Thinking about fiat money

Jim H
By Jim H on Sat, Aug 8, 2015 - 2:44pm

I have often said that you cannot possibly appreciate the why of Gold and Silver as monetary assets unless you understand (and become adequately reviled) by how our current debt-based, unbacked fiat monetary system works.  Almost nobody actually understands what fiat money is, or how it works, hence they don't understand the role that Gold and Silver play.  

Let's start by the idea that one should, if properly informed, be somewhat repulsed, if not reviled, by the nature of our system.  Let's review some quotes;

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

Henry Ford
Read more at http://www.brainyquote.com/quotes/quotes/h/henryford136294.html#EfwICMtjEWfP21td.99

And this;

The process by which banks create money is so simple that the mind is repelled.

Read more at http://www.brainyquote.com/quotes/authors/j/john_kenneth_galbraith_3.html#evJo4mO0OTz2DT3J.99

Most folks believe that banks take in money via deposits, and loan it back out at interest, making money on the spread.  That is not the case... almost every penny that is loaned out is created on the spot out of thin air because.. well.. that is what banks do and that is how our money system works.  As Chris has said in the Crash Course, "all money is loaned into existence".  Thus the, "debt" in debt-based money.    Even knowing that, without a very clear example of how this actually works, most people still won't quite get it.  They still won't really internalize what the two learned folks quoted above were getting at.  Let me, therefore, make it real to you through a hypothetical example;

Buying and losing a Home

This is a simple story.. we all probably know, or know of, someone who has gone through a similar experience.  A couple buys a house... YAH!  The American Dream!  They scraped together a down payment.. maybe fairly low on a % basis, but still many thousands of dollars.  They also scraped together the money for the closing costs, some of which flow back to the bank.  At closing the bank came in with a huge check that gets handed to the seller, and the couple now has a mortgage loan.  They get into the house and spend thousands more doing some work, painting, upgrading a few things.. cleaning up the garden beds.  House proud!

Things go well for a few years.. the couple have jobs, and they are making their mortgage payments, but the housing market has gone down a bit, wiping out the small amount of equity they had via their small down payment.  Not realizing at first that mortgage loans are heavily front-loaded with regard to interest, they notice that, although they have made more than $30K worth of combined mortgage and tax payments over the first two years.. they have made only the slightest dent in the principle they still owe.  They worked really hard for that $30K, as well as the $18K it took them to get into the house (some of it still owed back to the father-in-law), and the ~ $7K they have pumped in to home improvements.  $55K!!!!!  

Now the husband loses his job.  The couple have to make some hard choices because unemployment doesn't cover the expenses.  There is no real option to sell the house because they are in a negative equity situation.. they would have to come up with money they don't have in order to unload the house.  They stop paying the mortgage.  Eventually, the bank takes the house back.  The bank now owns the house outright.

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Now all of us, even me, accept that this is just how it works.  We also can all understand how hard one must work to earn all of the dollars involved in the scenario above.. that was real labor, and real saving, required.  What is kind of harder to understand is that a bank can create money out of thin air, as they did with the underlying mortgage for the house in this example, and end up owning it outright, even after the couple poured two or more years of blood, sweat, and tears, not to mention $55K, into it.  

We don't understand it because we can't ourselves relate to the ability to conjure money out of thin air.  We can't.. we have to work hard for it.  It feels good in our pockets.. and for most of us (me excluded) it makes us feel safe seeing a big balance in our bank account.  Banks conjure money out of thin air.  That is how money is made.. and how our money system expands.. more conjuring of loans.  It is, when viewed clearly, an OBSCENE power to have.  Through ignorance, we have come to accept this as normal.  We have given banks this power, and it has become all encompassing... it is at the root of our corporatocracy.  It is how and why we become debt slaves.  

Once you realize how obscene this system is... once your mind becomes repulsed and repelled..  then you will finally realize how important it is to find alternative forms of money in which to place your savings.  The rush for alternatives is less about their attractiveness and more about the repulsiveness of our fiat money.  The very small segment of the the US that understand this are in the process of backing up the truck as we speak;

http://investmentresearchdynamics.com/provident-metals-defaults-on-deliv...                                   

 

12 Comments

Jim H's picture
Jim H
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Money is easy for Banks to get, hard for people to get

One way to think about the workings of the fiat money system is to consider the degree of disparity that exists between the ease with which a large, money center bank can get or make it's own new money, vs. the ease with which the average person can earn (get) it.  I would argue that in the era of QE, the disparity has grown larger than ever before.  The central banks have created a whole new racket whereby the banks they serve get rid of their crap collateral (did they really need to since there is no mark-to-market?) in exchange for newly created money (that was easy!) then they get interest for "loaning" or storing that money back to the FED.  Banks make money, bankers get bonuses.  But for the rest of us... raises have not been keeping up with inflation for a long time now... global wage arbitrage, made easier through trade deals, has helped shift more of the revenue stream of corporations toward profits, less toward labor.  

One answer to making the money, and the system itself, more sound is to reign in the ability of banks to create money so easily.  We don't actually have to take away the capacity completely, just reform back to what used to be considered sound principles;  Don't let banks speculate with depositor money (Glass Steagall), don't let banks make loans that can go underwater so easily (larger down payments needed to extend credit on a car, or a house), etc.  Denninger talks about these ideas in depth here;

  https://market-ticker.org/akcs-www?post=209282

 One Dollar of Capital is simply the principle that nobody be permitted to "create credit out of thin air", thus artificially expanding the spendable supply of "money" in the system.  This, and only this, is the reason for all of the bubbles and financial collapses throughout history.  This sleight-of-hand is why Tulip Mania happened, it's why we had a crash in 1873, it's why we had a crash in 1929, it is why the tech market blew up in 2000 and it's why we had a crash in 2008 in housing.  It is why we're threatened with collapse in Europe now.  It is a scam as old as the money changers during the time of Hammurabi, and until we stop it there will never be stability in the banking and financial system.  This sleight-of-hand is in fact exactly identical in mathematical and economic impact to counterfeiting of the nation's currency, a crime which we all should recognize, condemn, and when it occurs the punishment should include both imprisonment and forfeiture of every dollar of ill-gotten gain.

(read the whole piece.. it is enlightening.  There are other ideas that compete, i.e. State banks, etc., but my point is to understand how fiat money and the banks work today - Jim H)      

That banks create money out of thin air is amazing enough.  But we need to recognize that fractional reserve banking has morphed into a monster much worse than it ever was before.  For the average Joe, money is harder to earn than ever before, hence the tendency to depend on credit is increasing again;

    http://www.zerohedge.com/news/2015-08-08/story-americas-debt-6-easy-grap...

Despite incessant pundit parroting of the "deleveraging households" meme, America is and probably always will be, addicted to debt. If you need proof, have a look at the latest statistics on non-mortgage debt, which, thanks to America’s twin trillion-dollar bubbles, recently soared to its highest level in a decade. To wit, from HousingWire, citing Black Knight Financial:

What we’ve found is that mortgage holders today are carrying more non-mortgage debt than at any point in the past 10 years, with an average of $25,000 per borrower. That’s $1,400 more on average than one year ago, and nearly $2,600 more than in 2011. The primary driver of this increase is a rise in auto-related debt, which accounted for 81% of the overall non-mortgage debt increase over the past four years [and] student loan debt [which] is at all-time high.

I am arguing that these effects are due to a fiat money system run amok.  Fiat money is bad enough... but the way our system is run today is scandalous.  All advantage goes to the banks.  They effectively control the legislature and the laws get written by the banks.  Taxpayers and depositors will be on the hook for derivative losses, and derivative losses will be senior to their interests.  

There is a way to opt out of all this insanity.  Bankers, and the popular (captured) media would have you believe that it's dangerous.. that you could lose your shirt.. and that it's as useless as a pet rock.  But I would argue that as you study Gold, Silver, and today's debt-based fiat currencies you will quickly conclude that the opposite is true.  Gold and Silver in physical form stand as un-corruptible forms of money - they cannot be printed, have no counter party risk, and are uniquely acceptable all over the world as a means of exchange.          

 

     

davefairtex's picture
davefairtex
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gatekeepers for money creation

Jim brings up a good point - not necessarily about credit creation itself, but implicitly asking the question, why are bankers are the gatekeepers for this process?

I think credit creation is a fine thing.  There is vendor financing, self-liquidating business loans - both are arguably reasonable things to have.  They grease the wheels of the economy, and that provides a net benefit to society.

But who says that bankers get to be the gatekeeper of the fiat money creation mechanism?  Sure that's their historical role, but if we were to imagine a new system, would we hand this power to the bankers?  I wouldn't.  Or rather, perhaps I'd strictly ration it, the way Jim suggests, and I might have other entities that also have this power.

Thought experiment: who in society should have the power to create money?  And - based on what criteria?

People?  Government?  Banks?  Perhaps all three?  And - how should we limit it?  Rules?  Direct democracy?  "Regulators"?  Some other framework?

One idea: peer-to-peer lending using created money.  Or "kickstarter", also using created money.

If you personally had the power to create some modest amount of money and loan it out, to whom would you loan it?  And what would be the implications of such a system?

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KennethPollinger
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Episode FOUR of Hidden Secrets of Money

Jim.  I still believe that the BEST way to explain or demonstrate how fiat money works is the chart in Mike Maloney's series on Hidden Secrets of Money.  Episode 4 does this issue justice.  Would that EVERYONE would download it and post it on their bathroom mirror and the kitchen fridge, maybe even on the front visor of their car.

Better yet, if EVERYONE STUDIED episode 4 many times and FINALLY get it!!

 

Thanks to you two for persisting in this endeavor.  Ken

charleshughsmith's picture
charleshughsmith
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link to Hidden Secrets of Money series

Here's a link to the series: https://www.youtube.com/user/whygoldandsilver

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charleshughsmith
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gatekeepers of money creation

Davefairtex, I don't suppose we need to keep it a secret that we've had conversations on this topic. here are a couple of other things re: gatekeeping the creation of money:

1. money must serve two roles: store of value and means of exchange. Gold is store of value but there isn't enough of it to mediate all transactions (at least that's what history tells us). So notched sticks, shells, chits, scrip, bills of exchange etc. are used to create means of exchange "money" out of thin air.

2. For more on this, I recommend "Debt: the first 5000 years" by Graeber.

3. My thesis is money can be created and should be created in a decentralized fashion in exchange for the production of useful and needed goods and services, not by centralized institutions for their own benefit.

4. what's broken with the status quo cannot be fixed without a new way of creating money that is decentralized.

davefairtex's picture
davefairtex
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too wonky

Charles-

I think the subject is too wonky for most people, perhaps too far out there in "never-gonna-happen-land."

And yet, I must ask, is going back to commodity money really the best thing we can imagine?  Most people will put their gold into a bank to keep it safe.  And then at that point, whomever has the gold then becomes the moneylender, and we have bankers once again being the gatekeeper.

There's a reason why bankers came to be - it makes sense to centralize guarding something so valuable as your life's savings.

But we aren't living in the middle ages anymore.  We have computers that can do amazing things.  Isn't there something more people-based, more decentralized - more peer-to-peer if you will, that we could imagine?

Jim H's picture
Jim H
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Not too wonky.. I don't think.

Thanks guys for engaging.  Ken, Dave, and CHS.  If we don't talk more about money, and really chew on it and understand how it works, and the implications thereof, we are not going to be able to take advantage of the next crisis .. instead, the existing bankers will simply use it to take advantage of all of us once again.  

To my mind, Gold is needed because the creation gate keeping is out of human control (for the most part.. I guess we could mine faster or slower).  Gold is naturally rare.. and we can't change that.  Now, I have to disagree with Charles' statement;

Gold is store of value but there isn't enough of it to mediate all transactions (at least that's what history tells us). So notched sticks, shells, chits, scrip, bills of exchange etc. are used to create means of exchange "money" out of thin air.

I kinda see the point in terms of history.. but the fact remains that there are one hell of a lot of atoms of Gold out there, and if we allow Gold to, "find" it's value relative to other stuff, there will always be enough, and we can always subdivide to smaller units of value.  Whereas you used to hold a nearly one oz. coin in your pocket to spend $20.. today that same coin represents $1100.. and almost nobody walks around with that much money in their pocket.  BUT.. you could easily walk around with a 1/10th gram Aurum, or a stack of them in our pockets, just like the dollars today.  If the the amount of stuff we can buy increases faster than the Gold, then we can do 1/20 gram versions... that would be easy today.  Maybe someday we just have a dot of Gold on our Aurum... 1/200th of a gram... still easy to control and assay analytically since that is still a hell of a lot of atoms.  

In Denninger's model banks can still create credit against an asset like a car or a house if they do it conservatively, with the borrower making a higher down payment, having more skin in the game.  Whether this is the right answer or not, it is a step in the right direction because it makes a higher hurdle for money creation to occur.

Regarding Kenneth's view of the Mike Maloney series... I actually find his part 4 confusing... I think he is mostly talking about QE when he illustrates some of the cycles.. and he talks about a more quaint version of fractional reserve lending, vs. what really happens today when the loan comes first, and the reserves second;

    http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/...

In any event, money is made effortlessly by banks, creating money as debt in the process.  Through this process, stuff can happen, like the bank ending up "owning" the house you bought and put your blood, sweat, and tears into, even though they never did anything other than "create" the money out of thin air to buy it in the first place (the mortgage).  And we all accept that as normal and fair.  It's as if we really believed deep down that the money the bank lent had been worked for... that it was real capital.  It was not.  It was created effortlessly.  The house was the asset that the mortgage money was lent.. i.e. created against.  The house actually made the money seem real.  Debt based money is odd stuff when you really think about it.  We consider it real because we have to work so hard for it.  Banks create it out of just a promise.  It's way too easy to spend ahead our futures with the current money system. 

Crowd sourcing money?  Decentralized money?  I say let there be competition in the money space.. that's all.  Bitcoin has proven that new ideas of money can flourish.  I would argue that in large part Bitcoin's success is due to the fact that money creation is algorithmic, transparent, and understandable.  There is not going to be a Bitcoin hoard coming out of somebody's computer to inflate away the value of existing Bitcoins.  On the other hand, most of us here at PP.com expect that there will be a next round of QE in the final, "Poom" after the current, "Ka" finishes up.  

The need to have more money.. the fact that hard money systems like Gold, or even Bitcoin, are, "not enough" is banker propaganda programming IMO.  I realize that this has some historical precedent, but that is because bankers have been with us for a long time, and they profit from the idea that we need money representations that can be inflated beyond the underlying money.  That is an old game.  I would argue that tally sticks are something altogether different.. they are borne from our desire to digitize, or virtualize, our money.. so that we don't have to carry around big pocketfuls all the time.  Makes sense to me.... digitization, and/or virtualization can happen separate of whether a form of money can be infinitely printed and expanded.. or not.  Bitcoin again attests to this, since it is strictly digital, yet strictly non-inflatable.. as hard a currency as Gold.  

I challenge anyone to make a cogent argument as to why there is not enough Bitcoin, or enough Gold, were either allowed to freely increase in buying power through normal market forces, to support any sized economy.  The reason you can't imagine this happening is because the actual benefit of this deflation effect would go to the savers.. not the bankers.  Bankers have so effectively propagandized us, for so many generations, that most of us can't even see it.                          

 

 

 

 

 

 

 

KugsCheese's picture
KugsCheese
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Gold Backed Anonymous Electronic Money System

Easy to do with today's tech (see Bitcoin).  But Psychos will never allow this.  And politicians will always vote to reduce the peg value.  Humans are doomed it would seem!

BBrady's picture
BBrady
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More than Gold

The above post from Charles Hugh Smith states: "Gold is store of value but there isn't enough of it to mediate all transactions (at least that's what history tells us)."  Historically, silver and copper were also included as money, and thereby used in the computation for the total value of all asset-based money.  For more than two thousand years, these three precious metals - gold, silver and copper - formed the basis for the world's exchange of money.

When people began to search for these precious metals, gold was the rarest, followed by silver and then copper.  As I understand, the amount of copper discovered approximated 16 times the amount of discovered silver.  The value of copper was therefore determined to be 1/16 the value of silver.  Coincidentally, the amount of discovered silver approximated 1/16 the amount of gold, and so the same ratio was applied to both.  One equivalent weight of gold was equal to 16 equivalent weights of silver, and 256 equivalent weights (16 x 16 = 256) of copper.

A good example is the Spanish Doubloon.  The word doubloon comes from the Spanish word "doble", or "two" in English.  The doubloon was actually a 2-escudo coin, which was half the size of a 1-escudo coin (there is also a 4-escudo and 8-escudo).  The gold 1-escudo coin was worth 16 times the equivalent weight of the silver coin, known as a "reale".  When lesser coins were not available for change, the doubloon could be cut into eight pieces - creating the well-known "pieces of eight".  One "piece of eight" from a doubloon was equivalent to 16 silver reales.

There are similar examples of coin denominations dating back to Roman times (the gold Aureus and the silver Denarius) and before.  The point is that for thousands of years, gold, silver and copper (and bronze) have served as denominations of money - not just gold.  In modern times, money could be anything that meets the classic definition as defined by Aristotle.  "Notched sticks, shells, chits, scrip," etc. may meet some of the definition of money, but not all the criteria.

As a side note, it is interesting to note the current value relationship between gold, silver and copper.  Gold (at $1,100/oz) is 72x the value of silver (at $15.24/oz).  Copper (at $2.33/oz) is 6.5x the value of silver.  If the classic 1/16 ratio with gold existed today, silver would be valued at $68.75 at today's depressed values.  Considering its unique medical and industrial uses, silver currently is grossly undervalued.

charleshughsmith's picture
charleshughsmith
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re: gold and money

Good discussion, thank you to everyone who commented.

I understand gold/silver could be subdivided digitally, but for this to work gold's $6T in current value would have to scale up to serve the transactional needs of billions of people in an $70T global economy.

I agree, competitive currencies is the only real solution. Let a privately issued (i.e. non-state)  gold-backed digital currency loose along with bitcoin and a bunch of other currencies. If there is a transparent market, the value will sort itself out.

A potential problem with PM-backed money is that "good money drives out bad money" means it will be hoarded by the wealthy (just like now). IMO the only solution is to distribute money directly to the bottom of the wealth/income pyramid. Right now, to do that, money is taken from someone else and distributed via social welfare (the state).  I would rather see a decentralized system that creates money in exchange for the creation of goods and services at the bottom of the wealth/income pyramid. Such as system could co-exist with a PM-backed currency.

KugsCheese's picture
KugsCheese
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Posts: 1429
charleshughsmith wrote: Good
charleshughsmith wrote:

Good discussion, thank you to everyone who commented.

I understand gold/silver could be subdivided digitally, but for this to work gold's $6T in current value would have to scale up to serve the transactional needs of billions of people in an $70T global economy.

I agree, competitive currencies is the only real solution. Let a privately issued (i.e. non-state)  gold-backed digital currency loose along with bitcoin and a bunch of other currencies. If there is a transparent market, the value will sort itself out.

A potential problem with PM-backed money is that "good money drives out bad money" means it will be hoarded by the wealthy (just like now). IMO the only solution is to distribute money directly to the bottom of the wealth/income pyramid. Right now, to do that, money is taken from someone else and distributed via social welfare (the state).  I would rather see a decentralized system that creates money in exchange for the creation of goods and services at the bottom of the wealth/income pyramid. Such as system could co-exist with a PM-backed currency.

Given the world GDP is vastly overestimated based on TRUE WEALTH we could easily see W-GDP tank 80% based on the 5-1 leverage that casino places on the betting table.  Then gold looks solid to take back its core duty.

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AaronMcKeon
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Re: More than Gold

Love the historical tid-bit by BBrady - thanks for posting.  Just one nit-picky thing that I never seem to hear anybody say regarding this:

If the classic 1/16 ratio with gold existed today, silver would be valued at $68.75 at today's depressed values.

That, or gold would be valued at $243.84...  Not that I believe gold should be at that price, but it seems whenever anybody mentions the gold/silver ratio that they use it to suggest silver should be higher but not that gold should be lower.

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