Creation of money, Economic cycles and Central Bank Digital Currency (CBDC)
At the heart of every modern economy lies the financial system, underpinned by one crucial element: money. Through its various roles and functions, money shapes societal structures, fuels economic activities, and even molds political landscapes. In this extensive exploration, we delve into the complex web that intertwines money, debt, credit, and economic cycles, unveiling how these factors shape our economic systems and global politics.
The Creation of Money and the Role of Banks
To grasp the impact of money on our economy, it’s crucial to understand the process of its creation. Commercial banks are pivotal in creating money through their lending activities. When an individual or entity deposits money into a bank, the bank can lend this out. For example, if someone takes out a loan of $500,000, the bank increases its assets (the loan) and liabilities (the deposit) by the same amount. This process (changing the number on the digital ledger on both sides) essentially creates money, illustrating the often-overlooked fact that debt is essentially credit, and vice versa.
The type of money created through this process, known as commercial bank money, makes up about 97% of all money. It exists primarily in digital form, representing a promise or an IOU by the bank to exchange this money for central bank money when required. Central bank money, on the other hand, constitutes roughly 3% of the total money supply. It comes in two forms: physical cash and reserves (also the digital form of money). The difference is central banks can create money at will, while commercial banks need loans to create money.
paper money can only printed by the central bank, such as FED. However, in HK, three commercial banks — HSBC, Bank of China, and Standard Chartered — are authorized to issue their own banknotes.
In this sense, banks serve as more than just intermediaries — they are the major creators of money. The implications of this power, however, can be far-reaching, particularly when coupled with the phenomenon of debt cycles.
Key Concepts
Productivity growth, short-term debt cycle, long-term debt cycle
Transaction: The basic building block of the economic machine. It is a process of credit and money exchange for services, goods, and financial assets. One person’s spending is another one’s income.
Trading: Involves exchanges of credit and money for services, products (goods) and financial assets. Total spending is equal to the quantity of credit and money.
Market: A collection of all buyers and sellers engaged in a transaction for the same commodity (e.g., the wheat market, stock market, oil market), which together constitute the entire economy.
Government: The biggest buyer and seller in the economy. It comprises the central government (tax collection and expenditure) and central bank (controlling money and credit supply via interest rates and money printing).
Credit and Debt: The most crucial and volatile part of the economy. Credit creation occurs when borrowers promise to repay and lenders believe in their promise. This is similar to the concept of banks creating money from loans. As credit is created, it transforms into debt. Debt is an asset to the lender but a liability to the borrower. When the borrower pays interest and principal, the asset and liability vanish, and the transaction is settled.
Long-Term and Short-Term Debt Cycles
The process of money creation is inevitably intertwined with debt. Debt cycles, both long-term and short-term, are vital concepts to grasp when examining the intricacies of economic systems. Short-term debt cycles, often referred to as business cycles, generally last five to eight years and involve a rise in borrowing, followed by increased spending and eventual repayment of loans. Central banks often manage these cycles by adjusting interest rates.
Long-term debt cycles, on the other hand, typically span 50 to 75 years and are more complex. These cycles consist of periods where debts rise faster than incomes, creating debt burdens that become increasingly unsustainable. As these burdens build, central banks often respond by lowering interest rates, which can encourage borrowing and spending and lead to debt bubbles. When these bubbles burst, it results in periods of deleveraging, where borrowers decrease debt levels by selling off assets. This sequence leads to slower economic growth and can even plunge economies into recession.
When the debt burden becomes so large (interest rate > GDP growth) that even low interest rates cannot stimulate borrowing and spending, central banks resort to another tool: quantitative easing. They effectively ‘print’ money, buying financial assets to inject money directly into the economy, aiming to stimulate spending and prevent deflation. However, these actions have their consequences.
Deleveraging solutions
Cut Spending (delfationary): However, this can lead to deflation, causing businesses to cut costs, resulting in less jobs and higher unemployment.
Debt Restructuring (delfationary): This involves reducing payments, extending the repayment period, or lowering interest rates. This helps the lender recover at least some of the owed amount.
Redistributing Wealth (delfationary): This could mean raising taxes or implementing other forms of wealth transfer.
Printing Money (inflationary): Central banks can print money to buy stocks and bonds, boosting the wealth of financial asset holders and making them more credit-worthy. This is an inflationary measure.
The right balance of inflation and deflation results in a “beautiful deleveraging”. If the GDP growth rate is less than the interest rate, more money must be printed to reduce the debt burden
The Perils of Money Printing and Inflation
Printing money, while an effective tool in theory, has considerable downsides. As more money enters circulation without a corresponding increase in goods and services, the value of money diminishes, leading to inflation. In turn, inflation erodes purchasing power, and if left unchecked, it can lead to hyperinflation — a severe and typically accelerating inflation that quickly erodes the real value of the local currency, as seen in cases like Zimbabwe or Venezuela.
Moreover, unchecked money creation and subsequent inflation exacerbate wealth inequality. The wealthy, who often have assets like real estate and stocks that appreciate with inflation, become wealthier. In contrast, the middle and lower classes, who primarily hold cash, see their purchasing power diminish. This growing wealth gap can lead to increased social tension, political extremism, and even social unrest or revolution, as history has shown us.
The Domino Effect of Excessive Money Printing
When the central bank prints too much money, it can set off a chain reaction:
Commercial banks lend too much: With more money supply, commercial banks tend to lend more.
Inflation rises: An increased money supply can lead to inflation, reducing the purchasing power of money.
Interest rates increase: To control inflation, central banks may raise interest rates, making borrowing more expensive.
Cost of living increases: Higher interest rates can raise the cost of mortgages, credit card debt, and other loans, indirectly increasing the cost of living for consumers.
Credit defaults rise: As the cost of borrowing increases, more people may fail to repay their loans, leading to increased credit defaults.
Money shortage and bank runs: An increase in loan defaults could lead to a shortage of money in banks, potentially triggering bank runs.
Financial system risk: If a large number of banks face loan defaults and bank runs, it could pose a risk to the stability of the entire financial system.
By understanding these dynamics, policy makers can manage monetary policy to balance economic growth with financial stability.
The Balance of Debt and Income
The economic system operates on a delicate balance between debt and income. When an economy is robust and growing, businesses and individuals are more inclined to borrow, believing they can repay their debts with increased future income. However, this confidence can lead to excessive borrowing, thereby inflating a debt bubble. When the debt levels become unsustainable relative to income — typically during an economic downturn — the bubble bursts, often causing financial crises.
Key Takeaways for Creating healthy economic cycle
- Avoid letting your debt rise faster than your income to prevent an unmanageable debt burden.
- Don’t allow your income to rise faster than productivity as it could lead to becoming uncompetitive in the long run.
- Always strive to increase your productivity for sustainable economic growth.
Money as a System of Control (CBDC)
Given the broad-reaching implications of money creation and management, it’s fair to characterize money as a system of control. Central banks, by adjusting the money supply and interest rates, essentially influence the ebb and flow of the economy. Furthermore, governments, through fiscal policies and taxation, can determine the distribution of wealth within a society.
The advent of Central Bank Digital Currencies (CBDCs) provides a potent tool for this control system. CBDCs are digital forms of central bank money, aiming to bring the advantages of digital currencies to the realm of traditional money. With the potential to reshape the financial landscape by providing a risk-free, token-based digital representation of a fiat currency, CBDCs can enhance the efficiency of payment systems and potentially allow central banks to monitor and even control transactions. The integration of blockchain technology adds an additional layer of security and transparency.
Advantages of CBDC
The idea behind CBDC is to create a more efficient and controlled system for implementing monetary policy. CBDCs have several potential advantages:
Greater Control: CBDCs can provide the central bank with more direct control over the money supply.
Efficiency: Transactions with CBDCs can be faster and cheaper, as they don’t have to go through commercial banks or other intermediaries. For example, the central banks can just distribute the right amount of money to the target people directly
Programmability: CBDCs can be programmed with specific conditions for use. For example, the money could be programmed to be spent before a specific date or could be designated for spending in specific industries only.
The development and deployment of CBDCs represent a significant shift in the structure of the monetary system and have the potential to redefine how we understand and use money.
Potential Impact of CBDCs on Commercial Banks
The introduction of Central Bank Digital Currencies (CBDCs), like the one piloted in China, can potentially disrupt traditional banking systems. As central banks could directly issue digital money to the public, the role of commercial banks in money creation and distribution may diminish. This disruption may reduce competition in the banking sector, as commercial banks currently vie to offer customers better services, products, and rates. This competition leads to innovation and improved customer service.
However, if commercial banks’ roles are reduced significantly, these pressures would lessen, potentially leading to a decline in innovation and customer-centric services in the banking sector. Also, central banks don’t typically possess the infrastructure or expertise for credit allocation and risk assessment, a crucial function commercial banks perform.
In Conclusion
With all its complexities and implications, money is at the core of our economic system and has significant effects on our societies and global politics. Understanding these complexities — the creation of money by banks, the intricacies of long-term and short-term debt cycles, the implications of money printing and inflation, the role of money as a system of control, the advent of CBDCs, and the balance between debt and income — is crucial for grasping the dynamics of our economic systems.
Our world operates on a delicate balance between these factors. Mismanagement can lead to devastating economic crises, widening wealth gaps, and political upheaval. But with informed policies and responsible economic management, we can use these tools to foster sustainable growth and societal stability. As we navigate the ever-changing economic landscape, understanding these intricate concepts equips us to foresee better and mitigate potential crises, ensuring a more stable and equitable economic future.
Sources:
- Principal — Ray Dalio
- How economic machine works — Ray Dalio
- How money is created — Money XYZ
- The Federal reserve and interest rate — Money XYZ
- Grammarly wording — GPT-4
- The psychology of the money — Morgan House
- Tokeny: Are Banks Missing Out on the Digital Money Revolution?
- China’s Digital Yuan
- Citi: Central banks are only helping the rich — and it ‘isn’t worth the benefit’
- The end of the road, how does money become worthless? https://www.youtube.com/watch?v=Co_tVd9gA2I
