Welcome to Ansar Finance Group

Does Usury form any part of the current Banking system?
Dishonest Goldsmiths and Paper Money
Fractional Reserve Banking
How Do Banks Create Money?
What Gives Money its Value?
Why Do Banks Charge Interest?
Consequences of Not Taking Out Loans
Conclusion
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Does Usury form any part of the current Banking system?

Let's start by asking a question, namely 'Who Creates Money?'

The type of money we know best is a typical national currency in note and coin form. However, far more money exists in the form of electronic entries in bank accounts than in the form of paper notes or metal coins. As for this electronic form of money, many people will be surprised that it is not the government or the the country's central bank that creates most of it, but rather the commercial banks themselves. There is no conspiracy to hide this fact. In his well known economics textbook, David Begg states: "Modern banks create money by granting overdraft facilities in excess of the cash reserves". He adds: "Bank-created deposit money forms by far the most important component of the money supply in modern economies."

This section of the web site attempts to answer the question "Does usury form any part of the current banking and monetary system?" (Ref: The Ecology of Money - Richard Douthwaite)

Dishonest Goldsmiths and Paper Money

So when did the current banking system begin?

This query takes us back to the late Middle Ages when gold and silver coins were the main form of money. During this period, if anyone obtained a large amount of coins (more than they felt safe with) then they would deposit them with the local goldsmith, the only person in the area with a reliable strongroom or safe. The goldsmith would give a receipt in exchange. The oldest surviving British record of money being deposited with a goldsmith is dated 1633.

Initially, depositors called at the goldsmith's to reclaim their coins whenever they wanted to make a payment, but as time went on some of them found it more convenient to transfer the goldsmith's receipts instead. Thus, by 1670, receipts frequently had the words 'or bearer' on them as well as the depositor's name. As coins were heavy and risky to carry around, the new receipts quickly became the preferred method of settling bills.

Fractional Reserve Banking

Shortly afterwards, the goldsmiths would have noticed that they had many coins in their vaults which were never taken out, since it was unlikely that all of a goldsmith's customers would present receipts and demand their coins at once. History doesn't record the name of the first goldsmith who was both smart and dishonest enough to realise that he could make money by lending out a proportion of the coins entrusted to him and charging the borrowers interest in return. Indeed he might not actually have to part with any of the coins at all. If he loaned receipts to the borrowers instead of gold, it would be rare for those who had received such receipts to bring them in and ask for redemption in gold. The goldsmith had to decide how many such receipts he could issue without being caught short if receipt-bearers did actually want to collect coins in exchange. If several receipt-bearers came in a short period, and there wasn't enough gold (or silver) coinage in his safe to meet their requests for repayment, he'd be disgraced and forced out of business.

This piece of sharp practice by a long-dead goldsmith laid the foundations of modern fractional reserve banking, the system under which banks maintain reserves of coins and notes in their vaults worth only a fraction of the cash they would have to provide if all their customers came simultaneously to demand the "money" that they have in the bank, money that they are entitled by law to withdraw. The goldsmith had created purchasing power (in other words, money) by issuing receipts that, in total, involved him in promising to pay out more gold and silver money than he had in his safe. Modern banks create money in the same way, by promising to pay out more paper notes and coins than they possess.

How Do Banks Create Money?

Begg explains how modern banks create money in the following way. He assumes that there are ten banks, each trying to maintain its lending at the point at which the amount of cash held in reserve in its vaults, or with the central bank, is equal to 10% of the amount that its customers could draw out from their accounts.

Imagine an individual goes into the bank and deposits £100 (we'll call the individual Person A); from this £100 deposit only 10% needs to be kept by the bank, the remaining 90% can now be lent out to someone else (we'll call this other someone Person B). Person A still has £100 in their account, but person B now has £90 as well. From out of thin air £90 has been created. But the process doesn't have to stop there. If person B puts the £90 into a bank account also, then the money creation cycle will be repeated once more. Ultimately, if each bank lends 90% of whatever deposit it receives, £900 in new money will be created. And of course £900 of interest-bearing loans will come into existence.

The answer to the question "Who creates money?" is that most of it is created by the commercial banks. Most people find this answer quite staggering. Lord Stamp, a director of the Bank of England, commented in 1937:

"The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented."

What Gives Money Its Value?

The answer to the question is actually our collective faith in money's value. It has been said that faith is the substance of things hoped for and the evidence of things unseen, but in the case of currency, it is even more than that. It is the vital ingredient that transforms paper into gold.

If we all stopped believing that our currency has value, then it would become worthless overnight. We do not accept currency because it features fine works of art or intricately engraved designs or even because it is produced by an official mint. We accept currency because we believe others will accept it from us later, in return for things we might want, and for no other reason.

In simpler terms, if people in general did not believe in the value of money, money would have no real value of itself. No central bank is standing by ready to exchange modern money for something tangible in exchange, as they were in the days when paper currency could be exchanged on demand for a specified weight of gold. Modern money is backed by nothing at all.

Why Do Banks Charge Interest?

The first thing to note is that as bank-created money only exists because people have borrowed it, it will cease to exist if they pay off their loans. This is because when borrowers assemble the funds they need to repay their loans and lodge them with their banks, those funds cease to be available to other people to use for trading unless the bank lends them out again. The money supply therefore contracts. Consequently, people need to take out new loans to maintain the amount of money in circulation.

Banks need to charge interest to make money from the loans. If they don't and the loans are repaid - they make nothing.

When money is deposited into a commercial bank - the bank creates a loan facility. This occurs whether the money is placed in a current or deposit account. If that loan facility is used the bank makes money on the sum lent and increases the money supply. The bank makes money from lending money.

Consequences of Not Taking Out Loans

The current banking system relies on people and businesses taking out loans. However, circumstances could easily arise in which they would not be prepared to do so and the economy could plunge into a depression. For example, suppose a crisis overseas caused exports to fall sharply. As redundancies at home increased and people lost their confidence about their future prospects, they might be unwilling to take out new loans. If debtors tried to repay loans in aggregate, then the amount of money in circulation in the country would fall. Unless 'the velocity of circulation' of money increased (in other words, money moved from hand-to-hand fast enough to compensate for the fact that there was less of it about), then the overall volume of buying and selling in the country would also fall.

Creating money on the basis of debt therefore makes the economic system fundamentally unstable. The system is always balanced on a knife-edge. If bank customers borrow too little, a recession or depression can result. If they borrow too much, inflation and a speculative boom can result.

Central banks therefore try to raise or lower the general level of interest rates so as to manage the level of borrowing within the economy, hoping that it does not fall or rise too quickly. Governments too play their part by instituting social welfare systems and taxation regimes in an attempt to counter the undesirable economic trends. History, however, shows how often these attempts fail. Banking systems and economies around the world have shown a repeated cycle of boom and bust since the interest-bearing monetary system was established.

Conclusion

Does Usury form part of the current banking system? Let's answer this question with a series of other questions and answers:

Question 1 Who Creates Money?
Almost all of it is created by commercial banks.

Question 2 Why do commercial banks create money?
To make profits by charging interest.

Question 3 How do they create money?
By granting loans on which interest is paid. This means that almost all the money in a country exists because someone, somewhere, has gone into debt and is paying interest on it.

Question 4 When do they create money?
Whenever there is a demand for loans at interest rates above that at which they can borrow from depositors or from the central bank.

Question 5 What gives the money its value?
Purely its acceptability to other people. The value is not guaranteed. It is backed by nothing at all.

Question 6 Does Usury form any part of the Banking system?
The current banking system is based on usury. Without this the banking system would completely fail. Click here for an explanation of what would happen if the banks stopped charging interest.