Wonder why you now need 100+ rupees to get 1 pound? How money is created, the policies by which it is governed and how it truly affects society are unregistered interests of the great majority of the population. In a world where 1% of the population owns 40% of the planet’s wealth, where thousands of children die every single day from poverty & preventable diseases, and where 50% of the world’s population lives on less than 2 dollars a day… one thing is clear:
Something is terribly wrong.
And whether we are aware of it or not, the lifeblood of all of our established institutions and thus society itself, is money. Therefore understanding this institution of monetary policy is critical to understanding why our lives are the way they are. You DO NOT need to be a Nobel laureate or a smarty to understand basics of economics / finance – macro, micro or whatever!
Unfortunately, economics is often viewed with confusion and boredom. Endless streams of financial jargon coupled with intimidating mathematics quickly deter people from attempts at understanding it. However, the fact is, the complexity associated with the financial system is a mere mask, designed to conceal one of the most socially paralyzing structures humanity has ever endured. Though following example focus on US, if you look closely and seriously, situation in other emerging countries (viz India) experimenting some new free market ideas and sticking to old colonial elitist rule books to easily suppress its commoners, can be even worse!
The Government decides it needs some money, so it calls up the Federal Reserve, and requests, say, 10 billion dollars”. The fed replies, saying ”sure… we’ll buy 10 billion in government bonds from you.” So, the government then takes some piece of paper, paints some official looking designs on them, and calls them ‘Treasury Bonds’. Then, it puts a value on these Bonds to the sum of 10 billion dollars, and sends them over to the Fed. In turn, the people at the Fed draw up a bunch of impressive pieces of paper themselves, only this time calling them ‘Federal Reserve Notes’… also designating a value of 10 billion dollars to the set.
The Fed then takes these notes and trades them for the Bonds. Once this exchange is complete, the government then takes the 10 billion in Federal Reserve Notes and deposits it into a bank account… and upon this deposit, the paper notes officially become ‘legal tender’ money, adding 10 billion to the US money supply. And there it is… 10 billion in new money has been created.
Of course, this example is a generalization, for, in reality, this transaction would occur electronically, with no paper used at all. In fact only 3% of the US money supply exists in physical currency. The other 97% essentially exists in computers alone.
Now, Government bonds are, by design, instruments of Debt and when the Fed purchases these bonds, with money it created essentially out of thin air, the government is actually promising to pay back that money to the Fed.
In other words… The money was created out of debt. This mind numbing paradox of how money, or value, can be created out of debt, or a liability, will become more clear as we further this exercise. So, the exchange has been made and now 10 billion dollars sits in a commercial bank account. Here is where it gets really interesting, for as based on the Fractional Reserve practice, that 10 billion dollar deposit instantly becomes part of the bank’s Reserves, just as all deposits do. And regarding reserve requirements, as stated in Modern money mechanics:
A bank must maintain legally required reserves, equal to a prescribed percentage of its deposits. It then quantifies this by stating: under current regulations, the reserve requirement against most transaction accounts is 10%.”
This means that with a ten billion dollar deposit, 10% or 1 billion is held as the required reserve, while the other 9 billion is considered an excessive reserve and can be used as the basis for new loans.
Now, it is logical to assume that this 9 billion is literally coming out of the existing 10 billion dollars deposit. However, this is actually not the case. What really happens is that the 9 billion is simply created out of thin air, on top of the existing 10 billion dollar deposit. This is how the money supply is expanded.
The banks do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes (loan contracts) in exchange for credits (money) to the borrower’s transaction accounts.”
In other words, the 9 billion can be created out of nothing, simply because there is a demand for such a loan, and there is a 10 billion dollars deposit to satisfy the reserve requirements. Now, let’s assume that somebody walks into this bank and borrows the available 9 billion dollars. They will then most likely take that money and deposit it into their own bank account.
The process then repeats, for that deposit becomes part of the banks reserves, 10% is isolated and in turn 90% of the 9 billion or 8.1 billion is now available as newly created money for more loans. And, of course, that 8.1 can be loaned out and redeposited creating an additional 7.2 billion…to 6.5 billion.. to 5.9 billion etc.
This deposit-money creation-loan cycle can technically go on to infinity… the average mathematical result is that about 90 billion dollars can be created on top of the original 10 billion. In other words, for every deposit that ever occurs in the banking system, about 9 times that amount can be created out of thin air.
So that we understand how money is created by this fractional reserve banking system, a logical, yet elusive question might come to mind:
What is actually giving this newly created money value?
The answer: The money that already exists. Your note of 100, is worth less now!
The new money essentially steals value from the existing money supply… for the total pool of money is being increased, irrespective to demand for goods and services, and, as supply and demand finds equilibrium – prices rise, diminishing the purchasing power of each individual dollar.
This is generally referred to as ‘inflation’ – essentially a hidden tax on the public. (We gave policy makers time, resources and mandate to figure out and fix all this, but they first need to fill-up the royal a/c of corruption loot for future elections and loan to billionaire cronies!). What is the advice that you generally get, and that is inflate the currency. They don’t say debase the currency, they don’t say devalue the currency, they don’t say cheat the people with savings, they say lower the interest rates.
The real deception is when we distort the value of money, when we create money out of thin air, we have no savings yet there’s so called capitol… so the question boils down to this – how in the world can we expect to solve the problems of inflation – that is the increase in the supply of money – with more inflation?”
Of course, it can’t. The Fractional Reserve System of monetary expansion is inherently inflationary. For the act of expanding the money supply without there being a proportional expand of good and services in the economy, will always debase a currency.
In fact a quick glance at the historical values of the US dollars vs the money supply, reflects this point definitively, for the inverse relationship is obvious. In fact, one dollar in 1913 required 21.60 cents in 2007, to match value… that is a 96% devaluation since the Federal reserve has come into existence.
Now, if this reality of inherent and perpetual inflation seems absurd and economically self-defeating… hold that thought, for absurdity is an understatement in regard to how our financial system really operates. For in US financial system money is debt and debt is money. Wonderful, and the only reason why wealthy capitalists hate the next best alternatives, probably socialism.
The story is no different and maybe more horrible in India, if you add-up corruption, loot of public resources, banking / tax terror, etc.. to the list of problems. Like many developing countries, we have invested (black + white) much more in US (and its associated safe heavens) than US (officially) has invested here. We are increasingly ravaged by crony capitalism & stealth corruption, while fooling / dividing the 99% slaved population with all other reality show items related to short-term election tactics.
Rampant public corruption in emerging market countries may contribute to the currency crises that have racked the developing world, because corruption acts to repel more stable forms of foreign investment and leaves countries dependent on volatile foreign loans to finance growth. The story and situation cannot change with mere change of governments led by Party A, B or C funded by same bunch of cronies – bigger mass movements and fundamental shifts are needed. Source, reference and other blogs, comments, publications & Blog of Capt Ajit Vadakayil)