Tuesday, July 21, 2009

The Black Magic of Debt Money Creation

Anything with market value can be monetized to create money. The most common example we can all relate to is housing. Here is how it works:

You give the bank your house, they give you money. You are then allowed to buy your house back from them, on a slow repayment plan. In short, they give you dollars up front, then you slowly give back the dollars to get your house back (except you give back about three times the number of original dollars, because of the interest charged).

This house for dollars scheme is one example of debt dollars. The dollars are based on a debt, the amount owed on a house. You supply the house, they supply the money. Where did they get the money? They created it.

Now, by creating it, I don’t mean they printed the dollars. In our modern system, that is not necessary. They simply created an account balance for you. On their accounting, they have a house as an asset, and you have money as your asset, so it balances out.

Hopefully, now you can better understand the meaning of economic statements like the following:

"Note that although the system of fractional-reserve banking creates money, it does not create wealth. When a bank loans out some of its reserves, it gives borrowers the ability to make transactions and therefore increases the supply of money. The borrowers are also undertaking a debt obligation to the bank, however, so the loan does not make them wealthier. In other words, the creation of money by the banking system increases the economy's liquidity, not its wealth." (N. Gregory Mankiw, Ph D., Professor of Economics at Harvard University, Macroeconomics, Fifth Edition, pg 485)

This easy creation of money by banks is the real reason why the rich always get richer. They create credit dollars, and they get to buy real assets like houses. As mentioned, they don’t even have to print actual paper dollars, they simply create money as an accounting balance. They get the house, you get the account balance. Of course, if you fail to scrounge dollars from other sources, they keep your house.

Nice little scam, really, but it’s only for the rich. In order to gain this money creating power, you have to prove you are sufficiently wealthy to start with. That’s because the rules state that banks have to have a minimum capital level before they can get chartered as a bank. Gotta have money to make money, as they say!

Housing was the traditional basis for a lot of money creation, but in today’s world, banks have found something even better: government cash flow. Now we all know that governments have a regular cash flow coming in from taxes. Bankers figured out that they can create money based on the promise of future cash flow. Creating money based on future money, it sounds kind of shady, doesn’t it? Here is how it works:

Any institution that generates cash flow can take out a loan, right? Except, long ago, they discovered the best way to get a loan is not go begging for money from individual sources, but to make the money sources come to them! They do this by issuing bonds. They advertise that they are in the market for some money, and they will take a loan from whoever gives them the best deal. Various people with money bid against each other, lowering the cost of the loan, until finally someone wins. The winner then buys the loan contract, which is called a bond. Both private companies and government bodies can gather money this way, by issuing bonds.

Bankers like bonds, because, as slips of paper, they are more easily bought and sold than real estate. If they didn’t want to hold the bond, they found they could sell the bond to someone else. Remember, at the root of the bond is a company or government paying off a loan. Whoever buys the bond gets that loan repayment money, so a market developed buying and selling bonds.

At some point the bankers realized that they could monetize bonds the same way they monetized real estate. Say you own a bond, and you sell it to the bank. You give them the bond, they give you money. As long as the bond has a market value, that process is just as legit as selling your house for money, right? It seems a bit shady because it has entered the realm of abstraction: creating money to exchange for the promise of other money.

This enters us into the ethereal realm of financial products, all the way up to the credit default swaps and derivatives which became notorious during the financial panic of 2008. As long as there was a market value for something, some creative banker could monetize it, creating money to pay for it, in an ever-growing mountain of credit leverage.

The dollar is often called debt money because it is based on the monetization of US government debt bonds. The US Federal Reserve is the source font of dollar creation, because it monetizes the bonds of the US government. The Fed Reserve is also responsible for releasing actual paper cash into the economy, but that is a separate issue. Interestingly, the US Mint releases coin cash into the economy in yet a third money creating process.

But at its most basic level, the Fed Reserve creates credit money by monetizing government debt. The Fed then provides that credit money to banks to distribute into the economy at large. That creates the base source of the money supply. The market value of the federal debt is the collateral that backs the money supply.

Because the debt is the basis of the money supply, if the government paid off its debt, what would be the basis of the money supply? Hmm, there is a good question. Obviously, there would be the paper bills and coins in circulation. There would also be the credit money that commercial banks created by monetizing assets into private loans. But obviously, the money supply would shrink drastically if the government paid off its debt.

As a practical matter, the government simply keeps up the process of turning over its debt, continually refinancing and expanding its debt. Obviously, that continues to expand the money supply as well, resulting in widespread easy credit and chronic inflation.

Individual banks also have the power to increase the money supply on their own, by monetizing assets into loans, as we detailed previously. There was a time in the early mid-1800s when the debt was paid off and the money supply for the nation was solely in hands of private state banks (called the Free Bank Era). The banks based their money issue on exactly what we have been talking about: the monetization of real estate and government bonds as collateral.

This era was criticized as the Wildcat Bank era, but it did not really end out of its own failure. It was brought to an end by the National Bank Act of 1863 to meet the financing needs of the Civil War.

After the Civil War, the government returned to the discipline of the gold standard. That was then criticized for being too inelastic in its ability to create credit. Which led to the formation of the Federal Reserve system in the 1910s to loosen up credit. Which worked spectacularly throughout the 1920’s to pump up the economy. The credit bubble burst, however, resulting in the Great Depression. To loosen up credit again, the dollar was taken off the gold standard. Since then we have had runaway economic growth and malinvestment fueled by easy credit and chronic inflation, culminating in the Credit Crunch of 2008 and the ongoing Great Recession.

There is a better way of these destructive and unsustainable cycle, and it involves moving out of the system of debt-backed money.

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