Sunday, January 31, 2010

Understand Money as Debt Concept

I came across this video sometime ago and personally I found it very interesting that you may want to watch it. This video was created by Paul Grignon in 2006. It is quite a long clip (i.e. 47 minutes) and I think it is worth spending watching it. You may need to watch it few times too because it is kind of difficult to understand.

This movie shows how the basic banking system works and how the money was eventually evolved into no longer represent value but debt. Let's watch it and if you're lazy, you can read my summary below. :)





What are the KEY messages from this video?


Message 1:
Money Is Now Backed by Loan or Mortgage


Yes, bank used to create money only if they have the real gold with them or someone deposit the gold to bank. But this is not how the bank operates today. Bank created money as long as you take loan from them and promise to pay back. Money is no longer backed by Gold but backed by the loan or mortgage. In short, bank loans money that they don't have and in reality the money now is actually created out of “Nothing”. Let's see how this works...


Message 2
: Bank Can Create as Much as Money We Can Borrow


As soon as we realize the bank creates money out of nothing, a new legal regulation is invented to protect our rights. This legal regulation is called “9 to 1 Fractional Reserve System” to limit how much money the bank can create.

In short, if the bank has $1K cash in hand and they can loan out up to $9K to us based on the 1:9 fractional reserve system regulation. However, does this really limit the bank to create money up to $9K? It seems so but in reality they can create the money up to $90K which is 1:90 ratio. Let's see the following example how this works:

Assuming when the bank started, the bank has $1K cash in bank. This means the bank can loan up to $9K to all of us. So, let's say Person A take the loan of $9K to buy a car from Person B. Based on the person A's promise to pay back the money, bank will create $9K cash and loan it to person A.

The tricky part is the Person B will then deposits $9K to the bank. Based on the 9:1 federal reserved regulation, the bank can then reserve $900 ($9K/10) and loan it out the rest which is $8100 ($90:$8100 == 1:9).

So it moves on to next loan transactions until the bank can't reserve anymore money. See the table below for the subsequent loan transactions until the bank can't reserve anymore money. At that point in time, the bank will have total of $10K cash in hand and the total of $90K loan has been created.







2 very important questions to ask yourself here:
  • Initially the bank has $1K and now the total cash in hand the bank has is $10K. Where does the $9K come from?
  • Initially the bank can only loan up to $9K. Why now the total loan is $90K?

The answer is pretty simple – the bank create money out of each loan transaction. With just $1K, now the bank can somehow create extra $99K($9K + $90K) out of all the loan transactions. So $1K has been somehow magically becomes $100K ($1K+$99K). Assuming $1K is backed by Gold, then $99K is now backed by loan. It seems like the banks only create $9K but in reality $99K (x10 times) of money has been created out of nothing.

Therefore, bank can create a much as money that you can borrow! As long as new loan agreement is signed, a brand new money is created!


Message 3: Our Monetary System is NOT Sustainable?

In previous example, you will notice that majority of the money that we have today in this economy is created by loan or debt. Therefore in other words, the money supply to this economy is equal to the total amount of loan principal. However, when you pay back to bank, you're paying not only the principal but the interest of the loan.
  • Money Supply = Loan Principal
  • Money Owed = Loan Principal + Loan Interest

The total of money circulate in this economy is approximately equal to the total of loan principal. So now you need to pay the extra loan interest to the bank, where do you get the money from? There are only 2 possibilities:
  • Not everyone will not able to pay back the loan together with interest
  • To avoid that from happening, bank will supply more money to the economy by creating more loans

In order to sustain this monetary system, more debts needs to be created to make sure the system have enough money supply to pay back the loan interest. The funny thing is when more debts are created, more debt interests are created too. Thus, more money you owe. This is the exponential thing and are fixing the things or making it worse? Will this continue forever or will it collapse one day?


Discussion

Now we know the truth that money is created from debt and the questions to be discussed here are, is that really wrong with this system? What's wrong with creating money as debt? What's wrong to have exponential growth? Is this man made or natural? Who should we blame if this is not right? Is this government fault? The most important question is that shall we even fix this system? If we want to fix this system, can we accept the consequences? Even if we want to fix this, can we?

12 Comments:

Michael Tsen said...

Message 1 and 2 ok, message 3 starts to deviate a bit.

You are assuming finance world is "finite" to start with when you use such a formula.

But is Universe finite or is it ever expanding (at least within our life time) ?

it will work in capitalism as long as new arena is explored, and therefore create an effect of infinity.

if we want to fix it, its possible too. The old solution is called communism.

ChampDog said...

That's why I put a question mark there... I don't have the answer for that.

stock market and investing said...

That's the reality about banking. Most of the money that we invest to the bank. 70% of it is invested on properties, state etc.. only 30% in liquid.. that's how it work here in our country. About the monetary system to be stable only if there are no crisis and individual are willing to invest on the bank.

ChampDog said...

The bank can invest on anything but the thing is that the bank created the money based on the impression of future money that they will get back. Is that a right way? Could this be also considered as investment?

I"m not sure whether this is important to be discussed at all as it may may comes out no conclusion at all the end. At least, I think it is still important for us to see the high-level picture.

stock market for beginners said...

Banking is all about money investment. That's how the bank works. The monetary system to be stable only if there are no crisis and individual are willing to invest on the bank

Tax preparation said...

Very informative blog post, "Understand Money as Debt Concept"

Kris said...

Good one. :P

Garfield said...

"Will this continue forever or will it collapse one day?"

it collapsed a few times before.

the most significant one is:
once is was happened in 1997, to ourself.

once is the most recent ones which happened to US. but Barack Obama is still using more loan to cover problem caused by loan....

ChampDog said...

So, I guess we can't avoid this?

Garfield said...

@ChampDog,
yup, only the country leaders can control it if they want.

Anonymous said...

The only way out is the Venus Project:
http://www.thevenusproject.com/a-new-social-design/resource-based-economy

ChampDog said...

This is interesting "Resource Based Economy". Can that be done? Thanks for the sharing anyway.


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