The Critical Flaw by Alan P. Chan, Pharm. D

Posted on Tuesday, July 30, 2013

Chapter 1 – Money’s Fractured Foundations

Reserve Banking and Interest Creation During Money Generation

"At the end, fiat money returns to its inner value - zero."

- Voltaire, French writer

Creation and Extinction of Money

Now that we have the fundamentals of money under our belts, we can move on to other important points. How is money created and extinguished, and what are the consequences of such a process? More importantly, how do the economic cycles of boom and recession define the economic equations of power in this world?

In order to understand how money is created, we need to first understand the concept of Fractional Reserve Banking (FRB). If the sum of all deposits in a bank is $1,000, for example, banks can lend up to $900, or 90%, while the remaining stays with the bank as reserve. This is the concept of FRB:  banks retain only a fraction of the total deposits as reserves.

All banks perform the basic function of accepting deposits from those with surplus funds and lending those surplus funds to others who need them for capital or for any other purpose. The banks charge interest at a greater rate on loans than the interest they provide to depositors on their deposited funds. The difference between the interest received and the interest paid is the profit of the bank.

How FRB ‘Creates’ Money

Suppose a person named Alan deposits $1,000 in Apple Bank. Banks can make money only by lending to someone. In accordance with fiscal regulations, Apple Bank can now lend 90%, or $900. Now, suppose $900 is loaned to a person named Britney who deposits this into another bank, named Bay Bank. Again, Bay Bank can lend $810, or 90% of $900.

The initial $1,000 has now ‘increased’ to representing $2,710 = $1,000 + $900 + $810.

The amount of money in circulation is $2,710, though only $1,000 was originally deposited. This process can be repeated, with the amount of money in circulation increasing with every step, until we find that the total money in circulation is ten times what was originally deposited into the first bank in this chain. Most of this money in circulation is debt that has to be returned to someone.

Thus, creation of money and debt go hand in hand. This example is only illustrative. Britney can deposit the loaned $900 in Apple Bank – or she can use, say, $500, and deposit the remaining $400 with any bank, Apple Bank or Bay Bank. The point of the matter is that through FRB, the amount of money in circulation increases, as does debt.

Between 93% and 95% of the need for money is created through such deposition lending in banks via the FRB process. The remaining 7% to 5% is created through dealings between the Federal Reserve and the Treasury.

FRB works only as long as:

·         People have faith in the economy and in the banks, and do not want to withdraw all their funds at once. In times of economic distress, when people lose faith in the economy and make a run to withdraw all their funds from the bank, FRB fails.

·         There are no defaults.

Talking about defaults brings us to the second part of this process. Because banks charge interest on all the funds they loan out, the amount of money that has to be paid back is greater than the amount that was originally loaned. Unless additional money is created by someone, the principal and the interest can never actually be repaid because there is just not enough money to go around.

Money has to be continuously created if the present system is to work. Interest, therefore, is a functional glitch in the system, and FRB is at the root of this need for the continuous creation of money. If interest was not charged, the money created when the loan originated would be extinguished when the loan is repaid.

Interest Creates Need for Generation of More Money

Suppose you borrow $100 at 10% interest. Where will the $10 come from? It comes from the printing of extra money.

Money required to repay the interest is not created when the loan is originated – only the amount of money borrowed as principal is created. The money required to pay the interest is created by the Federal Reserve, which is the central bank in the American economy. The heart of the matter is that when more and more money is created, its supply increases. In accordance with the rules of supply and demand, when supply of a certain commodity is greater than the demand for it, its value declines. With money creation, the value of money goes down in relation to goods and services, and its purchasing power declines. To put it simply, there is inflation, which creates price increase.

In such a state of affairs, default is inevitable. Default is also a product of fraudulent tendencies by certain unscrupulous borrowers. Because of default, banks require money themselves. The lender of last resort in the United States of America is the central bank of the economy, the Federal Reserve.

Actual Printing of Money

When Congress needs more money to lend out to these banks, it asks the Treasury Department to sell Treasury Bonds to large banks. These banks then sell these bonds to the Federal Reserve, and they simply print more money to make the purchase. This is possible because all money, especially fiat money that is not backed by commodities, is an abstract concept, as mentioned earlier.

Interest and FRB ensure that money created when a loan is issued is never extinguished, because more money has to be created to repay the interest and the principal. This means that growth of money, which we know as economic growth measured through the increase of the GDP, is always accompanied by inflation, the silent killer.

Power Equations Inherent in the Process of Money Creation

Economists always refer to the inevitability of economic cycles of high and low economic activity, something we respectively know as “boom time” and “slowdowns.” Such cycles are a result of the perpetual need for creation of more money. These cycles ensure that traders, both buyers and sellers, always remain at the mercy of the banks and the government.

When the cycle of money creation continues, the percentage of interest-inflation in the GDP increases exponentially. Because of the increase, more and more of the GDP is composed of interest and accompanying inflation. GDP grows due to:

·         An actual increase in the production of goods and services produced by everyone within the geographical boundaries of a country.

·         Inflation, a result of increasing interest load.

Real increase of GDP, or the increase in GDP without inflation, naturally decreases when the money generation cycle continues. The increased interest load also means that instability is inevitable because people will default. When this happens, banks have fewer funds to lend to other businesses. This situation, therefore, creates economic slowdowns when the interest load or debt is wiped out through bankruptcies and default.

Another consequence of default is foreclosure, or the confiscation of property that the borrower has pledged to the bank as a security against non-payment of his dues to the bank. Such property is referred to as collateral, and its confiscation by the bank leads to an increase in the assets owned by the bank.

In effect, this cycle of generation of money shifts the control of wealth toward those who control assets and the system of money creation:  the banks and the government. Traders – all buyers and sellers, ranging from common people to entrepreneurs and giants of the business world – are perpetually under the control of banks and governments.

It is widely but quietly acknowledged that heavyweights and heads of the industrial world always get loan waivers worth billions of dollars sanctioned from the government each year. Of course, it happens behind closed doors. It would not come as a surprise if these basics of the money generation process were used as a bargaining tool by industrial heads.

But where does that leave the common trader – normal people and small entrepreneurs? The answer is simple: nowhere. They certainly do not have the collective bargaining power of the colossal corporates to secure loan waivers. Then again, middle and lower class people who work as employees are the first to face the full blast of economic slowdowns in the form of layoffs and pay cuts.

Corporates can bargain because they are street-smart, provide employment to millions of people, and because they have financial muscle. No government wants to be seen as responsible for massive job cuts by refusing to bail out influential industrialists. And so goes the practice that some job and pay cuts are essential to prevent the same from occurring on a much larger scale.

This does not solve the problem. Slowdowns are bad not just because of the job and pay cuts, but because they introduce uncertainty and instability in the minds of people, especially those at the bottom of the socio-economic ladder. This robs people of peace of mind, destroys livelihoods, and is at the root of numerous problems.

Apart from smaller traders without any bargaining power, the fact that this process is complicated ensures that laymen do not understand the fundamentals. The disease is left undiagnosed and people only demand treatment of the symptoms in the form of stimulus and bailout packages.

Needless to say, this plays into the hands of the real powers. Through such programs, government makes a big show of doing something to improve the economy while leaving the fundamentals untouched. Through this charade, they become benevolent heroes in the eyes of the people, helping those in misfortune whose misfortune they have created, partially or wholly.

Economic democracy is absent, as wealth and control of this wealth is concentrated in the hands of a few. Political democracy does not automatically ensure economic democracy unless people understand the fractured foundation of the present economic system.

One cannot play God or micromanage a complex economy. As concentration of wealth and power acquires epic proportions, economy and culture decline, finally leading to disintegration of civilizations. Mesopotamian, Egyptian, Greek, and Roman civilizations declined due to some of the same reasons. When the civilization itself is destroyed, what is left for the micro-managers to manage?

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Genre – Business & Investing

Rating – PG

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