Money as Debt

Modern money is debt and debt is money in the modern monetary system. Almost all money is created in association with debt, with loans.

Most people think money is created by the government. False. Under the Federal Reserve System  which has been in force since 1913 (and even prior to that, but especially for these last 100 years) this is not the case. The monetary accounting unit is defined by the government but money is created by privately-held banks.

Most money is not in the form of currency. Rather it is electronic and sits inside highly secure computers, as digits representing the balance in the checking accounts and deposit accounts of people and businesses. It never becomes cash, but circulates via checks, electronic transfers, and debit cards. Currency in circulation is a small percentage of the money stock, and of the US currency base, much circulates overseas.

Money in the US is created by banks, not by the government, and in fact by the people themselves, when they take on debt. Money (not currency) in circulation is created when loans are made. So if you go into the bank and they approve you for an auto loan for $20,000, they will make a deposit into your checking account. To the bank that is a debit, and to you it’s a credit. The bank also makes a corresponding entry on their books representing your liability to repay the loan (secured by an asset, the car you are buying). That is a credit to the bank, and to you it’s a debit, your debt that must be repaid. With interest.

Currency is issued to banks to meet their day-to-day needs in exchange for reserve balances they hold with the Federal Reserve. The currency takes the form of Federal Reserve notes.

As you take out a loan, new money is thus created, and as you pay back the principal money is destroyed, just as if you had burned it! Reread the previous sentence. You and the bank collaborate to create and extinguish money. The bank does not provide you a loan based on money sitting in their vault, or even in other people’s checking accounts. That money has, by and large, already been loaned out and the banks are every day collecting interest and principal repayments on portions of those outstanding loans.

In theory banks are constrained from issuing too many loans and thus too much money by fractional reserve requirements. These state that banks must keep reserves in the Federal Reserve System (and cash and securities in their vaults) amounting to 10% for large transactions[1]. As a practical matter they make loans as they wish to customers they believe are qualified. And if they need additional reserves to support the additional lending, they can borrow those! And they borrow those at a very favorable interest rate from other banks with excess reserves, or from the Fed itself. Currently those reserve loans among banks cost only a fraction of 1%, around 0.25%. Even if they go to the Fed discount window, the cost is only 0.75%.

There are constraints on the total amount of loans that banks can issue, but these constraints are based mainly on their amount of capital. These capital requirements are regulations from the national bank authorities, and to harmonize between countries, the Basel Accords. The Bank of England imposes no reserve requirement in the UK, only capital requirements. And as we have noted, the reserve requirements in the US have little practical impact.

If everyone paid back their loans in full tomorrow, both the money supply and the economy would collapse, and an incredibly severe depression would result. This is what the Federal Reserve and other authorities were so afraid of in 2008 as the commercial paper (money market) and inter-bank lending markets froze up along with the market for CDOs, MBSs and other off-balance sheet liabilities.

Where do you get the money to pay back the loan, including the interest? (If you had extra money lying around you probably wouldn’t have taken out the loan, you would’ve paid cash). You work for it and earn it in the future, or sell some other asset. Mostly you work for it.

So the loan is a claim against future assets you have yet to earn through your labor. The underlying assumption is that you will be able to earn not only the principal, but also the interest, by commuting to work in your shiny new automobile. And that everyone else taking out mortgage loans, auto loans, credit card loans and business loans will be able to pay back their loans as well. Now the banks set the interest rates high enough to cover expected defaults, but even above that they are counting on a future when there will be even more money in the system to allow the loans to be paid back.

The whole system requires an expanding money supply to cover population growth and real growth in the economy, and inflation is built into the system by the need to pay back the loans outstanding with future money. Which itself is based on debt.

And the system is highly favorable to the banks for several reasons:

  1. They get the money first, as they create it, out of “thin air”.
  2. They can charge interest on this money they create.
  3. They are only mildly constrained in how much money they can create.
  4. They can use invest or speculate with their reserve and capital balances.
  5. If the case of a financial crisis, or a liquidity or solvency problem with a bank which is “too big to fail” the government will step in and bail them out with taxpayer money.

Look at a dollar bill or other Federal Reserve note – it says “legal tender for all debts, public and private”. There are two types of money: debt-laden money and debt-free money. Debt-laden money only comes into existence when a loan of some type is created. Debt-free money is issued directly by the government, the Treasury or the Mint. Coins in circulation represent an insignificant fraction of the money supply, and no debt is created when they are minted (at a profit since all circulating coins use base metal today).

The 2012 Star-Spangled Banner Uncirculated $5 Gold Coin issued by the US Mint is legal tender. Since it contains .24 oz. of gold, it is sold at a much higher price.

The goldbugs are wrong when they say that only gold and silver are real money and not fiat money. Yes, precious metal coins are (physically) hard money, but just like paper money they are also “fiat money” when issued by national governments. Today the US mints gold and silver coins for collectors with face values much lower (around 100 times lower) than the intrinsic values of the coins. They could be used as circulating money, but are not, due to their much greater value as numismatic items or as bullion. Such coins are debt-free money, however; no debt creation is associated with their issuance. The Mint realizes a profit between the sales price and the cost of manufacturing; this is known as seigniorage.

Fiat just means “let it be done” which indicates that the monetary unit and the forms of money in circulation are prescribed by the sovereign authority, by the government. The government determines this in each nation-state. (The Euro is a currency union among its member states.)

To further demonstrate that money is due to fiat and is an accounting unit, here is the essence of the Holy Roman Emperor Charlemagne’s monetary reform in the early 9th century[2].

“He established a new standard, the livre carolinienne (from the Latin libra, the modern pound), which was based upon a pound of silver—a unit of both money and weight—which was worth 20 sous (from the Latin solidus [which was primarily an accounting device and never actually minted], the modern shilling) or 240 deniers (from the Latin denarius, the modern penny). During this period, the livre and the sou were counting units; only the denier was a coin of the realm.”

The standard persisted for hundreds of years, until the 16th century, vastly longer than the short-lived empire which Charlemagne established. This system was also adopted in England with the same units and English names of pound, shilling (20 to the pound) and pence (240 to the pound, 12 to the shilling).

“The accounting system of 4 farthings = 1 penny, 12 pence = 1 shilling, 20 shillings = 1 pound was adopted from that introduced by Charlemagne to the Frankish Empire (see French livre).”[3]

It remained the accounting system of monetary measurement in England for over 1000 years, despite changes from a silver-based standard to a gold-based monetary system to a central bank paper monetary system, and considerable devaluation of the money relative to the value of a pound of silver (inflation).  Note that the sou coin was never minted and neither was the livre.

Money is first and foremost an accounting unit. The proof of this is that the U.K. continues to use the pound sterling (the sterling term comes from the original definition by Charlemagne over 12 centuries ago as a pound of silver), although since 1971 denominated in new pence with 100 pence to the pound.


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