Money As Debt Page #2

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Some borrowers started to demand real gold

instead of paper representations. Rumors spread.

Suddenly, several wealthy depositors showed up to remove their gold.

The game was up!

A sea of claim check holders flooded the street

outside the closed doors of the bank.

Alas, the banker did not have enough gold & silver

to redeem all the paper he had put into their hands.

This is called a "run on the bank"

and is what every banker dreads.

This phenomenon of a "run on the bank"

ruined individual banks and, not surprisingly,

damaged public confidence in all bankers.

It would have been straightforward to outlaw

the practice of creating money from nothing.

But the large volumes of credit the bankers were offering

had become essential to the success of European commercial expansion.

So, instead, the practice was legalized and regulated.

Bankers agreed to abide by limits on the amount

of fictional loan money that could be lent out.

The limit would still be a number much larger

than the actual value of gold and silver in the vault.

Quite often the ratio was 9 fictional dollars

to 1 actual dollar in gold.

These regulations were enforced by surprise inspections.

It was also arranged that,

in the event of a run,

central banks would support local banks

with emergency infusions of gold.

Only if there were runs on a lot of banks simultaneously

would the bankers' credit bubble burst

and the system come crashing down.

The Money System Today

Over the years, the fractional reserve system

and its integrated network of banks backed by a central bank

has become the dominant money system of the world.

At the same time, the fraction of gold backing the debt money

has steadily shrunk to nothing.

The basic nature of money has changed.

In the past, a paper dollar was actually a receipt

that could be redeemed for a fixed weight of gold or silver.

In the present, a paper or digital dollar can only be redeemed

for another paper or digital dollar.

In the past, privately created bank credit existed only

in the form of private banknotes, which people had the choice to refuse

just as we have the choice to refuse

someone's private cheque today.

In the present, privately created bank credit

is legally convertible to government issued "fiat" currency,

the dollars, loonies and pounds we habitually think of as money.

Fiat currency is money created by government fiat,

or decree, and legal tender laws declare that citizens must accept this fiat money

as payment for debt or else the courts will not enforce the obligation.

So, now the question is

if governments and banks can both just create money,

then how much money exists?

In the past, the total amount of money in existence

was limited to the actual physical quantities

of whatever commodity was in use as money.

For example, in order for new gold or silver money to be created,

more gold or silver had to be found and dug out of the ground.

In the present, money is literally created as debt.

New money is created whenever anyone takes a loan from a bank.

As a result, the total amount of money that can be created

has only one real limit - the total level of debt.

Governments place an additional statutory limit

on the creation of new money,

by enforcing rules known as

fractional reserve requirements.

Essentially arbitrary, fractional reserve requirements

vary from country to country and from time to time.

In the past, it was common to require banks

to have at least one dollar's worth of real gold in the vault

to back 10 dollars worth of debt money created.

Today, reserve requirement ratios no longer apply

to the ratio of new money to gold on deposit,

but merely to the ratio of new debt money

to existing debt money on deposit in the bank.

Today, a bank's reserves consist of two things:

the amount of government-issued cash or equivalent

that the bank has deposited with the central bank,

plus the amount of already existing debt money

the bank has on deposit.

To illustrate this in a simple way.

let us imagine that a new bank has just started up

and has no depositors at all yet.

However the bank's investors have made a reserve deposit

of one thousand one hundred and eleven dollars and twelve cents

of existing cash money at the central bank

and the required reserve ratio is 9:1.

Step 1:
The doors open and the new bank

welcomes its first loan customer.

He needs $10,000 to buy a good used car.

At a 9:
1 reserve ratio, the new bank's reserve at the central bank,

also known as "high-powered money",

allows it to legally conjure into existence 9 times that amount,

or $10,000 on the basis of the borrower's pledge of debt.

This $10,000 is not taken from anywhere.

It is brand new money simply typed into the borrower's account as bank credit.

The borrower then writes a check on that bank credit

to buy the used car.

Step 2:
The seller then deposits this newly

created $10,000 at her bank.

Unlike the high-powered government money deposited at the central bank,

this newly created credit money cannot be multiplied by the reserve ratio.

Instead it is divided by the reserve ratio.

At a ratio of 9:
1, a new loan of $9,000 can be created

on the basis of the $10,000 deposit.

Step 3:
If that $9000 is then deposited by a third party,

at the same bank that created it, or a different one,

it becomes the legal basis for a third issue of bank credit,

this time for the amount of $8100.

Like one of those Russian dolls, each layer of which contains

a slightly smaller doll inside, each new deposit contains the potential

for a slightly smaller loan in an infinitely decreasing series.

Now, if the loan money created is not deposited at a bank,

the process stops.

That is the unpredictable part

of the money creation mechanism.

But more likely, at every step, the new money

will be deposited at a bank, and the reserve ratio process

can repeat itself over and over until almost $100,000

of brand new money has been created within the banking system.

All of this new money has been created entirely from debt,

and the whole process legally authorized by the initial reserve deposit

of just one thousand one hundred and eleven dollars and twelve cents,

which is still sitting untouched at the central bank!

What's more, under this ingenious system,

the books of each bank in the chain must show

that the bank has 10% more on deposit than it has out on loan.

This gives banks a very real incentive to seek deposits

in order to be able to make loans, supporting the general

but misleading impression that loans come out of deposits.

Now, unless all the successive loans

were deposited at the same bank,

it cannot be said that any one bank got to multiply

its initial high powered money reserve almost 90 times

by issuing bank credit out of nothing.

However, the banking system is a closed loop, bank credit

created at one bank becomes a deposit in another, and vice versa.

In a theoretical world of perfectly equal exchanges,

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