(Part 1: History of Money)

(Part 2: Fractional Reserve Banking, You, John, Steve, Sarah)

(QnA: Inflation)

We left off on our juicy story of money with the basics of fractional reserve banking under a gold standard, using our example of you, John, Steve, and Sarah and how the banks had magically created money (currency) out of debt; specifically, $271 out of your original 100 gold coins.

We discussed how each of those “dollars” (debt-money) was worth only a fraction of the original value of the gold coins backing them (from $1 per gold coin down to $0.37 per gold coin in our example)…hence the term “fractional” reserve banking.

What Happens Next?

As you can imagine, as more and more currency is created from debt in this manner, the “fraction” of the value of the “debt-money” to the actual gold coins continues to decrease until it eventually approaches zero…the “dollars” or currency receipts are backed by nothing—no gold or silver whatsoever.

This is how banking has progressed throughout history in all countries, from the early Greeks and Romans to the Europeans and of course now, to the United States.

In fact, there has never, ever, ever been an instance throughout all of history (and I do not use the words “never” or “always” lightly…) when fractional reserve banking didn’t eventually lead to the creation of pure “fiat” money (money backed by nothing other than the law or decree of your respective government).

Today, in 2012, all money is fiat “money”. It is “money” backed by nothing other than the promise of your government to accept it as legal tender…the “full faith and credit of <insert your respective government here>”.

All money is debt.

In fact, it is rather funny that governments speak about “reserve requirements” at all, because these “reserves” are not gold or silver coins any longer…they are Treasury bonds and other certificates of debt.

Every U.S. dollar (and it works the same for other countries using their own central bank) has been borrowed into existence from a private bank, the U.S. Federal Reserve.

So How Do Dollars Get Created?

I’m glad you asked! 🙂 In three ways:

  1. The Federal Reserve makes a loan to a member bank (much like your bank made a loan to John the cobbler to expand his shoe-making business)…abracadabra, magic money!
  2. The Federal Reserve purchases a debt-instrument; namely, a U.S. Treasury bond, and writes a bad check for these bonds (I say “bad check” because it doesn’t have anything other than debt instruments itself in its “reserves”)
  3. The Federal Reserve lowers the reserve requirements for its banks (e.g. banks can lend 90% of their reserves instead of only 75% or 80%)

While each of these is interesting, I think #2 warrants a bit more explanation (we’ve talked about #1 ad nauseam and #3 is pretty self-explanatory).

You have probably heard of the Federal Reserve’s “Open Market Operations”, or “POMO’s” (Permanent Open Market Operations). But you may not understand what they are or how they work…I sure didn’t!

Let me take a stab at explaining how the Federal Reserve creates “money” by these POMO’s:

  1. The U.S. government issues a U.S. Treasury bond or note, which is a fancy name for I Owe You (IOU). It promises to pay a specified sum at a specified interest on a specified date.
  1. This bond/note is offered for sale, to the public, to other countries, and of course to the Federal Reserve.
  1. The Federal Reserve “buys” this bond/note by writing a bad check (again, because it doesn’t have much other than debt instruments itself in its “reserves”) and gives this bad check to the government in exchange for the bond/note.
  1. The government endorses this check and deposits it into its account at one of the Federal Reserve member banks.
  1. This is considered a “deposit” at the bank and is counted among that bank’s “reserves” (magic!).
  1. The government, having lots of newfound “money” in its account at the bank, proceeds to write government checks to pay its expenses.
  1. The recipients of these government checks deposit them into their own bank accounts (as “deposits”) and the wonders of fractional reserve banking take effect.
  1. These deposits are now considered “bank reserves” and the bank is free to loan out any amount determined “excess” reserves (currently 90% in most instances).
  1. Just like in our example where the bank took your 100 coins and promptly lent 90 of them out to John to expand his shoe-making business, the bank is free to create 90% “new money” and lend it out.
  1. If this 90% is then deposited at other banks, those banks in turn are free to do the same…and the fiat money supply expands, all based on debt or “promises to pay”.

This is the definition of inflation, an increase in the currency supply, and the same process works in reverse to cause deflation (although this is much, much rarer).

This is why all of our money is actually debt (and on a side-note, why yours truly is still bullish on gold and silver).

Today is Kung Fu Kid’s 6th birthday so I will stop there and wish you a happy Monday! We’ll get back to some more “so what’s in all of this education for *me*?” and “how do I use this info to make more money?” soon!

I’m off to Chile on Wednesday to explore Simon Black’s new real estate development and will have a full report for you…

To your financial success,

—Kung Fu Girl