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If you have understood the way banks create money, it’s all quite spectacular. But there are problems with this invention of ours we call banking. In some sense it is all rather arbitrary. Some guys back in Florence figured out that if they loaned out more money than they had in their vault, and everybody used letters of credit and accounting, that nobody would know. And after a century it just became accepted. Today this money created by loans is virtually the only money that exists.

That isn’t actually so strange really. Money is an agreement we have that we will accept it as a placeholder for real value. We can use this symbolic thing to buy stuff with. In the old world, money was physical, real gold and silver. Monarchs took things by force using armies. People mined this stuff from the ground to use as money. Banking changed all that. No longer was money just physical. We had a gold and silver “standard” that supposedly backed money. But in reality, there was more money than there was gold or silver. The gold or silver (or jewels, or copper, whatever it was) that backed money became less than the reserve money banks had retained. Only the original money (that $100 in our spreadsheet) was “real”. All the rest of it was something else.

We already know that when we only have physical money that investing is a losers game. Let’s revisit why. If no new money is created, then all financial transactions are what game theorists call “Zero sum“. So if you look at investing as a sector, there is no way for all the investors to get paid off. That means that for every winning investor there has to be at least one losing investor. But if you look at the sector as a whole, even at usurious rates of interest, money tends to flow from the investor to the borrowers. That means that investment, and with it, economic growth doesn’t happen.

Think about that. Think again about how banking creates money. It’s a fantastic thing, right? It has made everything you look at, from the computer and your iPad to cell phones, roads, schools and windows possible.

But, if you look at the graph for money creation you should see a problem.

The problem is that money creation flattens out. In the best case, we end up with 21 times the amount we had if our reserve fraction is 5%. (That’s maximum new creation of money of 20 times the original + the original amount.)

So with the invention of banking, things are peachy when we are in the early part of the curve. They are pretty good in the middle part of the curve. But then the curve flattens out. And the system hits its limit.  What happens then?

One of two things happens. Either the banking system finds a new source of original money (gold or silver) or else the economy stalls. Loans don’t happen. Back during the 16th and 17th centuries the solution was to go find gold. Go to the “New World” or send out your armies to take it from other nations.

When the banking system is near its limit, sooner or later somebody can’t pay off a loan. This always happens. The Medici Family in Florence used to do horrible things to men who didn’t pay back their loans. They would capture them, strip them naked in the market square, tie their hands to their feet, throw a rope over a bar 30 feet above (about 10 meters) haul them up on the rope, then let them drop to the pavement. Depending on how much the man owed them, he would be dropped more times. It was often fatal. It was always crippling.

When the system is near its limit, one person not paying off a loan tends to have a cascading effect. Because remember that with physical money the money supply is fixed. That creates a zero-sum situation so the only way to pay interest back is if someone else can’t pay their principal on a loan. But now we have created all this money on credit.

When one person defaults on a loan, that means that suddenly that money is gone from the system. So in a banking system when people start to default, the money supply starts contracting. As it contracts, it makes the game worse than zero-sum. It’s a game in which the total amount is dropping. When credit collapses, it can happen fast.

The worst credit collapse is a bubble. Money is loaned for things that are of less value than the loan. (Think of tulip bulbs selling for $50,000.) Money is loaned to people that cannot possibly pay off the loan. (Think of Citibank pushing liar’s loans that they knew would go bad.) Money is loaned based on “notional valuation” of things like stocks or derivatives. (Think of the 1929 stock market crash when people could get loans to buy stocks and have little money of their own in it.) In a bubble, the prices of fixed assets that don’t change in utility value rise beyond any reasonable pricing. When a bubble collapses, it starts another cascade impacting people who would have been just fine in normal circumstances.

History shows us the boom and bust cycle of banking finance. In the 19th century some smart guys decided to put a stop to it by creating the Federal Reserve. The job of the Federal Reserve is to be able to shore up reserves at banks so that we don’t get into the boom and bust cycle. It has worked better than anything else so far. It isn’t perfect. The boom and bust cycle of banking finance takes a long time – either a lifetime or a big fraction of a human lifetime. So people forget.

That’s why we tossed out Glass Steagall. The younger generation forgot. But I digress.

Anyway, the bottom line here is that the central banks of the world and our fiat currency system was created because the world population and world economy got to the point where trying to pretend that we could every have enough gold to meet banking reserve needs was laughable. When people can only laugh at an idea, its time is over.

Now, when a bank needs reserves it goes to the Federal Reserve Bank. Now, any time a bank can make a loan and support the economy by doing that, there is always money to loan.

The Federal Reserve isn’t perfect. That system is being gamed (as you read this) by a crew of shysters who are abusing the banking/finance system. They create dirty deals composed of notional value instruments. They run up the prices of those instruments and play games that do nothing to serve the real economy. This is always going to happen. It’s like bribery. You can never kill it. You can only keep it down to a supportable level that doesn’t damage society.

These days, finance-finance, (otherwise known as flim-flam) where no traceable benefit to the real economy exists is somewhere around 40% of all financial transactions.

So there are two basic problems with banking.

  1. When it is tied to a gold standard, the world is condemned to boom and bust.
  2. When central banks allow society to escape the gold standard, shysters can game the central bank (and the taxpayers) to trick the system into making them fabulously rich – but provide no benefit to society.

We accepted banking back in the Medici era because it benefited societies so much. We need to keep that part. What we cannot allow is for society to be wrecked by those who game the system.