How Money Works - Automated Financial Crisis

The financial meltdown we are experiencing (it is not over by any means) could, and was, predicted long ago. In the same vein, what will happen next can be plainly discerned, given a thorough study of the financial system and its pitfalls.

The Federal Reserve Act

It is important to recognize that our current monetary system was created by the Federal Reserve Act of December 23, 1913. The Founding Fathers knew, wrote and spoke about the dangers of a Central Bank. More on this topic in a later piece.

Contrary to widely held and persistent belief, the Federal Reserve is not a part of the Federal Government. It is a private corporation owned by its member banks, which in turn are owned by a group of individuals whose identities are protected by law. The Federal government has delegated power to create “legal tender” to this Central Bank. It did not delegate power to “Coin” money as this would violate the Constitution and the Coinage Act.

How Money Works - Simple Version

In the Federal Reserve system, money is created when a member bank deposits money in the Federal Reserve Bank (the “Fed”) It is a circuitous process but for the sake of example we will begin at the point someone deposits $1000 in their local member bank (All National banks are required to be members of the Federal Reserve, State banks’ membership is optional). Since the system is what’s known as a “Fractional Reserve” system, the member bank is only required to keep a portion of the money in reserve at the fed. For simplicities sake, let’s say that reserve is 10%. That leaves $900 for the member bank to re-loan to other customers. But it does not loan it by using the $900 in its Reserve account. If it did that, there would be no money creation involved, and banks readily admit that they create money when they loan it. The bank loans the $900 by adding it to the account of the borrower in return for their IOU (note) for that amount. Now the bank has an "additional" $900 on deposit, balanced on its books by the borrowers IOU. Now with that $900 on deposit, only $90 need be kept in reserve. So the bank is free to loan the remaining $810 again by simply adding it to the account of another borrower. Only $81 of that loan needs to be kept in reserve, so another $729 can be loaned.

Deposit	Reserve Requirement	Excess Reserves (Available to Loan)
$ 1,000.00	$ 100.00	$ 900.00
$ 900.00	$ 90.00	$ 810.00
$ 810.00	$ 81.00	$ 729.00
$ 729.00	$ 72.90	$ 656.10
$ 656.10	$ 65.61	$ 590.49
$ 590.49	$ 59.05	$ 531.44
$ 531.44	$ 53.14	$ 478.30
$ 5,217.03	$ 521.70	$ 4,695.33

	Deposit	Reserve Requirement	Excess Reserves (Available to Loan)
Original Deposit	$ 1,000.00	$ 100.00	$ 900.00	Moved to next line as deposit
	$ 900.00	$ 90.00	$ 810.00	Moved to next line as deposit
	$ 810.00	$ 81.00	$ 729.00	Moved to next line as deposit
	$ 729.00	$ 72.90	$ 656.10	Moved to next line as deposit
	$ 656.10	$ 65.61	$ 590.49	Moved to next line as deposit
	$ 590.49	$ 59.05	$ 531.44	Moved to next line as deposit
	$ 531.44	$ 53.14	$ 478.30
Totals	$ 5,217.03	$ 521.70	$ 4,695.33

The original $1,000 deposit becomes $4,695.33 of “money” loaned by the bank, all of which is simply created on paper. The actual Federal Reserve Notes (Dollars) are simply representations of the accounting figures. The represent nothing else and are not “backed by anything. Some make the assertion that the deposits are backed by the “Full faith and Credit of the US Government” but that is miss-leading and simplistic. Again, more on that in a latter post.

Seems like a pretty good system at first glance, there is lots of money to go around, lots of money to loan, and lots of money chasing goods and services. A couple of problems are evident right away; Firstly, suppose that 4 people want to actually withdraw the cash for a purchase instead of using a check? Remember there was only $1000 cash in the beginning, all the rest of the money is only numbers on paper. This problem has a simple solution. The member bank  requests money from the Federal Reserve who in turn instructs the Bureau of Engraving and Printing to print more. The Fed only pays for the actual cost of printing the money, not the face value. This is where money comes from. The Federal Government has no involvement in the process other than Appointing the Federal Reserve Chairman and actually printing the bills at the command of the Fed.

A serious problem arises however if we discover the original $900 IOU is no good. Now, we don’t just have $900 in jeopardy, but $4,695.33 is in danger of disappearing. This is the essence of the so-called sub-prime crisis. A huge percentage of defaults is not necessary to bring the whole system crashing down. A relatively few bad loans are enough to crumble the entire scheme.

Of course it is plain to see that the system is geared to promote more and more loans and more and more consumption. There is a real incentive to make more loans. More loans mean more money to lend and charge interest on, more loans mean more money to loan, etcetera. It is not simply a matter of a few greedy mortgage brokers or bankers or homeowners buying beyond their means. The problem is systemic. The fatal flaws are built in. Anyone can turn on the news or search on the Internet and hear or read countless complex explanations for the financial crisis, but in the simplest terms the Federal Reserve system is the cause of the problem. To be sure, there are countless other much more complex interactions and factors not taken into account in this article such as interest or derivatives. These are complete topics in themselves.

The more one studies the financial system, its history and structure, especially from an un-biased outside view, the more obvious the near and long term consequences become. What should you do to protect your assets? It is NOT what you hear and see on the mainstream media. We have seen that the Federal Reserve is at the root of the problem, the Federal government has capitulated its duties and mainstream talking heads are regurgitating the official line with little variance. What should you do? Stay tuned.

 

Do you remember reading earlier of the crisis that will arise when a nation's total productivity is insufficient to pay the interest on its debt? After all, our modern money provides no means for the ultimate payment of debt, but only its continual rolling over by re-borrowing. Well, that is happening now in Poland and Mexico. It places the largest banks--those that loan to governments--in jeopardy. But organizations smaller than governments also get loans from smaller banks, and these organizations and banks are also in trouble. Perhaps these banks are not big enough to be rescued by the international monetary fund. They may be allowed to fail. Eventually, larger and larger banks will fold as the companies whose IOUs they hold collapse under the crushing burden of debt.

It is not a matter of conjecture that the banks of the world are cooperating to provide further funds to Poland, for the reason that its default would be unthinkable. But it is equally unthinkable that Poland's inability to pay its debts can be remedied by placing it still further in debt. But when money is perceived of as debt, what is the alternative?

You will occasionally hear people express concern that the United States government may go bankrupt if it does not curtail spending. That is nonsense. The banks will not allow that for the same reason that they will not allow Poland to go belly-up. A bankruptcy of that magnitude would pull the entirely monetary system down. The fractional reserve requirement is a very sharp two-edged sword. It permits my deposit of $1,000 to be parlayed into $10,000. But it also permits an equally drastic contraction of loans (deposits) if the reserve should cease to exist, as in a bankruptcy. So why should the government go bankrupt, and bring the entire economy down? It isn't as though the government owes something like silver or gold. All it "owes" are its "obligations," which are not obligations at all. Bankruptcy is out of the question.

So much for the "good" news. The "bad" news is that the means by which the government avoids bankruptcy leads to what is at least as catastrophic: namely, runaway inflation. The government can always pay off its debts by borrowing ("rolling over" the debt) from the banks, which can hardly refuse the loan request, for to do so would trigger catastrophe. But the rapidly mounting flood of "money" tends to quickly become worthless. So the choice is between disaster on one hand, and catastrophe on the other. 

But you are forewarned. The people who will be hurt the most are the holders of---"money!" Do you have an IRA, or time-deposit?