“What is money?”
That’s the question asked in Paul Grignon’s video, “Money as debt.” Strangely enough, the real answer is not so straightforward as it seems.
To dispel some popular misconceptions (which included mine until I watched the video through a few times), here are a few things money is not:
* Money is not the stuff you carry around in your wallet.
* It is neither paper, coin nor plastic.
* Money is not deposit backed.
* Money is not gold, silver nor any other precious commodity, at least not in
the popular sense.
Money, it turns out, is debt. Period. More specifically, money is generated by a borrower’s promise to repay the amount of a loan plus interest.
When you sign an I.O.U. (known as a loan or mortgage), banks create money out of thin air. In fact, borrowing is tremendously important because if we didn’t have any debt, there would be no money. Really, this is true. And yes, it’s completely counter intuitive. Stay with me for a few minutes and I’ll explain. Or better yet, just flip over here to watch the video.
I had a hard time believing and understanding this concept at first. I thought, especially in light of our current economic crisis, that debt is the problem. If we all magically paid down our debts one day, we would wake up and everything would be perfect (at least economically) wouldn’t it?
Nope.
But how can that be? Well, it is complicated. Way over my head really, as I’m certainly no economist. But I can summarize, greatly paraphrasing Grignon.
(Digression: there are a lot of financial minds out there that greatly surpass mine. My hope in this post is not to provide a comprehensive, or even one hundred percent factual account of economic history and policy. Rather, I want to point out the elephant in the room that few people are talking about in order to generate awareness, the first step toward rational action).
A short history of money:
Here’s how banking started:
People used to trade all sorts of things (beads, animals, food, etc). Eventually countries settled on units of currency that were standardized and certified. Enter our anti-hero, the Goldsmith, who creates coins, keeps them safeguarded in a vault, and even loans some out for interest.
His loan service is going well because commerce is expanding and merchants need credit to expand their businesses. Meanwhile, neighbors want to safeguard their valuables (including gold coins) in the vault, so the Goldsmith is also able to make a small profit charging storage fees.
Easy enough, right? This continues for a while until simultaneously, two things occur to him: First, he realizes that people rarely “cash out” their holdings. There is a lot of gold (his own, plus the depositors’) sitting in his vault collecting cobwebs. Second, people begin trading his paper ‘claim notes’ (which would be used to redeem their gold) in the marketplace instead of actual gold. After all, paper is much more portable! In fact, the claim notes are so well received that people start asking for loans in the form of claim checks instead of the actual gold. Hence, the Goldsmith ends up with even more unused gold.
In a perfect world this primitive bank would only be able to loan out as much currency as it had on hand. But as industry continues its expansion, our cunning Goldsmith realizes that he can pass out claim checks against his depositors’ gold in addition to his own. After all, there are no regulations to determine which gold is his, and which belongs to the depositors, so he can get away with this charade. He begins lending on his customer’s gold, passing out more and more claim checks. And so long as the loans are repaid, ‘his borrowers will be none the wiser and no worse off.’ The goldsmith can make a ‘far greater profit than he could by lending only his own gold.’
But eventually people get suspicious and find out that the Goldsmith is making money from their deposits. And here’s the rub: instead of taking back their gold, the depositors become profiteers and demand to be in on the deal by getting a share of the interest! Capitalism is born.
Thus we have the beginning of formal banking: the Goldsmith-banker now pays low interest on deposits of other people’s money which he then loans out at a higher interest rate.”
Moving on, he eventually realizes that he can take this deal to an entirely new level: because nobody can actually get inside the vault and account for how much gold is on hand, he can lend out claim checks against gold that isn’t even there! As long as everybody doesn’t show up at the same time demanding his or her gold (i.e.: run on the bank) nobody would ever know.
The banker figured out how to get wealthy from gold that didn’t even exist.
Eventually people do catch on and begin demanding actual gold instead of promissory notes. This generates a run (where people do in fact withdraw their holdings), and badly damages the banking industry. But credit has fueled commercial expansion, so instead of banning banking, governments decide to regulate it.
Modern day banking:
You might hope at this point that we had learned our lesson. Alas, that’s not really the case.
Need for regulation led to creation of The Fractional Reserve System, which allows bankers to keep, for example, one dollar’s worth of gold for each $10 worth of promissory notes. Enforced by surprise inspections and support from Central Banks (which could infuse gold into the system if necessary) the overall banking system should only crash if there are runs on lots of banks simultaneously.
The bankers still get to lend money that doesn’t really exist, but only up to a point.
And this actually seems to have worked out pretty well for a while, not withstanding a little thing called the Great Depression that occurred from 1929-1933. Something else even more significant perhaps, occurred even later in the 20th century: in 1973 the U.S. decoupled our currency from the gold standard. What does this mean? Whereas paper dollars used to be redeemable for a fixed amount of gold or silver, currency (paper or digital) can now only be redeemed for other paper or digital dollars.
To be straight, money used to represent value. Now it represents debt.
When we were on the gold standard, more gold (or silver) had to be found in order to create more money. In the present, money is created as debt (whenever anyone takes out a loan). So the total amount of money that can be created has only one real limit: the total amount of debt.
Remember how the Fractional Reserve System used to allow bankers to keep one dollar’s worth of gold for each $10 worth of promissory notes? Now it’s even more arbitrary: today’s reserve requirement ratios no longer apply to the ratio of new money to gold on deposit, but merely to the ratio of new debt money to existing debt money on deposit in each bank. The quantity of gold backing our debt has virtually disappeared.
Think about it this way: how can governments, corporations, small business and families all be indebted for such huge amounts? As of March 26, 2009 the outstanding U.S. Public Debt is over $11 trillion dollars. With our population estimated at just over three hundred million persons, each citizen’s share of this debt is approximately $36,130. Oh, and by the way, the debt has been growing at a rate of $3.76 billion per day since September 28, 2007.
Grignon asks, “Have you ever questioned how there can be that much money out there to lend? There isn’t! Banks do not lend money. They simply create it from debt and since debt is potentially unlimited, so is the supply of money.”
Perpetual debt (a non-functioning economy):
Ok, we’re almost done with the hard stuff.
The last problem we need to consider for now is the simple fact that banks only create money for principal. They don’t create money to pay for interest.
Think about it this way: when you take out a loan for $20,000 to buy a car, how much money gets produced in the form of debt? The answer is…$20,000. However, you actually need to pay back the twenty thousand dollars plus interest.
Again, here’s Paul Grignon:
“The only place borrowers can go to obtain money to pay interest is the economy’s overall money supply, but almost all of the overall money supply has been created exactly the same way – as bank credit that has to be paid back with more than was created – so everywhere there are borrowers in the same situation, frantically trying to obtain the money they need to pay back both principal and interest from a total money pool that contains only principal. It is clearly impossible for everyone to pay back principal plus interest, because the interest money doesn’t exist! The big problem is that for long-term loans such as mortgages and government debt the total interest far exceeds the principal. So unless a lot of extra money is created to pay the interest it means a very high proportion of foreclosures and a non-functioning economy.
To maintain a functional society the rate of foreclosure needs to be low, and so to accomplish this more and more debt money has to be created to satisfy today’s demands for money to service the previous debt. But of course this just makes the previous debt bigger, and that means more interest must ultimately be paid, resulting in an ever escalating and inescapable spiral of mounting indebtedness!”
The only remaining factor is time lag. If we can stay ahead of the curve, then we can put off the inevitable.
This, my friends, is exactly what our government is trying to do right now. Grignon bottom-lines it for us: “If it is the fundamental nature of the system that causes the problems, tinkering with the system cannot ever solve those problems. The system itself must be replaced.”
We are not however, headed toward replacement of a broken model. We are headed further into debt at an ever-accelerating pace.
And ultimately this means that our consumer engine keeps going by producing and replacing our stuff so that our economy doesn’t collapse.
Here’s the pick-me-up!
Ok, ok…enough doom and gloom already!
Remember when I said up front that I was covering this topic in order to take the first step toward rational action? There are a few things that could be done, all of which include varying levels of economic discomfort. But at least there is an element of pragmatism about them that is worth discussing.
1. Demand that we teach financial literacy in schools. Become financially
literate ourselves. Teach our children what nobody taught us.
2. Insist that our government create interest-free money for itself instead of
subsidizing, borrowing from and paying massive interest to banks.
3. Focus our attention on the question: “what do we need to change in order to
create a sustainable economy?
4. Spend on infrastructures (like transportation, information and energy) that
create value.
5. Encourage local economic development through complimentary currencies
such as time banking.
Have any other ideas? Offer your comments and let me know!
