Money is Debt – The Fractional Reserve Banking System
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"....Money is made by the mint but most money is created by private corporations which are known as banks. Folk believe that banks lend out money which has been entrusted to them but the fact is banks create the money they loan, not from earnings, not from the money deposited but directly from the borrower’s promise to repay. The borrower has an obligation to pay back the loan plus interest or lose the assets placed as collateral. The bank’s obligation is to conjure into existence the money for the loan and tap it into the computer.
Little History – Goldsmith Tale
Money – anything can be used as money so long as it is portable and contains the community’s faith that it can be traded for goods. Gold and silver are attractive, soft and easy to work with. Goldsmiths began to cast coins for circulation and to protect his gold kept it in big vaults, soon fellow towns men wanted their own gold, coins and valuables kept safe, so the goldsmith started to rent out his vault.
Goldsmith Observation – depositers rarely took out their valuables and never came in at once to remove them. That was because the claim cheques the goldsmith had written as receipts for the vauables were being traded in the market as if they were the gold itself. Paper money was more convinient than heavy coins and amounts could be written rather than counted for each transaction.
Goldsmith Business Venture – goldsmith started lending out his gold charging interest. When his own claim cheque-money came into acceptance, borrowers started asking for loans in this form rather than lumping around gold. As business expanded more and more people asked him for loans, this lead goldsmith to make further observations.
1) few depositors removed their gold from his vault
2) so goldsmith could lend out claim cheques against his depositors’ gold and his own stock of valuable
3) so long as loans were repaid the depositirs were be no worse off, and the goldsmith could make far more profit than he would just lending on his own gold. Goldsmith thus earned interest on everyone else’s deposits into the bank.
Suspicions grew of goldsmiths growing wealth and the depositors thought he was spending their money. They threatened to withdrew their gold if the goldsmith didn’t state how his new found wealth came about. The goldsmith showed his depositors that they hadn’t lost anything, that their gold was still in the goldsmith’s vault. Rather than withdraw the gold the depositors demanded a share of the interest made by the goldsmith. And this was the beginning of banking.
The banker paid a low interest rate on the deposit of other people’s money that he then loaned out at a higher interest. The difference covered the cost of the bank’s operation and its profit. Banking satisfied the demand for credit. However, this is not the way banking works today.
Goldsmith-Banker’s Observation – demand for credit grew as Europeans ventured out upon the world but his loans were limited by the amount of gold he had in his vault and the goldsmith-banker was no longer content with just the income remaining after sharing the interest with his depositors. New idea, since no one knew what was in his vault he could lend out claim cheques on gold that wasn’t even in his bank. As long as all the claim cheque holders didn’t come to the bank and demand the real gold how would anyone find out?
The new system worked well and banks became wealthy on the interest of gold that did not exist. Bankers created money out of nothing. Overtime, there were problems such as ‘runs’ on particular banks whereby claim cheque holders lost faith in their cheques and flooded the bank demanding gold rather than the paper money representation. But in the long run the credit bankers were offering had become essential to the success of European commercial expansion. So instead of government outlawing the practice of making money from nothing it was legalised and regulated. Bankers agreed on limits of the amount of fictional loan money which could be lent out and in the event of a bank run, central banks would support local banks with emergency infusions of gold. Only if there were a lot of runs on banks simutaineously would the banker’s credit bubble burst and the system come crashing down.
Essentially this practive is known as the Fractional Reserve System – an integrated net work of banks backed by a central bank. The dominant money system of the world. The fraction gold backing the debt money has shrunk to nothing. The basic nature of money has changed. Money used to represent value, money now represents debt. In the past the paper money was a receipt that could be redeemed for a fixed weight of gold or silver, in the present the paper or digital money can only be redeemed for other paper or digital money.
In the past each privately created bank credit existed only in the form of the particular private bank’s cheques and notes which could be accepted or not, but today privately created bank credit is legally convertable to government issued fiat currency. Fiat currency is money created by government fiat or decree. Law states that citizens must accept this fiat money as payment of debt or else courts will not enforce the obligation.
So, if governments and banks can just create money, how much money exists? In the past the total money in existence was limited to the physical quantity of whatever commodity was in use as actual money. For example, in order for gold or silver money to be created more gold and silver had to be found and melted. In the present money is created as debt. New money is created whenever anyone takes a loan from the bank and as a result the total amount of money that can be created has only one limit - the total level of debt.
Governemts place a statatory limit on the creation of new money by enforcing rules called ‘fractional reserve requirements’; fractional reserve requirements vary from country to country and from time to time. In the past it was common to require banks to have at least 1x of real gold in the vault to back 10x of debt money created. Today reserve requirements 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 the bank. Today a bank’s reserves consists of two things: the amount of government issued cash or equivalent which the bank has deposited in the central bank plus the amount of already existing debt money the bank has on deposit.
To offer an example of what this means, imagine a new bank has started with no depositers. However, the bank investors have made a reserve of 1111.12x of existing cash money at the central bank. The required reserve ratio is 9:1.
Step 1: first loan customer. He needs 10,000x to buy a new car. At the 9:1 reserve ratio the new bank’s reserve at the central bank (also called high powered money) allows it to legally conjure into existence 9 times that amount. Or 10,000 on the basis of the borrowers pledge of debt. This 10000x is not taken from anywhere, its brand new money typed into the borrowers account as bank credit. The borrower then writes a cheque or whatever on that credit to buy his car.
Step 2: the seller of the car then deposists this newly created 10000x into her bank but unlike the high powered money deposited at the central bank this newly created credit money cannot be multiplied by the reserve ratio. Instead it is divided by the reserve ratio. At the ratio of 9:1 a new loan of 9000x with the reserve of 1000x can be created on the basis of the 10000x deposit.
Step 3: If that 9000x taken as a loan is then deposited by a third party at the same bank that created it or at a different one it becomes the legal basis for a third issue of bank credit. This time at the ratio of 9:1 the new loan will be 8,100x and 900x in reserve. Thus each new deposit on that first 10000 created contains the potential for a slightly smaller loan in an infintely decreasing series.
If, however, the loan money created is not deposited at a bank the process stops and this is unpredictable part of the money creation mechanism. But more than likely at every step the new money will be deposited at a bank and the reserve ratio process can repeat itself over and over until almost a 100,000 of brand new money has been created within the banking system. All this new money has been created entirely from debt and the whole process has been legally authorised by the initial reserve deposit of 1111,12 which is still sitting untouched at the central bank.
By law each bank in the chain must show on its books that it has 10% more on deposit than it has out on loan. This gives banks the insentive to seek deposists in order to be able to make more loans, supporting the general but misleading impression that loans come out of deposists.
Now, within our example, unless all the successive loans are deposited at the same bank it cannot be said that any one bank got to multiply its initial highpowered money by 90 times (1111.12x90=100,000) by issuing bank credit out of nothing. However, the banking system is a closed loop, bank credit created at one bank becomes a deposit in another. In the theoretical world of perfectly equal exchanges the ultimate effect would be exactly the same as if the whole process had taken place within one bank.
Thus, banks loan money they do not have. In many countries the requirements to make a reserve deposit at the nation’s central bank have all but disappeared and that actual reserve ratios can be higher than 9:1. For some type of accounts 20:1 or 30:1. In raising loan fees, banks have also found ways to circumvent fractional reserve requirement limitations.
As we have seen, banks can potentially create as much money as we can borrow. Government created money accounts for about 5% of the money in circulation. More than 95% of all other money in existence is created by someone somewhere signing a pledge of indebtedness to a bank. This bank credit money is being created and destroyed everyday as new loans are made and old ones repaid. The amount of the loan (P - principle) is created from the borrower’s promise to repay and once repaid the principal (P) is uncreated ceasing to exist as money.
Banks can only enact this money making system with the coroporation of government. First governments pass legal tender laws to use the national fiat currency. Secondly, governments allow private bank credit to be paid out in this currency. Thirdly, government courts enforce debts. Lastly, governments pass regulations to protect the money syetms functionality and credibility with the public while doing nothing to inform the public about this kind of set up.
The bottom line is that when one signs on the dotted line for a loan or mortgage our sign pledge of payment backed by the assests we pledge to forfeit should we fail to pay back the loan is the only thing of real value involved in the actual transaction. That loan or mortgage agreement is now a portable, exchangable and saleable piece of paper. It’s an ‘iou’, it represents value and is therefore a form of money. This money the borrower exchanges for the bank’s loan. A loan in the real world means the lender must have something to lend, but in the world of money the banks give money they don’t have which is allowed to be passed of as money. And we accept it as such.
Once the borrower signs the pledge of debt, the bank then balances the transaction by tapping in a matching debt to the borrower. From the borrower’s point of view this debt becomes loan money and because the government allows this debt of the bank to the borrower to be converted into government fiat currency everyone has to accept it as money. So, without the loan or mortgage document the borrower signed the bank would have nothing to lend. Thus, banks do not lend money they create it from debt. And because debt is potentially unlimited so is the supply of money. It turns out that the opposite situation will also be true. No debt, no money.
On an individual level if debts are paid one does have more money to spend, but on the global scale there would be no money if all debts were paid. We are totally dependent on continually renewed bank credit for there to be any money in existence. No loans, no money. Which is what happens in depressions, money supply shrinks as the supply of loans dry up. Someone has to borrow every dollar we have in circulation – cash or credit. Our system requires perpetual debt.
Banks create only the amount on the principal, they don’t create the money to pay the interest. So where does that come from? The only place borrowers can go to obtain the money to pay interest is the general economy’s overall money supply but almost all that money supply has been created exactly the same way, it is bank credit which has to be paid back with more than was created. So everywhere there are other borrowers in the same situation, frantically trying to obtain the money they need to pay back both principal and interest from the total money pool which contains only principal. It is impossible for everyone to pay back the principal plus the interest because the interest money doesn’t exist.
The problem is that for long term loans the total interest far exceeds the principal loan, so unless a lot of extra money is created to pay the interest it means a high proportion of foreclosure. To maintain a functional society the rate of foreclosures needs to be low and so to accomplish this more and more new debt money has to be created to satisfy the demands for money to erase the previous debt but of course, this just makes the total debt bigger which means that ultimately more interest must be paid resulting in an inescapable spiral of mountain indebtedness.
It is only the timelag between money’s creation as new loans and its repayment which keeps the overall shortage of money from cathching up and bankrupting the entire system. However, as the bank’s credit gets bigger and bigger the need to create more and more debt to feed it becomes increasingly urgent. Why are interest rates so low? Why do we get unsolicited credit cards in the mail. Why is the US government spending faster than ever, could it be to stave of collapse of the entire monetary system. One has to ask, can this go on forever? Isn’t collapse inevitable?..."
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This was copied from the given link above by some of my practicing English students who went about it as a listening exam. I think they did an excellent job! I'm sorry for any spelling mistakes and the such but I just don't have the time to go through it. Nevertheless, I think the script covers the general idea and hopefully will save folk a little time.