Forum Post: Monetary System Basics
Posted 12 years ago on Oct. 5, 2011, 9:03 p.m. EST by sfcharles
(41)
from San Francisco, CA
This content is user submitted and not an official statement
Here is my attempt to describe the basics of our monetary system. All comments are welcome.
We have a system in which money is created as debt. Banks are given the privilege of creating money when they get a deposit. They can ultimately create nine times as much debt money (loans) as what they have on deposit. This is called fractional reserve banking. This is where most of our money comes from. Another portion of the dollars in the system is created directly by the Federal Reserve Bank (the Fed), which is a consortium of private lenders.
Thus, the vast majority of the money that is circulating in the system is debt created by lending institutions, and that debt requires repayment along with interest payments. When the principal is fully repaid, that money essentially 'disappears' from the system. The bank can then create more money as another loan, if it has adequate deposits and decides to make the loan.
If that bank and others like it stop lending, then the amount of money circulating in the economy shrinks. The government and/or the Federal Reserve Bank may then choose to intervene through programs designed to inject money into the system. The Fed can attempt to encourage banks to lend through various easings. The Fed can also directly increase the money supply by purchasing Treasury bonds/bills from the government. When the Fed purchases Treasuries, it creates the money to buy them out of thin air - it prints the money. The government then must pay the Fed back for its loan, both in principal and interest. This arrangement is the result of the Federal Reserve Act of 1913, which was supposed to prevent boom and bust cycles in the economy. It took the power to create currency and regulate its value out of the hands of the government (which is where the Constitution says it rests) and put it into the hands of the Reserve Bank.
When the government injects money into the system through spending programs, it funds them through additional taxes or by issuing Treasuries, which are essentially IOUs with interest payments. When it issues Treasuries it goes into debt, and has to later make interest payments on that debt. It pushes the actual payment of that debt into the future. The US Treasury does not have the direct ability to increase the money supply to pay for government programs. This power rests solely with the Fed. Treasuries can be purchased by nearly anyone: US citizens, corporations, foreign entities, the Chinese government, or the Fed.
All of the money that is created as debt, including Treasuries and bank loans, requires interest payments. In order for the entire banking sector of a whole nation to successfully collect those interest payments, the GDP of that nation must grow, or there must be more money circulating in the system ('inflation') or some combination of the two. There's no other way around it, if the banking sector is to survive and profit. The majority of that should be economic growth if the bankers really want to profit.
Have you ever wondered why a perpetually growing economy is considered a good thing? In fact, a geometrically growing economy will run out of resources at some point, and by definition it harms our environment at an ever-increasing rate. Shouldn't we just aim to have a steady-state economy with full employment and stable population levels where people live their lives to the fullest? Doesn't that sound like a worthy goal as a society?
The answer to all this is that lending at interest depends on a perpetually growing economy, and the American monetary system is particularly vulnerable to this. Increasing production and increasing population levels both grow GDP, generally speaking. So we are trained to believe that the economy needs to grow in order for us to be OK individually. In fact, this is true in the present system: if the economy does not grow, interest payments are not made, then banks stop lending, and then the money supply contracts. When money becomes scarce, people stop buying, then companies stop producing, then people lose their jobs.
While the Fed chair is appointed by the President, the Fed itself is a collection of private bankers that does not really answer to any of the three branches of the Federal government in any formal way. And that collection of private bankers profits from the interest payments that are made by the government on Treasuries that the Fed buys with the money it created out of thin air.
A start would be a system in which private bankers were not financially rewarded for creating money to lend to the government to buy US Treasuries. The Reserve Bank could become a part of the Federal government, or the US Treasury could take on the Bank's role and regain the power to create money.
More complete solutions will be more radical and will require that we change the way the entire banking and monetary system works. A system in which the banks create money and then lend it at interest must ultimately be replaced with one that is sustainable, in which most money is created as something other than debt.
Some misconceptions here (on this website in general) that I will try to clear up.
• TARP is almost completely paid back. In fact, there is less than $30 billion still outstanding - stemming from GM and AIG (a government entity today) and the US Treasury estimates that it will eventually make an 8% gain. Considering that the US5yr is currently yielding 1.08%, that's a pretty great return for US taxpayers.
• $16 Trillion is a number often referenced as the total bailout given to banks. This is the sum of all loans given out over a long length of time to banks from the Fed. Large banks have thousands of loans (Assets to the bank) maturing and deposits withdrawn (Liabilities to the bank) everyday. Sometimes, this activity does not net to zero and a particular bank is not able to meet the 10% reserve requirement of deposits at the Fed. Typically, the bank would seek to just borrow overnight money from another large bank that had a surplus reserve but the crisis escalated to the point that banks were unwilling to lend to each other out of fear of never getting repaid. Thus, the Fed stepped in to make multiple large but very short term loans that were trued up the next day. Had they not done this, we would have been much worse off today.
• The Fed's actual purpose is 1. To create price stability and 2. To be the lender of last resort to banks. What it did during the Debt Crisis is completely consistent with its intended purpose. Furthermore, the Fed is actual capitalized through the aggregate of all US banks' reserve deposits. In other words, the Fed has money from the banks in the first place. • The Fed does not literally print money. The treasury print's the actual bills, which it then gives to the Fed. The Fed injects this into the economy through Open Market Operations. Meaning, it goes into the marketplace and buys various duration US government debt (T-bills and bonds). This may sound like the Fed gets free money but please keep in mind that the Fed is a quasi-government entity and is required to give all of its profit to the Treasury. So essentially, it's a clean swap, accounting wise, an exchange of US bonds for dollars.
• Money multiplier and velocity of money. I see these terms used incorrectly all of the time. Money multiplies because every time someone makes a $100 deposit at the bank (surplus cash in the economy), the bank deposits the required 10% reserve at the Fed and reallocates the remaining $90 surplus to loans to people and businesses. The $90 ends up at another bank after it is spent by the people/business and that bank is now required to make a 10%, or $9, deposit at the Fed and free to make an $81 loan. This goes on until there is no more money left to loan. The end result with a 10% reserve requirement, $900 is created in the economy and $100 is held at the Fed.
• The Fed is a quasi-government entity. Yes, they operate independently - and for a reason. Have you noticed how politicians spend money? Economics/Money Supply and Politicians should be kept as far away as possible. Can you imagine the swings in Fed policy as different parties get elected? Anyways, the Fed's Board of Governors are appointed by the POTUS. Additionally, there are a number of layers of additional personnel including banking representatives and representatives from all of the major industries in the US.
Thank you. You explained that very nicely. At times I've wished that the Fed could have control of the budget and the tax code instead of leaving to the politicians in Congress. Fiscal policy like monetary policy is too complicated and too important to leave in the hands of politicians who only care about getting reelected.
Geez after reading more of those replies to this post, it really is where the smart people come to chat...... I can feel a $5 latte shop about to be opened.....
MY GOD SFCHARLES!!
If that hot blonde chick they interviewed on the factor is the face of this protest, then you, good sir, are the brains. That is the best, educated and well written post I have seen. I have a masters in economics and you sum it up better than most teachers.
Pay attention all those hippies with passion but no direction! Get behind this guy, you are looking for a leader? Here one with some intelligence.
If only people realised that income tax was introduced to pay the interest due to the fed from the treasury for creating this fraudulent fiat currency, they would stop demanding higher taxes on anyone and finally deal with the root of the problem.
May you continue your excellent work, and I will take down any that disrespect ye.
I appreciate that.
Looks like these forums have been taken over by a bunch of trolls, for now.
Kudos sir
First, it's refreshing to read a well-written, informed post. Second, you are absolutely correct that it would be a start to eliminate the Federal Reserve System and have the Treasury take over its duties. At least we wouldn't be paying interest on money created from nothing. However, you have to recognize that the current arrangement is very beneficial for the government. More importantly, you have to recognize that this does not get to the root of the problem: fiat money and central banking, the two pillars upon which the modern state rests. The only sustainable system is a market system with a market-chosen money and a banking system that enjoys no special legal privileges.
I like the cut of your jib too moneyandbanking
Thanks. If you mean that the current arrangement is beneficial to the government relative to one in which they have no power to create money other than through the acquisition of precious metals, then yes, that's true.
When you say a market system, do you mean returning to a gold (or some precious metal) standard? I see many problems with a precious metals standard.
It is not necessary that the market chooses a precious metal as money, but there are obvious reasons why the process of voluntary exchange has resulted in precious metals outcompeting other goods and serving as money for thousands of years: homogeneity, durability, divisibility, relative scarcity, etc. Increasing the supply of precious metals involves considerable expense. Their supply cannot be expanded quickly and inexpensively. Credit booms are severely limited in their size and scope.
Contrast this with paper money, or electronic money, which allows those with the legal privilege of creating it to produce it in unlimited quantities. A growing economy does not need a growing supply of money. We do not need an elastic money supply controlled by a central bank. The stated reasons for the existence of such a bank are to provide a monetary unit with stable purchasing power, and to be able to inject extra money into the economy during times of crisis. It is a historic fact that commodity money has always provided a reasonably stable medium of exchange, while the entire history of paper money has been an unmitigated disaster when judged on this basis. It is borderline ridiculous to claim that paper money provides more stability than commodity money. If you define hyperinflation as a monthly rise in prices of 50 percent or more, there were 29 hyperinflations in the 20th century. Since 1971, the world has been entirely on a paper money standard, and the number and intensity of international banking crises has risen markedly (see Carmen Reinhart and Kenneth Rogoff). Ever larger sums of money are increasingly needed to keep the overstretched credit edifice from collapsing. In the two years after the collapse of Lehman Brothers, the Fed expanded bank reserves and the monetary base by more than $1 trillion, more than it had created in total up to that point since its inception in 1913.
The history of paper money systems is a history of failure. Without exception, paper money systems have led to economic volatility, financial instability, and rising inflation. If a return to a commodity money was not achieved in time, the currency collapsed. Elastic money is dangerous, destabilizing, and unsustainable. It has never been the result of voluntary exchange. It has always been imposed upon people by government. What we need is freedom in money and banking, not state monopolization.
If left to its own devices. The market would choose gold and silver, I think the protesters should realise this, you don't need a labour based money or an energy based money, we don't need a medium of exchange created by decree, leave the people to their own devices and you will soon see what they use...... I know what I would bet on
Thanks for your explanation.
You bet. Hope it helped.
Must see TV:
Money As Debt http://www.youtube.com/watch?v=Dc3sKwwAaCU
The Zimbabwe solution is proposed all over the net in order to deflect criticism of the Fed and the roots of its power: paper money. Don't fall for it. It's a red herring. It would be jumping from the frying pan into the fire.
Your money should be yours. You have private property rights in the money you earn. If you store your savings as something tangible like gold or silver, its value cannot be stolen from afar. With paper, its only reason for existence in the first place is so that its value, your value, can be stolen silently from afar.
Back in the days when Andrew Jackson killed the central bank and the government had zero debt for the only time in our history, the arguments of the the greenbackers came from what were referred to as 'Friends Of Paper Money'.
Don't fall for the Zimbabwe solution.
The pernicious nature of the fractional reserve system would be retained if Congress could simply print money, plus the money would be inflated at ever-bigger rates.
Gold and silver are mentioned in the constitution. For some very, very good reasons. Primary among them, you can't print them and pretend to get something for nothing.
(reposted) The question is about Value. What do we value, how do we value it. To my understanding there are two forms of valuation: quantitative and qualitative. There are things in this world that have intrinsic value and should not be, and in truth cannot be quantifiable without some amount of exploitation (read: corporate externalities). These things that have intrinsic value need to be taken out of the marketplace, and be relegated to the commons, that which cannot be commodified. In a just society, based on liberal and democratic principles the goal of the national system is one that promises Life, Choice, and the Means pursue these just goals. Placing those intrinsic resources in a free, and protected commons would take them out of the marketplace and would make them accessible to all. The Commons would include the environment, (ecosystems, biodiversity, clean air, clean water, etc), a secure community, agriculture and food, education, transportation, basic healthcare, and occupational opportunity (eg, work-placement opportunities for those who cannot find a place for their own potential. If you are bored, able bodied, with no interests, then the community can find work for you, where you choose to work is up to you, but the community should have the means to find you opportunity.)
The creation of a commons would drastically improve the quality of life for everyone at once, and with proper popular oversight could lead to the solution to many of the problems facing modern society such as consumerism, environmental and economic instability, health and welfare issues, and many cultural issues through the reconnection and rejuvenation of communities and their infrastructures. The question is how do we value what can be commodified and justly quantified?
The current financial and economic system is intrinsically flawed because of its power structure. The vast majority of people who use it have no say in how much it's worth, and the people who do are taking advantage of their positions. In our fiat currency the value is constantly fluctuating, and is not reflective of the actual economic movement that is happening.
Many have offered a solution in a "sound" currency, backed by a single finite resource, but if all natural resources have intrinsic value than any quantification of it's value is exploitative and diminishing of that resource's potential. Also, a single-resource value system brings a designed inflexibility to the monetary instrument, and makes it very very prone to sudden change (like the possibility that everyone at once will no longer value precious metals, or postage stamps, or whatever else you base your currency on). Furthermore, supply-side economics dictates that any currency based on a single resource has designed into it the potential for greed. In a famine food is far more valuable than gold, and if gold is the currency then those with the food can demand whatever amount of gold they want, thus disenfranchising all those without gold. Also, how do we feasibly calculate that one resource? Is it just that which is in reserve or is all of that kind of resource? Will the gold in any jewelers shop be worth as much as the gold in the mint? Will the gold in the jeweler's shop be included in the quantified valuation of the nation's currency?
So instead of a fiat currency, or a sound currency, what about something like a trust currency, where the value of money is based on the sum contribution of all of the members, and the constant flow of resources and participation within the economy.
We live in a society that is striving to be democratic, yet our economic system is structured like a perverted feudal machine.We need a system that is organic, and can adapt to major changes, but one where the decision making powers are shared equally by all.
Credit Unions and the Cooperative Enterprise offer a model which is a far better way toward achieving a democratic economy.
Money is a wonderful tool in the evolution of society, the issue is not that it exists, it's how it works. Right now the value of money is determined by a few aristocratic oligarchs. The FED is run by bankers. The banking system is structured on the corporate enterprise model where power is located and money is funneled to the top. Replacing the FED with a FEDERAL CURRENCY UNION or, where the banking system is structured on a cooperative model, and the powers of inflation and deflation are given to the members of the credit union (us the people) in a confederated membership system.There could be professional, local, state, and national credit union branches all buying into the currency powers through membership in the confederated cooperative.
To clarify: The US Dollar is currently backed (given value) by the national debt. A debt that can never be paid off, due to interest. It is a credit fiat system. What if we replaced the credit with social trust, and changed the Federal Reserve into a confederated Federal Currency Union, which would be modeled after cooperative enterprise (http://en.wikipedia.org/wiki/Cooperative), and would be made up of various local and professional credit unions. These credit unions would replace the banks, and would have the power to lend money directly to entrepreneurs based on community or professional interests (the needs should already be met). The powers of currency valuation (inflation and deflation) would be represented by the membership of the credit unions, which in turn would derive it's value based on the membership of their individual members (the people). The sum value of the currency would be in direct correlation with total membership and the movement of the economy.
This in effect is a proposal for two economies: one based on intrinsic value (the commons), and one based on quantifiable trade (the commodities market). The two would be inter-related, but the commodities market would be subject to the limitations presented by the commons. Example: A filmmaker wants to start a cooperative film production company. So, they go to a professional credit union to request capital to fund their overhead. Through this request they are also requesting membership into the the credit union, and to the commodities market as a whole. After deliberation, if the Credit Union would decide to endorse the venture through a vote, thus inducting the new venture into the economy. The induction would come with a contract containing a clause outlining the venture's responsibility to the commons, and how the venture wold provide compensation for diverting resources away from the commons, hopefully some kind of public good, like the production of some public broadcast media. If the venture is structured cooperatively and democratically, as well as the credit unions, and the currency union, then the power of the issue of currency will remain in the hands of the public, and not in a central bank headed by those who would take.
I like your ideas, but your proposal sounds fairly complicated to implement, and it seems like it leads back to pricing the commons, at least in your filmmaker example. Am I wrong?
Hopefully, pricing the commons would not exist because of checks and balances brought in through a venture's contractual obligations to compensate for its diversion of resources. So, in effect every private, cooperative venture would serve two purposes, the creation of its commodity, and the support it gives to the commons. If a computer manufacturing company can offset it's resource and pollution costs via, a secondary function of solar panel manufacture, or investment in a reforestation program, then there is no reason they shouldn't be allowed to "profit" off of their commodity.
It's not too complex, we just need to 1.) eliminate corporate personhood to level the enterprise playing field. 2.) Invest in the creation of more local and professional credit unions and cooperative enterprises 3.) when the credit union infrastructure is strong enough, organize and confederate it into a joint system and shift the powers of the FED to the credit unions, representing the people through the ventures involved. This could happen before any discussion on what should be commodified
After, or during this process, something would need to be drawn up to define what belongs in the commons, and how to meet the demands of creating the infrastructure. An Environmental Bill of Rights and a Citizens Bill of Responsibility would need to be drawn up to ensure the protections of and the obligations to the Commons. It is daunting, and obviously difficult, but there is no reason that some of these steps can't be taken now.
No thanks.