We’ve all heard the countless cries by our leaders and government officials about “ending poverty,” “waging the war on poverty,” and “eliminating poverty for future generations.” They claim that if we just give them more of our wealth, more of our earnings, then we can finally, once and for all, put an end to poverty.
Meanwhile, the very system we live under, and which our government preserves and protects at every turn, continues to create poverty for millions of Americans – a system which in turn, supports and funds those leaders telling us to sacrifice more for the good of all. That system is called the “monetary system.”
You’re probably not familiar with this term, not only because it’s never mentioned in the mainstream media or in your school textbooks, but also because when you think of our economy you think of capitalism. This is not surprising since we’ve been conditioned to think we live in a capitalist society. And to some extent, we do. But the problem is, by thinking of it that way and describing it by that one word alone, we omit an important aspect of the overall system that governs our economic livelihood.
Now, the term monetary system is quite broad, and so we need to look closer at what that really entails. In general, a monetary system is any economic system that assigns goods and services a value that is exchangeable through a medium such as paper (fiat) money, gold/silver, or other means. Capitalism per se does not imply the use of money – rather, it traditionally refers to things like the free market exchange of goods and services and private property rights. Thus, it is important that we separate capitalism and the monetary system in our minds in order to understand the true nature of the overall system we live under.
The use of money to govern transactions within a capitalist system is not a bad thing in and of itself. In fact, if the money has intrinsic value (such as gold or silver), this can improve the integrity of the overall economy by ensuring that the monetary value remains stable and intact, versus fluctuating significantly over time. An example of such fluctuation would be the US dollar (a fiat currency not backed by anything of value), which has lost over 90% of its purchasing power in the last century. (Indeed, most of this erosion in value occurred after 1971, when the dollar was unhinged from the gold standard.)
The US monetary system, of course, is based on the use of fiat money, which can be created arbitrarily through policy decisions originating from the Federal Reserve System. In conjunction with this capability, the employment of “fractional reserve banking” provides further flexibility to the monetary system, and encourages the creation of money from, essentially, nothing. Simply put, fractional reserve banking is when banks only maintain a portion or fraction of customer deposits in reserve, while using the remainder to originate loans and thus create higher amounts of interest income. The amount of money the bank must retain in reserve is called the “reserve ratio.” Traditionally, US banks have maintained a reserve ratio of 9 to 1, meaning for every dollar kept on deposit, $9 can be lent out.
The practice of fractional reserve banking is actually detailed in a booklet issued by the Chicago Federal Reserve Bank (one of the 12 regional banks under the purview of the Fed), called Modern Money Mechanics. While I think it’s worth reading the entire 40 pages of this document, this quote should suffice as a summary:
“The purpose of this booklet is to describe the basic process of money creation in a ‘fractional reserve’ banking system. The approach taken illustrates the changes in bank balance sheets that occur when deposits in banks change as a result of monetary action by the Federal Reserve System - the central bank of the United States….The illustrations in the following two sections describe two processes: first, how bank deposits expand or contract in response to changes in the amount of reserves supplied by the central bank; and second, how those reserves are affected by both Federal Reserve actions and other factors.”
We can translate this summary to mean one thing: banks create money out of nothing. By illustration, we can see how fractional reserve banking accomplishes this:
Bank A receives a deposit of $10 million from a customer. It places $1M in reserve (according to its 10% reserve ratio requirement), and then lends out the other $9M to Bank B, collecting interest payments from Bank B.
Bank B puts $900,000 in reserve (again, 10%), and lends out the other $8.1M to Bank C, collecting interest from Bank C in the process.
Bank C puts $810,000 in reserve, and lends out the remaining $7.2M to Bank D, while collecting interest from Bank D.
…And so on, until approximately $90M (nine times the original $10M) has been created, loaned, and monetized into interest payments for all banks involved in the transaction. Thus, you can see how $1 of actual “wealth” (I use quotes because even the original fiat money deposit has no intrinsic value) becomes $9 of artificial money.
There are two things that are very pernicious about this. First is the simple fact that money that never existed in the first place is used to make even more money, through the payment of interest. Second, and more insidious since it is unseen and intangible, is what I would call the “debt-to-wealth gap” that is created by the monetary system and fractional reserve banking. Here’s what I mean by this:
There are only so many goods and services that can be produced or performed, and subsequently sold in the marketplace. In other words, there is a physical, tangible limit to it (however large and unquantifiable it may be to us). At the same time, the creation of money from nothing is dislocated from this reality, since the money is created artificially and arbitrarily, when compared to the actual value of all the goods and services available in the marketplace.
In other words, there is simply more available debt than available wealth. The ease with which new and virtually endless amounts of debt/fiat money are created is the reason why there is so much more available debt than wealth.
Again, the catalyst for this is relatively simple to understand -- through our monetary system and the use of fractional reserve banking, debt is generated rapidly and artificially. Conversely, wealth (for the vast majority of us) can only be generated through the exertion of labor over time.
Think of it this way: in one day’s time, assuming I placed no limits on you from a credit perspective, how much debt could you get into in that one day? Probably a whole lot. A house purchase, a trip to the Ferrari dealership, maybe a new yacht – you could easily be millions of dollars in debt in the span of 24 hours. Now in that same one day’s time, how much wealth could you create? If I gave you one whole 24 hour span to generate wealth from scratch, how far do you think you’d get? Probably nowhere, and it would have nothing to do with your aptitude. Simply put, the creation of wealth would take time, energy, and effort that would far exceed one day’s time.
This surplus of debt compared to available wealth comprises the debt-to-wealth gap. So what, you might be thinking…what does this have to do with you, or the poverty problem I referred to in the beginning of this article?
Here’s why it is directly relevant to you: you cannot function in our economic system without getting into debt. It’s virtually impossible. If you are able to pull it off, it probably means you’re living something unlike the “American dream.” You certainly don’t have a house, and you probably don’t have a car. You most likely never went to college. In other words, all of the trappings of the American lifestyle are unavailable to you – until you take on that debt load.
Once you’ve taken it on, you must generate enough cash flow to service that debt. In other words, you need a job. Now of course, we all need cash flow for the necessities of life, but the kind of job, frequency of how often we must perform that job, and length of time we must keep that job changes considerably when we have a mortgage, car loan, student loan and other debt payments to service. It’s one thing to truly work to pay for the basics (food, rent for shelter, medical care when needed), but another thing entirely to work to cover the trappings of the American lifestyle we’ve been conditioned to believe are “necessary” (nice house, two cars, vacations, yearly wardrobe changes, sundry electronic gadgets, other luxury items, etc.).
In other words, the availability – and more accurately, the necessity – of debt, turns us into indentured servants, who must hold jobs whether we like them or not in order to function economically. Furthermore, when that imperative is combined with the illusion that we must continue to spend/consume in order to achieve the “American dream,” the average person’s debt load rises considerably.
And what about the poverty issue I mentioned at the beginning of this post? How does the system create poverty purposefully? Now that you understand the monetary system and fractional reserve banking, it’s easy to see how. Let’s look at it through a rudimentary example:
Say a bank has a home loan portfolio totaling $100 million. It created these loans off of just 10% of that figure, or $10 million (so there is only $10 million of actual deposits at stake here). The other $90 million is artificial debt created through fractional reserve banking. Now let’s say of the $100 million, $15 million worth of loans is spoiled by foreclosures and bankruptcies. Let’s see where that leaves the bank:
$10 million of initial capital, turns into…
$100 million of loans, with an average of 7% interest a year yielding…
$7 million a year in interest income…
With only $15 million of the total loan portfolio gone bad.
Since the $15 million of bad loans is fake money anyway, the bank doesn’t care, since it never had that money to begin with. Its loan portfolio is generating $7 million a year, which across a 30 year standard mortgage period yields the bank revenues of over $200 million. Ultimately, the bank turned $10 million of seed capital into over $200 million…do you think it cares one bit about the $15 million in bad loans (which really translates to foreclosed homeowners, homeless people, etc.) it perpetrated along the way? Of course not – it’s just the cost of doing business.
The bottom line is, the bank doesn’t care who goes bankrupt or forecloses – the bank simply cares that enough debt is created to generate enough interest income for it to be profitable. If it overshoots the mark on debt creation, and individuals go bankrupt/lose their home, it matters not – it simply performs a write-down of the loan on its books and moves on. It was fake money anyway – it never existed in the first place.
The key for the banking/monetary system is to continue creating enough debt to generate enough interest to continue to be profitable and aggregate more wealth. The collateral damage along the way, in the form of impoverished/bankrupt/homeless individuals, is simply the byproduct – the remainder off of the proverbial mathematical equation – that is tolerated in the overall process.
Using this premise as a backdrop, I would go on to assert that the entire 2007-09 housing collapse was nothing more than the rabid creation of debt in order to fuel more interest payments into the system, with zero regard for how many loans went bad or homeowners were devastated along the way. Why would this matter, when the banking system knew the government would step in, bail them out and cover the losses?
But put the recent housing market crash aside for a moment. The real problem is this: the monetary system is on its last legs. Eventually, there is too much debt created, and no one left to service it. And when not enough entities can afford to take on debt, then the debt creation begins to grind to a halt. And when debt creation grinds to a halt, interest payments decrease and profits begin to shrink. The outstanding debts remain, but there’s less profit to offset it and make the process worthwhile for lenders.
We are seeing this breakdown in the monetary system in the news every day, when we read about bank failures, rising foreclosures and shrinking home sales, states going under financially (i.e., California), entire countries going bankrupt in the EU due to systemic financial failure (i.e., Greece, Ireland, etc.), and the rising ranks of unemployed who’ve been victimized by the system and will never return to the same standard of living they once had.
Once you understand that the system you’re living within places you into servitude, creates poverty knowingly and purposefully, and is impossible to get ahead within, as an individual you begin to realize that your financial and investing priorities must adapt to such realities. Ultimately, the monetary system needs to change, as it simply does not serve the interest of the vast majority of the people. When we make such a claim, and it’s a significant one, we need to do so with the full and accurate knowledge of what the system actually is and how it operates, and only then can the proper reforms be put in place.
Meanwhile, the very system we live under, and which our government preserves and protects at every turn, continues to create poverty for millions of Americans – a system which in turn, supports and funds those leaders telling us to sacrifice more for the good of all. That system is called the “monetary system.”
You’re probably not familiar with this term, not only because it’s never mentioned in the mainstream media or in your school textbooks, but also because when you think of our economy you think of capitalism. This is not surprising since we’ve been conditioned to think we live in a capitalist society. And to some extent, we do. But the problem is, by thinking of it that way and describing it by that one word alone, we omit an important aspect of the overall system that governs our economic livelihood.
Now, the term monetary system is quite broad, and so we need to look closer at what that really entails. In general, a monetary system is any economic system that assigns goods and services a value that is exchangeable through a medium such as paper (fiat) money, gold/silver, or other means. Capitalism per se does not imply the use of money – rather, it traditionally refers to things like the free market exchange of goods and services and private property rights. Thus, it is important that we separate capitalism and the monetary system in our minds in order to understand the true nature of the overall system we live under.
The use of money to govern transactions within a capitalist system is not a bad thing in and of itself. In fact, if the money has intrinsic value (such as gold or silver), this can improve the integrity of the overall economy by ensuring that the monetary value remains stable and intact, versus fluctuating significantly over time. An example of such fluctuation would be the US dollar (a fiat currency not backed by anything of value), which has lost over 90% of its purchasing power in the last century. (Indeed, most of this erosion in value occurred after 1971, when the dollar was unhinged from the gold standard.)
The US monetary system, of course, is based on the use of fiat money, which can be created arbitrarily through policy decisions originating from the Federal Reserve System. In conjunction with this capability, the employment of “fractional reserve banking” provides further flexibility to the monetary system, and encourages the creation of money from, essentially, nothing. Simply put, fractional reserve banking is when banks only maintain a portion or fraction of customer deposits in reserve, while using the remainder to originate loans and thus create higher amounts of interest income. The amount of money the bank must retain in reserve is called the “reserve ratio.” Traditionally, US banks have maintained a reserve ratio of 9 to 1, meaning for every dollar kept on deposit, $9 can be lent out.
The practice of fractional reserve banking is actually detailed in a booklet issued by the Chicago Federal Reserve Bank (one of the 12 regional banks under the purview of the Fed), called Modern Money Mechanics. While I think it’s worth reading the entire 40 pages of this document, this quote should suffice as a summary:
“The purpose of this booklet is to describe the basic process of money creation in a ‘fractional reserve’ banking system. The approach taken illustrates the changes in bank balance sheets that occur when deposits in banks change as a result of monetary action by the Federal Reserve System - the central bank of the United States….The illustrations in the following two sections describe two processes: first, how bank deposits expand or contract in response to changes in the amount of reserves supplied by the central bank; and second, how those reserves are affected by both Federal Reserve actions and other factors.”
We can translate this summary to mean one thing: banks create money out of nothing. By illustration, we can see how fractional reserve banking accomplishes this:
Bank A receives a deposit of $10 million from a customer. It places $1M in reserve (according to its 10% reserve ratio requirement), and then lends out the other $9M to Bank B, collecting interest payments from Bank B.
Bank B puts $900,000 in reserve (again, 10%), and lends out the other $8.1M to Bank C, collecting interest from Bank C in the process.
Bank C puts $810,000 in reserve, and lends out the remaining $7.2M to Bank D, while collecting interest from Bank D.
…And so on, until approximately $90M (nine times the original $10M) has been created, loaned, and monetized into interest payments for all banks involved in the transaction. Thus, you can see how $1 of actual “wealth” (I use quotes because even the original fiat money deposit has no intrinsic value) becomes $9 of artificial money.
There are two things that are very pernicious about this. First is the simple fact that money that never existed in the first place is used to make even more money, through the payment of interest. Second, and more insidious since it is unseen and intangible, is what I would call the “debt-to-wealth gap” that is created by the monetary system and fractional reserve banking. Here’s what I mean by this:
There are only so many goods and services that can be produced or performed, and subsequently sold in the marketplace. In other words, there is a physical, tangible limit to it (however large and unquantifiable it may be to us). At the same time, the creation of money from nothing is dislocated from this reality, since the money is created artificially and arbitrarily, when compared to the actual value of all the goods and services available in the marketplace.
In other words, there is simply more available debt than available wealth. The ease with which new and virtually endless amounts of debt/fiat money are created is the reason why there is so much more available debt than wealth.
Again, the catalyst for this is relatively simple to understand -- through our monetary system and the use of fractional reserve banking, debt is generated rapidly and artificially. Conversely, wealth (for the vast majority of us) can only be generated through the exertion of labor over time.
Think of it this way: in one day’s time, assuming I placed no limits on you from a credit perspective, how much debt could you get into in that one day? Probably a whole lot. A house purchase, a trip to the Ferrari dealership, maybe a new yacht – you could easily be millions of dollars in debt in the span of 24 hours. Now in that same one day’s time, how much wealth could you create? If I gave you one whole 24 hour span to generate wealth from scratch, how far do you think you’d get? Probably nowhere, and it would have nothing to do with your aptitude. Simply put, the creation of wealth would take time, energy, and effort that would far exceed one day’s time.
This surplus of debt compared to available wealth comprises the debt-to-wealth gap. So what, you might be thinking…what does this have to do with you, or the poverty problem I referred to in the beginning of this article?
Here’s why it is directly relevant to you: you cannot function in our economic system without getting into debt. It’s virtually impossible. If you are able to pull it off, it probably means you’re living something unlike the “American dream.” You certainly don’t have a house, and you probably don’t have a car. You most likely never went to college. In other words, all of the trappings of the American lifestyle are unavailable to you – until you take on that debt load.
Once you’ve taken it on, you must generate enough cash flow to service that debt. In other words, you need a job. Now of course, we all need cash flow for the necessities of life, but the kind of job, frequency of how often we must perform that job, and length of time we must keep that job changes considerably when we have a mortgage, car loan, student loan and other debt payments to service. It’s one thing to truly work to pay for the basics (food, rent for shelter, medical care when needed), but another thing entirely to work to cover the trappings of the American lifestyle we’ve been conditioned to believe are “necessary” (nice house, two cars, vacations, yearly wardrobe changes, sundry electronic gadgets, other luxury items, etc.).
In other words, the availability – and more accurately, the necessity – of debt, turns us into indentured servants, who must hold jobs whether we like them or not in order to function economically. Furthermore, when that imperative is combined with the illusion that we must continue to spend/consume in order to achieve the “American dream,” the average person’s debt load rises considerably.
And what about the poverty issue I mentioned at the beginning of this post? How does the system create poverty purposefully? Now that you understand the monetary system and fractional reserve banking, it’s easy to see how. Let’s look at it through a rudimentary example:
Say a bank has a home loan portfolio totaling $100 million. It created these loans off of just 10% of that figure, or $10 million (so there is only $10 million of actual deposits at stake here). The other $90 million is artificial debt created through fractional reserve banking. Now let’s say of the $100 million, $15 million worth of loans is spoiled by foreclosures and bankruptcies. Let’s see where that leaves the bank:
$10 million of initial capital, turns into…
$100 million of loans, with an average of 7% interest a year yielding…
$7 million a year in interest income…
With only $15 million of the total loan portfolio gone bad.
Since the $15 million of bad loans is fake money anyway, the bank doesn’t care, since it never had that money to begin with. Its loan portfolio is generating $7 million a year, which across a 30 year standard mortgage period yields the bank revenues of over $200 million. Ultimately, the bank turned $10 million of seed capital into over $200 million…do you think it cares one bit about the $15 million in bad loans (which really translates to foreclosed homeowners, homeless people, etc.) it perpetrated along the way? Of course not – it’s just the cost of doing business.
The bottom line is, the bank doesn’t care who goes bankrupt or forecloses – the bank simply cares that enough debt is created to generate enough interest income for it to be profitable. If it overshoots the mark on debt creation, and individuals go bankrupt/lose their home, it matters not – it simply performs a write-down of the loan on its books and moves on. It was fake money anyway – it never existed in the first place.
The key for the banking/monetary system is to continue creating enough debt to generate enough interest to continue to be profitable and aggregate more wealth. The collateral damage along the way, in the form of impoverished/bankrupt/homeless individuals, is simply the byproduct – the remainder off of the proverbial mathematical equation – that is tolerated in the overall process.
Using this premise as a backdrop, I would go on to assert that the entire 2007-09 housing collapse was nothing more than the rabid creation of debt in order to fuel more interest payments into the system, with zero regard for how many loans went bad or homeowners were devastated along the way. Why would this matter, when the banking system knew the government would step in, bail them out and cover the losses?
But put the recent housing market crash aside for a moment. The real problem is this: the monetary system is on its last legs. Eventually, there is too much debt created, and no one left to service it. And when not enough entities can afford to take on debt, then the debt creation begins to grind to a halt. And when debt creation grinds to a halt, interest payments decrease and profits begin to shrink. The outstanding debts remain, but there’s less profit to offset it and make the process worthwhile for lenders.
We are seeing this breakdown in the monetary system in the news every day, when we read about bank failures, rising foreclosures and shrinking home sales, states going under financially (i.e., California), entire countries going bankrupt in the EU due to systemic financial failure (i.e., Greece, Ireland, etc.), and the rising ranks of unemployed who’ve been victimized by the system and will never return to the same standard of living they once had.
Once you understand that the system you’re living within places you into servitude, creates poverty knowingly and purposefully, and is impossible to get ahead within, as an individual you begin to realize that your financial and investing priorities must adapt to such realities. Ultimately, the monetary system needs to change, as it simply does not serve the interest of the vast majority of the people. When we make such a claim, and it’s a significant one, we need to do so with the full and accurate knowledge of what the system actually is and how it operates, and only then can the proper reforms be put in place.
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