The Worm at the Core of Capitalism

It is not widely recognized that the recurring economic crises and increasing economic uncertainty of recent years signify a fundamental weakness in the free-market reforms made to the capitalist system in the last two decades. The mainstream media try to persuade us and their owners that such crises are always ‘corrected’ by the market. Moreover, they never tire of telling us, ‘the fundamentals are sound.’ In the long term they’re almost certainly wrong, but it’s not an easy thing to prove. Whether capitalism as we know it—for capitalism in some form will last as long as industrial civilization—will end catastrophically, or in a rather more soothing manner, is impossible to predict. But every instinct for probability and common sense should tell us that this phase of capitalism will eventually come to an end, and probably sooner than later. There is a sort of soft proof we can offer for this assertion. It runs as follows.

John Maynard Keynes said that ‘Capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight.’ But he also added, ‘in itself it is, in many ways, extremely objectionable,’ and its most objectionable feature is the extremely lucrative power of money creation that governments foolishly and irresponsibly grant to private corporations called chartered banks, such as The Bank of Montreal, The Bank of Nova Scotia, The Royal Bank, The CIBC and the TD Bank—to name the big five. Thus the benefit of money creation, which rightly belongs to the whole community, disproportionately enriches the banking and rentier classes. The most persistent fallacy about banking is that banks are just intermediators between lenders and borrowers. In fact, banks create about 95 percent of our money supply, and what they lend "for the most part" is money they create at the time of the loan. If, like many people, you vaguely believe that the money the bank lent you (for your mortgage or whatever) actually existed before you borrowed it, then you’re probably resigned rather than appalled to have to pay (in the end) almost as much in interest as you pay on the principal (i.e. the original loan). But if the public understood that bank credit is basically just accounting, and that the interest on that "money" is really just an exorbitant accounting fee, they might be less philosophical about this sly form of economic exploitation.

By the way, it is not just the private sector that forms the banks’ lawful prey, but also governments. However, unlike the private sector the federal government, through the Bank of Canada (i.e. the central bank), can lawfully create interest-free credit for itself and other levels of government. In practice it does charge itself interest, but as sole shareholder it receives about 95 percent of that interest back as dividends. In other words, aside from relatively small administrative costs, money borrowed by the government from the Bank of Canada is essentially interest-free. However, for the most part our government chooses not to exercise this option. If it seems preposterous that a government that can create money for itself would allow private banks to create money that the government then borrows and pays back with interest, we need only remind ourselves that democratically elected governments are not invariably faithful to the public interest.

To pick up the main thread of our argument, most of the money supply under the present form of capitalism depends on people and governments going into debt, and the level of debt within an economy is roughly equal to the amount of money that the banks have created. We say "most of the money supply" because the cash (approximately $32 billion in 1999) that circulates in public hands is not created as debt, and is therefore interest-free. Economists call this part of the money supply ‘government created money,’ or GCM. The remaining $557 billion (1999) of our money supply is ‘bank created money,’ or BCM, and bears a great deal of interest. This fact leads us to our next objectionable feature. In making loans banks create enough money for the principal to be repaid, but not enough to repay both the principal and the interest. For conceptual clarity, if all loans had to be repaid on the same day some borrowers would obviously have to default since there’s not enough money in the system. The fact that in real life all loans don’t get repaid on the same day doesn’t change the end result in the slightest: a shrinking money supply. (Note that when a bank loan is paid off, the principal disappears

as mysteriously as it was created, namely, a few taps on the computer keyboard. Even banks can’t be allowed to create money out of thin air and then simply keep it. Unlike the principal, however, the interest collected on loans does not disappear. It lives on as bank profit).

Now here’s where it really gets interesting. There’s only one way that an economy subject to such an odd economic arrangement can sustain itself. Every year, on average, the supply of BCM needs to be increased by at least the average rate of interest that banks charge on their loans. If the average rate of interest on $557 billion of BCM is 7 percent or $39 billion, then there must be net new loans of $39 billion over a one year period. In other words, in order to remain healthy the economy must grow, regardless of whether the population grows, or people’s needs or wants grow. If, under our present form of capitalism, the economy doesn’t grow, there won’t be enough people and businesses taking out the new loans needed to pay back the interest (as well as the principal) on the old loans. In some ways our whole monetary system resembles a house of cards. Or perhaps a better image is that of a juggler who can only keep all the balls in the air by continually adding more—up to a point.

We said above that our economy needs to grow to stay healthy. You can see though that "healthy" is not really the right word since both public and private debt is continually increasing and must increase to sustain the growth. But it can’t be sustained indefinitely. Eventually debt loads become too great, debtors default, and the economy falters or even contracts. It is in the very nature of the system to create this type of problem. Though unpredictable in the short term, economic weather—also known as the business cycle—is actually man-made.

It’s actually quite easy to put some numbers to this sorry situation. A good estimate of real interest (i.e. nominal interest minus inflation) on $557 billion of BCM (1999) would be about 6 percent. This amounts to $33.4 billion. Dividing this number by $952.7 billion, Canada’s Gross Domestic Product (GDP) in 1999, we get 3.5 percent. This is the number that tells the tale. The economy must expand by 3.5 percent just to keep all the balls in the air. This means that failing companies must not only be offset by new companies and new investment, but there must be enough additional economic activity to generate the new loans that will be needed to avoid defaulting on the old loans. Although the economy did grow by 3.5 percent in 1999, that rate of growth is hardly ever sustained for more than a year or two in developed nations. According to OECD (Organization for Economic Cooperation and Development) historical studies the real GDP growth from 1960 to 1995 averaged 2.3 percent for Canada and 1.8 percent for the U.S.

"Very well," you say, "it may seem like a pretty crazy system, but it performed brilliantly for two decades after the war, and more or less adequately since then. It may not be ideal, but it’s infinitely preferable to socialism, and why shouldn’t it continue to work at least as well in the future as it has in the past?" We agree that it’s infinitely preferable to socialism, if only because, by a kind of fluke, the chief safeguard of personal freedom in a democratic society is the anarchy and disorder of capitalist individualism. And, to give it its due, capitalism unleashes powerful wealth-creating forces which, properly managed, benefit the community as a whole. However, capitalism has historically been prone to bouts of financial euphoria called "bubbles" or "paper booms." (When Alan Greenspan, at the height of the tech bubble, applied the milder term "irrational exuberance" to the stock market he was told to mind his own business). Bubbles are periods of apparently spectacular economic performance (like the 1920s) followed by the disappearance, sometimes virtually overnight, of huge amounts of stock valuation (such as Nortel or the dot.coms). Without stock value to balance the often massive debts incurred to run up the stock, the associated corporation (such as Enron) frequently collapses. Bubbles of the magnitude we have recently witnessed do enormous structural damage to the economy, but the damage is not always immediately apparent. Indeed, it may take some years before their full effects are known and visible to all. The next five years should be very interesting.

"So what do you suggest?" you may be asking, a trifle impatiently. Well, for a start re-regulate the financial industry (see and, especially, reinstate required reserves. (Required, or statutory, reserves are cash amounting to some percentage of BCM that banks must leave idle in their vaults. Reserves act as a brake on money creation, and by raising or lowering the reserve ratio the central bank is able to fine tune the economy. Now that reserves are gone the central bank must resort to its single blunt instrument, raising or lowering the interest rate, which indiscriminately impacts almost everything in the economy.) When the banks got themselves into trouble in the 1980s through speculative misadventure, the Mulroney crowd surreptitiously bailed them out (i.e. made good their losses) by phasing out required reserves between 1991 and 1994. However, a sincere commitment to economic justice would involve much more than reintroducing required reserves to curtail the money-creation powers of private banks. What we really need are major monetary reforms, such as de-privatising our debt-money system as far as possible, and, in general, making money creation a matter of public interest rather than private profit.

Money, essentially, has always been accounting. That fact should be obvious to everyone, especially now that we have abandoned the gold standard in favour of more flexible and efficient "fiat" (let it be) money consisting of paper and computer entries. Money, ideally, is nothing more than fair accounting. This conclusion suggests a modern understanding of usury, which historically was defined as any interest whatever on an unproductive loan. For contemporary purposes usury may be thought of as morally fraudulent accounting through the manipulation of money—even if such manipulation is legal. Currency speculation is a perfect example. Based on data from the Bank for International Settlements (BIS) it now accounts for 98 percent of all international transactions. Condoned by governments of many powerful nations currency speculation has wreaked havoc and made the poor even poorer in Mexico (1994), Southeast Asia (late 1990s), Russia and Brazil (1998), and Argentina (2001).

But we must face the fact that until there is a widespread admission that capitalism has some very unpleasant and unacceptable features, urging the powers-that-be to make the necessary reforms is a fool’s errand. All their mental machinery will be mobilized to find reasons why the suggested reforms are wrongheaded or impractical; and not because they are interested in curing capitalism of its historic tendency to distribute wealth in an extremely unequal manner. Either they like things just the way they are, or they’ve been persuaded that, in Margaret Thatcher’s words, "There is no alternative." Somebody should have reminded her of the words of another famous Prime Minister, William Pitt: "Necessity is the argument of tyrants and the creed of slaves."

Before leaving you to contemplate the mysterious persistence of scarcity and economic insecurity even in resource-rich, technologically advanced societies, we would like to comfort and fortify you with some words from John Kenneth Galbraith: ‘Few [economic problems], if any, are difficult of solution.  The difficulty, all but invariably, is in confronting them.  We know what needs to be done; for reasons of inertia, pecuniary interest, passion or ignorance, we do not wish to say so.’ (This piece, and others on related subjects, can be found at, a website dedicated to presenting a simple model—for discussion purposes only—of a universal basic income for all Canadians.)

Some Supportive Quotes

I believe that banking institutions are more dangerous to our liberties than standing armies.... The issuing power should be taken from the banks and restored to the people to whom it properly belongs.

Thomas Jefferson

Until the control of the issue of currency and credit is restored to government and recognized as its most conspicuous and sacred responsibility, all talk of sovereignty of Parliament and of democracy is idle and futile... Usury once in control will wreck any nation.

William Lyon Mackenzie King