People say money can’t buy happiness; others vehemently disagree. Still others say there’s more to being rich than money itself. What there is no denying, however, is that money will, for sure, relieve the financial strain many of us feel on a day to day. And since these financial strains constitute most problems in our world today, then I think undermining the importance of money will be, maybe, not a wise thing to do.
Since our childhood we’ve been told that money is a very hard thing to come by and we should study half of our lives and work the rest of it to find it.
But where does this money come from? Who makes it? We all know that our employers don’t and neither does the company that they work for. This is a subject that I usually wonder why is not taught in schools. But when I came to learn this mysterious subject I suddenly understood why. That time that people will understand where money comes from then they’ll lose their trust in it. “It is well enough that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning” Henry Ford
But what is money? Now, I don’t want you to confuse money and currency. The history of money can be dated back to ancient Egypt, roughly 5000 years ago, where they’d exchange products for pieces of gold and silver as their predominant form of currency, but it was not yet money. The pieces of silver and gold that they were using were of odd sizes, weight and purity, which means it was not yet interchangeable; where each unit is the same as the next, which means that nothing really had a price yet. Trade was still a guessing game.
Now what is currency; currency is
- a medium of exchange
- a unit of account
- it’s portable
- it’s durable
- and it’s fungible
money on the other hand is all of these things plus a store of value over a long period of time. The optimum form of money is the precious metals; gold and silver.
GOLD AND SILVER
The reason as to why gold and silver are the optimum form of money is because of their properties. It is an easy medium of exchange because they store a large amount of value is a small area.
They are a unit of account because pure gold has the same value all over the planet.
It’s durable; the same gold that Egyptians used to trade 5000 years ago is still there today, it does not corrode.
It’s portable
It’s fungible; pure gold is the same wherever it is on earth i.e., it can be used to buy the same thing wherever you are on earth.
And lastly; it’s limited in quantity, that’s the reason it has maintained its value because a certain government cannot print gold. Over the last 5000 years only gold and silver have maintained their purchasing power. There have been thousands of fiat currency but they’ve all gone to zero.
What is Fiat currency you may ask.
Fiat currency
Fiat is a Latin word that means an authoritative order or an official decree.
Therefore, a fiat currency is a currency that exists at the dictate or fiat by the government. The paper money is printed then they give it a fiat designation which makes it official. Simply put, the government says this is money, and so it is. Fiat currencies are all unbacked by gold or silver.
When Addison Wiggin took over at the Daily Reckoning, Bill Bonner asked him to catalogue all of the fiat currencies throughout history and what happened to each one of them. Addison dutifully went to work, within a short period of time he had gone through the alphabet, all the fiat currencies starting with later A and halfway through B had all gone to zero, and there were 600 of them. So, in short no fiat currency has ever survived.
Winston Churchill once said that the further you look into the past the further that you can see into the future. And as we have seen no fiat currency has survived in the past and I think the currency today are no exception. The currency that are circulating in the world today are all fiat currencies.
We’ll use the dollar as an example as it is the reserve currency all over the world. The dollar has lost 95% of its purchasing power since the creation of the Federal Reserve in 1913.
Before world war I, each note that the treasury issued would say that they had been deposited with the United States Treasury, x dollars in gold coin payable to the bearer upon demand. The money was in the vault. The currency that they gave was a claim check. So, the currency that circulated was the paper U.S. dollars and they were claim checks on money in the vault.
When the post-World War II system was created, called the Bretton wood system, all the U.S, dollar was backed by and exchangeable for gold. A by-product of this was that currencies used to be stable in relation to each other. Unfortunately, in an attempt to curb deflation, as there was not enough money in circulation, and the government needed to ensure more gold in order to print more money, and also to prevent foreign nations from overburdening the system by redeeming their dollars for gold, the then president Nixon took the dollar off the gold standard. Since then, the dollar has been floating and since it is the reserve currency then it means all currencies are backed by nothing tangible and rather by faith in the U.S. government!
The consequence of this action is inflation, every time they print money, they dilute the currency. And since the dollar is the reserve currency, every time the Fed prints money, they dilute other countries’ currencies. Some countries like China and Russia have noticed this, and in reaction to the money printing, they have been selling their dollar reserves and buying gold over the same period.
Some of you might be asking, if the currency is backed by nothing how is it that you are able to pay for anything. Well, the whole economic system is running because it is backed by faith. Faith that the currency is worth something and you can exchange it for goods or services. Truth be told, part of that faith is ignorance, not many people know where that money comes from.
So where does this money come from? How is it created? And who’s going to pay it back? Here we’ll explore the three ways money is created.
Physical Money by the Government
The first type of money is physical money created by the government. This is outsourced to the central bank royal mint and controlled by the government. It comes in two ways either paper money or coins. This type of money constitutes only a fraction of the total economy, and in many economies, this physical money only makes up about 3-8%. The government creates this type of money in order to meet the obligation of private banks. When you go to an ATM to withdraw cash, banks need to make sure that they have the money.
When creating the physical money, the government incurs profit. Let’s take a ten dollar note for example; it costs approximately 3 cents to ‘print’ it. Which means there is a $9.97 profit. This type of revenue is called seigniorage. This income reduces government debt and taxpayer’s burden. But the government won’t keep printing money continuously because then they’ll be risking inflation.
Private Banks & Debt Based Money
Vast amount of money is created this way. In most developed economies it makes about 97% of the total economy, hence most money is privatized.
Bankers managed to persuade law makers to allow them to create money after many earlier bank runs. A bank run is an occasion where depositors try to get their money out at once. They argued that they should be allowed to create more deposits than actually exists based upon debt.
But this idea of debt-based money actually started earlier than that, the English bankers set the stage for banks being the creator of money. In 1704, the English parliament passed the promissory notes act. A promissory note was a written promise to say that you will pay back, say, $20 that you borrowed. Under the law that paper was as good as $20. Banks were authorized to circulate this note as money, hence, they were able to create and destroy money they rented out with interest.
In the modern world the whole economy is based upon these promises. It has been modernized as a number in a computer and called debt.
When you go to a bank to borrow money, the banking license gives that bank the ability to create money through a double accounting system. If you borrow, say, $200k for a car, the bank creates a 200k account, and you have 200k in debt. This 200k enters the wider economy because the owner of the car will use the 200k created by the bank and received from you to buy other things. This means if we want more economic growth, we need more debt. The next time you hear someone say we are in a debt-based economy, this is what they mean.
The beneficiary of this money is the bank, because they make profit through the interest charged. Later when repaying, the debt disappears so does the money but the profit remains.
Well, that’s about loans, what about our deposits? When we deposit our money in a bank, we are no longer the legal owners of it, but the banks are. And since the money we deposited always shows up in full on our screens, we assume that the bank always keeps our money in their vault. Or do they? We need to understand that banks exist to make money, holding our money for us is just a means to that end. Due to inflation banks can’t afford to keep money idly in the vaults. And that is where fractional reserve banking comes in.
Fractional reserve banking is a system under which banks that take deposits from the public are required to hold a portion of that deposit liabilities in liquid assets as a reserve, and are at liberty to lend the remainder to borrowers. Interesting, isn’t it?
The central banks of a specific country are the ones to determine the minimum amount to be held back in liquid assets, or as it is known, the reserve requirement. These reserves are held back as cash in the bank or as balances in the bank’s account with the Central Bank.
For years the reserve requirement has been 10%. This has helped commercial banks practicing reserve banking to increase the quantity of broad money. This is how it works;
Say you deposit $100 in a bank. Through fractional reserve lending they are allowed to keep 10% of your deposit, that is, $10 and loan out $90. Then the person who borrowed the $90 deposits that money in a bank which keeps $9 and loans out $81. and the process continues.
An initial deposit of $100 with 10% reserve requirement can ultimately lead to a $1000 in total money circulation. Or at least that was how it used to be. On March of 2020 the reserve requirement ratio was lowered to 0%. “This action eliminated reserve requirements for all depository institutions.” Talk about infinite money glitch. Now banks can create infinite amount of money with no reserve. No wonder we have been witnessing a number of bank failures.
The Central Banks
We have already seen how the Central Bank creates physical money. But that is not all that it does. Buckle up cause it is about to get crazy.
A central bank is an institution that manages the currency and monetary policy of a country and oversees their commercial banking system. I would argue that a central bank is more influential than laws and politicians but strangely not the focus of the general public.
The booms and burst in an economy can be narrowed down to a particular path that the central bank decided to take. For example, one of the functions of a central bank is determining the interest rate charged. When they lower the interest rates, banks will charge lower interests on their loans, incentivising people to take on more debt from a bank and buy things that normally they couldn’t afford, this causes more growth in the economy as everyone feels richer.
But eventually, people can’t afford to take on more debt and can’t pay back the ones they owed. The banks stop lending and defaults start to take place and the economy takes a downturn. Remember banks create 97% of all money through debt and if it can’t be paid back it can cause a systemic failure, a risk of collapse of the entire monetary system. This has taken place in the past. Like in the financial crisis of 2008. I know the greed of the commercial banks was the cause but I would argue that the central bank had more say in it. A decade of low interest rates after the dotcom bubble had made the cost of borrowing money almost free had caused market distortions.
But in 2008 something different happened, the world didn’t want to go through the pain of an economic downturn. As the banks had become largely involved in the crisis and were about to collapse, the governments had to use the central banks to bail them out. And so we come to the next type of money creation.
Quantitative easing, also known as QE. Basically, QE is the introduction of money to the economy by the central bank. This is achieved when the central bank purchases government bonds and other financial assets in order to stimulate the economy during a financial crisis. The opposite is quantitative tightening. Quantitative easing was first used by the Bank of Japan to fight domestic deflation in the early 2000s. The result of this is that the central bank’s balance sheet has gone so out of control in order to sustain an economy a little bit longer.
The first time this was tried out of Japan was during the 2008 crisis. The $700 billion controversial bail out. When the US government bought $700 billion worth of bad loans from commercial banks and other financial institutions, this action raises the price of those assets and lowers their yield, at the same time increasing the money supply in the economy.
This was thought to be a one-off thing, but they couldn’t be more wrong. As in the coming years they kept doing it over and over again. To give an idea of how significant this was, it took from the foundation of America, in 1776 all the way up to 2008 for the nation to attain less than $1 trillion in debt. By 2014 that number was $4.4 trillion. If that seems crazy then the next one will blow your mind. Since the onset of Covid-19 pandemic, $3 trillion was added in 3 months.
But remember all this is debt that will later fall on the taxpayers’ tab.
The central banks resort to QE when their nominal interest rate target approaches or reaches zero. QE can help bring the economy out of a recession, and help ensure that inflation does not fall below the central bank’s inflation target.
However, QE is also criticized for its unfairness and possible risks involved.
Most people term it unfair as it reaches the average person later on and by that time its value would have already dropped. How is this? Well since the 1980s, the wealth of the upper class of the society has been tied to the stock market. When the economy went on life support in 2008, the stock market became glued to the Federal Reserve, hence the more the Federal Reserve prints money the richer they get. And that is the cause of wealth inequality.
And also the cause of inflation as when it is released, the wealthy are the first beneficiary, as they will buy assets pushing the prices of those assets higher ending up ridiculously wealthy while there is little to no growth in the real economy. The rich get richer while the poor get poorer. The first recipients of that money will enjoy higher standards of living at the expense of the later recipients when inflation has already taken place. This is known as the Cantillon effect. It is believed that when the rich finally start to sell their assets in times of distress the money velocity will start to pick up and that is when inflation in the general economy will be seen.
QE programs can also fail to be effective enough when the banks remain reluctant to lend money to its customers as it were after the 2008 crisis; the banks instead chose to use the money to pursue their own investments. The effect of this was that the stock market was brought out of reality and now it does not reflect the economy as it used to. For example, in April of 2020; 30 million people became unemployed while the stock market had its best month since 1987.
There is more insanity in the economy than we can look at today, but that will be a topic for next time.
So what’s next?
In my view, I think this is going to lead to something big and unpleasant that will involve massive inflation and a slow economic growth. I would argue that the banks could direct their focus on empowering wealth creation than continue in their greed in money creation.
Banks should provide loans to productive areas of the society like small and medium businesses, entrepreneurs, education, manufacturing, innovation, research and development, these kinds of things. It may be riskier for the banks but the benefits are much more; job creation, more innovation, better competition and better living standards in the long run. Also governments can collect more taxes from this income without necessarily increasing taxes.
But as we all know, this takes time and requires hard work. The very thing that the age of easy money has taken away from people. Maybe it is too late for this.
For now we have to deal with the consequences of a fragile system.
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