By Timothy Rand
Disclaimer The information presented here is for informative and educational purposes only and is not intended as curative or prescriptive advice.
Money can be anything that is widely accepted as “payment” for products and
In all modern monetary systems, money is supported by debt, or more precisely, the collateral backing that debt. Whenever a saver deposits his hard-earned dollars in a bank, the bank turns around and lends these same dollars out. The saver's deposits are only as valuable as the collateral behind these bank loans.
Perhaps one of the greatest economic innovations in history has been the development of a fractional-reserve banking system. Before the invention of banks, money usually took the form of unique physical assets: gold, silver, grain, shells, or anything rare, long-lasting, valuable, and hard to counterfeit. The one commodity that has stood the test of time is gold, so Rand uses that as his base case of "hard money". One of the problems with the "gold as money" system is one of liquidity. There is a massive amount of wealth and wealth-generating potential in the world --- such as real estate, land, labor, inventions, trade, etc., - but only a limited amount of gold. Before the days of banks, to convert any of these things to spendable cash, you would have to locate and convince someone with surplus gold to lend some of it to you, or else bide your time until you had earned enough gold to consume or invest on a significant scale. Economic progress in such a system is slow, as the liquidity required to make long-term investments is confined to the very few who possess excess gold reserves.
On the other hand, fractional-reserve banks greatly expand the money supply by creating a brand new type of money: the bank note. Banks accept deposits (originally gold), and then take these funds and lend them out as bank notes [Federal Reserve Notes in our current system]. The banks only keep a fraction of their total deposits as a reserve against future withdrawal. The saver in this system may actually believe his deposit is liquid and readily available, when in fact it has been loaned out by the bank and is not - in aggregate - readily retrievable. This liquidity mismatch is both a great engine for economic growth and the potential fly in the ointment of the entire enterprise. Banks expand the money supply by literally creating and redefining money: rare physical gold is supplanted by collateralized banknotes as the new "legal tender for all debts, public and private."
The great power of banks is the expansion and democratization of money. Many forms of wealth and wealth-generating enterprise - not just gold - can be converted to spendable cash by borrowing from a bank. Furthermore these borrowed funds are treated as newly created money that adds to the overall money supply. For example, a home equity loan can be obtained to convert a homeowner's existing home into spendable cash, a mortgage can be obtained to convert a worker's future income stream into the spendable money needed to buy a brand new home, a small business loan can be obtained by an entrepreneur to start a new enterprise. In each of these cases, the overall money supply is increased as the borrower spends the proceeds from his loan, and the ultimate recipient deposits these same bank notes as newly found money into his bank.
With the rise of fractional-reserve banks comes the phenomenon of "debt-financed expansion." Through bank-enabled financing, entrepreneurs are able to borrow against collateral and/or future income to buy houses, expand businesses, and start new ventures. As the money supply grows, there is more than enough liquidity available to pay off debt service, hire new workers, and garner profits. It is a virtuous cycle that ignites the "animal spirits" and drives economic growth.
One of the problems with fractional-reserve banking, however, is that once the overall debt level reaches a saturation point, the liquidity mismatch at the heart of the enterprise rears its ugly head, causing instability and a potential reset. When the debt levels reach a critical and unsustainable level, newly issued loans can no longer be supported and the money creation phase of the expansion grinds to a halt. Suddenly depositors need to withdraw money en masse to pay off their accumulated debt service. Since the liquid money is not even available to the bank (since it has been converted almost entirely to long-term mortgage loans), panic sets in and a bank run can ensue.
One of the open questions as we progress through our current financial crisis is whether our debt-based monetary system has reached (or over-reached) its carrying capacity for debt. A second question is whether our financial system is even salvageable in its present form if indeed it has reached its limit.
To view a video about money:
The video below explains how money is created in the United States:
Plummer Joseph, "Meet The System: The Who, What, When, Where and Why of the Federal Reserve System," [Kindle Edition] Aug. 12, 2007 Plummer: The system
Rand Timothy D., "The Nature of Money," January 23, 2010 Rand: nature of money