Through September and into October, I have been discussing the process of how free market action determines what is used as money and how the elite power brokers throughout the world havm slowly taken away the concept of real money (precious metals or other valuable commodities) and replaced it with dishonest or paper money. I think it’s important to understand just how the process or mechanism of paper money creation occurs. I will use the US as our example but there are only relatively minor differences among the many countries throughout the world which use central banking.
All the money which comes from the the Federal Reserve System is not necessarily dishonest but almost all of the honest money eventually is expanded into dishonest money. So let’s begin with the honest portion.
When the government needs funding beyond the amount of taxes it takes in, it offers US Treasury notes or bonds for sale. When these notes and bonds are purchased by private individuals or entities who use savings for the purchase, there is no money creation, only government debt increases. We are aware that many foreigners also purchase the bonds and notes offered by the US Treasury. To the extent that these purchases are the savings of private foreign individuals, again no money creation occurs.
But what happens if there are inadequate private savings or even though the savings may exist, there is not enough desire by private entities to purchase more Treasury bonds or notes? In this case, in accordance with the agreement between the US government and the private banking cartel known as the Federal Reserve Bank (the Fed) which established the Federal Reserve System, the Fed itself will purchase the bonds or notes. In essence, what happens is the US Treasury puts some fancy designs on a piece of paper and calls it a bond or note. A value is established for the bond or note with the US Treasury promising to pay back the face amount plus some amount of interest withing a specified time frame. Typical time frames are 3 months, 6 months, 1 year, 3 years, 10 years and 30 years. The Fed accepts these pieces of paper from the US Treasury and puts them on their books as an asset. In return, the Fed prints up some equally fancy pieces of paper called Federal Reserve Notes (aka dollars) and deposits these in an account at one of the 12 regional Fed banks in the name of the Treasury.
For the Fed, The Treasury bonds or notes are an asset and the dollars deposited in the name of the US Treasury in one of their banks are a liability. But the liabilities and assets are equal and the accounting books balance. For the Treasury, the pieces of paper they printed and sold to the Fed are a liability but the Federal Reserve Notes received from the Fed and deposited in one of the Fed’s banks is an asset. Again the books balance. But it’s clear that this money came from nowhere. It was created simply with the use of a printing press or more likely, with a few key stokes on a computer keyboard. In a later blog, we will discuss more thoroughly the idea of inflation but this process is pure and simple inflation. That is, the money supply has been increased without an increase in either goods or services offered in the markets on which the dollar operates. But actually, we have only witnessed so far the tip of the iceberg.
In both of the scenarios above, in the end, the government has a bank account with one of the Fed banks and there is a sum of money in it. Let’s just for the sake of ease to understand, use round numbers. We will suppose there is $1,000,000 in that account. The government has thousands of projects in which it is spending money. Let’s say that the one million dollars were spent on the reparing of a bridge that collapsed in Minnesota. The contractor who did the work gets this money and puts it in his bank.
Under the fractional reserve rules established by the Fed, this bank can use some of these funds to make loans. This is what fractional reserve banking means. Before the fractional reserve system came into being, banks and savings institutions could only make loans using funds which individuals had placed in long term savings accounts. These savers were not expecting to take their money out from the bank for a long time. They were saving for the future and the bank promised them a return (interest) for leaving it in the bank to use for loans. Both the bank and the individuals savers received a portion of the interest which the bank received for making the loan.
Under the fractional reserve system, the bank is not limited to just long term savings to be used for loans but rather all funds. So lets examine how this works. Going back to that contractor in Minnesota, let’s call his bank A Bank. A Bank now has an extra $1,000,000 on hand. The fractional reserve requirement has been in the range of 10% for many years. So A Bank takes 10% of the $1,000,000 which is $100,000 and places it on deposit with the regional Fed bank and now it has $900,000 available to make loans. A well heeled couple come into the A Bank seeking a loan to build a new house. They are planning a magnificent structure that will cost $1.5 million. They have $600,000 available in cash savings but need an additional $900,000. A Bank just happens to have the funds. After doing the necessary credit check on the couple, A Bank makes the loan. A Bank simply puts the $900,000 in an account in the name of the couple.
The couple already has a contractor. They write a check for $900,000 to the contractor so he can start work and promise to pay the remainder when the job is completed. The contractor takes the check to his bank, B Bank and deposits it in his account. Now B Bank has $900,000 it did not have previously. It takes 10% of that amount, $90,000, and places it on deposit with the local regional Fed back for its fractional reserve requirement. This leaves $810,000 available to make loans.
You can see that we can keep re-iterating this process through a series of loans, additional deposits in banks, subtracting the 10% and so on. Eventually we find that the $1,000,000 deposited in A Bank results in an additional $9,000,000 of money that is nothing but debt. But remember where it came from in the first place. The government either borrowed the original $1,000,000 or simply asked the Fed to create it. Thus we have $10,000,000 of money that was created from nothing and is backed by nothing but debt. This is pretty cool. It seems to me that if one really wants to “make money” in his life time, he should do whatever it takes to become a central banker or simply a high level officer in any bank that is part of the Federal Reserve System.
I wonder if there is a name for a system of interest in which one group of people gets paid for simply creating money from nothing? Thomas Edison summed up the immorality of the system when he said:
People who will not turn a shovel of dirt on the project nor contribute a pound of materials will collect more money…than will the people who will supply all the materials and do all the work.
[ As quoted by Brian L. Bex in The Hidden Hand (Spencer, Indiana: Owen Litho, 1975)]
Let’s consider the purchase of a $200,000 home in which $60,000 represents the cost of the land, architect’s fee, sales commissions, building permits, and so on and that $140,000 is the cost of labor and building materials. If the home buyer puts up $40,000 as a down payment (20%), then $160,000 must be borrowed. If the loan is issued at 7% over a 30-year period, the amount of interest paid will be $223,214. The amount paid to those who loan the money is about 1.6 times greater than that paid to those who provide all the labor and all the materials. It is true that this figure represents the time-value of that money over thirty years and might be justified on the basis that a lender deserves to be compensated for surrendering the use of his capital for half a lifetime. But that assumes the lender actually had something to lend, that he had earned the capital, saved it, and then loaned it for construction of someone else’s house. What are we to think about a lender who did nothing to earn the money, had not saved it, and, in fact, simply created it from nothing? What is the time-value of nothing?
An interesting aspect of creating money from nothing is that as the loan is paid off, money is destroyed or rather simply disappears. Let’s see how this works. The bank creates a note when it leds the money. The note is an asset and the bank notes are a liability. It’s worth noting that the bank notes are not much of a liability because the banks need not redeem the bank notes in anything of value. Remember, this is a fiat money system. The Federal Reserve Notes we use as money are not backed by anything of value. If the depositors at any given bank should become concerned about the credit worthiness of their bank, there are two mechanisms that provide a safety valve.
The first mechanism is the Fed itself. Every bank that is a member of the Fed system (there are very few which are not) is guaranteed to have funds made available to it on extremely short notice. Thus in times past, before the Fed existed, if the depositors in a bank became concerned about the bank’s financial condition, there were “runs” on the bank. Of course, bank notes at that time were worth something because each bank was required to redeem its notes in gold or silver coin. But now our dollars are simply pieces of paper–this is our money. Still, a number of depositors might be concerned about their money. This happened at the Great Northern Bank in England just last year. There were lines running out into the street with individuals trying to get their cash. This might happen because with a fractional reserve system, each bank will have only perhaps 10% of the cash on hand versus claims on that cash. But the Fed provides a system for any bank which might experience this problem. The Fed simply supplies the funds needed to the member bank on a short term basis until the depositors are reassured there is no problem.
The second mechanism is the Federal Deposit Insurance Corporation (FDIC). This is another government agency that insures the accounts of bank depositors. Up until last year, each depositor was guaranteed up to $100,000 in a given bank. During the financial crisis last year, to help ease the concerns of depositors, the government increased this limit to $250,000. The banks all contribute funds to the FDIC so that if a bank should fail each depositor will get all of his money as long as the total does not exceed $250,000. If many banks fail in a short period of time that might put a strain on the FDIC reserve funds, the US government has guaranteed that it will provide the funds necessary. The FDIC plays a role when individual banks mismanages its assets and liabilities. If the bank made too many bad loans and kept these loans on its books, then the FDIC will step in. The FDIC will close the poorly managed bank and transfer the deposit accounts to “supposedly” a more trustworthy bank. The FDIC uses its reserve funds to provide the difference between the bad bank’s assets versus liabilities. So as long as an individual depositor’s funds do not exceed $250,000, his money will simply exist in an account created in his name by the bank named by the FDIC to take over for the failed bank.
But going back to the earlier point that as debts are paid, the money created by the debt disappears. Let’s see how that works. Lets say someone takes out a loan for $10,000 for a year at 9%. The bank simply creates an account or places the money in an existing account in the borrower’s name. The borrower spends the money and the plan is to pay it back at the rate of $909 per month about $80 of which is interest. The note which the bank holds is an asset and the bank notes issued to the borrower are a liability. [As discussed above, it not a real liability because the bank has no real obligation to redeem the loaned out notes with anything of value.]
The borrower starts into his payment plan but he is struggling to make his payments. He decides to take on another part time job to help. The bank wants its floors cleaned and waxed each month and it has an extra $80 coming in each month. The borrower agrees to clean and wax the bank’s floors for $80 per month. So as the borrower makes his monthly payments, the value of the note decreases at the same rate that the liability of the bank notes decreases. The payment of the note in effect extinguishes the dollars created by the debt. But the interest does not just disappear. In effect, the bank bank got its floors cleaned and waxed each month for nothing.
This is the essence of creating money from nothing. By doing almost nothing of any value, the bank was able to get work done on its behalf by the borrower. This is the way the system works. It is a very sophisticated form of serfdom. Because the private bank cartel controls our monetary system, all of us who are forced to use this money are supplying free labor. In the simple example used, the borrower worked directly for the bank. But obviously it does not work this way in normal circumstances. But the net effect is exactly the same. The creator of the money gets the benefit of the exchange value of labor of the borrower.
Ain’t life just grand–for some folks, especially those at the top of the economic barrel.