Understanding Money – Part 1: Making Magic

moneyinthehat

Whether we are aware of it or not, the lifeblood of all of our established institutions and society itself is money. Therefore understanding monetary policy is critical to understanding why our lives are the way they are.

Unfortunately, economics is often viewed with confusion and boredom. However, the fact is, the complexity associated with the financial system is pure garbage, designed to conceal one of the most socially paralyzing structures humanity has ever endured.

A number of years ago, the central bank of the United States, the Federal Reserve, produced a document entitled “Modern Money Mechanics”. The introductory paragraph states: “The Purpose of this booklet is to describe the basic process of money creation in a fractional reserve banking system”. It then proceeds to describe this fractional reserve process through various banking terminology. A translation of which goes something like this:

The United States Government decides it needs some money, so it calls up the Federal Reserve, and requests, say, $10 billion. The Fed replies, saying “Sure! we’ll buy $10 billion in government bonds from you.”

So, the government then takes some piece of paper, paints some official looking designs on them, and calls them ‘Treasury Bonds’. Then, it puts a value on these Bonds to the sum of $10 billion dollars, and sends them over to the Fed. In turn, the people at the Fed draw up a bunch of impressive pieces of paper themselves, only this time calling them ‘Federal Reserve Notes’…also designating a value of $10 billion dollars to the set.

The Fed then takes these notes and trades them for the Treasury Bonds. Once this exchange is complete, the government then takes the $10 billion in Federal Reserve Notes and deposits it into a bank account…and upon this deposit, the paper notes officially become ‘legal tender’ money, adding $10 billion to the US money supply. And there it is… $10 billion in new money has been created. [Of course, this example is a generalization, for, in reality, this transaction would occur electronically, with no paper used at all. In fact only 3% of the US money supply exists in physical currency. The other 97% essentially exists in computers alone.]

So, the exchange has been made and now $10 billion sits in a commercial bank account. Here is where it gets really interesting, for as based on the Fractional Reserve practice, that $10 billion deposit instantly becomes part of the bank’s reserves, just as all deposits do. And regarding reserve requirements, as stated in Modern Money Mechanics: “A bank must maintain legally required reserves, equal to a prescribed percentage of its deposits. It then quantifies this by stating “under current regulations, the reserve requirement against most transaction accounts is 10%.”

This means that with a $10 billion deposit, 10% or $1 billion is held as the required reserve, while the other $9 billion is considered an excessive reserve and can be used as the basis for new loans.

Simply enough, right?

Now, it is logical to assume that this $9 billion is literally coming out of the existing $10 billion deposit. However, this is actually not the case. What really happens is that the $9 billion is simply created out of thin air, on top of the existing 10 billion dollar deposit. This is how the money supply is expanded.

This is crucial in understanding this game:

As stated in Modern Money Mechanics: of course, they (the banks) do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes (loan contracts) in exchange for credits (money) to the borrower’s transaction accounts.”. [2]

In other words, the $9 billion can be created out of nothing, simply because there is a demand for such a loan, and there is a $10 billion deposit to satisfy the reserve requirements.

Now, let’s assume that somebody walks into this bank and borrows the available $9 billion. They will then most likely take that money and deposit it into their own bank account. The process then repeats, for that deposit becomes part of the banks reserves, 10% is isolated and in turn 90% of the $9 billion or $8.1 billion is now available as newly created money for more loans. And, of course, that $8.1 can be loaned out and re-deposited creating an additional $7.2 billion…to $6.5 billion.. to $5.9 billion etc…

This deposit-money creation-loan cycle can technically go on to infinity… the average mathematical result [assuming a 10% reserve rate] is that about $90 billion can be created on top of the original $10 billion. In other words, for every deposit that ever occurs in the banking system, about 9 times that amount can be created out of thin air!

The deposit-money creation-loan cycle process can be depicted as follows, assuming a 20% reserve ratio and a $100 initial deposit:

LendingProcess

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio. Take a look at the graph below.

Fractional_reserve_lending

Although no new money was physically created in addition to the initial $10 billion deposit, new commercial bank money is created through loans [aka: debt]. Therefore, all money in the world is essentially debt, for in our financial system money is debt and debt is money.

The more money there is, the more debt there is… the more debt there is, the more money there is.

Take a quick glance at the U.S. money supply and compare it to the U.S. national debt and you’ll find an interesting relationship. It shouldn’t be a surprise to know that the Federal Reserve owns roughly half of all the debt.

This all leads to the next step: Inflation…the silent killer.

The creation of more and more money eventually leads to inflation. In fact, as absurd as it sounds, the entire system is inherently inflationary. Inflation is simply inevitable because it’s built into the system!

In fact, a quick glance at the historical values of the US dollars Vs the money supply, reflects this point definitively, for the inverse relationship is obvious. One dollar in 1913 required $21.60 cents in 2007, to match value…that is a 96% devaluation!

m3-vs-cpi

It’s ironic that according to the Federal Reserve, formulating and executing monetary policy is explained as actions taken “to make sure the purchasing power of the dollar is kept stable over time” [3][4].

The facts just don’t support any of the Fed’s statements. The devaluation of currency can be seen all around the world, not just in the U.S.

Ever notice when people say things like “I remember when $5 would buy you a half a tank of gas” or “I remember when cigarettes where $2 bucks”. Think about it…

So far we have discussed the reality that money is created out of debt, through loans. These loans are based on a bank’s “Reserves” and Reserves are derived from deposits. Through this fractional reserve system, any one deposit can create 9 times its original value, in turn debasing the existing money supply, raising prices in society.

As dysfunctional and backwards as all of this might seem… there is still one thing we have omitted from this equation… and it is this element of the structure which reveals the truly fraudulent nature of the system itself.

Stay tuned for my next article where I will discuss the application of interest.

Thanks for reading,

Understanding Money – Part 2

Notes:

  1. Disclaimer: Most of the information and words used on this article come directly from Zeitgeist: Addendum. I highly recommend watching the movie: http://video.google.com/videoplay?docid=7065205277695921912#
  2. Modern Money Mechanics: http://en.wikisource.org/wiki/File:Modern_Money_Mechanics.pdf
  3. About the Federal Reserve System – The Drawing Board Video: http://www.clevelandfed.org/About_Us/who_we_are/about_the_system/index.cfm
  4. Time Magazine: Person of the Year 2009; How the Federal Reserve Works http://www.time.com/time/specials/packages/article/0,28804,1946375_1947930_1947942,00.html
  5. Federal Reserve Education: http://www.federalreserveeducation.org/
  6. The Federal Reserve – Duties: http://www.investopedia.com/university/thefed/fed2.asp
Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s