Money happens. How does it do that?
John Kenneth Galbraith once said, “The process by which money is created is so simple that the mind is repelled.” And, he was right. How money is created is mind-bogglingly simple, but almost impossible to accept. Here goes:
First weird concept: Money happens because it is loaned. Once it is loaned, it exists. Here’s where we need to get metaphysical. Say, you have $1,000 in your bank account. You go to a bank and you borrow $5,000. Suddenly you “have” $6,000. Money happened.
Conversely, when you pay off that $5,000, the money that “happened” suddenly disappears.
The banking laws allow banks to loan out a large portion of the money they “have on hand” (up to 90% of deposits from their savings customers) to others (borrowers). Banks must also retain a fraction of these deposits in reserve. The process of retention and regulatory oversight is called fractional reserve banking. Don’t worry, or feel stupid or drift off here. This is as technical as this is going to get.
Example of money happening: You walk into a strange town with $1,000 cash, and open an account with a bank for that amount. Now, you have a new asset (your $1,000 bank account) and the bank has a new liability (your $1,000 bank account). Another person goes into the same bank and borrows $400. The bank has your $1,000 so it can loan $400 because that number is well within the 90% rule. The borrower takes that $400 and pays it to his hairdresser. The hairdresser deposits $400 in her bank (could be the same one or a different bank) and now the bank has a fresh $400 to work with, so it gets busy finding a borrower to take out a loan for 90% of that $400, or $360.
The banks finds one and issues another loan, this time for $360, and it gets spent and redeposited in the bank, which then creates a fresh deposit of $360, 90% of which is now available to loan out. So the bank loans out 90% of $360, or $324, and on it goes, until the original $1,000 deposit has metamorphosed into a total of $10,000 (trust me).
Is this all real money? Absolutely. But, because you are smart enough to be following this blog, you will have realized that several things happened here. First, we’ve got $1000 held in reserve by the bank (10%), $10,000 in total in various bank accounts, and $9000 dollars of new debt (90%). The original $1000 is now entirely held in reserve by the bank, but every new dollar, all $9,000, was loaned into existence and is “backed” by an equivalent amount of debt. Now, obviously the actual dollars aren’t the exact same ones that each lender and borrower had their hands on, and the banks could all be different, but the math works just the same.
And, because you are smart, you have probably already figured out that if everyone tried to remove their assets from the bank at once, they wouldn’t be able to do it because the banks had loaned out 90% of all their money. That is what happened in the GREAT DEPRESSION. You also have figured out then, that if one person defaulted on their debt, the banks would be equally screwed when it came time to settle up with everyone. We’ll get to these problems in another post.
Right now, I just want you to get this weird concept of how money is created (sort-of from thin air, yes?)
The next part of this story goes to debt. If money happens, how does debt happen? As you will see from our stupid little example, debt happens because the banks’ entire reason for being, is what they all refer to as a “net-on-funds” business. That is to say, banks make money (net) by borrowing at interest rate “x” and lending it out at interest rate “y”, thus making “z” in profits. First grade algebra, “y-x=z”. Let’s say “y” is 12% (rate they charge borrowers) and “x” is 1.5% (rate they pay to depositors), then the banks net profit is “z” or 10.5% (net-on-funds).
If in our example, if no interest was charged to the borrowers, we could undo the entire string of transactions and everyone would get their original money and go home.
But, instead, banks charge interest on the loans it makes to borrowers, and if at some point all of the depositors wanted to withdraw all of their funds, the banks would not be able to pay them back. Four problems: one, the banks keep 10% in reserve; two, the money is in constant circulation, so the original deposits are not really there; three, people occasionally default on loans, so the value of the original deposits are eroded; and four, the money paid in interest to depositors lags the money collected in interest from borrowers. Amazingly, just like our Federal Government, which is what we’re about to see.
Is it weird enough yet? It gets even weirder, but you will soon see why we have an enormous national debt and why the guys behind the green curtain aren’t worried about it.
As we said at the beginning, Money happens because it is loaned. Once it is loaned, it exists.
The Federal Reserve tells us (as law) that when you or I write a check, there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check (law again) there is no bank deposit on which that check is drawn. Since all Federal Reserve checks are drawn to cover debt, money only happens when it is loaned. These loans are made through the US government, usually to the citizens of the US (or banks too big to fail) and are always backed by US Treasury bonds, which are the means by which the US government borrows money, almost always from foreign governments.
In other words, when your local bank wants to loan money, it must find enough depositors to cover the loan amount. When the Fed wants to loan money, it simply issues bonds which are then purchased by investors, and then the Fed just prints new money. Cool, huh?
All US money is backed by debt and there are really two separate classes of money. The class of money that is loaned at the local bank level from existing deposits, is based on fractional reserve banking principals (90% rule) and must, by law, be backed up by deposits and reserves.
The class of money loaned at the Federal Reserve level, is simply manufactured out of thin air and then exchanged for interest-paying government debt. And infinite debt expansion is a requirement of our banking system, in order for it to continue working. Here’s why:
Congress doesn’t have any money. When it needs money to do whatever, it asks the Fed for it. The Fed doesn’t have any money either (well, no more than a few weeks’ worth of cash at any time), so it needs to print some. The way it does this is by printing bonds. These bonds have a face value and an interest rate. The face value is the amount the Fed will sell the bond for and the interest rate is the amount it will pay annually to the bond-holder.
These bonds are typically sold at auctions where foreign banks purchase them and transfer funds into the US Treasury and from there it can be disbursed for whatever. These bonds are being bought with money that already exists.
The new money, which is created out of thin air, must be loaned each year in sufficient quantities to cover the interest payments on all of the prior outstanding debt.
Say you sold $1000 worth of bonds with an annual interest payment of 7%. Each year, those bonds would be worth $1070. In order to pay that $70, you would need $70 in income from somewhere else. Since you as the issuer, don’t have any real income, you must either issue more bonds or buy back some of the bonds. The only way you could buy back the bonds is by issuing new debt (money you made up from nothing) in exchange for the bonds, which is essentially the same as issuing new bonds. Except that in the case of issuing new debt, you were simply expanding the National Debt and making a bet that the offsetting GDP would act as a governor on GND. Which it usually does, either through actual economic expansion or the issuance of new debt. In the meantime, we make sure that rating agencies like Moody’s and Standard & Poors keep the US bond ratings at AAA. This is never a problem for the same reason that they rated all of the junked up CDOs as AAA right before crash of 2008.
Either way, the guy behind the curtain has two levers. One increases money supply. The other issues new debt. He has a simple valve that he watches. It has a dial that wavers between “Go” and “Stop” depending on which lever he leans on. He simply has to keep the dial in the middle.
The average US citizen has no clue as to how US debt is created or why. He doesn’t understand how all of it works, but he has sort-of a blind trust that when he wakes up tomorrow, everything will be all right.
As long as the global money supply keeps doing its thing, which is to expand perpetually in order to service the amount of debt in the system, which continues to expand as the result of continuous lending necessary to service the prior debt, it will all remain groovy.
You can now see that it is literally impossible to change any of this, and why the process itself is blatantly shielded from rational inspection by keeping it transparent and totally out in the open. I mean, there it is, and who could possibly understand it? Like Galbraith said, it is “mind-numbingly simple.”
And, really frightening.
iPeopleFINANCE 