Summary on how money and the monetary system work (english)

Even though almost everybody uses money on a daily basis, only few people know how the monetary system itself works. This articles deals with the question, where money originates and why the global monetary system is in an essential crisis :

1. Money as debt

In the past money was backed by precious metals like gold or silver. At that time it was theoretically possible to take your money to the bank and exchange it for an equivalent value in precious metals. Today this is not the case any more. The last western country with a gold backed currency was Switzerland. When Switzerland joined the International Monetary Fund in 1992 they were forced to abandon the gold backing of the Swiss franc.

Today all western currencies are only backed by debt. It is absolutely essential to understand the implications of this fact : The backing which 100 years ago was done by gold has been replaced by a promise to pay on a piece of paper. Contrary to gold a promise to pay can go poof if the debtor goes bankrupt. Like a pair of scales with money on one side and gold on the other, today we have money on one side and debt on the other. If this debt goes bad, because the debtor goes bankrupt in today's system also the money looses its value, since it is not backed by anything when the promise to pay becomes worthless.

This is one of the main reasons for all the bailouts of major banks or even entire countries. If a small company goes bankrupt and their promise to pay their debt becomes worthless, the bank who gave the loan to this company has to write off this money as financial loss in their balance sheet. If the same thing happens with a major bank or even an entire country this could result in a chain reaction causing the implosion of the entire monetary system rendering all money in the system worthless. If a country goes bankrupt - by not being able to pay their regular expenses - this is called a national bankruptcy. More on this subject in bullet point 4


2. Money creation in a debt-based monetary system

As just described, money is inseparably linked to debt in the existing system. When asking the question "where does money originate" or how it is "created" there is a clear answer : Money can only be "created" when somebody signs a debt obligation - in other words a promise to pay back the loan. Two scenarios have to be differentiated :

a) If a company issues a loan, it can borrow money from private individuals who already have this money. In this case no new money is created but money just changes hands.

b) Money is "created" by central banks (like the Federal Reserve Bank in America or the ECB in Europe). If a government issues a government bond the central bank can "buy" this bond. Contrary to the process described earlier the central bank does not need to have the money to pay the government. Since a central bank has the monopoly to "create money out of thin air" it can simply "create" money equivalent to the value of the bond. The government bond is then seen as collateral for the newly created money and the government receives the money from the central bank.

During the financial crisis of the recent years, central banks (especially the American FED) accepted also other collateral besides government bonds in order to print new money for it in return. One example of inferior collateral that was accepted is what became know as "subprime" loans given to heavily indebted home owners. These "subprime" loans were bundled in large quantities by major banks and then handed over to the FED in exchange for money "created out of thin air".

The sum total of new money the FED created since the year 2007 is unknown, since in 2006 the FED decided it would not publish the volume of money in circulation any more - a figure also known as "M3". Even though this concealment tactic obscured the exact amount of money created, in December of 2010 the FED was forced by a US court to disclose figures related to their bailout programs for major banks. This disclosure unveiled that within the "TAF" bailout program 3.3 trillion Dollars were created (1.25 trillion for "subprime" loans). Additionally to their "TAF" program an additional program called "PDCF" was issued to provide access to additional loans for major banks. When adding up the available figures for all different bailout programs we are ending up with the following amount of money for these banks : Citigroup 2.2 trillion Dollars, Merrill Lynch 2.1 trillion Dollars, Morgan Stanley 2.0 trillion Dollars, Bank of America 1.1 trillion Dollars, Bear Stearns 960 billion Dollars und Goldman Sachs 620 billion Dollars. The overall sum of the bailout money is in the two-digit trillion Dollar range - an outrageous figure if we compare it for example to the national debt of Germany which was at 2.042 trillion Euros by March 2012.

The term "quantitative easing" was used a lot recently on the mainstream media when referring to the latest measure of the FED. Even though the term might sound appealing, what it stands for is yet another program by the FED to buy government bonds and create new money out of thin air in return. In first steps 600 billion Dollars were agreed but the next steps are to be expected.

An article in the German Spiegel Magazine from May 22nd 2011 shows, that also the European Central Bank has accepted collateral with questionable value. The collateral in question amounts to "several hundred billion Euros". In a Spiegel article published on June 6th 2011 the collateral mentioned amounts to 840 billion Euros, of which 360 billion are labelled as "not marketable". These sums do not yet include government bonds of Greece, Spain, Portugal and Ireland which the ECB bought over the recent months. Between May 2010 and early October 2011 the ECB has bought government bonds for 160.5 billion Euros.

These measures permitted the system to continue running without imploding but at the expense of confidence and safety because the provided collateral might turn out to be more or less worthless. The crash of the entire system thus was only postponed.


3. Interest in a debt-based monetary system

As you just learned, the creation of new money in a debt-based monetary system always requires that somebody takes on new debt. But any debt does not only have to be paid back in the future it also requires a payment of interest on top of the initial loan. Since the interest has to be paid also in form of money, this situation creates an insolvable problem : When money is created by someone taking on debt, only the exact amount of money equalling the loan is created. When the loan is paid back additional money is needed in order to pay the interest. Certainly there is other money in circulation than just the money of this loan and the person owing the loan could work in order to earn money and thus pay back his loan and the interest. But if you take a look at the entire system including all money in circulation, then ALL money in circulation is in existence because somewhere somebody took on a loan and this loan needs to be paid back WITH interest. So it should be clear that there is ALWAYS a lack of money in the system equal to the interest required for all issued loans. Due to the overlapping of the various credit periods, this problem is not directly visible but if all loans in the world had to paid back on one particular day, it would become obvious that only the loans themselves could be paid but there would be no money left to pay the interest.

Thus in a debt-based monetary system the amount of money in circulation is forced to grow indefinitely due to the interest mechanism. The additional money required in order to pay the interest has to be created by issuing new loans to somebody. If private individuals and companies decide not to take on new debt (or they simply can't) then there is only one credit receiver of last resort : The government. Thus the government has to constantly increase the amount of national debt in order to inject new money into the system. At this point it should be clear that any political rhetoric about "putting a cap on new government debt" is pointless. The government HAS TO go increasingly into debt and paying back the national debt is IMPOSSIBLE. There is not enough money in circulation to pay back the entire national debt plus interest and any repayment of government debt without instantly creating new debt withdraws money from the system. The amount of money in circulation has to grow constantly. That is the reason why almost every time a government bond is due the money required to pay back this loan is simply created by issuing a new government bond and using the money from the new bond to pay for the old bond that is due. After all a debt-based monetary system is a Ponzi scheme legalized by the government and it will come to an end just as any other Ponzi scheme eventually came to an end .


4. National bankruptcy and monetary reform

The term national bankruptcy describes the situation when the government of a country can not meet its payment obligations - in other words they run out of money. This can only happen if the government neither can raise money by taxes or by issuing new government bonds. Issuing government bonds becomes increasingly difficult if potential buyers loose faith in the ability of the government to pay back their debt. In this case only the central bank can help out by making use of their monopoly to create money out of thin air in return for receiving government bonds. This process of turning government bonds into new money is also called "monetisation" of government bonds.

Since monetisation of government bonds causes an increase of the amount of money in circulation, the money which was in circulation before this monetisation looses part of its value - especially if large amounts of government bonds are monetised. This loss in purchasing power is also referred to as inflation. Within a debt-based monetary system there is no limit to the amount of money the central bank can create. Thus this process usually causes hyperinflation, which implies that money rapidly looses its purchasing power. The term hyperinflation is generally used if the rate of inflation exceeds 50% per month or - due to the effect of compound interest - 13000% per year. Hyperinflation causes a flight into real assets e.g. precious metals, which do not loose a large amount of their value during hyperinflation.

This is a list of countries which experienced hyperinflation in the recent past. Usually this is not a topic covered by the mass media because it is too explosive : Austria, Hungary and Poland (1921-1924), Greece (1943/44), People's Republic of China (1949/50), Bolivia (1985), Nicaragua and Yugoslavia (1988), Brazil and Argentina (1989/90), Russia (1992), Georgia (1992-1994), Angola (1994-1997) and Zimbabwe (2006-2009).

Hyperinflations usually end with a monetary reform. During a monetary reform the old currency becomes practically worthless and is replaced by a new currency. In this process different conversion rates apply for cash, deposits and debt. A national bankruptcy is the main cause for a monetary reform. Government bonds are usually devalued more heavily than all other forms of debt. The government, corporations and sections of the population are treated unequally in this process.


5. Epilogue

I hope this short article helped you to understand more about the existing monetary system. Even if politicians and experts keep telling us that "the money is safe", you might now have understood that this is only the case as long as the majority of the population still has faith in their currency. It is part of the job of politicians and experts to maintain this illusion of reliability and they are acting on behalf of the system by lying to their own population. Nevertheless the life expectancy of any debt-based monetary system is limited. So let me conclude this article with a fitting quote by Voltaire :




"Paper money eventually returns to its intrinsic value : Zero"

Voltaire ( 1694-1778 )




If this article was a bit too boring for you, I would recommend watching the animated movie "The American Dream". It is a documentary disguised as an animated short film and it gives an excellent overview of the way money works as well as the history of the Federal Reserve System. This documentary is available in the Resource section 

In case you have problems believing some of the information you just read, it is recommended to check out a publication by the German Bundesbank in which the process of creating money "out of thin air" is bluntly explained. Unfortunately this publication is only available in German language but the most important passages have been translated into english. The publication and the translation can be found in the Resource section

Additionally an interview with financial expert and former Central Banker Bernard Lietaer on the topic "What about money ?" is available in the Resource section.

Addendum : Even though I started this article with a historic view on how a gold-based monetary system changed to a debt-based monetary system, I do not see the return to a gold standard as a feasible "easy" solution. If I was aware of a good solution, I would have mentioned it here but I have not found any real solution yet that seemed convincing to me. In order to reach any humane and realistic consensus, we first need more awareness and understanding within the population about the systemic flaws in the current system and this article tries to raise this required awareness. A few ideas worth pondering should still be mentioned : Bernard Lietaer presents his solution approach in his FEASTA lecture (second video in the article). Also you can find several interesting lectures in the "Money & Economy" section but most of them are in German.


+1 #14 Berhane Semerelul 2020-02-07 18:51
I have got the medicine I was looking for. This question of creating money out of the thin air has been daunting me for years. The mystery of economics will remain a mystery until the Economics get its independence from politics. I wish the interdependence was a Ponzi shceme.
0 #13 Jason Richards 2018-03-31 21:52
Thank you for this easy to understand article. After I discovered how the monetary system works I have been trying to educate others. I'm often looked at as a conspiracy buff and people tend not to believe what I'm saying. Most of them have there own theory on how it works and absolutely refuse to believe otherwise. Thank you
0 #12 yz 2017-12-20 14:53
how about crypto-based monetary system? Supporting decentralised crypto currency may be a new way out of the debt-based monetary system?
0 #11 Alan Morgan 2016-12-29 15:14
You dont seem to have mentioned that far more money is actually created by private banks via fractional reserve banking, why is this?
-1 #10 sylla Moussa 2016-11-03 23:42
The explanation in This article of the current global monetary system is so clear and easy to understand. I ve been looking for such a relevant document for quite a long time now. I cant say I did not grow after This discovery.. God bless You
-1 #9 joninva 2016-08-28 13:10
Fiat currency is not money, although many call it that. It has no real store of value, only the faith we give to it as a debt obligation. Although all the Central Banks will say Gold is not money for obvious reasons, they all hold tons of it and Russian and China are a couple of nations which are increasing their holdings, while Germany is repatriating theirs from the NY Fed, Venezuela has repatriated theirs due to their economic ruin which is fast approaching.
-2 #8 Simon 2016-04-04 10:57
There is already a good solution, but it won't see the light of day until there is a crisis with no other way to solve it. The solution requires that two functions of money - a means of exchange and store of value - are separated. The solution is called Freegold and the architects of the euro understood this. In a Freegold system, gold becomes the reference point. Paper currencies (debt) still exist, but they all float freely against gold. You would still use paper currency for commerce and short term saving, but gold would be the store of value. It's possible that in a Freegold system a well-managed (stable) paper currency could also provide a store of value. You can read more about Freegold theory at (start from the beginning - ).
+1 #7 jmm 2016-03-31 21:14
point #3 is written very very well, everyone needs to understand that including elected government officials. the federal reserve bank should not exist, the treasury should not pay interest and the treasury should control the continued gradual expansion of the money supply at the direction of the house, senate, and president. Basically there should be no concept of sovereign debt and only a concept of sovereign monetary base. Governments and central banks should remove themselves from the interest rate and debt market and merely provide a facility to store / transfer / transact their currency in near real time, but no lending, no paying interest, and no charging of interest. What I am suggesting here is not terribly dissimilar from our current system, just less accelerated. The money supply would still need to be stably increasing relative to the population, but in what I am proposing there would be no need to consider and perpetuate the loss of interest when expanding the money supply.
-3 #6 ernest perez 2016-03-30 02:37
I found this article very interesting,

The way I look at it, if President Obama had not created
all this debt with trillions of dollars, this Country would
have been bankrupt a long time ago. WOW.
-8 #5 maNNy 2016-03-11 14:42
This article is quite misleading.
+4 #4 Matrixwissen 2016-01-19 10:11
Hi Andy,

you're raising difficult questions but just a few thoughts on them: Economists will tell you the value for almost anything is determined by "the market" so in essence the willingness of the majority to pay a certain price. Asking for a price to make sense would imply that "the market" acts rationally which it does not. You might read in the press why certain prices go up or down and why high or low prices are good or bad but these rationalizations are changing all the time. When oil prices are high, it is bad for the economy, ok so as of writing this oil prices are really low, which suddenly is "bad for the economy" as well. Sometimes flooding the financial system with trilions of dollars is a good thing to "save the system", then suddenly it is a really bad thing, depending on which central bank is doing it. Since most people only have a very short attention span rationalizations only have to make sense to them short term which makes life a lot easier. You're looking for things to make sense in the long term... that's a laudable thing to do but it makes the world a complicated place where you tend to freak out easily ;-) Try to find someone to talk to about this in your local environment, there are not many people who ponder these things deeply but you'll find someone eventually. Btw check out the movie "The Big Short", you'll have a good time watching it...
-2 #3 Andy Burns 2016-01-19 09:52
and i have to add, is there any possible way to change any of this? like we just have to hope that enough people don't think "thats just how it works there's no better solution"?
Is there a better solution? i guess we should more democratically decide that values of every action and how much each substance is valued. Or required to survive. but there like 8 billion people on earth. how can we democratically decide that?
0 #2 Andy Burns 2016-01-19 09:38
Hey this article is great. I just started rapidly thinking about money tonight and had to google to see what money real was and this confirmed so much of what i've been thinking. but the other question i still really need answered is how do we "earn" money? is it all just like a reverse "I owe you" note where if you do someone a favour you get an I owe you but you can redeem with anyone for anything? then how have we decided what each and every task or action is worth? and if if the worth of that action is decided by the value of that country, then how is that country's value decided? by its resources on its land? how is that value decided? by the entire atomic mass of that substance available in the entire universe, how easy it is to obtain, and it's usefulness?
but nobody is giving any of this the thought it would require to actually make any sense.
so now we have it as that we each earn a higher number. we can turn that number into a physical quantity of something. if we had a rule that you couldn't represent your number physically. couldn't write it down and couldn't collect things to represent that number. then everyones worth in society would be based on "cool points." the more stuff you did that people though was rad the more leeway you would have to act as you please. thats our society. and the motivation to do things that everyone else thinks is pretty cool is that the less people that think you're cool the more cool things they will allow you to do. and ultimately, if nobody at all thinks you're cool you aren't allow any assistance in living and no right to any of the substances on the planet that would assist you in living without cool points.

I'm freaking out and really just want someone to talk to.

0 #1 Ammabel 2016-01-12 23:55
I found this article quite insightful, and thank you for summarising all this information so that people like myself with basic education may still understand the system and join in on activities surrounding this information. Keep up the great work and I look forward to reading your views on how to better the system.