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How Money is Created

Paper Type: Free Essay Subject: Economics
Wordcount: 4184 words Published: 23rd Jan 2018

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Essay

Where Money Comes from

Student: Gulnaz Miniakhmetova

Introduction

“The process by which banks create money is so simple that the mind is repelled”

John Kenneth Galbraith, Economist.

There are many social institutions in our world but one of them seems to be the most difficult to understand – monetary institution. Why do we have it and how it works? Being small children, we already understand that to get a toy parents need money. Stuff costs money. Money is a tool, and not necessarily one which facilitates access to the resources necessary for survival, as they are given freely on the earth[1]. If we look back at the history of the great Depression, we will see that people can’t live without money. During the Great Depression, money stopped circulating – yet the sun still shone, the plants were growing but people starved. Food was available because nature does not depend on our monetary problems. It continues to exist as many times ago. Why then people lose access to food without money? It sounds incredible but how our society allow money to function as a barrier to nature resources. Nature does not take money for her great work[2].

Few people are interested in the way money are created and in who controls the system. Complicated economic terminology and calculations keep most of the people away from understanding the system but one attentive look at it helps to see how simple the scheme actually is.

This paper is going to investigate where money come from and what makes the ink on the paper be so valued, if it is really valuable?

Ancient Money. Modern Money.

It is interesting to trace the evolution of money across years and check if “money-of-today” has the same value as “money-of-yesterday”.

It is fascinating that long ago money appeared in different corners of the world in a nearly similar way. We observe various currencies in those times. American Indians used Wampum; West Africans were trading in decorative metallic objects called Manillas; Fijians used whale’s teeth. Shells, amber, ivory, decorative feathers, a large number of stones – were all used for trade across the world. We cannot but agree that these funny forms of money are sensible things for trading. Later gold and silver were the most favorite currencies.

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The appearance of coins in our life was a significant step for economy, which still exists. The first coins appeared about 600 B.C. in a place where Lydians lived, ancient Greece territory where now modern Turkey is located. It had a form of lion’s head and were made of electrum. If we compare other ancient types of money, coins were the first to become a firm currency. Coins spread throughout the Mediterranean very fast. By the 6th century Athens, Aegina, Corinth and Persia, all had their own coins. Coins helped to expand trading easier. Soon coins were made out of gold and silver thus reflecting the actual value of the metal. Modern currency, unfortunately, lost this value.

Money evolved from barter but barter had two limitations:

1) the traders must have products of equal value and;

2) as society grows, traders must be ready to make the trade at the same time, as the trust of the small group no longer exists.

What if the person who has what you need might not need what you want to trade? What about large transactions? In this case, money appeared to be a convenient value for everyone and perfectly dealt with barter limitations. Even gold and silver are bulky for large transactions. The need for lighter equivalent generated paper money.

Modern money system comes from the Middle Ages from the goldsmith trading. People started storing their gold and silver to the goldsmith who was supposed to keep it safe. The owner of the gold got a receipt for what had been left at goldsmiths. This way a paper started to circulate in the society being much easier to carry than gold and silver. Precious metal was replaced by paper.

After a while, the enterprising goldsmith figured out that only few of his depositors come to demand their gold. Therefore, he decided to loan out the gold for other customers or just issue a receipt instead of actually giving the gold. Finally, clever goldsmiths found out that they could print and give printed loans even more that they had it in gold. In the idea of loaning the value of gold they did not own, but only held in trust, and the value of gold that did not even exist, was the germ of the invention of modern money[3]. The goldsmiths or bankers were doing a clever thing. They received interest by loaning the gold that they were paid to hold in trust for others. They received interest from loans on gold that did not even exist. This system has a name of “Fractional Reserve Banking” which means lending much more money than you have assets on deposit.

This simple scheme follows human beings up to the present moment. Modern banks are allowed to loan out ten times the amount they are actually having. If you are charged 11% interest rate, be sure it is not 11% a year they make on that amount but actually 110%[4]. One thing that differs modern monetary system is that money can no longer be redeemed for gold. If earlier, we could find a phrase “in silver payable” on the American dollar banknote, today there is only “Federal Reserve note”. It means that money used to represent value by gold and silver and could be redeemed by gold or silver. The gold standard lasted until 1971. President Nixon announced that the United States would no longer exchange dollars for gold. It happened because the volume of gold reserve came to a dangerous point. For example, at the end of the World War II France insisted on changing their American dollars to gold. America was in a critical situation.

Henry Hazlitt forecasted the dollar devaluation at the beginning of 1971. He said that America would have to increase the cost of one ounce of gold (previously it was 35 dollars per ounce). The decision of the present was unexpected. No devaluation followed. Nixon just stopped “gold standard”, which actually can be accounted as a financial bankruptcy. Since that date, the world trade is conducted with the help of dollars, which are nothing more that paper. All the rest world currencies related to the gold through dollar, became “gold-free” too.

Earlier “gold standard” prevented countries from printing too much money, as the supply of gold does not change quickly. The supply of money was stable. If there is too much money, people start to exchange it for gold. Finally, treasury may run out of gold. Quitting the “gold standard” modern America can buy nearly whatever they want with a currency having no inner value. Now dollar can be redeemed only to another paper or digital dollar.

In fact, “old” monetary system backed up by gold and silver was “debt free” while modern one is “debt based”. How? The proof of the money’s debt nature will be discussed in the next chapter of the paper.

How Monetary System Functions Today

As a basis for discussing the modern monetary system, I would like to take the views and explanations of the Zeitgeist Movement since I find it clear and laconic for perception. However, there are many other followers of the idea “money is debt”.

If we ask an ordinary person on the street, “How money is created?” The most probable answer will be “By governments and banks”. Governments only borrow money from the banks. Alternatively, one can say, the bank takes money from savers, and then lends it out to the borrower. That is not true. Banks do not need a customer deposit for giving a new loan. It is viсe versa. Loans create new deposits. Let us illustrate how the system works.

Government of the USA decides that it needs money. It requests the Federal Reserve (The Fed) for $10 billion. The Fed agrees to buy $10 billion government bonds. The government takes a paper and draws Treasury bond where it shows the value of the bonds $10 billion and sends them to the Fed. In its turn, the Fed draws their papers, which are called “federal reserve notes”. Their price is $10 billion. Then the Fed trades these notes for bonds. As soon as government gets the notes from the Fed, it puts it into bank account. Only on this account money become real money adding $10 billion to the USA.

In reality, the process is done without any paper, i.e. electronically. Necessary to note that only 3% of physical currency exist in the USA. The other 97% is digital nowadays.

Now we see that money which appeared in such a simple way are equal to debt. The Federal Reserve purchases government bonds with the money created out of thin air. The government promises to pay back that money to the Fed. In other words, money were created out of debt.

The most interesting thing is that ten billion dollar deposit becomes a part of the banks’ reserves. As stated in the “Modern Money Mechanics” – “Under current regulations, the reserve requirement against most transaction accounts is ten percent”. It means that with a $10 billion deposit, 10%, or one billion is held as a required reserve (10%*$10,000,000,000.00=$1, 000,000,000.00). While the other $9 billion is considered an excessive reserve, and can be used as the basis for new loans. Therefore, we assume that this $9 billion comes out of existing $10 billion deposit but that is not true. The Zeitgeist states, what is really happening is that $9 billion is created on top the existing $10 billion deposit. Totally, bank has $19 billion. This is how money supply works. Banks do not really pay out loans for money, which they receive as deposits. It is important for banks to receive loan contracts in exchange for money. $9 billion is created out of nothing just because there is a demand for such a loan and there is $10 billion deposit to satisfy the reserve requirements.

Let us assume that someone borrows that available $9 billion from the bank and most likely, he puts this money to his bank account. Therefore, this deposit becomes banks reserve. Ten percent is isolated and we get 10%*$9,000,000,000.00 = $900,000,000.00 and $9,000,000,000.00 – $900,000,000.00 = $8,100,000,000.00[5]. This $8,1billion is now available as newly created money for more loans. This process of money creation is endless and it is based on debt. Money is debt. Debt is money.

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If money is created so easily, why is it so valuable? It is simple. There is always demand for money because people want it. A person needs money because he knows that other person needs money as well, so money can be used to others to get goods and services in return. In its turn, those others can also use the money they got to satisfy thir needs. Goods and services function as engines in the economy, and money helps people to exchange goods and services. It seems the process of modern money creation will go on forever.

Money is Debt

We are afraid of the word “debt” but it often helps people to raise their living standards. Debt is risky and has future obligations, but can also provide a means of generating future income. Everyone knows how disastrous debt can be for a person or a business. In history there are examples when “growth and prosperity have flourished at times when overall indebtedness was rising rapidly, and some economic slowdowns have coincided with periods of debt reduction”[6]. Thus, it is a paradox that debt can be both good and bad.

Looking back at the history, we may find out that once the national debt was fully paid off. It happened in America in 1835. The president Andrew Jackson shut the Central Bank, establishing Federal Reserve instead. Jackson called the debt a “national curse.” He vowed to “pay the national debt, to prevent a monied aristocracy from growing up around our administration that must bend to its views, and ultimately destroy the liberty of our country[7].” However, the period of “zero debt” did not last long. International bankers established another Central Bank. While there is such an institution, the debt is there too.

Many economists admit the Debt nature of money. For example, governor of the federal Reserve, Marriner Eccies once said “If there is no debts in our money system, there wouldn’t be any money”. Or, “the dollar is based on credit and every dollar in existence represents a dollar of debt owed by an individual, a business firm, or a government unit.”[8]

Apart from the fact of money creation on the debt principle, there is one more important trick about banks. That is interest. When a person gets a money from the bank, he has to pay them back with the interest. A question arises here: if we borrow money from the banks through loans, where do money for paying off interest come from? The answer is – from nowhere. The fact is that the money people or companies owe to the bank will always exceed the amount of money that is available in circulation. That is why inflation takes place. New money is needed to cover the deficit caused by the need to pay the interest. Inflation is built into the system as well as defaults and bankruptcy.

Nowadays more and more people join the endless debt system by taking home mortgages, personal loans, and credit cards. Some kinds of debt are long-term. For example, home mortgage may spread for more years than a person has active working years. If you are unable to pay the loan, the bank takes your property. It is frustrating, when you understand that the banking system and the fact that those money on the day of singing the contract did not even exist.

There is one interesting court case which took place in America, Minnesota and which proved the corrupt nature of the banks. The case took place in 1969 between First National Bank of Montgomery and a citizen Jerome Daly. Daly took a mortgage from the bank. Daly was demanding the foreclosure of his home by the bank. The bank provided the loan to purchase the house. His argument was based on the fact that mortgage contract stands for equal participation of both parties. Each party put a legitimate form of property for the exchange. Daly was trying to prove that the money was not the property of the bank since money was created out of thin air on the day of signing the agreement.

If we look up at the “Modern Money Mechanics” booklet, we will find out the following about loans “what they do when they make loans is to accept promissory notes in exchange for credits…Reserves are unchanged by the loan transactions. But deposit credits constitute new additions to the total deposits of the banking system.”[9] It means that money does not come from already existing assets. In a cunning way the bank simply invents money and there is nothing like a property on the bank’s side, except for a liability text on paper.

Mr. Daly won the case, as the bank’s president admitted the fact of unexciting money and he noted that this was a standard banking practice. Here is the speech of Mr. Morgan, the bank’s president “Plaintiff admitted that it, in combination with the Federal Reserve Bank of Minneapolis, did create the entire $14,000.00 in money and credit upon its own books by bookkeeping entry. That this was the consideration used to support the Note dated May 8, 1964 and the Mortgage of the same date. The money and credit first came into existence when they created it. Mr. Morgan admitted that no United States Law or Statute existed which gave him the right to do this. A lawful consideration must exist and be tendered to support the Note”[10]. As a result, the court rejected the bank’s claim for foreclosure and Daly lived happily in his home.

This case once again proves the corrupt nature of modern monetary system. One feels miserable when realizing that any time he borrows money, the money appears to be not only a counterfeit, it is even an illegitimate form of agreement. The bank never has the money as property in contrast to golden standard period. If there was a successful case with Mr. Daly, why do banks continue mocking at people? Well, we proved that money is debt. What are your actions when you are in debt? You go to work in order to pay the debt off. But, if money is created only out of loans, it means that society cannot be debt free. People are slaves of banks running on the hamster wheel. Only those at the top benefit from the system. There will always be the rich and the poor with our present system.

It is an incredible system ever created for social manipulation. “Debt is the weapon used to conquer and enslave societies and Interest is its prime ammunition”[11]. Banks are making private profit out of what should be public revenue. Rich countries developed the international money system which serves their interests at the expense of the poor countries.

Conclusion

Earlier monetary system was more honest in its nature compared to present times. “Modern Money Mechanics” answering the question “what makes money valuable?” say that a dollar bill is just a piece of paper. Coins do have some value as a metal, but less than their face value. The value is explained just by the fact that people believe in money’s power to be able to be exchanged for goods and services whenever there is a need.

Money is actually created of debt and it is not money that make debt possible. Money and debt appear at exactly the same moment. Money is a blood of society and it goes and will go on circulating to provide life.

Bibliography

  1. A Primer on Money, U.S. Congress, House, Committee on Banking and Currency, Subcommittee on Domestic Finance, 88th Congress, 2nd Session, Government Printing Office, 1964, page 23
  2. Federal Reserve Bank of Chicago: Two Faces of Debt, http://freedom-school.com/two_faces_of_debt.pdf , (17.03.2014)
  3. Federal Reserve Bank of Chicago: Modern Money Mechanics, http://www.dollarnoncents.com/MMM.pdf, (18.03.2014)
  4. David Graeber: Debt. The First 5,000 Years, https://libcom.org/files/__Debt__The_First_5_000_Years.pdf , (17.03.2014)
  5. John Steele Gordon (February 18, 2019): A Short History of the National Debt, http://online.wsj.com/news/articles/SB123491373049303821 , (17.03.2014)
  6. Mongomery vs Daly, http://criminalbankingmonopoly.wordpress.com/montgomery-vs-daly/, (18.03.2014)
  7. Money Owned and Owed, http://www.thetwofacesofmoney.com/files/money.pdf , (19.03.2014)
  8. Paul Krumm: How Money is Created, Disappears, and Works, and the Values Involved in the Process, http://www.vantagequest.org/trees/money.htm#.UycKMah5PtU , (15.03.2014)
  9. The Fractional Reserve Banking System / Zeitgeist Addendum (March 27, 2009), http://truth11.com/2009/03/27/the-fractional-reserve-banking-system-zeitgeist-addendum/ , (16.03.2014)
  10. The Monetary System, http://www.zeitgeistaustralia.org/the-monetary-system/, (15.03.2014)
  11. XAT3. The History of Money: http://www.xat.org/xat/moneyhistory.html , (17.03.2014)

1


[1] The Monetary System, http://www.zeitgeistaustralia.org/the-monetary-system/, (15.03.2014)

[2] The Monetary System, http://www.zeitgeistaustralia.org/the-monetary-system/, (15.03.2014)

[3] Paul Krumm: How Money is Created, Disappears, and Works, and the Values Involved in the Process,

http://www.vantagequest.org/trees/money.htm#.UycKMah5PtU , (15.03.2014)

[4] XAT3. The History of Money: http://www.xat.org/xat/moneyhistory.html , (17.03.2014)

[5] The Fractional Reserve Banking System / Zeitgeist Addendum (March 27, 2009), http://truth11.com/2009/03/27/the-fractional-reserve-banking-system-zeitgeist-addendum/ , (16.03.2014)

[6] Federal Reserve Bank of Chicago: Two Faces of Debt, http://freedom-school.com/two_faces_of_debt.pdf , (17.03.2014)

[7] John Steele Gordon (February 18, 2019): A Short History of the National Debt, http://online.wsj.com/news/articles/SB123491373049303821 , (17.03.2014)

[8] From A Primer on Money, U.S. Congress, House, Committee on Banking and Currency, Subcommittee on Domestic Finance, 88th Congress, 2nd Session, Government Printing Office, 1964, page 23

[9] Federal Reserve Bank of Chicago: Modern Money Mechanics, http://www.dollarnoncents.com/MMM.pdf, (18.03.2014)

[10] Mongomery vs Daly, http://criminalbankingmonopoly.wordpress.com/montgomery-vs-daly/, (18.03.2014)

[11] The Fractional Reserve Banking System / Zeitgeist Addendum (March 27, 2009), http://truth11.com/2009/03/27/the-fractional-reserve-banking-system-zeitgeist-addendum/ , (16.03.2014)

 

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