PCDForum Article #15 Release Date June 1, 1996

by John H. Hotson

An understanding of the true nature of money is essential for those seeking
economic reforms toward the creation of sustainable societies. People today have
more erroneous ideas about money than Victorians had about sex, so please read
the following with care.

Let’s begin with the distinction between "legal tender" money
which only the government or its agency, the Bank of Canada in the case of
Canada, can create, and the "money" created by private banks-and
increasingly by "near banks". If you happen to have a Bank of Canada
note, on it you will read the words "This note is legal tender."

These notes, and checks drawn on the Bank of Canada, are the only legal
money in Canada. What that means is that if you owe someone $20 and you give him
a $20 bill he is paid and if he refuses payment in this form you are absolved of
the debt. By contrast, he does not have to accept your check drawn on a private
bank, or even a certified check of a private bank. Money issued by the Bank of
Canada is sometimes called "Right of Purchase" money to distinguish it
from "Promise to Pay" money created by private banks.

While private banks are in effect creating money out of nothing, they are
providing an important service as their "promise to pay money" is for
many purposes safer and more convenient to use and store than actual cash.
Furthermore, it costs the banks billions of dollars to maintain the payments
system that clears your check back to your account and to keep the necessary
records. All those nice, or not so nice, people who work in those banks,
deciding who gets a loan and what happens if they can’t pay have to be paid
their salaries. Banks also have to pay phone bills, electricity, heat and so on.
What they create is intangible, but at the same time very real. Essentially, the
bank is substituting its promise to pay-which is accepted as money-for your
promise to pay, which is not.

Today only about 4 percent of the money in circulation in Canada is Bank of
Canada legal tender. In other words, 96 percent of our money is created by
private banks. In 1945 the Bank of Canada accounted for 27 percent of our money.
At that time the bank rate of interest was only 1.5 percent and the Canadian
economy boomed.

Some 96 percent of the "money" we are now using is not Bank of
Canada "legal tender," but rather the promise of private banks to pay
the bearer Bank of Canada legal tender on demand. This promise is what a private
bank provides for you when you take out a loan with the promise to repay it with
interest. The bank knows that mostly you don’t want legal tender. What you want
is a checking account or a bank issued check for the amount borrowed so that you
can send the bank’s promise-to-pay to folks you owe money to-folks who also
don’t want legal tender, but do want to deposit your check in their own bank

The money supply of Canada increases at the moment a bank issues you a loan.
As you repay your loan the money supply shrinks. So money is being created and
destroyed every day.

Banking came into existence as a fraud. The fraud was legalized and we’ve
been living with the consequences, both good and bad, ever since. Even so it is
also a great invention-right up there with fire, the wheel, and the steam

In the 16th century as the gold and silver the Spanish had stolen from the
American Indians poured into Europe, coins grew larger, more plentiful and
heavy. Merchants needed a safe place to keep them when they weren’t needed. The
goldsmiths had large safes and fierce dogs and it became customary to leave
coins on "safe deposit" with them. Next people saw that a "gold
certificate" or warehouse receipt signed by the goldsmith was more
convenient to circulate than those heavy coins made of soft metals that quickly
wore out if they passed hand to hand. So the smiths printed up receipts in
convenient denominations promising payment in gold to whomever presented the
receipt. Some people took to writing notes to the smith ordering him to transfer
the ownership of some of their coins to someone else. Thus the personal check
was born.

Then one day one of the smiths had a brilliant, and wholly dishonest, idea.
He noticed that people so much preferred his paper money to its "gold
backing" that the gold in his vault hardly circulated-some of it hadn’t
moved in years. So he thought, "I could print up some extra gold
certificates and lend them out to gain the interest." The idea was
irresistible, and thus banking was born!

Just 300 years ago, in 1694, William Patterson talked King William III into
chartering a private bank with the official sounding title of "The Bank of
England." The King had another war to fight with France’s King Louis XIV
and not much money to pay for it. Being a Dutchman, he was unpopular with the
British Parliament and it balked at voting the needed taxes. The royal credit
was zilch because of his predecessors’ extravagance. What to do?

He jumped at Patterson’s promise to lend him lots of "Bank of England
Notes"-which had little or no gold "backing"-at a reasonable
sounding 3 percent interest. Thus national debt was born.

King William seems never to have asked His Royal Self the obvious question, "Why
the hell should I pay William Patterson interest to print money for me? Why
don’t I get a printing press and print some money myself?" Nor did he
notice that his humble subjects in the Massachusetts Bay Colony, in what would
one day become the United States, had already come to just this solution to
solve a similar problem.

In 1690, the Massachusetts Bay Colony decided to do its bit in King
William’s War by invading Canada. The soldiers were told, "We can’t pay
you, but the French have lots of silver. So beat them out of it and we will pay
you with the spoils." But the French won and the soldiers came back to
Boston sore, mean and unpaid. Necessity being the mother of invention, a bright
Yankee named Benjamin Franklin thought of printing up government "promissory
notes," declaring them "legal tender" and using them to pay the
soldiers. That worked so well that the other colonies copied the idea. From that
day until the American Revolution (1775-1782) there were no banks in the 13
British North American colonies.

By the time of the Revolution, Pennsylvania was the richest place on earth.
Franklin liked to boast that part of the credit was due to the government money
he printed. As he pointed out, the government could spend the money into
circulation for a new bridge or school, then tax the cost back over the useful
life of the project. It could also lend the money to businessmen at 5 percent
interest instead of the 10 percent the British banks charged. Or it could
transfer the money into circulation to take care of widows, orphans and other
unfortunates. Pennsylvania made so much money out of creating money-and selling
off lands stolen from the Indians-that it hardly had to levy any taxes.

When word of this reached Great Britain, the Bank of England decided to
destroy the competition of the colonial money. It got Parliament to forbid the
colonies to produce any more of the stuff and the fat was on the fire. The
Continental Congress met and defied Parliament and the King by issuing its own
currency-the Continental. As Franklin saw it, the attempt of Britain to restrict
the coloniess from issuing paper money was one of the main causes of the

The Continentals paid for most of the cost of the revolution. Since they had
to be overissued, prices rose greatly. Much of the inflation, however, was
caused by massive British counterfeiting of the Continentals. "You
revolting Yankees like paper money? Here! Have lots of it!" So Americans
still have a saying. "Not worth a Continental." After the war banking
came to America.

Some historians have much criticized this method of financing the American
Revolution and held up British practice as a model of "sound finance."
However, as William Hixson shows in his book, Triumph of the Bankers, those
historians have it backwards. According to Hixson, the total cost of the war to
the Americans was about $250 million and much of this was financed by the "Continentals"
and other paper monies. An additional war debt of $56.7 million accumulated some
$70 million in interest before it was all paid off in 1836.

The direct war costs to the British government came to about $500 million.
However, the British financed their side of the war almost entirely with
borrowed money. Since they have never since reduced their national debt below
$500 million, they still owe this money! Assuming a modest average interest rate
of 4 percent, the British taxpayer has by this time paid the British bondholder
over $4 billion in interest on the initial $500 million loan-and is still
paying! Sound finance?

What a pity that King William did not have a Benjamin Franklin to advise
him! What a pity that the wisdom of Franklin was lost and Alexander Hamilton was
able subsequently to charter the Bank of The United States modeled directly on
the Bank of England! What a pity that many historians, like many non-historians,
so badly misunderstand money and banking!

The financial system the world has evolved on the Bank of England model is
not sustainable. It creates nearly all money as debt. Such money only exists as
long as someone is willing and able to pay interest on it. It disappears, wholly
or partially, in recurring financial crises. Such a system requires that new
debt must be created faster than principal and interest payments fall due on old

A sustainable financial system would enable the real economy to be
maintained decade after decade and century after century at its full employment
potential without recurring inflation and recession. By this standard, a
financial system that creates money only through the creation of debt is
inherently unsustainable.

When a bank makes a loan, the principal amount of the loan is added to the
borrower’s bank balance. The borrower, however, has promised to repay the loan
plus interest even though the loan has created only the amount of money required
to repay the principal-but not the amount of the interest. Therefore unless
indebtedness continually grows it is impossible for all loans to be repaid as
they come due. Furthermore, during the life of a loan some of the money will be
saved and re-lent by individual bond purchasers, by savings banks, insurance
companies etc. These loans do not create new money, but they do create debt.
While we use only one mechanism-bank loans-to create money, we use several
mechanisms to create debt, thus making it inevitable that debt will grow faster
than the money with which to pay it. Recurring cycles of inflation, recession,
and depression are a nearly inevitable consequence.

If, in the attempt to arrest the price inflation resulting from an excessive
rate of debt formation, the monetary authorities raise the rate of interest, the
result is likely to be a financial panic. This in turn may result in a sharp
cutback in borrowing. Monetary authorities respond to bail out the system by
increasing bank reserves. Governments may also respond by increasing the public
debt-risking both inflation and growing government deficits.

Governments got into this mess by violating four common sense rules
regarding their fiscal and monetary policies. These rules are:

1. No sovereign government should ever, under any circumstances, give over
democratic control of its money supply to bankers.

2. No sovereign government should ever, under any circumstances, borrow any
money from any private bank.

3. No national, provincial, or local government should borrow foreign money
to increase purchases abroad when there is excessive domestic unemployment.

4. Governments, like businesses, should distinguish between "capital"
and "current" expenditures, and when it is prudent to do so, finance
capital improvements with money the government has created for itself.

A few words about the first three of these rules, as the fourth rule has
been discussed extensively elsewhere.

1. There is persistent pressure from central bankers and academic economists
to free central banks from the obligation to consider the effects of their
actions upon employment and output levels so that they can concentrate on price
stability. This is a very bad idea indeed. Dominated by bankers and economists,
central banks are entirely too prone to give exclusive attention to creditor
interests to the exclusion of worker interests. Amending central bank charters
to give them independence from democratic oversight, or to set up "price
stability" as their only goal would complete their subjection to banker
interests. Canada’s own Mackenzie King said it all, "Without Government
creation of money, talk of sovereignty and democracy is futile."

2. Anyone who understands that banks create the money they lend can see that
it makes no sense for a sovereign government, which can create money at near
zero cost, to borrow money at high cost from a private bank. The fact that most
governments do borrow from private banks is one of the greatest errors of our
times. If a government needs money created to pay for public spending it should
create the money itself through its own bank; or spend the money debt and
interest free as the United States did during the Revolution and again during
the Civil War. If a government does not wish to "monetize" its
deficits during periods of unusual need such as wartime, it should either make
up the deficit with higher taxes or borrow only from the non-bank public-which
cannot create the money it lends to the government.

3. One of the most mistaken ideas, with which Canadians especially are
cursed, is the idea that a country should maintain its interest rates higher
than those of its main trading partners "to attract foreign investment."
To begin with, high interest rates inhibit real investment spending on new
buildings, machinery and equipment by diverting funds to finance government
deficits. Furthermore, the foreign funds attracted to Canada by high interest
rates cannot be spent on Canadian employees and products. They are only useful
for importing foreign goods and making payments on foreign debts. Moreover,
these funds bid up the value of the Canadian dollar in foreign exchange markets,
giving foreign goods a domestic price advantage over similar goods produced in
Canada, while making it harder for Canada to export. Thus the inflow of foreign
funds actually contributes to a "current account deficit" and
depresses the Canadian economy. Those who argue that Canada must borrow on "capital
account" because she has a "current account deficit" have cause
and effect totally reversed. Canada has a current account deficit because
she is borrowing on capital account. What she needs to do is to stop
borrowing, lower interest rates until she stops attracting foreign
funds, and let the Canadian dollar find its own level in the foreign currency

When the Bank of Canada encourages the Canadian government, provinces, and
municipalities to borrow in New York and Tokyo it is a betrayal of Canada. Where
should they borrow when new money is needed for government spending? They should
borrow at the government owned Bank of Canada, paying near zero interest
rates-just sufficient to cover the Bank’s running expenses.

John H. Hotson was professor emeritus of economics
University of Waterloo and executive director of the Committee on Monetary and
Economic Reform (COMER), a Canadian based network of economists working for
economic and monetary reform. This article is based on a series he published in
the October 1994, November 1994, and January 1995 issues of Economic Reform,
the COMER newsletter, Comer Publications, 3284 Yonge St., Suite 500, Toronto,
Ontario, M4N 3M7, fax (416) 486-4674. He gave the PCDForum permission to use
this material only five days before his untimely death on January 21, 1996
following heart surgery.

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