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August 21, 2007

Money As Debt Economy

With all the turmoil in the markets (real estate, stocks, you name it) and all the talk of a credit bubble, this might be a good time to stop and think about the fundamentals of money and credit. It's a story very few people understand.

Where does money come from? To the extent people think about it at all, they imagine government printing presses cranking out paper currency, like we've seen all those times on the tv. But the overwhelming bulk of money — something like 95% — is just numbers in accounting systems, on checks, or on some bank computer's hard drive. Where does it come from? It is created by banks, in the form of loans.

And where do banks get the money they lend? Again, to the extent people think about it at all, they imagine that banks take in money from depositors and lend that money back out to borrowers. But a moment's reflection tells you that this makes no sense: collectively, we save almost nothing, and our borrowing grows by leaps and bounds — all those unsolicited credit cards in the mail, all those home equity loans and second mortgages. Lending dwarfs saving, more so with every passing day. So it cannot be savings that the banks are lending out. Besides, when has anyone ever tried to take out a loan only to be told that the bank has run out of deposits to cover it? That's not how it works. In reality, banks lend out far more — many times more — money than they have on deposit (it's called fractional reserve banking).

It is debt that creates money. You sign a loan agreement, and they put a number in your account. Presto. Banks have a license to print money, metaphorically speaking — nice work if you can get it — and they'd just as soon you didn't understand what's really going on.

It's a difficult thing for most people to get their heads around: banks just create money out of thin air when people borrow. There's nothing backing up that money other than the borrower's collateral and promise to pay. And since people have to pay back more than they borrowed, the whole system depends, fundamentally, on continual growth in the supply of money — i.e., continual growth in the amount of indebtedness. It's a gigantic game of musical chairs. If the music ever stops, look out.

If you're like most people, you probably think I'm crazy. That can't be how it works. Well, here's an excellent animated video that explains it all in clear and entertaining fashion. Do yourself a favor and invest the time to watch and understand it. We'll come back to this topic in a little bit. Meanwhile, go watch the video.

Posted by Jonathan at August 21, 2007 10:16 PM  del.icio.us digg NewsVine Reddit YahooMyWeb


Great to have you back, Jonathan.


Posted by: Wolf DeVoon at August 22, 2007 09:34 AM