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Alchemy - Creating Money Out Of Thin Air
Have you ever wondered how money is created?
Most people believe that the government simply prints the money the nation needs and inject this money into the economy. This unfortunately is a very simplistic view and not entirely true.
John Kenneth Galbraith, a renounced economist remarked that “The process by which banks create money is so simple that the mind is repelled”.
For the sake of simplicity, I will describe the basic process of how money is created. The relationship between governments and central banks may differ in different countries but the process is somewhat similar.
This process of creating money is known as the Fractional Reserve Banking system
When a government needs money, it will generally get this money in 2 ways.
- Raise Taxes (existing money)
- Issue government bonds or treasury notes (new money)
Let’s look at how new money is created through government bonds
Let’s say the government wants 10 billion dollars. It will approach the central bank with the request for this money.
The central banks confirm the request and proceed to produce 10 billion dollars of new credit, through a combination of printing more paper currency or simply updating this new credit in their computer system.
The government than prints out a bunch of papers called government or treasury bonds and send them to the central bank to be sold to the open market. These bonds have the total value of 10 billion dollars with a promise to pay interest to the holder of the bonds and then pay the bonds back at cost when they expire. There are government bonds with terms for 5 years, 10 years or even 30 years.
Government bonds are instruments of debts. All money is created and comes into existence because of liability and debt.
So how does the government pay the interest on this debt? Well, by taxing the people or issuing more government bonds, of course.
Because the government can issue more bonds and collect more taxes, they can literally borrow massive amounts of money and place the burden on paying back the loans on future tax payers, for many generations to come.
The 10 billion dollars for these bonds are then deposited from the central bank into a bank account. This is when the fractional reserve banking system performs more of its money making magic.
By law, a certain percentage of deposits (let’s say 10%) has to be kept as reserves but the rest of the money, the other 90% or 9 billion dollars in this case is known as excessive reserve which forms the basis for new loans.
Let’s say someone borrows this 9 billion dollars from the first bank, let call it Bank A. Bank A deposits the 9 billion dollars into Bank B.
Now using the fractional reserve banking generous formula, Bank B is obliged to hold back 10% of the 9 billion dollars as reserve and can lend out the other 90% or 8.1 billion dollars as new loans.
Someone borrows the 8.1 billion dollars and Bank B credits this money into Bank C.
Hey Presto! Now Bank C need to keep 10% of this money and can loan 90% or 7.2 billion dollars out. And the process continues. The table below will give you a visual understanding of how this is happening.
It is estimated that up to 9 times the original amount is created or 90 billion dollars of new money is created on top of the original 10 billion dollars.
Banks can also created money in other ways
Banks can create credit (money) by increasing the limit an existing borrower has, whether it is a mortgage, credit card or personal loan.
Now, an important point to note is that the central bank is the only bank that can legally print the nation’s currency or fiat money.
Because most of this extra money is created electronically, the commercial banks are not breaking any laws.
It is estimated that about 3% of the money today is circulated as hard currency while the rest is simply numbers stored on computer systems.
Criticism of the Fractional Reserve Banking System
Since paper money and even worse, electronic money is not pegged to anything of intrinsic value, such as gold or silver, central banks tend to wreak havoc on an economy by over producing new easy credit by the fractional reserve banking system.
Critics of this system have included mainstream economists like Irving Fisher, one of the earliest American neoclassical economists, Frank Hyneman Knight, founder of the Chicago School, author of the book, Risk, Uncertainty and Profits and Milton Friedman, economic advisor to the former US President Ronald Reagan and recipient of the Nobel Memorial Prize in Economic Sciences.
The fractional reserve banking system is a debt-based or credit-based monetary system which requires the issue of loans from the banking sector or people going into debt in order for any new money to be created. Although there is a constant need to expand the money supply as the economy and population grows, many critics find it problematic and unfair that banks could simply create money out of nothing, with little or no consequences (so far).
This negative feature of modern monetary systems of fractional reserve banking and the government endorsement of fiat currency simply debase the value of the dollar. There is no control or limits imposed on the creation of new credit or the growth of the money supply.
The by products of this flawed monetary system is inflation, unsustainable bubbles in real estate, stocks, commodities and other forms of assets caused by an ever increasing money supply and market speculations.
Around October 2008, the national debt in the United States passed the 10 trillion dollar mark. In March 2011, this debt increased to over 14 trillion dollars and continues to grow each minute.
If we take the population of the US, currently around 310 million people and divide the national debt by the number of people; each US citizen (men, women and child) owes around $45,000. If we only look at current US taxpayers, each of them owes around $128,000. With the graying population and baby boomers retiring en mass in the next decade, this national debt has only one direction and it is UP.
Here’s an interesting link to the US Debt Clock
It does not take a genius to know that if a government or country keeps borrowing or by going into more debt, it will not take long before this debt gets totally out of control and the ability to repay the debt becomes impossible, even the interest payment.
When that happens, the consequences of fiscal policy mismanagement will be dire.
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