Also read Day 71: The Money Supply for additional Context
When someone takes out a loan from the bank, we believe (and most of the time have been taught) that this money is money that has been entrusted to them by depositors. This is not what happens in reality. The money that is received as a loan is actually created by the bank. This money does not come from what people have deposited and it also does not come from the banks own revenue. It is created from the borrower’s promise to repay.
When you sign a loan agreement, you agree to pay back the bank the amount borrowed, plus interest. You also agree that in the event that you are unable to pay back your loan, the bank has the right to confiscate your car, your house or whatever asset that was pledged as surety. The only thing of real value that is involved in a loan transaction, are the assets one has pledged to the bank in the event one fails to pay back the loan. (This loan agreement now carries value. The promise that sometime in the future you will pay off your loan means that at some point in the future, the bank will have this money. And even though the bank does not have the money now, it will use this loan agreement as if it is worth the amount of money owed – and use/spend it as such.)
Once the loan agreement has been signed, the bank is allowed to summon into reality the amount of the loan and just insert it into the borrower’s account.
The concept of lending out more money than you actually have stored is called “fractional reserve banking”.
This concept emerged during the 17th and 18th centuries in Europe. Halfway through the 17th century, as a consequence of the civil war, goldsmiths were making less money with their traditional way of doing business as forging objects out of gold and silver. As a way to survive, they started accepting other people their precious metals and keep it safe for them in their vaults at a particular fee. The goldsmith would then issue a receipt for the deposit made to the depositor. These receipts started circulating as a form of money, functioning as a representation of the actual physical precious metals that were stored in the vaults. As time went on, the goldsmiths realised that not all of the depositors would use their receipts to claim their gold and silver at the same time. The goldsmiths would thus be able to lend out more money as receipts than what he actually had in stock, and nobody would notice. Fractional reserve banking was born.
Fractional reserve banking is where only a fraction of bank deposits are backed by actual cash that is present and available for withdrawal. This system started with the goldsmiths and is currently still being applied in most countries all over the globe.
When the people realised what the goldsmiths were up to, it was already too late. Their money making mechanism had become a vital and essential part to the expansion of European commerce. So instead of banning fractional reserve banking, the government decided to regulate it instead.
Over the years, the fraction of gold backing the debt money has gradually declined to zero. Presently, paper or digital money can only be redeemed for another piece of paper or digital money.
In the past, the amount of money that was in circulation was limited and in accordance to whatever physical commodity was used and valued as money (e.g. gold, silver). For there to be more money, there had to be more of the particular commodity (e.g. more gold and silver).
Nowadays, money is created as debt. Using the fractional reserve banking method, new money is created through issuing loans. The only limit to the money supply is the total level of debt.
The most common ratio by which money is created is 9 to 1. Where for each actual dollar the bank has, it can bring 9 more “fictional” dollars into being. If this ‘new money’ then circulates between individuals and banks, even more ‘new’ money can be created from the previously ‘new money’.
This practically implies that money can only come into being through debt, and that essentially money is debt.
This has the even more disturbing implication that without debt, there will be no money.
Let use some simply mathematics to illustrate this point.
We start with zero ( 0 ) amount of money.
If we now pay off our loan, the money count will simply go back to zero, as the equation has been balanced out again. And the money is gone. We are thus completely dependent on debt for the existence and circulation of money! If everyone in the world would pay off their debts -- which sounds like a ‘good thing’ and considered by most to be a form of ‘improvement’ -- then there will be no more money!
Banks will borrow you the principle amount of your loan, but where does the money come from to pay off the additional interest? The only way borrowers can pay the additional interest is by using money from the overall money supply in circulation. But now as we’ve just seen, most of this money has been created through debt which also has to be paid back with more than that which was created/borrowed.
We are faced with a situation where many (if not everyone) has to pay back both the original amount borrowed - plus interest - using money from the overall money supply. But this overall money supply consists of only the sum of all the principle amounts borrowed. It is thus impossible for everyone to pay back the original / principle amount and pay back the additional interest (unless the interest that is being paid to the banks gets spend immediately so others can use it to pay off their interest as well). Unless a vast amount of extra money is created to pay off the interest, a high level of foreclosure will be prominent in society. For a society to function at an effective level, foreclosure rates require to stay low. To be able to achieve this, more and more money needs to be created (= more and more debt), just to be able to meet the plea for money to be able to pay off the previous debt. We are literally taking out loans just to pay off our previous loans. This results in to a never-ending cycle of going into more debt to be able to pay off previous debts. The only thing that keeps the system going is the time lag between money being created and the loans being paid off over time. If this time lag was not in place, the whole system would collapse instantaneously.
It is an unsustainable system that eats itself up from the inside out.
When you sign a loan agreement, you agree to pay back the bank the amount borrowed, plus interest. You also agree that in the event that you are unable to pay back your loan, the bank has the right to confiscate your car, your house or whatever asset that was pledged as surety. The only thing of real value that is involved in a loan transaction, are the assets one has pledged to the bank in the event one fails to pay back the loan. (This loan agreement now carries value. The promise that sometime in the future you will pay off your loan means that at some point in the future, the bank will have this money. And even though the bank does not have the money now, it will use this loan agreement as if it is worth the amount of money owed – and use/spend it as such.)
Once the loan agreement has been signed, the bank is allowed to summon into reality the amount of the loan and just insert it into the borrower’s account.
The concept of lending out more money than you actually have stored is called “fractional reserve banking”.
This concept emerged during the 17th and 18th centuries in Europe. Halfway through the 17th century, as a consequence of the civil war, goldsmiths were making less money with their traditional way of doing business as forging objects out of gold and silver. As a way to survive, they started accepting other people their precious metals and keep it safe for them in their vaults at a particular fee. The goldsmith would then issue a receipt for the deposit made to the depositor. These receipts started circulating as a form of money, functioning as a representation of the actual physical precious metals that were stored in the vaults. As time went on, the goldsmiths realised that not all of the depositors would use their receipts to claim their gold and silver at the same time. The goldsmiths would thus be able to lend out more money as receipts than what he actually had in stock, and nobody would notice. Fractional reserve banking was born.
Fractional reserve banking is where only a fraction of bank deposits are backed by actual cash that is present and available for withdrawal. This system started with the goldsmiths and is currently still being applied in most countries all over the globe.
When the people realised what the goldsmiths were up to, it was already too late. Their money making mechanism had become a vital and essential part to the expansion of European commerce. So instead of banning fractional reserve banking, the government decided to regulate it instead.
Over the years, the fraction of gold backing the debt money has gradually declined to zero. Presently, paper or digital money can only be redeemed for another piece of paper or digital money.
In the past, the amount of money that was in circulation was limited and in accordance to whatever physical commodity was used and valued as money (e.g. gold, silver). For there to be more money, there had to be more of the particular commodity (e.g. more gold and silver).
Nowadays, money is created as debt. Using the fractional reserve banking method, new money is created through issuing loans. The only limit to the money supply is the total level of debt.
The most common ratio by which money is created is 9 to 1. Where for each actual dollar the bank has, it can bring 9 more “fictional” dollars into being. If this ‘new money’ then circulates between individuals and banks, even more ‘new’ money can be created from the previously ‘new money’.
This practically implies that money can only come into being through debt, and that essentially money is debt.
This has the even more disturbing implication that without debt, there will be no money.
Let use some simply mathematics to illustrate this point.
We start with zero ( 0 ) amount of money.
Now we want to take out a loan of let’s say, 500 dollars.
By taking out a loan of (+) 500 dollars, we are creating debt for the amount of (-) 500 dollars.
If we now pay off our loan, the money count will simply go back to zero, as the equation has been balanced out again. And the money is gone. We are thus completely dependent on debt for the existence and circulation of money! If everyone in the world would pay off their debts -- which sounds like a ‘good thing’ and considered by most to be a form of ‘improvement’ -- then there will be no more money!
“This is a staggering thought. We are completely dependent on the Commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money, we are prosperous; if not, we starve. We are, absolutely, without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is.”
- - Robert H. Hemphill, Credit Manager of Federal Reserve Bank, Atlanta, Georgia
But now, as you may have noticed, we have not yet addressed the point of paying back interest.
Banks will borrow you the principle amount of your loan, but where does the money come from to pay off the additional interest? The only way borrowers can pay the additional interest is by using money from the overall money supply in circulation. But now as we’ve just seen, most of this money has been created through debt which also has to be paid back with more than that which was created/borrowed.
We are faced with a situation where many (if not everyone) has to pay back both the original amount borrowed - plus interest - using money from the overall money supply. But this overall money supply consists of only the sum of all the principle amounts borrowed. It is thus impossible for everyone to pay back the original / principle amount and pay back the additional interest (unless the interest that is being paid to the banks gets spend immediately so others can use it to pay off their interest as well). Unless a vast amount of extra money is created to pay off the interest, a high level of foreclosure will be prominent in society. For a society to function at an effective level, foreclosure rates require to stay low. To be able to achieve this, more and more money needs to be created (= more and more debt), just to be able to meet the plea for money to be able to pay off the previous debt. We are literally taking out loans just to pay off our previous loans. This results in to a never-ending cycle of going into more debt to be able to pay off previous debts. The only thing that keeps the system going is the time lag between money being created and the loans being paid off over time. If this time lag was not in place, the whole system would collapse instantaneously.
It is an unsustainable system that eats itself up from the inside out.
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