Debt-based Monetary System
The practice of central banking and fractional reserve banking, combined with fiat money creates an economic system where virtually all new money is currently created by people or businesses or governments further indebting themselves to banks. When the demand for debt increases, the money supply expands, and when the demand for debt decreases, the money supply stalls or contracts.
As you now know, the central banks create money by monetizing debt. This process starts with a central bank creating money out of thin air to buy government bonds, through the banking system, where the banks get a check in exchange for the bond.
Taking the US for example, the Fed writes checks to buy the government bonds - Treasuries - and then hands these checks to the banks. At this point, currency comes into existence. The currency created in this process by the Fed is called base money. Thus, base money is made up of checks from the Fed. What is a check? A check is a claim or promise for currency. To sum up, base money = currency.
In a "hard" monetary system, a note was a bank note or a central bank note that was redeemable or backed by gold or silver. In the US, before the Fed inception, currency was just a claim check for the gold and silver that was held on deposit at the Treasury. On the other hand, in a fiat monetary system, the currency is really nothing but a claim check on a government bond. Therefore, the currency is backed by a promise of a future payment - bond. In other words, it's simply backed by debt.
From base to broad
Now let's see how the practice of fractional reserve banking adds fuel to the fire. Resuming to the example of the US, the banks take that currency (checks from the Fed) and buy more bonds at the next Treasury auction. The Treasury then deposits the newly created currency in the various branches of the government, so that the government gets financed to pay for its expenditures on public works, welfare and warfare. The government employees, contractors and soldiers then deposit their pay in the banks.
As you learned in Fractional Reserve Banking, when you deposit your currency with the bank you're not actually depositing it into an account to be safely held in trust for you. Instead, you're loaning the bank your currency and it can do with it pretty much anything it pleases. This includes investing in risky assets and loaning it out. Now the money multiplier effect kicks in.
Considering that the reserve ratio of the banks is 10%, if you deposit $100 in your account, the bank can legally take $90 of it and loan it out without informing you. The bank must hold $10 of your deposit in reserve just in case you want some of it. Yet, your bank keeps the information that you have $100 in you account. Despite the bank taking $90 from your account, it left something called "bank credit" in its place. When someone asks for a loan, the bank creates a check to grant that loan, by adding new deposit dollars in the borrower's account in exchange for his promise of future payment - debt. Although the bank credit is very different from base money, since the former only exists in the banks' books, it's still currency.
So now there's $190 in existence. One reason people take out loans from the banks is to buy something. Hence, the borrower takes the $90 that the bank loaned to him from your account and pays the seller of the good. Then the seller deposits that currency into his account and his bank loans out 90% of that and leaves bank credit in its place. There's now $271 in circulation. This process goes on and on until the money multiplier (1/reserve ratio = 1/0.1 = 10) compounds the base money of $100 to the broad money of $1,000. To sum up, currency = broad money = base money + bank loans = $100 + $900 = $1,000.
Reserve requirements
Moreover, reserve ratios vary immensely. On some banks these ratios are like the example, 10%, on others they are 3% and there are some which have no reserve requirement. The Garn-St Germain Depository Institutions Act of 1982 allows some banks to be exempt from the requirement rule. Currently the threshold for exemptions is set at $2 million, which means the first $2 million of reservable liabilities - deposits - are not subject to reserve requirement rules. The threshold is adjusted each year as set forward by a calculation provided in the act. As of January 1, 2018, banks with deposits less than $16 million have no reserve requirement. Banks with between $16 million and $122.3 million in deposits have a reserve requirement of 3%, and banks with over $122.3 million in deposits have a reserve requirement of 10%. Non-personal time deposits and eurocurrency liabilities have had a reserve ratio of zero since December 1990.
Accordingly, the expansion of the broad money supply is far greater than this example would lead you to believe. As a result, 92-96% of all currency in circulation, either digitally or physically, is created not by the Fed but through the FRB system.
Nothing but debt
In conclusion, all currency is created by individuals, businesses and governments going into debt. In the current fiat monetary system, the whole world knows every bill and coin, as well as the digital currency in the credit and debit cards, plus banks' reserves make up what is called money. What only a few people know is that this "money" is nothing more than promises of future payments (bank loans) and claims on those promises (base money). To make long story short, ALL fiat money is debt.
What is the problem? The combination of central banking, fiat money and FRB is inherently destructive and inevitably generates debasement of the currency, extreme inequality, the destruction of the middle class and wrenching business crises (Austrian business cycle theory).
On the next part, you'll see in detail the complications, predicaments and setbacks that emerge on the economy. In addition, we'll take a look at some potential solutions.
As you now know, the central banks create money by monetizing debt. This process starts with a central bank creating money out of thin air to buy government bonds, through the banking system, where the banks get a check in exchange for the bond.
Taking the US for example, the Fed writes checks to buy the government bonds - Treasuries - and then hands these checks to the banks. At this point, currency comes into existence. The currency created in this process by the Fed is called base money. Thus, base money is made up of checks from the Fed. What is a check? A check is a claim or promise for currency. To sum up, base money = currency.
In a "hard" monetary system, a note was a bank note or a central bank note that was redeemable or backed by gold or silver. In the US, before the Fed inception, currency was just a claim check for the gold and silver that was held on deposit at the Treasury. On the other hand, in a fiat monetary system, the currency is really nothing but a claim check on a government bond. Therefore, the currency is backed by a promise of a future payment - bond. In other words, it's simply backed by debt.
From base to broad
Now let's see how the practice of fractional reserve banking adds fuel to the fire. Resuming to the example of the US, the banks take that currency (checks from the Fed) and buy more bonds at the next Treasury auction. The Treasury then deposits the newly created currency in the various branches of the government, so that the government gets financed to pay for its expenditures on public works, welfare and warfare. The government employees, contractors and soldiers then deposit their pay in the banks.
As you learned in Fractional Reserve Banking, when you deposit your currency with the bank you're not actually depositing it into an account to be safely held in trust for you. Instead, you're loaning the bank your currency and it can do with it pretty much anything it pleases. This includes investing in risky assets and loaning it out. Now the money multiplier effect kicks in.
Considering that the reserve ratio of the banks is 10%, if you deposit $100 in your account, the bank can legally take $90 of it and loan it out without informing you. The bank must hold $10 of your deposit in reserve just in case you want some of it. Yet, your bank keeps the information that you have $100 in you account. Despite the bank taking $90 from your account, it left something called "bank credit" in its place. When someone asks for a loan, the bank creates a check to grant that loan, by adding new deposit dollars in the borrower's account in exchange for his promise of future payment - debt. Although the bank credit is very different from base money, since the former only exists in the banks' books, it's still currency.
So now there's $190 in existence. One reason people take out loans from the banks is to buy something. Hence, the borrower takes the $90 that the bank loaned to him from your account and pays the seller of the good. Then the seller deposits that currency into his account and his bank loans out 90% of that and leaves bank credit in its place. There's now $271 in circulation. This process goes on and on until the money multiplier (1/reserve ratio = 1/0.1 = 10) compounds the base money of $100 to the broad money of $1,000. To sum up, currency = broad money = base money + bank loans = $100 + $900 = $1,000.
Reserve requirements
Moreover, reserve ratios vary immensely. On some banks these ratios are like the example, 10%, on others they are 3% and there are some which have no reserve requirement. The Garn-St Germain Depository Institutions Act of 1982 allows some banks to be exempt from the requirement rule. Currently the threshold for exemptions is set at $2 million, which means the first $2 million of reservable liabilities - deposits - are not subject to reserve requirement rules. The threshold is adjusted each year as set forward by a calculation provided in the act. As of January 1, 2018, banks with deposits less than $16 million have no reserve requirement. Banks with between $16 million and $122.3 million in deposits have a reserve requirement of 3%, and banks with over $122.3 million in deposits have a reserve requirement of 10%. Non-personal time deposits and eurocurrency liabilities have had a reserve ratio of zero since December 1990.
Accordingly, the expansion of the broad money supply is far greater than this example would lead you to believe. As a result, 92-96% of all currency in circulation, either digitally or physically, is created not by the Fed but through the FRB system.
Nothing but debt
In conclusion, all currency is created by individuals, businesses and governments going into debt. In the current fiat monetary system, the whole world knows every bill and coin, as well as the digital currency in the credit and debit cards, plus banks' reserves make up what is called money. What only a few people know is that this "money" is nothing more than promises of future payments (bank loans) and claims on those promises (base money). To make long story short, ALL fiat money is debt.
What is the problem? The combination of central banking, fiat money and FRB is inherently destructive and inevitably generates debasement of the currency, extreme inequality, the destruction of the middle class and wrenching business crises (Austrian business cycle theory).
On the next part, you'll see in detail the complications, predicaments and setbacks that emerge on the economy. In addition, we'll take a look at some potential solutions.