Thursday, January 20, 2011

How money is created: As a debt

Not a lot of people sit around and wonder how money is created, but for some reason I did.  I found my answer and thought I would share it with you.  In our economy, money is created by borrowing it.  The story of money creation starts when someone wants to take out a loan.  Say you want to borrow twenty-thousand dollars to buy a car.  You go down to Bank of America (BofA) and take out a loan.  They then put that money into the auto dealer's bank account and you drive off the lot with a new car.  At this point:
  • You are twenty thousand dollars in debt
  • The auto dealership is twenty thousand dollars richer
  • BofA has twenty thousand less dollars, but have a twenty thousand dollar asset (your loan) which nets to zero(not counting interest).

This is an example of money being created using the Money Multiplier concept.  If you add up all the money spent and borrowed, it equals the amount that was earned and is owed.  However, until that loan is paid off there is now extra money in the economy rather than sitting in a bank account.  Now, let's say that BofA didn't have the money to loan you.  That's no problem, they can just borrow that money from the federal reserve.  Before BofA gives you the money, they go to the federal reserve and borrow twenty-thousand dollars.  The federal reserve goes *poof* and money is deposited into BofA's account, then they give it to you, and you give it to the auto dealership.   In this case,
  • You are twenty thousand dollars in debt
  • The auto dealership is twenty thousand dollars richer
  • BofA has a twenty thousand dollar asset (your loan).
  • BofA has a twenty thousand dollar debt to the federal reserve.

While all the assets and liabilities equal zero, that 20 thousand dollars that the federal reserve created is now in the economy, and that's how money is "created".
The government has to borrow money too.  Any money spent by the federal government that isn't offset by taxes must be borrowed from the federal reserve.  The federal reserve temporarily loans the government that money and puts it into U.S. treasury's account at the federal reserve.  The federal reserve then auctions off that borrowed money as U.S. bonds and other securities.

This leads me to make two observations of this system.  I call them "observations" because I'm not sure if they are bugs or intended features of the system.

The first observation is that for our money supply to grow, people must continually borrow money, not just from each other, but from the banks and, eventually, the federal reserve.  Not only that, but each year more money must be borrowed than the previous year just to keep up with interest.  That's because when I borrow 20 grand, I have to pay that back with interest: Say, 21 grand in total(just to keep the math simple).  That means I have to earn back the 20 thousand I gave the auto dealership plus another thousand dollars.  I could work for the auto dealership and earn back the 20 grand, but where am I going to get the extra thousand dollars?  It's going to have to be from someone who takes out a new loan (for money that came from the federal reserve) and pays me a thousand dollars for some service like driving them around in my brand new car.

Therefore, what this means for the economy at large, is that if the amount of money being borrowed ever levels off or drops, somebody-somewhere, is going to have to default on their loan.  The reason will be because there won't be enough money in the economy to pay back all those previous loans with interest.  Again, I don't know if this is a bug or an intended feature when congress setup the federal reserve system.

My second observation is that if every entity in existence paid off all their debts, there would be no money left in the economy.  Think about it, what money would be left if all money is created as a debt?  There's no way for someone to save a dollar without another person or entity owing someone a dollar.

These two observations disturb me.  You would think this would cause problems, but I don't really see or hear many people talk about it.  If you think my two observations are incorrect, or I missed something, please let me know in the comments.
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