The Pyramid Scheme of Money Creation and Destruction

Money is created and destroyed in one giant chain of credit clearing, both by the government and banks.

It officially starts in the creation of the monetary base by the Federal Reserve when it buys US Treasury securities. The Fed acquires Treasury securities, meaning it finances a loan to the US government. The Treasury then pays interest to the Fed for holding its bonds. The Fed pays for the Treasury bonds in cash, but it does not really pay the Treasury, it pays the people, by disbursing the cash to banks and citizens.

Say you get a loan from the bank. The bank gives you the money, but creates a loan you have to pay back. The loan is a negative balance for you, but a positive balance for the bank.

But where did the bank get the money? From the Fed! The Fed did the same thing for the bank that the bank did for you. The bank takes a loan from the Fed, getting cash to spend, but having a negative balance with the Fed, owing the Fed that money.

Ok, good so far, but where does the Fed get the money? The Fed gets the money from the Treasury. The Fed balances its cash distributions with assets of US bonds. Technically, the Fed gave a loan to the Treasury, and receives interest payments from Treasury just like anyone else when they buy a Treasury bond.

When the Fed buys bonds from the public, they are paying out money to the public, thereby expanding the money supply. When the Fed sells bonds to the public, they are taking money in from the public, thereby shrinking the money supply. When the Fed buys bonds directly from the Treasury, they are going through the motions of giving a cash loan to the Treasury, which really means distributing cash to the public, thereby expanding the money supply.

Why does the Treasury take loans from the Fed, and pay the Fed interest on those loans, rather than just distributing the money directly to the people? Good question. There are many people calling for the Treasury to do just that, taking direct control of the money supply and eliminating the role of the Fed.

However, it is a mistake to assume that this process starts at and is controlled by the Fed. In actually, most money is actually created by banks. When a bank gives you a loan, they give you the cash, an asset for you, and they get the loan note, an asset for them.

They are required to have a certain reserve cash amount, to be equal to about 10% of outstanding loans. But they don't check their reserves before they give you the loan. They give you the loan, then later, check to see if they have enough reserves to cover their outstanding loans. If they are short on reserves, they borrow the money from other banks, or directly from the Fed.

This is the Fed's role as lender of last resort. As the public demands more and more loans, the Fed is in the back of the whole system, creating more and more cash for the banks to loan out.

This is why Obama and his banking handlers are always talking about "getting credit going again" and other vacuous phrases. To them, the whole thing is a top down process, but one based on people's appetite for loans. So, to them, encouraging the people to spend more and go into greater debt makes perfect sense.

The whole system is leveraged to the hilt, due to the effects of fractional reserve banking. Because a loan at one bank deposited elsewhere becomes the basis for a new loan, which is then deposited elsewhere to become the basis of a new loan, the whole money system becomes a huge pyramid scheme built up on the much smaller value of original loans.

Thus, one bad loan destroys at least 10X its own value of money in the rest of the system. This inevitably happens in a debt deflation, as loans go bad on a large scale, the monetary system collapses, feeding further loan failure, and further monetary destruction. The so-called "credit crunch", which is a monetary black hole created by bad debt sucking in all the money around it and gaining strength as it goes.

This deflationary black hole wipes out the value of capital which had been bid upwards with debt leverage. The falling value of capital then wipes out the loans built upon that inflated capital base, dragging down the value of the remaining capital in a vicious cycle. Productive enterprises are wiped out and labor laid off as loans fail and debts become unpayable.

It's all quite inevitable given our system of credit money and fractional reserve banks. It happened even when our currency was on the gold standard, so that is no panacea. In fact, many blame the gold standard for prolonging the crisis, since it prevented the government from inflating the money supply to counteract the deflation.

The current government effort to reinflate the system with cash reserve injections and happy-face propaganda cannot work because it is targetted precisely backwards. The effort should not be to pump the banks full of capital, because the whole system is based on the demand of the people for more loans and their ability to pay them back. The government should let each and every bad bank fail, but provide massive stimulus checks directly to the people. That would do more than anything else to keep consumer confidence high and stimulate spending, far more than the vague terror caused by seeing our banking system on life support. Or, more simply, as I have been advocating from the start, cancel massive amounts of debt, which would stimulate optimism and spending without the pernicious effects of currency inflation.