I’ll attempt to tie-up my previous musings on Money as Debt with this article. Hopefully these are neither over-simplified as to be patronizing, nor so abstract as to be irrelevent. I believe the issues here are very important, and at the very least we should understand how money works and thereby have a context for the current recession and the moves that government makes to intervene.
Previously we learned that all money currently in cirulation is debt. That is, somebody, somewhere is owed the money you have in your possession. Ultimately, that’s the bank.. namely the Central Bank (or the Federal Reserve in the US). Consider the following question:
If all money that enters, or can enter, circulation does so through a loan from a bank, where does the money come from to pay off the interest payments due on the loan?
Take a moment to ponder this question. Once as you understand the astounding gravity and implications of this, the reason I feel so strongly that we each should know the principles upon which our “economy” is based becomes a little more apparent.
So where does it come from? Since all money is spontaneously generated from the central banks, which is of itself a loan, it is impossible for any economy to pay off all debts – that is, the principle of the loan plus the interest accrued on it.
Debt, failure and bankruptcy are intrinsically built-in to the system. As long as this system is perpetuated, there will always be losers – people who can’t meet their loan commitments. They may declare bankruptcy and the slate is wiped clean. We are raised in competition with everyone else in the system. We study hard, work hard … always trying to get ahead; increase our relative value. Granted we may work in cooperation with colleagues and business partners, but what we’re all trying to do is get ahead of the curve. Create our own tap into the money flow so that we may eke out the existence we so desire.
Fractional Reserve
On a slightly different angle, the Fractional Reserve system employed by modern banking sheds some light onto how such large sums of money are generated and enter the system. A bank is required to retain a certain percentage of the deposits it receives and is allowed to loan the remainder out to customers. The retained amount is called the ‘reserve‘. The ratio between the reserve and the remainder is the Reserve Requirement. Take the following simplified example:
Mr. Flush has $1000 in his possession. He takes this money to his bank and makes a $1000 deposit into his account. If the reserve requirement was 10%, the bank could receive the $1000, keep $100 dollars on the books and make a loan to another customer to the value of $900. This $900 could then be loaned from the bank and the customer in this case would then likely make a purchase with it, which would ultimately see that money then deposited with another bank. The second bank, with the same reserve requirement of 10% would retain $90 and then loan out $820.
Rinse and repeat.
From that $1000, and through repeated application of this principle with a reserve requirement of 10%, approximately 10 x $1000 of new money can be generated by the banks and enter general circulation. Magic. This is all well and good so long as the banks can satisfy every withdrawal requirement by its customers at any given time – hence the need for the reserves. The problem comes when all depositors come looking for their money at the same time. If the bank has loaned out 90% of the deposits how does it satisfy the demands of the depositors? Recent examples of this problem include Northern Rock in the UK. Depositors lost confident in the bank’s ability to provide their money upon demand and so rushed to get their money out before their worst nightmares were realised. This phenomena is so-called a Run on the bank.
What’s the problem with this? If the reserve requirement ratio is 1:9 as above, and much of the loaned money is high-risk, say bad mortgates or mortgage-backed securities, and those loans default… a massive amount of the pinciple in these cases is wiped out. The bank is highly leveraged at 1:9 and risks bankruptcy through non-payment of its outstanding loans. This is just part of the big puzzle that we are facing today.
I honestly don’t understand a lot of what is happening that is bringing our economies into recession, but I now understand a little bit more of the fundamentals and how such a situation can be fostered given today’s banking practices. It is by no means the sole fault of the system and banks… consumers that purchase goods and services on credit that they cannot realistically afford perpetuated the problem. The traditional method for obtaining what you want is to spend within your means, and to save your money until you could afford what you desired. The purchase of a home was done such that it could be afforded first through a sizeable down-payment and the gradual return of the loaned money. This practice was seemingly not followed and banks carelessly loaned money to people, not on the basis that they could return the money, but on the fact that (house) prices always rise.
Anyways, there are many facets to this problem and a lot of time is needed to really understand the financial system. I hope this has somehow helped clear some of it up for you.
My understanding of this, at the time of writing may be flawed, but that’s cool, I’m just telling it how I see it right now. Please feel free to set me straight on any point I may have err’d.
Much of what I understand has come from many sources, but primarily my awareness of this has come from the following:
I really highly recommend you give some time to a couple of the videos above. If you don’t agree with some of the theories posted there, no problem. It does no harm to expose yourself to alternative views which you are free to discount or consider as you feel appropriate.
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