The Future of the Financial System


A modern, developed economy’s main problem consists of trying to answer the question of how to distribute surplus goods while maintaining the reproduction mechanism and maximum employment? Put simply, the question is how to give people an opportunity to buy goods and services so that manufacturers of these goods and services make a profit and keep the consumers occupied.

Today, the point at issue is not organizing people in order to produce more. The point is simply how to organize people. Economic growth in a modern society means improvement of social institutions regardless of their economic effect in the form of the volume of produced goods. In the circumstances where people’s basic needs are met, social affairs are not only a production tool, but also the end product.

This concept, despite its obviousness, looks like a paradox, primarily due to the fact that the rich crops yielded by the modern economic system are distributed in favor of a minority of the society. Although the overproduction problem does exist, both inside national economies and globally, there is a huge number of underconsuming people.

The problem is rooted in the disparity of financial resource distribution. Potential consumers have no money to purchase vital goods and services. As for the well-to-do, they have neither the need to spend their money nor the desire to invest it, given the oversupply circumstances where future return on the investment is highly questionable.

Until recently, the problem was solved by stimulating demand with loans. In that case, ownership of the consumed goods was exchanged for the obligation to overcompensate for the investors’ expenses. This model provides people material values for current consumption while saving the money of those unwilling to spend it. More exactly, it creates an illusion of saving.

The macroeconomic effect of the credit financial system consists of outstripping growth in economic entities’ expenses compared to the growth in their income attained through the banking system that creates money by credit emission, as well as through the government that funds its expenses by issuing bonds. This system stimulates the economy to create a new type of income generated from newly created money, which would be impossible under the fixed-money stock conditions.

The system has a natural limit, which is when the amount of accumulated debt becomes so large that nonrefundability of “loans” becomes self-evident. This limit has already been reached, and the current crisis involves rethinking of the old forms that will lead to radical revision of the financial system. And it should be noted that the financial system has reached a level of globalization where no single country is able to reform separately.

Very often changes simply represent acknowledgment of things already existing in popular consciousness and their subsequent formalization as official regulations. The changes in the financial system must be universal and cover all of the world’s important economies. We can suggest three fundamental changes lying ahead:

  • Government debt liabilities will become perpetual and noninterest-bearing debentures and thus will turn into the same form of money as CB liabilities. Money will be issued only by the government, while the banking system will lose its money-issuing privilege. Under the new conditions, growth in money stock will be tied to the fiscal policy. That is, it will consist of a fixed percentage of annual money stock increase directed to government expenditures. In such an environment the issuance of money will be much more transparent and nondiscretionary.
  • The banking system will operate on the full reservation principle so that any balances on clients’ accounts protected by the government are 100 percent covered with money issued by the government. The current measures to separate the commercial and investment banking businesses is symbolically important but just the first part of the way. The commercial banking business also needs to be divided into settlement banking—working on the full reservation principles—and the financial intermediation business. Mortgages and other loans secured by real assets are eventually investments in those assets, and the related risks should have the respective legal form. Investors should assume all the risks related to these assets but not pretend that they have a fixed amount of money and guaranteed interest income. Noncollaterized business loans are eventually some kind of equities and can be returned only if the business generates sufficient cash flows. Again these risks should be explicitly taken by investors rather than hidden behind artificial financial products. Any financial asset that is not money will not be covered by government protection, either expressly or implicitly, and will be saved or generate revenue, depending on how successfully it is managed.
  • Negative real interest rates will be formalized as a direct tax on money (including government debts as a part of money stock). This tax would be charged on money held in the full-reserve banks. The good example of this tax is negative interest rates in marketable US Treasury bill auctions. It means that some investors are ready to buy a USD 1000 bill for USD 1001. This voluntary decision of investors to pay to the US government for the security of their savings supports our conclusion that the full-reserve banking system would be appreciated by the market now and investors would be ready to accept the tax on their money secured by this system. The existing infrastructure provides a technical opportunity to implement this tax, and the existing situation requires it to solve the current dilemma, i.e., the need to stimulate the economy and reduce the budget deficit. It’s better to charge 2 to 3 percent of savings than 20 to 30 percent of income. This is the great shift to the new concept of the taxation. Such a tax is ideal for fulfilling both fiscal and stimulating functions. Funding government expenditures without increasing the money stock prevents inflation at consumer markets and formation of bubbles at capital markets. At the same time, transferring the tax burden to passive savers serves to promote consumption and investment through the change of economic motivation.

The principal drawback of the modern financial system is that it remains on its own principles, in its own spirit, using old “industrial” language, while the world has changed. Economic growth today is not as much about increasing commodity weight as—primarily—development of ties between people that enable them to improve the quality of their lives. The reformed financial system will provide the infrastructure for such development.