By Kitdor H. Blah
The title of this article is inspired by a 1996 book written by Harvey Francis Barnard, ‘Draining the Swamp – Monetary & Fiscal Policy Reform.’ What is the ‘swamp’ in the context of monetary reforms? To put it plainly and simply, the swamp is the rising public debt, rising fiscal deficit, bloated government budget, rising taxation, rising inflation, a currency that is collapsing and cycles of recession. Draining this swamp then means a need to reform and revamp the whole monetary system. A new theory of money is the need of the hour. Let us look at inflation as the first feature of our current monetary system. Inflation is best defined as the decrease in value of money because of an increase in the amount of money in the economy. Since inflation erodes the value of our deposits, it is the number one enemy of every citizen. Also since inflation is caused by an increase in the amount of money, therefore money creation is the most crucial aspect of the monetary system.
The basic and misconceived belief is that the government creates money. But government created money comprises a very insignificant part of the total money creation in the country. This is the minting of coins which is why coins have the words ‘Bharat Sarkar’ or ‘Government of India’ on them. The proper answer would be that the Reserve Bank of India creates money, which is why every currency note has the words ‘Guaranteed by the Government of India.’ Currency notes are not government money, but they are bank notes which are only guaranteed as legal tender by the Government of India. What is the difference between these two kinds of currency? Coins are permanent money, in that they are created and circulated permanently in the economy. Currency notes or bank notes, on the other hand, are not permanent money, any more than a personal loan is permanent money. A loan has to be repaid, and that is the nature of the Central Bank’s currency notes. In other word, this money is debt. It has to be repaid and it bears interest. It is this very system of money creation that necessitates fiscal deficit. Why? Because since money is created as debt, then the repayment of that debt will always exceed the amount of money available in the economy because of the added interest on that debt.
Moreover, since money is created as debt, then even if only the principal of that debt were to be repaid, there would be a constriction in the flow of money in the economy, which would decrease economic activity, causing a recession. Now, even when the government raises funds from the market, that money must still be repaid with interest or at a premium, which makes it necessary for the government to always go back to borrowing from the Central Bank. When the government reduces the fiscal deficit through increase in taxation, this decreases the immediate purchasing power of the citizens, which is like fast-track inflation and is extremely unpopular. Therefore, the government always has to resort to borrowing.
There is a third aspect of money creation that is mostly overlooked, and this is where most of the money in the economy actually comes from, and that is through commercial banks. There is a misconception that banks give loans out of deposits. If this were strictly so, then every increase in loans and advances should reflect a corresponding decrease in deposits in the books of the bank. The reality is that banks actually create money through loans because the loans created by a bank automatically become deposits once the money is spent by the borrowers and deposited at the payees’ bank accounts. Now, when you consider that banks only need to keep a small percentage of deposits as reserves (cash reserve ratio & statutory reserve ratio), you can see how money is created exponentially by the banking system. If you suppose that the reserve requirement for banks is 20%, then from a pool of deposits of Rs. 100 the bank can give out loans of Rs. 80 which then becomes deposit money when it is spent by the borrower and deposited at the payee’s bank accounts. From this newly created deposit of Rs. 80 the bank can give out loans of Rs. 64, which then become new deposit money at the payee’s bank account. Out of the original pool of deposits of Rs.100 we now have a pool of deposits worth Rs. 244. If you continue the process, you will eventually have created almost Rs. 500 of deposit money from an original deposit money of Rs. 100.
This way of money creation by the commercial banks through this minimum reserve system is what creates most of the money in the economy. And since this money is also created by debt, this has the same characteristics as the money created by the Central Bank, i.e. it is not permanent but has to be repaid and it bears interest. Again, just like the Government’s public debt, the repayment of this commercial debt will always exceed the amount of money available in the economy because of the added interest on that debt. Again, just like public debt, even if only the principal of this commercial debt were to be repaid, there would be a constriction in money flowing in the economy, which would cause a recession.
So, the swamp is caused by the two main ways of money creation – government borrowing from the Central Bank and private commercial loans. Since all government and private spending is ultimately rooted in these two ways of money creation, we can conclude that all economic activities are ultimately rooted in debt, and not just the economic activity of the person who is the immediate borrower. Therefore, all economic growth is driven by debt. If there is no debt, there is no money because money is debt. Since this debt cannot be repaid without constricting the flow of money, therefore this system necessitates perpetual borrowing. And since this debt incurs interest, the public debt and fiscal deficit will continue to increase in perpetuity as the Government will never be able to meet its spending simply by increasing taxation and borrowing from the market. In fact, the Government spent 20% of its expenditure in 2021 on paying just the interest on public debt alone, and in 2023, this had increased to 25%. Government spending on servicing just the interest on its public debt exceeds its spending on other critical areas such as education and health care. And since the National Debt comprises mostly internal debst and only around 10% is external debt, this speaks volumes on the need to reform our monetary system and monetary theory.
Apart from inflation, the rising public debt, the rising fiscal deficit, the rising amount of taxation, the rising expenditure on interest payments, which all lead to a collapsing currency, there is also the problem of business cycles of booms and busts. When the quantity of money is increased through the debt based system of money creation, there is an economic boom which may be caused by speculative investments, price bubbles created by loans, and general economic activities. But since this money is not permanent, this growth requires a constant flow of new debt. Once commercial debt or public debt is restricted, this economic growth is also constricted, which results in an economic bust. Thus, this system of money creation allows for business cycles of booms and busts. In fact, it allows for manufactured cycles of booms and busts, and manufactured recession.
The last and most critical problem with the current monetary system is that it creates inequality on the basis of access to credit. Why are there corporations that are deemed “too big to fail?” First, these are banks whose loans and NPA’s are so high that if they were to fail, they would fail to make good on their payment of depositors’ money and cause a cash crisis, otherwise known as a run on the bank. This is caused by the minimum reserve system, where only a fraction of the deposits are ever kept as reserves and the rest is loaned out. Then there are also giant corporations that have access to a large amount of the credit that if they were to default on their debt, they would burden the banking system with huge NPA’s, and cause a banking crisis.
If both these banks and corporations were to fail, then it would wipe out a large chunk of the depositors’ money. Our current monetary system puts the security of the citizens’ deposits at the mercy of banks and corporations. Therefore, they cannot fail, and are refinanced, and the cycle continues in perpetuity. Since big corporations and big government are also bedfellows, this leaves the citizens of this Republic as hapless victims of the borrowing habits of the government and corporations. In fact, I have a strong suspicion that Demonetization was done in order to increase deposits in the banking system in order to meet the Modi Government’s capital requirements which were necessary to increase flow of credit and to conform to Basel 3 norms. This may be why ‘no frills accounts’ quickly became minimum balance accounts.
Just as America exports inflation to the rest of the world, big government spending and corporate borrowing is spreading inflation in the country today. But while countries can mitigate the dollar through de-dollarization, Indian citizens cannot circumvent the loss of value of the national currency and the loss of security of their deposits. So, in order to secure the future of this Republic and its citizens, there must be a total revamp of our monetary system and monetary theory.