we see that unemployment is falling. Companies have trouble finding suitable personnel. In the USA too, companies are having trouble finding employees and are creating fewer jobs than expected. USA government supplements unemployment benefits, and therefore unemployed people do not look for a job. And new sectors cannot find the right people and training.
The increased money supply has found its way into the financial markets, causing share prices to rise. Central bank policy has also made borrowing cheap, pushing house prices (and rents) up. Bubbles are forming on the stock and real estate markets. First-time buyers have no opportunities on the housing market. If rising inflation materializes, volatility in the financial markets could increase. The prices on the financial markets (which have risen enormously due to 0% interest and the rolling of the digital money presses) can just plummet, just like the (hugely increased) house prices. In addition, if interest rates start to rise, private individuals (for renting and buying a house) and companies will have to deal with rising monthly costs.
Due to the central banks’ buy-back program there is less need for productivity improvements and less technological progress is taking place (creative destruction, Schumpeter). Zombie companies do not fall due to corona support, but they do depress economic growth.
Internationally, there are signs of monetary adjustment. In New Zealand, for example, government bond buying ended in July 2021 and New Zealand, the Czech Republic and Norway raised interest rates in November 2021. However, the central bank don’t want to change the interest rate, and therefore says that the current inflation is only temporary. Even at 5% inflation in the US, the Fed is not going to reduce the monetary space! The policy of the central banks will continue and will exacerbate the problems outlined until: the next crisis!!!
5. Towards growth of cryptocurrencies
Digitization in society is inevitable. This development makes also digital money possible. Cryptocurrencies work in a decentralized way and prevent many problems of the central monetary system of the banks. Cryptos will introduce a completely new monetary system. We are currently seeing many developments in this area. An example of this is 2local.
Take the initiative together with the 2local platform. The 2local platform is an innovative blockchain powered loyalty platform using cryptocurrencies, which offers a cash back and a smart marketplace that connects local and sustainable companies and consumers. Payments can be made easily, cheaply, digitally and quickly, also internationally. The 2local platform has three key points:
1. A cashback for local and sustainable products, by which people with less money also have access to sustainable products. This will increase sustainability and prosperity in the world;
2. The cash back system is integrated in the own blockchain of 2local;
3. The value creation of 2local is shared with people who actually use the cryptocurrencies of 2local.
More information about 2local can be found on the website: https://blog.2local.io/
Harry Donkers
21 Nov 2021
