How the current money system works
Almost all the money in circulation is created by bank loans. Characteristics of the current money are:
1. Banks create money out of thin air by making a loan. At the moment someone loans money, the money comes into existence.
2. Banks demand interest on the money they lend.
3. All the money in circulation should raise interest for the banks. Because there is not enough money in circulation to pay for the interest, not everybody can fulfill his or her obligations, unless new debts are created.
4. As a result, debts grow exponentially and so do the interest payments.
5. If the economy is growing slowly, serious problems arise. As the Western economies are in the mature phase, economic growth is therefore relatively low, and the problem starts becoming acute. Therefore, it is also true that in emerging economies, this problem has not yet come into play.
How banks create money out of thin air
When you go to the bank to close a loan, the money is made on the spot by closing the loan deal. In economic theory this is the money-creating function of the banking system. The extent to which banks create money out of thin air depends on the reserve ratio. When we start from a reserve ratio of 1:10, the practice is as follows:
1. To start with, a bank needs money that is created by the government in the form of banknotes or a balance at the central bank. When the bank owns € 1000 of this money, and the reserve ratio is 1:10, then the bank can create a € 10,000 loan, even though that money did not exist.
2. A person who borrowed money, can use it for a payment. The recipient of the payment may bring the € 10,000 to his own bank. Since this money has not been created by the government, the bank of the receiver, using a reserve ratio 1:10 may only use 90 percent of the money for a new loan. On the basis of the € 10,000 that is in the bank's account, a new bank loan of € 9,000 can be made.
3. The € 9,000 can be spent by the person who has borrowed it, and the recipient of that money may bring it to his own bank. This bank can create a new loan of € 8100 on the basis of the € 9,000. This process can be repeated endlessly, until the original € 1000 of the government has been used by the banks has been to create approximately € 100,000 out of thin air.
At the moment, reserve ratios of banks are even lower than 1:10, so that banks can create even more money out of thin air with € 1000 of government issued money.
Correction mechanisms in the current money system
Within the current money system, the following correction mechanisms exist:
1. When the economy is slowing, the deficits of governments increase. Because consumers and businesses are reluctant to take on more debt, governments have to do it, because otherwise the economy would be slowing further.
2. When the economy is slow, central banks lower interest rates for consumers and businesses to encourage them to add more debt. If the economy goes well, new debt is created in a faster pace, and central banks raise interest rates to curb debt growth, because otherwise money supply is growing fast, which results in higher inflation.
3. Authorities are trying to regulate the banking system by imposing requirements for equity in relation to outstanding loans and savings. Over the years, these requirements were increasingly stretched, because more debt was needed to keep the financial system functioning.
4. When despite these measures, the financial system fails, government money can be created by running the printing presses, using the following procedure, to mask the real nature of the activity:
- Governments spend money or buy bad loans so government debt is increasing.
- This debt is purchased by banks. If the government buys up bad loans, banks exchange the bad loans for government debt.
- The central bank prints government money and acquires the government debt from the banks. The central bank now holds the government debt and collects interest on the government debt. If the central bank is an agency of the government, this is printing money outright, because government is indebted to itself, so the debt does not really exist. If the central bank is a private enterprise, as is the case in the United States, interest on goverment debt is a tax on the public to benefit of the banks owning the central bank.
- The banks now have more government money on their balance sheets, so using the same reserve ratio, they can lend more money.
The foreign countries are disregarded in this explanation. This would make it far more complicated. The matter is difficult to understand even when ignoring foreign countries.
Problems with free markets in the current money system
If the government did not interfere with the economy and interest rates, markets will correct, but in a rude way with businesses and banks going bankrupt, economic recessions and even economic depressions. In this process, much useful capital is destroyed which could be productive if there was demand. The destruction of capital also results in a destruction of wealth. Since we live a democratic society, this will not be accepted and such issues will automatically lead to a strong call for government intervention and regulation.
Problems with government intervention in the current money system
Government interventions reduce the severity of economic recessions and economic depressions in the short term, but create an ever bigger problem long term, namely increasing debt on which interest must be paid. When this issue was raised, the famous economist Keynes, who was a strong supporter of government intervention, responded: "In the long run we are all dead." In other words, it would not be the problem of his generation. Now we entered a vicious circle of ever larger problems, which require more and more government intervention.