Transcending False Dilemmas with Living Income Guaranteed – Part 3 – Tools of Intervention

This post is a continuation to the blog-posts:

Transcending False Dilemmas with Living Income Guaranteed – Part 1
Transcending False Dilemmas with Living Income Guaranteed – Part 2 – Sustainability vs Full Employment

Please read them first for context.




Example 2

‘The government has two kinds of policy at its disposal to correct market failures: fiscal policy and monetary policy – not using these policies means letting the free market dictate economic conditions.’

Most economists have come to accept that the free market is the ideal way of conducting economic activity – let market forces dictate prices and output and don’t try to control these forces, because they eventually create the best outcome for everyone. Most economists, however, have also come to accept that there are certain situations in which intervention is called for – to correct market failures and inefficiencies. Looking at only the national economy – the ways in which intervention happens, apart from declaring laws that set standards, minimum or maximum requirements, quotas, etc. – fall under the categories of either fiscal policy or monetary policy.

Fiscal policy refers to those policies that have to do with tax collection and government spending. In overly simplistic terms: if the government sees it is needed to increase output and income/employment – it can implement expansionary fiscal policy through reducing taxation and/or increasing government spending.

Monetary policy refers to those policies that have to do with the rate at which money is released into the economy. Here the government has no authority, it is the central bank in each country that influence interest rates to either contract or expand the economy.

Both kinds of policies, when used to achieve a certain goal, always have certain drawbacks in other areas. In other words, the usefulness of their application is always limited by the nature of the free market principles – where their use becomes a careful balancing of adjustments here and there to ‘kind of’ have ‘some’ movement in a certain desirable direction.

Problems such as poverty, deprivation, insufficient incomes and job insecurity, to name but a few, cannot be tackled directly from within this economic paradigm – to do so with the use of fiscal and monetary policies would in most countries require substantial interventions – and create substantial drawbacks, crippling the economy in other areas, and over time, undoing its own efforts. So – what can we do? This is just how it is, right? This is just the nature of economics, right? ‘Sorry for those fellas struggling to survive, but there’s really not that much we can do for you. Sure, in theory you have certain basic human rights, but looks like it’s just not gonna happen.’ In brutal terms, that is the attitude that has been adopted when it comes to our economies and the intertwined question of human rights.

At the Equal Life Foundation, we take the guaranteeing of human rights very seriously – in our view, they are not optional and they should not be seen as variables that are dependent on the grace of market forces that may or may not grant these rights at some points in time. Seeing that the conventional paradigm and available policies lack the capacity to ensure these rights, it became clear that it was necessary to step outside of this paradigm and dare to look for alternative measures that CAN guarantee human rights, yet won’t result in the crippling and destabilizing of the whole of the economy.

Providing a Living Income to those who are unemployed or retired through the profits of companies that are considered human rights companies and national resources companies is exactly such a measure. It’s not a fiscal policy, because it is not funded through taxation and it’s not a monetary policy, because it is not funded through printing more money. Fascinatingly – if a measure is none of those two – and it’s not purely free market… ‘well… well… then… it has to be communistic!’ Lol. Yet, it’s not communistic, because the economy will still operate according to free market principles, there will be no centralization of ownership – there will be decentralization – and the role for government would become smaller than it is now.

For more information about Living Income Guaranteed,
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Day 78: Monetary Policy - Part 1

Now that we know what is involved with the supply for money and the demand for money - let's have a look at one of the policies used to influence the money supply in a certain economy.

Note that there are several policies, but we limit the discussion here to the accommodation policy.

Accommodation policy

In The Demand for Money - Part 1 it was mentioned how the interest rate will influence the demand for money. If the interest rate goes up - and thus, loans become more expensive - the demand for money will go down and, in turn, the supply of money will go down as well. Why do I say that the supply of money will go down if the demand for money goes down? Because money is mostly created through loans and loans are only created when there is a demand for it. We therefore speak of a 'demand-determined money supply'.

If the interest rate of individual banks has such an influence on the money supply - then what influences the interest rate? What influences the interest rate is the repo-rate.

The repo-rate

What is the repo-rate?

When banks are having liquidity problems - meaning: they don't have enough cash - they will usually borrow funds from other banks on 'the interbank market'. However, if all the banks are simultaneously experiencing liquidity problems, they turn to the central bank. We say that the central bank acts as 'lender of last resort'. Borrowing from the central bank is done by means of repurchase agreements. A repurchase agreement is the sale of securities together with an agreement that the seller will buy the securities back after a specified period of time - for instance, 7 days. So, in terms of banks requiring liquidity: they will sell securities to the central bank - with the money obtained from the sale, the individual banks relieve their liquidity shortage. However, the indivudal banks must agree to repurchase those same securities from the central bank after, for instance, 7 days. You can see that repurchase agreements are in essence the same thing as a loan - where money is given to the individual banks (in exchange for securities) and the individual banks have to pay this money back after a specific amount of time (after which they also get back their securities).

Now - in the same way as individual banks charge a 'fee' for their lending services by charging interest, so does the central bank make use of the repo-rate. The repo-rate is basically the interest rate that the central bank uses. It means that the amount at which the individual banks repurchase the securities from the central bank, will be higher than the initial amount. And this higher amount is determined by the repo-rate.

So - what does the repo-rate have to do with the money supply?

Well - we're dealing with a domino-effect. If the repo-rate is high, it means that it costs a lot for individual banks to get funds.
If banks are faced with higher costs, they will 'pass the cost down' to their clients, by making their interest rates higher as well. And if the interest rate is higher, the demand for money will go down, as it becomes less interesting for individuals to get a loan at a bank, knowing it will cost more to pay the loan back.

On the other hand - if the repo-rate goes down, individual banks can afford to lower their interest rate as well and will do so to become more competitive. With lower interest rates, the demand for money will go up, and thus also the supply for money, because it is more interesting to take out a loan at a low cost (low interest rate) than at a high cost (high interest rate).

So - the accommodation policy refers to the decision of the central bank to make the repo-rate higher or lower. Because - if the repo-rate changes, other interest rates will follow and if the interest rate changes, the amount of money in circulation changes.

For instance, if the central bank wishes to avoid inflation - it can raise its repo-rate, which in turn raises interest rates, which will refrain people from taking out loans and increasing the money supply to a point where all prices increase and keep on increasing.

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Day 71: The Money Supply - Part 1

What is 'Money Supply'?

The money supply refers to the liquid assets that are held by individuals - it includes coins, notes and demand deposits (cheque accounts). What notes and coins are is clear - but what are demand deposits? If you have a cheque account in which money was deposited - the bank has to pay out deposits in cash on demand, or has to transfer it immediately on demand to another bank or account holder. So - demand deposits - the money in your cheque accounts, is as good as notes due to immediacy with which the money becomes available. The money supply, in simple terms, refers to all the money that is in circulation in an economy, that is available to individuals to purchase goods or services with.

Why does it matter how much money is in circulation?

The amount of money available in circulation has an influence on the prices of goods and services. Remember the following from the blog-post 'Inflation - Part 1':

"In other words - whenever the amount of money in circulation increases in an economy, the prices will go up. Check: the more money is available in an economy, the less it is worth, which is reflected in higher prices - because with the same amount of money in your pocket, you can now purchase less stuff, which means that your money is not worth as much as it used to anymore."

If the money supply keeps on increasing - so will prices - and the result will be inflation. Why?

Because - more money in circulation means more money available to people to buy goods and services with. In other words: the demand for goods and services goes up. If the demand for goods and services goes up (more people are willing and able to buy goods and services), so do their prices.

What factors influence the Money Supply?

1. Banks

The supply of money can be increased by increasing either the amount of notes, coins or demand deposits. Banks play a crucial role within the latter: banks have the ability to create money by increasing the amount of demand deposits.

The question, then, is:

How are demand deposits created?

Firstly: if a person deposits, for instance, $100 in banknotes with a bank, the bank will in return give the person a cheque book, which will give the person the right to write out cheques to the value of $100.

Secondly - and more importantly: Banks noticed that the demand deposits held by them were never all claimed/withdrawn at the same time. They would always have demand deposits 'laying around'. They figured that, instead of leaving the money to collect dust, they could lend this money to other people and charge interest on the loan. This means: the bank would give money to people who hadn't put money in the bank beforehand.

In the First case, nothing actually happened to the money supply: $100 was deposited into a bank - and thus removed out of circulation. This means the money supply decreased by $100. However, the bank issued a cheque book of the value of $100, thereby again increasing the money supply by $100. The money supply before the creation of the demand deposit is thus the same as afterwards.

In the Second case, however, the money supply does change. Using the same amount as an example: Someone deposits $100 into a bank. The bank issues a cheque book of $100 - the money supply balances out. However, of the $100 deposited, the bank decides to lend out $80 to someone who needs and seems creditworhty enough (showing the capability to pay back loans). Now the money supply has increased with $80. At first there was just one person with $100 in their pocket, after the bank did its magic: there was one person with a $100 cheque book and another person with $80 of credit.

Is there a limit to the amount of money a bank can create?

Although small, there are limitations to the amount of money a bank can create.

At any time, a bank must have sufficient cash reserves to be able to provide for cash withdrawals. Secondly, a bank must be able to provide for claims of other banks. What does this mean?

Remember our example of someone bringing in $100 in his bank and receiving a cheque book of the value of $100. If this person writes a cheque of $100 to his landlord, the landlord will go to his bank to cash the cheque and receive $100 for it. The thing is that the landlord's bank and the bank of the person who wrote the cheque, are not necessarily the same one. A bank must therefore always make sure that it is able to provide for the claims of other banks.

Individual banks don't decide how big a percentage of received deposits they keep aside in the form of cash reserves - this is the job of the monetary authorities: the central banks.

Let's say that the central bank dictates that at all times a bank is obliged to hold 2.5% of their total demand deposits in the form of cash resrves. We say that 2.5% or 0.025 is the 'cash reserve ratio'.

Taking again our example of someone depositing $100 at his bank - what implication does a cash reserve ratio of 2.5% have in terms of limiting the bank's ability to increase the money supply?

Firstly - consider what would happen without there being a cash reserve requirement:

Step 1: A person (Person A) deposits $100 at the bank and receives a cheque book of the value of $100.
--------> Money Supply: Nothing changed
Step 2: The bank lends out the $100 that was deposited to someone else (Person B).
--------> Money Supply: + $100.
Step 3: Person B deposits the $100 at his bank and receives a cheque book of the value of $100.
--------> Money Supply: still + $100.
Step 4: The bank lends the deposit Person B made and lends it out to Person C.
--------> Money Supply: + $200.

As you can see - the process could just keep on repeating itself until an endless amount of money is created.

What happens then in case of there being a cash reserve ratio of 2.5%?

Step 1: A person (Person A) deposits $100 at the bank and receives a cheque book of the value of $100.
--------> Money Supply: Nothing changed
Step 2: The bank keeps $2.5 dollars in reserve and lends out $97.5 to someone else (Person B).
--------> Money Supply: + $97.5
Step 3: Person B deposits $97.5 at his bank and receives a cheque book of the value of $97.5 in exchange.
--------> Money Supply: still sitting at +$97.5
Step 4: Bank keeps 2.5% of Person B's deposit in the form of cash reserves ($2.44) and lends out $95.06 to Person C.
--------> Money Supply: + $192.56

As you can see, with each deposit, the amount a bank can lend out decreases in comparison to the initial amount of $100. There is thus a limit to the amount of money that can be created this way. We can actually calculate how much money will be in circulation if this process is continued until there is nothing more to lend:

$100 * 1/0.025 = $100 * 40 = $4000

The initial $100 that was in circulation, the fractional reserve banking system (which is what this banking system is called) can turn into $4000 in circulation.


We continue on the subject of the money supply within the next blog.

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