The majority of people and organizations in today’s society have more liabilities than assets, more debt than income, more “in the red” than “in the black“, more money going out than coming in. The root cause of this is the process of how money is created. My goal with this chapter is to shed light on this cancer because I believe in the following quote:
“To really understand something is to be liberated from it.”
– Four Horsemen Film by The Renegade Economist
In the previous chapter, we touched on Fiat money, which is the type of currency that all nations use today. This money is only created by the banking system when a person or an entity takes out a loan and goes into debt. Many people think commercial bank loans come from its customers’ savings. Let me enlighten those who aren’t aware of what Fractional Reserve Banking is.
Fractional Reserve Banking
What is Fractional Reserve Banking, and why should I care you may ask? As you will see, this deceptive practice of lending is a scam on everyday people because many don’t understand how it works.
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Let’s say you set up an account with a bank and deposit $10,000. The bank can now loan out up to 9 times the amount of your initial deposit ($90,000) to other account holders (not at one time, but over a period of time). Where does the extra $90,000 come from? Yup, probably guessed it right; the banks created it out of thin air! The irony of this is if people did this exact process, we would be arrested for counterfeiting because only the banking system can create national currencies! The banking system in the United States gained this privilege from the government by enacting The Federal Reserve Act into law in 1913.
Compound Interest Debt
Now here is where it starts to get even worse. In addition to the banking system creating money out of thin air in the form of loans, banks create another layer out of thin air, compound interest, on top of the original loan.
For example, imagine I needed a mortgage loan of $100,000 from a bank to buy a house. They tell me I can get the loan if I pay an interest rate of 5% for up to 30 years and have a monthly payment of $694.44; $277.77 of that amount goes toward the principal and $416.67 goes toward the interest, which will total the loan to $250,000. Where did that extra $150,000 of interest come from? Yup, out of thin air again by a banker not doing 30 years of labor, but by simply pushing a button transferring numbers from one account to another!
Now, let’s say I took the loan stated above and they credited my account with $100,000 (the principle). How do I pay back the extra $150,000 (the interest) if it never existed? I have two options. First, I can take money from someone else in the economy in the form of “competition”, and I end up winning while the other person loses. Second, if I can’t get money by “competing” with others, then I can take out another loan and go in even more debt (refinancing).
Here’s where it gets even more interesting. Using the $100,000 loan example above, let’s say times are tough and I’m late on making my monthly payments. I also have to pay interest on the interest ($150,000 in total / $416.67 monthly), which can lead to my debt multiplying (or compounding) over time if I don’t pay it off. Scenarios like this keeps a lot of people trapped in debt slavery indefinitely. If a person is not eligible for additional loans, they default on the loan, go into bankruptcy and/or lose the collateral they put up for it.
Essentially, the only way to pay back loans that are based on compound interest debt is to continuously increase the money supply, or keep people and organizations in debt. Furthermore, because there is more debt than money existing, this makes money inherently scarce. Now you can understand why a lot of people feel like they never have enough money. It’s designed to be that way!
Now some people might say “If I don’t take out any loans and go into debt, I won’t be affected.”
Well, I’m sorry to say you can’t avoid this cancer either. Most businesses need to take out loans in order to go into business, and the interest charged to them is passed on to their customers in the form of higher prices. A study by Margrit Kennedy, an economic professor, states that all of the prices in our economy has about a 40% capital cost added to it. So, if there wasn’t any compound interest charged by banks, people would enjoy about a 40% savings on what they buy.
Margrit Kennedy also noticed how compound interest also redistributes wealth from the people at the bottom of the financial pyramid to those at the top. Interest is being paid by people borrowing money and is received by people who have a lot of it. This leads to about 80% of the poorest people paying more interest than they receive to the richest 10%. The next richest 10% pay as much interest as they receive. This means that a huge majority of people are losing a substantial part of their income to interest. The wealthiest people either own the banks or have a lot of capital in them.
Fiat money is open to abuse by the banking system printing more money than goods and services are available; thus driving their prices higher – which is inflation. Inflation is created by the banking system through the Fractional Reserve Banking process, and adding compound interest to loans. Guess who are the biggest recipients of those loans? Governments! Governments such as the U.S., have what many call “an unlimited credit line” with the Federal Reserve.
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Here’s an analogy I like to use when explaining inflation. Imagine Joe the farmer sells milk to a community. He wants to make more money per sale and comes up with an idea to do so. His plan to make more money per sale is to dilute the milk with water. First, he starts out with a formula of 90% milk/10% water. Then, it’s 80% milk, 20% water, 70% milk/ 30% water, and continuing on until it’s 95% water/5% milk. However, Joe the farmer is selling his quarts as 100% milk! This is similar to the inflation that the banking system creates today.
I would like to give you an idea of how much of an impact inflation has had on the economy in America. How much do you think a dollar in 1913 would be worth today? According to the Consumer Price Index, the answer is 5 cents! The dollar has lost 95% of its purchasing power since that time period! Using an inflation calculator , it shows something that costs $1.00 in 1913, now costs around $22.41 today. Let’s say a small wooden table costs you $1.00 in 1913. What changed in almost 100 years to justify a price today of $22.41? Is there less trees available? Is it a lot harder to make a small wooden table today? The answer is no! The money we use to buy goods just lost its value since that time period.
As a rule of thumb, when interest rates are low, usually an economy is experiencing inflation.
There’s a lot of people who feel we should go back to Money 2.0, when money was backed by gold. This prevents the money supply from being manipulated like in the farmer/milk example stated above. However, money backed by gold is in limited supply, but there’s an unlimited amount of work that needs to be done as time passes. What happens when the amount of money existing isn’t enough to enable the amount of trade that is needed? Prices fall. Now at first, as a consumer, you might be happy. You’ll get the things you need at lower prices. But if you are running a business, you would not like this at all because you are losing more and more profit as time goes on. Businesses employ the people that consume, and if their profit margins continue to fall, the workers wages will do the same until they would eventually have to start laying workers off and might soon go out of business.
The main problem with an economy that’s experiencing deflation is no one is spending money, but only hoarding it because whatever you want is sure to become less expensive in the near future. During deflationary periods, people only spend money on absolute necessities and most businesses don’t spend it on hiring. This leads to massive unemployment and little to no economic activity, also known as a Depression. In order to reach economic growth, there has to be a growing money supply as well, and that can’t happen in a deflationary period or with a deflationary currency. When the economy grows, the money supply should grow too.
As a rule of thumb, when interest rates are high, usually an economy is experiencing deflation.
Serving Two Masters
Money serves three functions: medium of exchange, store of value, and unit of account. I’m not going to focus on the unit of account function, although change is also needed there. The main problem consists with the other two use cases.
National currencies such as the Dollar try to act as a medium of exchange and a store of value. As stated earlier, a medium of exchange is anything used to facilitate exchanges of goods and services. It can be a piece of paper, sea shells, wooden sticks, or virtual bits of information. Its main goal is to continuously circulate within an economy. A store of value is anything that holds a financial worth over time. It can be a financial document such as a stock certificate, gold, art, a house, paper money, and virtual bits of information as well. Its main goal is to be accumulated with hopes of it gaining more value. Its main goal isn’t to circulate in an economy (although it can), but to be accumulated and hoarded. A unit of account is a standard of valuing goods and services.
So what’s the problem with national currencies trying to serve two masters? When money is constantly circulating (velocity) from person to person, person to business, or business to business, we have a good economy. When money is hoarded and doesn’t circulate, we have a bad economy. By acting as a store of value, money doesn’t have a shelf life, it lives forever. This doesn’t give people with a lot of capital an incentive to keep it circulating, but to have it sit still and accumulate interest.
If we look at money and the economy the same way we look at blood and the circulatory system, we’d understand why hoarding money is a major problem. Imagine if 93% of our blood only went to our brains, but didn’t reach the rest of our body; the other areas of our body wouldn’t get nourished and suffer. Well, 20% of the U.S. population controls 93% of the financial wealth, while the remaining 80% of the population only controls 7%! We see the side effects of this wealth inequality everyday in the form of crime, distressed social relations, suffering local economies, and more. We need to add a feature to money called demurrage, which would incentivize circulation instead of hoarding. I’ll touch on that in Part 2 of the book.
No Local Allegiance
National currencies such as the Dollar have no allegiance to local areas. The main goal for these currencies is to get back to the financial centers of a country. When money is spent at a big chain store, it’s more likely to leave the local area where it is doing business. This leaves less money to circulate in that local area to spur more economic activity. However, when money is spent locally, there’s a much higher chance of it staying local and benefiting the community.
A study by Civic Economics, an organization that studies the economic activity of local communities, covering Louisville, Milwaukee, Ogden, Utah, and the Six Corners area of Chicago, proves that money spent at independent outlets is more likely to stay local than that spent at a chain. For example, in Louisville, independent businesses recirculated 55.2% of revenues compared to 13.6% for big retailers, and that local restaurants recirculate 67%, while big chains do 30.4%.
There are various efforts in creating local currencies to keep wealth from leaving the community. I’ll also touch on that topic in more detail in Part 2 of the book as well.