Friday, December 05, 2008

Do most people think about the nature of money ?

Heres the reality; Every single modern nation defines money as debt, pyramided upon a base of central bank reserves, and implemented through a private banking cartel where a central bank and its member banks are free to engage in fractional reserve lending, usually with some required reserve ratio, leading to a never ending process of inflation (growth in the supply of money) as prices steadily (and sometimes not-so-steadily) grow year over year.

It seems like a rhetorical question to ask if people think about money. Only the most hardened communists and agrarians contemplate living, trading and working without the use of money.

But the question actually is - "do you think about the nature of money ?"

I'll be adding a poll for this question in the sidebar.

We all carry those coins and notes, and keep bank accounts. We all earn dollars and spend them. And this aspect of our behaviour seems a natural and free outcome, ever since man traded food for cattle, worked hard to build things, and thought of ways to get food and shelter.

It wouldn't take much effort or thought to say that we naturally view money (notes and coins and deposit receipts with banks) as a medium of exchange, a store of value and a unit of account.

We can swap them, we can "price" them, we can store them for the future, borrow them and repay them and every party involved in the trade knows exactly what they are getting in to.

A $50 note is a $50 note. All of them do the same thing, none of them rot away, everybody accepts notes to settle payments, and they are easy to carry around.

If you don't want to carry around all your wealth with you, for practical and security reasons, we approach banks to store and safeguard our money. But banks don't quite do that, at least not for the past 200 years.

Things are more complex, as plainly admitted by one of the left's favorite economists:

"The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it (Galbraith, 15). The process by which banks create money is so simple that the mind is repelled." (Galbraith, 29)"

Your newly deposited money at a bank does not get stored in a vault or set aside in your name.

Instead, it gets used a reserve for the creation of new money when another person applies to borrow money from that bank. This process is called fractional reserve, and its been around since the early 19th century thanks to the Bank of England.

Basically, when you deposit $5000 to a bank, they issue you with whats known as a deposit receipt, saying you can redeem on demand, the $5000. But the process doesn't stop there. Banks then use that $5000 base, to lend out a few more thousand, say $4000 or $4500 to somebody else, and they issue the borrower with deposit receipts for that amount.

And you've suddenly got a bank with more deposit receipts than actual reserves. There are more liabilities than assets, and if people only demanded redemption and payment of their liabilities (i.e went to a bank to withdraw their money), then the bank would declare bankruptcy.

This is the unavoidable reality in Australia, America, Europe, Asia .. anywhere you'd care to look. Every bank is vulnerable to a bank run and every bank cannot afford to pay out all of its liabilities.

If you care to quibble or think this is outrageous, ask yourself - why is it, that banks in the news are always reported as collapsing or failing when there is a "bank run" - i.e when a large number of customers queue up to get their money ???

Simple - because they don't have enough reserves to pay them out !

The reason banks play these games, and lend more than their actual reserves, is because after years of experience, they noticed that most people leave the vast majority of their wealth in the banks. Depositors are either "confident" or blissfully unaware of the risks involved.

The whole banking system and economy is based on confidence/ignorance these days. Firstly, people do not carry around a big portion of their wealth as notes/coins to carry around with them or lock up at home in a safe. Customers with savings leaving most of their money in the bank, and they've lived most of their lives comfortably and practically using electronic banking and demand deposits to pay their bills and transfer funds.

So here's the question - what do we do about it ? The system "works" after all, doesn't it ? Well for practical purposes, and as far as the eye can see, it has indeed worked so far. But you'll have to apply your mind a bit and go beyond what is visible. The argument that "if it aint broke don't fix it" must be done away with, because unseen aspects to the money and banking system are no less real or tangible than the plainly visible ones.

For example, if I ran a hidden printing press in my basement and printed myself millions of dollars, that would "work" too, and to most people's eyes, the system would still function. But it would be a gross form of theft for me to counterfeit money that wasn't earned through productive efforts of mine. If everybody did it, then there'd be a lot of money going around, which would dilute the value of every existing dollar, yet not a single ounce of extra wealth, goods and services is created (good old Scrooge Mcduck explains this in a fun youtube video).

Well today banks do just that. They conjur into existence, new demand deposits when a person applies for a loan. They put an entry into their accounts which is a new liability, yet they don't have a corresponding asset. This is how new money is created. The supply of money is a lot more than coins or notes, its also deposit receipts with banks. These days we use our bank deposits for the most part, to pay bills and transfer funds. So if you woke up tomorrow with an extra zero in your bank account balance, then its as if you'd counterfeited real notes and coins.

Counterfeiting money is plain theft - from everybody else who has money. You dilute the value of their holdings. Yet our entire banking system has been doing it for decades, acting as a cartel, expanding the deposit receipts and liabilities, a major part of the supply of money. Its no wonder
that we see prices rising. Goods and services are hardly more scarce than they were 20 years ago, after all, our economy grows and we become more productive and efficient at producing things. But there is so much more money chasing those goods and services.

The supply of money in Australia more than doubled between 1996 and 2006. And we saw shares and real estate prices follow.

Another issue to consider - if all these deposit receipts are created when new loans are made, what happens if everybody repaid their loans instead of just carrying them for decades and re-financing them ? ? The answer - huge amounts of money would be destroyed.

This leads to another phenomena, passionately investigated by the Austrian economists, known as the Austrian Business Cycle Theory. All this new money creation profits certain people at the expense of others, which leads to the cycle of booms and busts. And we've certainly seen our fair share of them in the last century, since the Federal Reserve bank was created in 1913. So perhaps this theory has some substance to it.

Read more here. Or print out a free copy of Murray Rothbard's "The Mystery of Banking".