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absolutely essential to understand the implications of this fact : The backing which 100 years ago was done by gold has been replaced by a promise to pay on a piece of paper.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.
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.