ONCE UPON A time Mr Macavity, a respected citizen, had a heavily locked vault but nothing else of any value – this is a mythical story but you might notice parallels with modern banks – and people put gold into his vault for safe keeping.

Over time he realised that many of these people seldom withdrew their gold, so he started lending it to others and charging interest on the loans. But these borrowers found that gold was heavy and fell through holes in their pockets, so they were happy to receive chits instead that said “I promise to give the bearer on demand X” – a certain amount of gold.

With this interest Macavity now had a regular income. Instead of asking people to pay him for storing their gold, he paid them a small percentage of its value. So others took gold from under their mattresses and put it in his vault.

Getting bolder, he lent more and signed promissory chits for many times the value of gold in his vault. He grew fat from the interest on these loans.

Seeing Macavity’s girth expand, people realised what was happening and demanded that he be restrained. But by this time trade in the kingdom depended on the promissory chits that were circulating, so the King, who was preoccupied with fighting his neighbours, took the easy option and legalised Macavity’s dodgy practices. What’s more – and Macavity was surprised though delighted at this – the King said that anyone could swap Macavity’s promissory chits for the national currency, the ‘pounds’ that the King himself issued. People now felt happy to place any chits they had saved into Macavity’s vault for safekeeping alongside the original gold.

The King had to tax his citizens in order to build the schools and hospitals they needed and he had to pay the builders upfront before the next year’s revenue came in. He started to act strangely. He could have issued more of his pounds but instead he borrowed the money from Macavity and paid him interest! Muttering in the marketplace was overheard: “Has the King lost his marbles?”

However, in order to provide some restraint, the King said that Macavity must not lend more than ten times the value of the reserves in his vault. Now things really started to get out of hand. Macavity was able to lend and charge interest on ten times the value of gold and promissory chits in his vault. As more interest came in he could lend and charge interest on ten times this additional money as well. He took every opportunity to lend to anyone who came along. His promissory chits multiplied until they far exceeded – by twenty times – the number of the King’s pounds. Yet the citizens were allowed by the King to swap any amount of Macavity’s bits of paper for the King’s real pounds.

The citizens started to get suspicious, “Hey,” they asked, “is what you’re storing for us gold, the King’s pounds or just those bits of paper you printed?” Macavity didn’t answer.

Macavity realised that he was taking a huge risk by issuing so many chits without having the pounds to back them up, so he sold some of them to financial dealers who bundled them up with other kinds of assets and sold these bundles to yet other dealers. It all became so complicated that no-one knew which bundles had risky chits or who would have to fork out if people demanded real money.

Then trade slowed down. Instead of borrowing, people started withdrawing their savings. But they wanted the King’s pounds, not Macavity’s bits of paper. As the pounds ran out people came hammering on Macavity’s door.

The King was caught in a trap because he himself had been responsible for allowing this fat cat of dubious virtue to exploit his citizens. But instead of putting Macavity in prison the King said that he himself would manage the business for a time and honour Macavity’s debts even if this meant more taxes on his citizens. The guarantee meant that Macavity now had an advantage over his rivals, who were also struggling. He was delighted.

THIS STORY IS, of course, about commercial banks: private institutions that have been given the incredible privilege of being allowed to create the country’s money and charge interest on it.

Who makes the money we use? The Mint, you might have said. Wrong. Absolutely wrong! Only 5% is created by the Mint as notes and coins; the remaining 95% is created by commercial banks, and this percentage is rising as electronic cards take over from cash.

Government coins and notes are real and don’t attract interest. But the money created by banks (computer entries are the equivalent of Macavity’s promissory notes) can exist one moment and cease to exist the next. It is virtual money and there is nothing real about it, but it attracts real interest for the bank that issues it. “The modern banking system manufactures money out of nothing,” said Lord Josiah Smith, former Director of the Bank of England. “The process is perhaps the most astounding sleight of hand that was ever invented.”

To understand this virtual money, walk into a bank or building society and ask for a loan. You will get an IOU for the money if you give your house as security. Then, if before leaving you say sorry, you don’t want the loan after all, the manager will tap into his computer, and the money, to the value of the loan that had existed – was ‘in circulation’ – for a few minutes, now no longer exists.

Most of the country’s money is unreal. It is debt. Your debt. Your house on the line. The word ‘mortgage’ means, literally, a death-pledge.

In the real world everything decays. Your clothes rot. Your house needs maintenance. But debt doesn’t conform to the laws of Nature. Debt doesn’t decay. Your investments may crash but your debt increases. Bankers love debt because it grows and they are owed more money each year. And you, not they, have pledged it. This orgy of unreal money, created as debt, now sloshes around the world among the wealthy to the tune of US$2 trillion a day. It is several times the value of goods and services available for exchange. It is a virtual commodity in a fantasy world.

You may have noticed that the bank only creates the original value of a loan. Where does money to pay interest come from?

The economy has to grow. New loans create new money and there is a time lag before this money is paid back. In the meantime it pays the interest on previous loans. Without this money interest could not be paid, banks would not be willing to lend, and the economy would crash. So a stable economy, one without growth, is not possible with the money system we use. Unfortunately, we live on a planet with finite resources. Resources are depleting and our frenetic activity is harming the sky, oceans and land. A growth economy is only sustainable in the fantastical minds of economists, not in the real world. When the economy slows they get alarmed and encourage people to consume what is left at a faster rate.

Commercial banks should be forbidden to create money, just as you and I would go to jail if we were to counterfeit banknotes.

We would, of course, pay banks a fee for handling money, just as we pay other professionals. All the money needed for exchange should be issued free of interest by a central authority that is independent of government, in the way that notes and coins are issued. This would be the first step towards a sane and stable money system. You can guess who rubbishes that idea.

James Bruges is the author of The Big Earth Book.