It has been said that money doesn't grow on trees. But in reality the current financial system creates money at a rate far faster than trees can grow. Most people don’t have a clue of how money is created. Economist and bankers make it sound so complex that it creates the illusion that only very select few are able to understand it. But I’ll try to decode and present the whole monetary system thing in a way that it’s easy to digest and understand. Since most modern financial systems work the same way and the US dollar is the world's most dominant reserve currency, we’ll focus on it for the purposes of this article.
It all starts when some politician says “vote for me and I’ll make sure the government provides more free stuff that my opponent will”. But to provide that “free stuff” the politicians vote for the country to spend more than its income. This is called deficit spending. The government does deficit spending to fund social programs, public works and war. To pay for that deficit spending the treasury borrows currency by issuing a bond. In other words it is loaned into existing. These bonds are basically I.O.U.’s and they state that the government will pay back the entire amount of the I.O.U. plus interests. The problem is that treasury bonds are the national debt. These I.O.U.’s are to be paid back by you and me and your descendants though future taxation.
The treasury then holds a bond auction, and the world’s largest banks buy up our national debt and make a profit by charging interests. Then through open market operations the banks sell the bonds to the Federal Reserve at a profit. To pay for these bonds, the Federal Reserve then writes checks to the banks from their cero balance account. These checks, in practice, should bounce but this is where the system creates new money out of thin air.
To quote from the Boston Federal Reserve “When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money.”
Federal Reserve Bank of Boston, Putting It Simply (1984)
The banks then take that newly created money and loan it out to their depositors through a process called fractional reserve lending. Fractional reserve banking is the practice whereby a bank holds reserves, to satisfy demands for withdrawals that are less than the actual amount of its customers' deposits. Reserves are held at the bank as currency, or as deposits in the bank's accounts at the central bank. Because bank deposits are usually considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying reserves of base money originally created by the central bank.
In other words banks are allowed to reserve only a fraction of your deposits and loan the rest out. Although the ratio varies most banks hold around 10% reserves on their deposits. To give an example, if you deposit $100 on your bank account, the bank is allowed to legally loan out $90 out and keep $10 as reserve in what’s called the “vault cash” in case you want some of it back. But why does your account still says you have $100 if the bank loaned out $90? Because the bank put IOU in its place called bank credits. This expands the money supply from the original $100 to $190.
Here’s in black and white from the Federal Reserve. “Commercial banks create checkbook money whenever they grant a loan, simply by adding new deposit dollars in accounts on their books in exchange for a borrower's IOU.” –Federal Reserve of New York “I Bet You Thought.
The receiver of the $90 loan goes out and spends the money on purchasing an item. The seller of this item deposits the money into his account and his bank is allowed to loan out 90% of that deposit creating additional money. So now there’s $271 in existence from the original $100. This process repeats itself until a deposit of $100 can create up to $1,000 all backed by the same $100.
This fractional reserve lending process is where the vast majority of our money supply comes from.
The prices goods and services of act like a sponge on an expanding money supply. This is where inflation comes from. Inflation is an expansion of the money supply; rising prices are merely the symptom. The expansion of the money supply causes the value of each dollar to be diluted. Therefore, with an expanding money supply, it takes more dollars to pay for the same amount of goods than before. The main flaw with our money system is that it is a debt based system. Think about it if there was only $1 in existence created by this process, meaning it has to be paid back with interest, where does the money to pay the interest come from? It has to also be loaned into existence. This is explained in further detail in our article “The Death of The Dollar”.
I hope this article has helped decipher and given you a better understanding of how our monetary system really works and how money is created.
It all starts when some politician says “vote for me and I’ll make sure the government provides more free stuff that my opponent will”. But to provide that “free stuff” the politicians vote for the country to spend more than its income. This is called deficit spending. The government does deficit spending to fund social programs, public works and war. To pay for that deficit spending the treasury borrows currency by issuing a bond. In other words it is loaned into existing. These bonds are basically I.O.U.’s and they state that the government will pay back the entire amount of the I.O.U. plus interests. The problem is that treasury bonds are the national debt. These I.O.U.’s are to be paid back by you and me and your descendants though future taxation.
The treasury then holds a bond auction, and the world’s largest banks buy up our national debt and make a profit by charging interests. Then through open market operations the banks sell the bonds to the Federal Reserve at a profit. To pay for these bonds, the Federal Reserve then writes checks to the banks from their cero balance account. These checks, in practice, should bounce but this is where the system creates new money out of thin air.
To quote from the Boston Federal Reserve “When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money.”
Federal Reserve Bank of Boston, Putting It Simply (1984)
The banks then take that newly created money and loan it out to their depositors through a process called fractional reserve lending. Fractional reserve banking is the practice whereby a bank holds reserves, to satisfy demands for withdrawals that are less than the actual amount of its customers' deposits. Reserves are held at the bank as currency, or as deposits in the bank's accounts at the central bank. Because bank deposits are usually considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying reserves of base money originally created by the central bank.
In other words banks are allowed to reserve only a fraction of your deposits and loan the rest out. Although the ratio varies most banks hold around 10% reserves on their deposits. To give an example, if you deposit $100 on your bank account, the bank is allowed to legally loan out $90 out and keep $10 as reserve in what’s called the “vault cash” in case you want some of it back. But why does your account still says you have $100 if the bank loaned out $90? Because the bank put IOU in its place called bank credits. This expands the money supply from the original $100 to $190.
Here’s in black and white from the Federal Reserve. “Commercial banks create checkbook money whenever they grant a loan, simply by adding new deposit dollars in accounts on their books in exchange for a borrower's IOU.” –Federal Reserve of New York “I Bet You Thought.
The receiver of the $90 loan goes out and spends the money on purchasing an item. The seller of this item deposits the money into his account and his bank is allowed to loan out 90% of that deposit creating additional money. So now there’s $271 in existence from the original $100. This process repeats itself until a deposit of $100 can create up to $1,000 all backed by the same $100.
This fractional reserve lending process is where the vast majority of our money supply comes from.
The prices goods and services of act like a sponge on an expanding money supply. This is where inflation comes from. Inflation is an expansion of the money supply; rising prices are merely the symptom. The expansion of the money supply causes the value of each dollar to be diluted. Therefore, with an expanding money supply, it takes more dollars to pay for the same amount of goods than before. The main flaw with our money system is that it is a debt based system. Think about it if there was only $1 in existence created by this process, meaning it has to be paid back with interest, where does the money to pay the interest come from? It has to also be loaned into existence. This is explained in further detail in our article “The Death of The Dollar”.
I hope this article has helped decipher and given you a better understanding of how our monetary system really works and how money is created.
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