Social Credit and Monetary Circuit Theory

The Surprising Similarity between the Work of C H Douglas and Augusto Graziani

Three weeks ago, in The Forgotten Prophet, I began an exploration of the thought of Major C H Douglas. In that first installment, I explored the predicted problems that Douglas foresaw for Western civilization in his day, and noted how accurate many of his predictions had been. In the second installment, The A + B Theorem, I introduced Douglas’s best-known concept, the so-called “Social Credit theorem” or “A + B theorem.” Some “toy” economic models led me to conclude that there might be truth to Douglas’s theorem - but also that there might not be! I ended by asking:

Is [Douglas Social Credit], in fact, a specious theory, nonsensical when applied at the macroeconomic level, merely an illusion created by mistakenly isolating certain aspects of production without seeing the big picture? Is there, in fact, no problem at all - or, perhaps, a different problem altogether?

Now, since writing that second article two weeks ago, I’ve been engaging in contemplations on the tree of COVID-19. This has been my first encounter with Coronavirus; it’s not been a pleasant one. The fortnight of illness did, however, afford me an opportunity to widen my reading on macroeconomics in order to better evaluate Douglas Social Credit theory.

That wider reading has led me to the remarkable conclusion that Douglas Social Credit theory (developed 1919 - 1940) is homologous to a Franco-Italian school of thought known as Monetary Circuity Theory (developed 1984 - present).

Before we proceed into the main body of the article, I want to offer a few caveats. Feel free to skip these if you’re a busy Type A personality who doesn’t have time for such nonsense.

• First, I do not mean for my exploration of Douglas Social Credit and/or Monetary Circuit Theory to necessarily imply endorsement of it. Whenever I’m exploring thinkers, I attempt to do so from their point of view, seeing the world as they see it. I’ve made footnotes about my own personal thoughts where relevant.

• Second, I cannot and do not claim to be an expert on Douglas Social Credit or Monetary Circuit Theory. This is my first encounter with them; the exercise of writing these essays is designed to help me learn.

• Third, because I can present only the most shallow overview of very complex theories in this twitter-like musing, I ask that, should you be tempted to fire repeated first-order criticisms at Douglas Social Credit or Monetary Circuit Theory, that instead you query how those theorists answered the criticism, rather than assume they didn’t even see it. I am writing simplistically on complex topics.

Now, on to the essay!

An Introduction to Monetary Circuit Theory (MCT)

Monetary Circuit Theory (MCT) is a heterodox economic framework that focuses on the central role of money, particularly bank-created credit, in the functioning of capitalist economies.

The foundation of MCT is the idea that money is endogenously created—meaning that it is created within the economy, particularly by the banking system, rather than being imposed from outside (as in traditional monetarist views). Banks do not simply act as intermediaries that move pre-existing money between savers and borrowers. Instead, they create new money when they issue loans, which sets off a circuit of production and consumption.¹

The development of MCT has largely been driven by Italian and French economists, particularly Augusto Graziani, who laid the theoretical groundwork in his book The Monetary Theory of Production - a book that has largely occupied my time while I recovered from COVID!

Graziani argues that in the contemporary capitalist economy, production is financed by bank credit. Money enters the economy through loans, which are used by firms to pay wages. Workers, in turn, use these wages to buy goods and services, completing the monetary circuit. However, this system is inherently fragile: it relies on the continuous creation and circulation of credit, and imbalances can arise that disrupt the circuit and lead to economic crises.

The basic framework of MCT can be broken down into a few key phases:

• Initial Bank Loan (Creation of Money):

  • The circuit begins when firms seek to finance production by borrowing from banks. When a bank issues a loan, it creates money ex nihilo (out of nothing), expanding the money supply. This money is not physical cash but a deposit in the firm’s bank account, allowing the firm to pay wages and purchase inputs necessary for production.

• Payment of Wages and Intermediate Inputs:

  • Firms use the newly created credit to pay wages to workers and to purchase intermediate goods and services from other firms. Workers are crucial because they receive wages, which become the primary source of demand in the economy.

• Consumption and Sales:

  • Workers (a group which broadly includes all recipients of income from businesses) now spend their money on goods and services. This spending allows firms to sell their output. The critical assumption in MCT is that workers’ wages and other forms of income flow back to firms in the form of demand for goods and services. This consumption allows firms to generate revenue.

• Repayment of Bank Loans (Destruction of Money):

  • Firms now use the revenue generated from sales to repay their bank loans. As loans are repaid, the money that was initially created is effectively destroyed, reducing the money supply. The circuit comes to a close once loans have been repaid and firms have cleared their debts.

As we did in our last installment, let’s explore MCT with some “toy economies”.

The First Model

First, let’s consider a very simple model with three economic actors (worker-consumers W, firms F, and banks B), no savings, and no interest.

In the initial bank loan phase, F borrows money M from B. B creates this money from thin air; on its balance sheet it gains an asset (a debt owed to it by F) and a liability (a deposit of funds to F). F, likewise, gains an asset (a deposit of funds from B) and a liability (a debt it owes to F).

F then spends M on the wages, salaries, and other payments it makes to W, the worker-consumers, who in turn create CG, consumer goods. With a quantity of goods CG and a supply of money M available, the price P is M/CG. Therefore, when the worker-consumers spend the M they received, the total cost is P, and they receive all of CG.

F then repays M to B. F’s asset (M) and its liability (owing M to B) is extinguished. Likewise, B’s asset (its debt from F to itself) and liability (M) are extinguished. The circuit is complete. Note that all credit, all debit, and all money has been destroyed at the end of the circuit.

The Second Model

Now let’s consider a more complex model. Now we have workers in the consumer sector Wc; workers in the investment sector Wi; consumer good firms Fc; investment goods firms Fi; and banks B. We will still ignore savings and interest.

In this model, Fi borrows money Mi from B to pay the wages of Wi, thereby creating investment Goods IG. Fi sells these IG goods to Fc.

To get the money to IG, Fc now borrows Mi from B. The sum of money Mi thus passes from Fc to Fi, who pays off the bank loan. At this point, an amount of money Mi is in the hands of Wi.

Fc now borrows Mc from B. It uses Mc to pay the wages of its own workers, Wc. At this point, Fc now owes the bank the total of Mc + Mi. The funds available in the hands of the worker-consumers, Wc + Wi, are also equal to Mc + Mi. The price of the goods P for the consumer goods is now (Mc + Mi) / CG, such that the total sum of money spent by the consumers buys them CG, and returns Mc + Mi to Fc.

Fc now re-pays B for its bank loan and the circuit is complete. Note that although this model is more complex, the circuit ends up essentially identical. The cost of investment goods to consumer good firms is simply the revenue of investment goods firms, and cancels out in the circuit.

The Third Model

Since the first and second model yield the same outcome, we will revert to the simpler first model (with three economic actors). This helps keep the model simple without jeopardizing its utility. In this third model, however, we will assume that the worker-consumers W wish to save some money, S.

In the initial bank loan phase, F borrows money M from B. F then spends M on the wages, salaries, and other payments it makes to W, the worker-consumers, who in turn create CG, consumer goods. With a quantity of goods CG and a supply of money M available, the price P is M/CG.

However, rather than spend all of its wages on consumer goods, W decides to save some of its money in its savings account. Therefore, what the worker-consumers spend is not M, but M-S. And this breaks the circuit!

Why? This brings us to a very important point, perhaps the key point in MCT. In neoclassical economics, banks function as financial intermediaries; they loan out (at some multiplier) deposits. But in monetary Circuit theory, the banks are not financial intermediaries, they are financial manufacturers - the loans they make create the deposits. It is therefore irrelevant to the banks whether W saves its money in the bank or saves it in cash under the bed, because they can create new money regardless. When W saves money, what actually happens is that it is “leaks” from the circuit. It’s the equivalent of hoarding cash in a physical money system.

If F charges P for each CG, then the amount of money required (M/CG) to purchase all of the CG is M. But consumers W are only willing to spend M-S, so the demand is insufficient to purchase all of the goods. F collects M-S. W buys [M-S) / P] goods, and the excess goods rot in warehouses!

If F lowers the price P to [(M-S)/CG], so that it sells all of its inventory, then the sum of money that F receives is M-S. In this case, W still buys [(M-S)/P] goods but since the price is now [(M-S)/CG] this is sufficient to buy all of the goods. F collects M-S.

In either case, though, F has only collected M-S. It has not collected sufficient funds to re-pay the Bank the debt it owes.

In a “real” (as compared to “toy”) economy, where there are many firms competing, the firms will fully account for their cost M that was paid as wages, and therefore charge a price of M/CG for their own goods. Each firm’s owners will expect (or at least hope) that through superior quality, advertising, and distribution that they will earn enough to pay back M to the bank, while the other guys’ firms suffer the losses caused by the leakage. While some firms will be “winners” and others “losers,” in the aggregate, there is not enough money available to firms (M-S) to pay back the loan owned to the bank (M). The result will either be bankruptcies of the firms and write-offs by the banks, or it will be rising levels of debt for the firms. (In an economy with widespread consumer lending, consumer debt can replace some or all of the firm debt; in either case, debt goes up.)

The Fourth Model

We again return to our simple first model, but now we assume that instead of the worker-consumer W saving money, it is the firm F that saves money S - perhaps it wants to set aside a capital reserve for bad times.

In the initial bank loan phase, F borrows money M from B. F then sets aside S for its capital reserve and spends M-S on the wages, salaries, and other payments it makes to W, the worker-consumers, who in turn create CG, consumer goods.

But now F is in quandary. It has only spent M-S on wages. If it prices the goods at [(M-S)/CG], it will only earn back M-S, but it will not have sufficient funds to pay the bank back the sum M. If it prices the goods at M/CG, the consumers still only have M-S to spend, and so it will be left with goods unsold and a debt to the bank of S.

In a “real” economy, where there are many firms competing, the firms will account for the money they have set aside as a cost of doing business, and charge a price of M/CG for their goods. Again each firm’s owners will hope, through superior business acumen, to earn enough to pay back M to the bank, while the other guys’ firms suffer the losses caused by the leakage. But it should be clear that in the aggregate, there is not enough money available to firms (M-S) to pay back the loan owned to the bank (M). Again the result will either be bankruptcies of the firms and write-offs by the banks, or it will be rising levels of debt for the firms and/or worker-consumers.

The Fifth Model

We return to our simple first model, but now we assume that the bank B charges an interest payment R on the money it lends M.

In the initial bank loan phase, F borrows money M from B. However, unlike the prior models, F has received M, but now owes M+R. F nevertheless spends M on the wages, salaries, and other payments it makes to W, the worker-consumers, who in turn create CG, consumer goods.

F is again in a quandary. With a quantity of goods CG and a supply of money M available, the price P that the worker-consumers can pay is only M/CG. However, if F receives M for CG, it will not have enough to pay back its loan because of the interest M + R. The circuit is broken again!

As before, in a “real” economy with many firms competing, the firms will account for the interest payment owed as a cost of doing business, and charge a price of (M+R)/CG for their goods. Again each firm’s owners will hope, through superior business acumen, to earn enough to pay back M+R to the bank, while the other guys’ firms suffer the losses caused by the leakage. But it should be clear that in the aggregate, there is not enough money available to firms (M) to pay back the loan owned to the bank (M+R). Again the result will either be bankruptcies of the firms and write-offs by the banks, or it will be rising levels of debt for the firms and/or worker-consumers.

The Sixth Model

Let’s now make a sixth model. Again, for simplicity, we will ignore the investment good firms and use a one-firm model; the addition of the business-to-business firms adds complexity without adding value. We will also ignore consumer savings, since the same effect is gained by modeling business savings.

• F = firms

• B = banks

• M = money created by banks

• R = interest demanded by banks

• W = wages paid to worker-consumers

• CG = consumer goods created by worker-consumers for firms

• P = price charged for goods

• Sf = savings by firms

In order to pay back its loan to B, F needs to collect M + R. Therefore the price it must charge for its goods must be [(M + R)/CG].

Since F is saving Sf, the amount it pays to worker-consumers, W, is equal to M - Sf. The amount the worker-consumers spend on CG is equal to W. Since W = M - Sf, the amount available to purchase goods, P is, M - Sf. Therefore the price they can afford to pay for goods is [(M - Sf)/CG].

Since M + R > M - Sf, there is not enough effective demand for the goods produced by the system, and the circuit breaks.

Once again, in a “real” economy with many firms competing, the firms will account for the interest payment owed as a cost of doing business, and charge a price of (M + R)/CG for their goods. Again each firm’s owners will hope, through superior business acumen, to earn enough to pay back M + R to the bank, while the other guys’ firms suffer the losses (R + Sf) caused by the leakage. But it should be clear that in the aggregate, there is not enough money available to firms (M) to pay back the loan owned to the bank (M+R). Again the result will either be bankruptcies of the firms and write-offs by the banks, or it will be rising levels of debt for the firms and/or worker consumers

The Sixth Model is Homologous to the A + B Theorem

Let’s now return to Douglas Social Credit and the A + B theorem. Douglas explained the A + B theorem as follows:

A factory or other productive organization has besides its economic function as a producer of goods, a financial aspect — it may be regarded on the one hand as a device for the distribution of purchasing power to individuals, through the media of wages, salaries, and dividends; and on the hand as a manufactory of prices — financial values. From this standpoint its payments may be divided into two groups.

Group A — All payments made to individuals (wages, salaries, and dividends)

Group B — All payments to other organizations (raw materials, bank charges, and other external costs.)

Now the rate of flow of purchasing power to individuals is represented by A, but since all payments go into prices, the rate of flow of prices cannot be less than A plus A. Since A will not purchase A plus B, a proportion of the product of at least equivalent to B must be distributed by a form of purchasing power which is not comprised in the described grouped under A.

Translating this into Monetary Circuit Theory, A (payments to individuals) is homologous to W (payments to worker-consumers) while B (all other payments) is homologous to Sf (savings by the firms) and R (interest payments by firms to the bank).

Douglas’s theorem stated that A + B > A. Given MCT’s formula, W + Sf + R > W. But since W = M - Sf, we can simplify this to M - Sf + Sf + R > M - Sf, which yields M + Sf + R > M.

A + B > A is homologous to M + Sf + R > M; the two theories say the same thing.

Social Credit Theorists Discussing the Monetary Circuit

While in his earlier writing, Douglas devoted much of his earlier analysis of the A + B theorem to issues such as capital depreciation, reserve charges, and so on, by the time he published his 1931 book The Monopoly of Credit, he had begun increasingly to emphasize the central role of debt to the banking system. Today, Douglas scholars put his critique of the banking system at the center of his work.

For instance, Douglas’s most important modern follower is M. Oliver Heydorn, whose book Social Credit Economics is to DSC what Graziani’s Monetary Theory of Production is to MCT. Consider how Heydorn summarizes the A + B theorem in this key passage in the chapter “How does Finance Artificially Limit the Economic Social Credit”:

A truncated way of explaining the A + B theorem, i.e., of explaining why there is a disparity in the rate of flow of prices as compared with the rate of flow of purchasing power, would be to regard the charges to cover the B payment of the last firm in a cycle of production, i.e. those that must be met by consumers, as debts to the banking system…

Such an approach is justified because much production is run on revolving lines of credit, and so, the B payments of the last firm having already been made with borrowed money, all that remains is the necessity of paying that money back before borrowing it again for the next cycle of production… [but] no corresponding credit has been made available from within that cycle of production with which these debts may be met.

“Under modern conditions the present financial system automatically creates debts in excess of the power of the public to liquidate them by its outstanding credits.” [quoting Douglas]

Professors J. M. Pullen and G.O. Smith, writing in the March 1994 UNE Working Papers in Economics, provide further evidence that Douglas Social Credit was an early incarnation of monetary circuit theory. In their article “Major Douglas and the Banks,” Pullen and Smith note:

Douglas argued that… the capitalist system survives because the purchasing power gap is filled by either exports or bank credit. These sources of extra purchasing power supplement the A payments and enable producers to cover their total payments, thus permitting continuity of production. Exports cannot provide a permanent and universal solution for every country, and the closing of the purchasing- power gap must therefore rely, according to Douglas, on bank credit.

Douglas emphasized that banks create credit out of nothing, and do not merely act as intermediaries or pawnbrokers, transferring funds from depositor to borrower. He cited numerous authorities in support of the credit-creation concept. Most frequently cited were the words of the Right Honorable Reginald McKenna, Chairman of the Midland Bank, who said "every bank loan creates a deposit" (see for example, Douglas 1935, p.3). Other authorities included the article on Banking in the Encyclopedia Britannica: "bankers create the means of payment out of nothing" (Douglas 1935); and "Banks lend by creating the means of payment" (see Douglas 1934a, p. 14); 4 and Sir Edward Holden, Managing Director of the London City and Midland Bank: "Bank loans create bank deposits" (see Douglas 1922d, p.7).

He reiterated this credit-creation theme time and time again throughout his writings:

• “Thus, for example, the banking system is a mechanism for actually creating purchasing power.” (Douglas 1934a, p.14)

• “No bank ever paid a dividend in the last hundred years on the process of merely lending that which it took in. There is no possible doubt at all about this thing. I sometimes wonder why it is that certain protagonists - certain defenders of the present banking system - go on arguing about this matter. There is no possible doubt about it.” (Douglas 1934a, p.14)

• ... banks are the only institutions claiming the legal right to monetize the credit of the People to such an extent that they create and issue monetary credits many times in excess of the legal tender money they hold.” (Douglas 1942, p.32).

…[And] he predicted that, because of the banks’ role in creating credit to fill the endemic purchasing-power deficit “ultimately the whole of every country - its industries, its loans, all of its institutions, must mathematically go into the control of the financial institutions.” (Douglas 1935, p.10)

Douglas Social Credit thus cleanly aligns with Monetary Circuit Theory in both its assessment of how the banking system functions (by creating and destroying money) and also in its assessment of what that system implies. The banking system, responsible for creating money, fails to create sufficient money to close the monetary circuit, and causes every consumer and firm to go more and more in debt to the banks.

Monetary Circuit Theorists Discussing the Social Credit Theorem

MCT theorists have actually written quite extensively on what Douglas called the Social Cred Theorem and the A + B Theorem, although they have not called it by that name.

Let’s start with Graziani, the preeminent scholar in the field. In his book he writes:

It is self-evident that since the only money existing in the market is the money that banks have lent to the firms, even in the most favorable case, the firms can only repay in money the principal of their debt and are anyhow unable to pay interest… There seems to be no way out: either a debt equal to the interest payments remains unsatisfied, or interest is paid in kind.

What does it mean for interest to be paid in kind? Graziani explains that it effectively means that

the banks buy equities issued by the firms.

According to Graziani, then, the flow of money available from consumers to firms is insufficient for firms to cover their expenses because of the debt owed to the bank, which means that the debt is written off, the firm borrows more and goes increasingly in debt, or the firm sells itself off to the banks over time. These are exactly the same predictions, and conclusions, that C H Douglas made.

Lous-Philippe Rochon is another monetary circuit theorist. His article The Existence of Profits Within the Monetary Circuit explores what he calls the “paradox of profit.” Rochon explains:

[I]n an endogenous money framework, if firms borrow M from the banking system in order to pay wages and other production costs, how can they recover more money than they first injected into the circuit? [A]t best, firms can only take back what they first injected, such that profits and even the payment of interest on the initial loan seem to be out of the reach of firms. Of course, individual firms can earn profits… but at the macroeconomic level, where does this extra money come from? As Febrero argues, ‘if the maximum amount of money that firms can get is limited to production costs, how can profits (and interest on debt) be monetized?’…

[I]f firms borrow, say, to cover their wage bill, at best, assuming no household savings, they can extract only what they initially injected through the payment of wages… But in order for firms to earn a profit, the market exchange must somehow generate at least [enough] to cover firms’ interest payments on existing debt…

According to Zazzaro, ‘[i]f in an economic system (closed to external exchange) the only money existing is what the banks create in financing production, the amount of money that firms may recover by selling their products is at the most equal to the amount by which they have been financed by banks’.

Is this problem merely a side dish for monetary circuit theory? No, says Rochon - it’s the main course:

This is the central question of the theory of the monetary circuit, and the failure to find a consensus reveals the degree of confusion on this matter. Indeed, it remains probably the only issue on which there is considerable disagreement, at least on the surface… Over the years, many solutions have been proposed from different perspectives…

What are the solutions that Rochon discusses?

The first of these possible solutions relies on ‘opening up’ the circuit, and to include some external injection of money, such as through the existence of state and fiscal policy, or through the existence of a foreign sector…

In the specific circumstance of relying on a government sector, profits depend on the permanent existence of fiscal deficits (that is, governments must adopt expansive fiscal policies and accept deficits in every period of production) or, in the case of an open economy, on a permanent trade surplus…

Rochon acknowledges the insufficiency of this latter solution, because a permanent global trade surplus cannot exist. Someone has to have a surplus of imports, such that the losses to the system then fall on them. Note that this is the same conclusion that Pullen and Smith ascribe to Douglas: “the capitalist system survives because the purchasing power gap is filled by either exports or bank credit…. [but] exports cannot provide a permanent and universal solution for every country.”

A second approach consists of borrowing the profits that firms will be making in advance of the production process and injecting them into circulation; presumably, such profits would be built into wages. This solution has been proposed, among others, by Renaud (2000) and Rossi (2001).

Rochon dismisses this solution because the funds borrowed for the profits will themselves have an interest payment associated with them. Douglas and Heydorn would concur, of course.

A third possible solution consists in assuming the existence of a number of overlapping monetary circuits… The idea is that, in the real world, economies do not operate as neatly as suggested by circuit theory, in the sense that not all firms borrow and reimburse their debt at the same time.

If there are several circuits overlapping each other, then there is always more money being injected at any one time than is being extinguished through the repayment of bank debt, and there is no need to assume that firms borrow profits from banks. It is therefore not a question of how M becomes M’ : firms always borrow M, but since there are many circuits overlapping each other, there is always M’ in existence at any one time.

When Rochon speaks of M’, he is referencing a term or shorthand used by MCT theorists to refer to the amount of money needed to close the circuit, in our terms, the amount M + R + Sf.

This solution “works” but only if the economy continuously grows (and debt grows with it). If in the monetary circuit C1, firms which borrowed M, needs M + R to be repaid, then the additional funds R can only have come into existence if in the successive circuit C2, firms borrowed and spent M + R, and need to repay M + R + R. They in turn can only do this if in circuit C3, firms borrow and spent M + R + R, which in turn means M + R + R + R, and so on.²

This is, of course, precisely the bad outcome that Douglas warns of.

A fourth explanation would see the linearization of production (Febrero, 2008) within the investment-goods sector, that is, dividing it into subsectors, where one subsector would sell capital goods to the consumption-goods sector, the proceeds from which would be used to purchase capital goods from another subsector, and so on. This process is repeated indefinitely. This solution is proposed notably by Lavoie (1987) and Renaud (2000).

Rochon admits that this solution also fails, because “in the end, there would still be a subsector that would be unable to acquire capital goods to produce its own output…. however one chooses to subdivide the investment-goods sector, there seems always to emerge a group of firms in the investment goods sector who cannot fully validate their output in money terms.” Douglas, in his analysis of capital investment, comes to the same conclusion.

Rochon finally concludes:

If we assume that banks only finance wages, then we can show that, at the macroeconomic level, profits cannot exist, as profits in the consumption-goods sector are exactly equal to losses in the investment goods sector. Indeed, firms producing consumption goods earn profits equal to the wages of the firms producing investment goods, whose losses exactly equal the wages paid to their workers. In this simplest version of the circuit model, profits at the macroeconomic level cannot exist, hence the conundrum. The issue is further compounded if we include the interest firms need to pay on their existing loan.

Rochon does go on to discuss some ways MCT might be modified to address this (such as by assuming banks also finance capital goods, or that consumers might finance firms), the material so far suffices to show that MCT theorists stumbled upon the same thing that Douglas did.

Concluding Thoughts on DSC and MCT

The fact that Monetary Circuit Theory (MCT) and Douglas Social Credit (DSC) are homologous does not, of course, mean that either theory is correct. Douglas Social Credit was sharply rejected by mainstream economists as wrong in the 1930s, and Monetary Circuit Theory is sharply rejected by mainstream economists today — and the reasons for which mainstream economists rejected DSC in the 1930s are largely the same as those for which mainstream economists reject MCT today.

Limits of space preclude a deeper discussion of which (if either) school is correct, so instead let’s simply say that if mainstream macroeconomics is correct, then MCT and DSC are necessarily wrong; if MCT and DSC are right, mainstream macroeconomics is necessarily wrong; and if mainstream macroeconomics is wrong, MCT and DSC are possibly right. It’s also possible that MCT is right, and DSC is wrong. There are many other competing theories.

However, the fact that an entire school of contemporary economists has reached conclusions homologous to those of Major Douglas does suggest that DSC is perhaps not as “crackpot” as its 20th century critics would have had us believe.

It seems to me likely that Douglas Social Credit theory died out when it did because it confronted mainstream economic theory at the height of its power without having access to the necessary tools to rebut it. Today, monetary circuit theorists have a lot more scholastic firepower available, among which is an important 2014 empirical study that has proven that banks really do create money out of thin air.³

I believe we must give great credit to Major C H Douglas for his foresighted analysis of the banking system some 85 years in advance of the MCT scholars.

Let’s close out with a few tangential points.

What about the Profit of Individual Firms?

It is important to remember that both Douglas Social Credit and Monetary Circuit Theory are all assessing the economy at the aggregate level. The fact that there is not sufficient money available for businesses to pay off their expenses does not mean that no business earn profit. Quoting Rochon:

At the microeconomic level, profits are not difficult to explain. Indeed, there will always be some firms that will make some level of profits, owing to strong sales, for instance, while other firms will have losses or even declare bankruptcy. As such, firms will compete with each other for household consumption… Some firms will be better able to attract consumers than others…

Profit at the microeconomic level can and does exist regardless of whether the monetary circuit is functioning. Profit at the macroeconomic level only exists if the monetary circuit is either functioning or if debt is growing. MCT and DSC are in agreement on this.

What about the Effect of Consumer Savings?

The astute reader will have noted that in my third “toy” model I took into account the effect of consumer savings on the monetary circuit, whereas in the later models (fourth - sixth) I ignored consumer savings. This should not be construed to mean, however, that addressing consumer savings would change the outcome, nor to mean that Douglas didn’t understand the effect of savings. As M. Oliver Heydorn writes in Social Credit Economics,

The effect which savings have on the gap between final prices and incomes must also be included in any attempt to gauge the full extent of the underlying deficiency of consumer incomes. As the saving of consumer income simply involves a diversion of a proportion of the A payments from their proper end and not a lessening of the rate of flow of A payments in and of themselves, the overall effect of monetary saving acts as an extrinsically exacerbating influence on the disparity in rates…

Thus, Douglas Social Credit and Monetary Circuit Theory are in complete agreement as to the effect of consumer savings on the monetary circuit.

What about the Velocity of Money?

One of the criticisms that mainstream economists (including neoclassicals of both Keynesian and Monetarist bent) make of Douglas Social Credit and Monetary Circuit Theory is that it ignores the velocity of money.

In mainstream economics, banks do not primarily create and destroy money; they primarily mediate the traffic of exogenous money through the economy, secondarily creating new money when existing money is deposited with them. If mainstream theory is correct, then money changes hands many times without ever being destroyed, e.g. it has velocity. It is the velocity of money that makes it possible for it to be both saved and spent, used for both wages and interest, and so on.

In contrast, the version of MCT I have presented in this essay argues that money is never “passed along;” it is always created and destroyed during each cycle. Mainstream economists are allegedly mistaken when they believe that money is circulating at a velocity through the economy, because what’s actually happen is that old money is being destroyed and more new money is being created, with more debt to go with it.

So who is right? Well, one of the world’s leading heterodox economists, Steven Keen, recently wrote an essay entitled “The Dynamics of the Monetary Circuit” where he answered that question. Keen, while a monetary circuit theorist, believes that MCT has gotten it wrong when it argues that money is destroyed by the repayment of debt:

The argument that repaying debt destroys money – and therefore that debt is, in effect, ‘negative money’ – is commonplace in the endogenous-money literature, with writers routinely surmising that money is destroyed when debt is repaid:

• As soon as firms repay their debt to the banks, the money initially created is destroyed. (Graziani, 1989, p. 5)

• If debts are to banks, then the payments which fulfill commitments on debts destroy ‘money’. In a normally functioning capitalist economy, in which money is mainly debts to banks, money is constantly being created and destroyed. (Minsky, 1980, p. 506)

This implies that money used to repay a debt goes into a debt account, and negates the equivalent sum of debt. While this is intuitively appealing, we believe that it is a fundamental misspecification of the nature of debt.

First, one of the essential differences between commodities and money is that the former are destroyed – or at least depreciated – in use, whereas money does not depreciate by use. To treat money as effectively indestructible when used in transactions, and yet destroyed when used to repay debt, is incongruous.

Secondly, though the apt framework for considering the models below is a purely electronic payments system, consider, as a thought experiment, a pure credit banking system using an entirely paper money, and issuing its own notes as money. If a debt to a bank were repaid, would it make sense for the bank to duly destroy the returned notes? Of course not: the bank would instead record that the outstanding debt has been reduced, and store the returned notes in its vault, ready for relending…

[I]f money is not destroyed when debt is repaid, but instead stored as an asset of the bank, then… they can be relent at the rate mR · BV, enabling a constant level of economic activity to be maintained from a single injection of money…

Keen then goes on to show, in a complex mathematical model, that firms can sell their goods, earn a profit, and repay interest, without encountering the sort of problems Graziani and Douglas predict.

Most adherents to Monetary Circuit Theory disagree with Keen, but since he is an economist of surpassing excellence, I shall not be so foolish as to do the same. Instead I shall end my essay by neither agreeing nor disagreeing with him, merely contemplating it all on the Tree of Woe.⁴

Further Reading

I refer readers interested in learning more about Douglas Social Credit and Monetary Circuit Theory to the following works, which I found fruitful in writing this essay series.

• C.H. Douglas, Credit-Power and Democracy (1920)

• C.H. Douglas, Economic Democracy (1920)

• C.H. Douglas, The Monopoly of Credit (1931)

• Augusto Graziani, The Monetary Theory of Production (1984)

• Richard Arena and Neri Salvadori, Money Credit and the Role of the State: Essays in Honor of August Graziani (2004)

• J. Ponsot and S. Rossi, The Political Economy of Monetary Circuits (2009)

• M. Oliver Heydorn, Social Credit Economics (2014)

1. Those of you who have read my prior work on the petrodollar will remember the argument I made there that the banking system creates money out of thin air. I was not at the time familiar with monetary circuit theory as such, but nothing I wrote in Running on Empty is incompatible with MCT.

2. Environmentalists who propose “sustainable economics” (e.g. “red greens”) frequently criticize capitalism for allegedly “requiring” constant growth. In fact, these “sustainability” advocates are actually just criticizing the particular solution (growth in the monetary circuit) our economy has adapted to the problem of insufficient money to repay debt created by our particular banking system. Steady-state circular flow economies are possible under other banking systems.

3. I refer here of course to the seminal 2014 paper “Can Banks Individually Create Money Out of Nothing?” This paper presented the first empirical evidence in the history of banking on the question of whether banks really do create money out of nothing:

Three hypotheses are recognized in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, ‘out of thin air’.

This paper was the primary reason I became persuaded that the financial intermediary theory of banking was wrong. I cited it several times while writing Running Without Empty and elsewhere. While I am not entirely confident that MCT or DSC are totally correct, I am quite certain that mainstream economics is very wrong about how banks work.

4. The answer to the question “Is money transported by the banking system when a transaction occurs, or is money destroyed and created out of thin air?” is perhaps the same as the answer to this question: “Is Captain Kirk transported when he beams on to the Enterprise, or is he destroyed and a new Captain Kirk recreated out of thin air?”