Part 2: The Dollar Standard – A Ticking Time Bomb

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If you were to ask any economist how money is created in today’s economy, 10 out of 10 of them would give you some kind of spiel about the government or central bank. They’d be wrong, every single one of them, and wrong in two senses: Firstly, as you’ll know from Part 1, there is no money in today’s economy, only credit. Second, the majority of credit is created not by the government or Central Bank, but by regular banks such as JP Morgan, Citi Bank, Deutsche Bank, HSBC, Barclays etc.

The failure of economists to understand this isn’t entirely their fault. The banking system is complex, and most people who work in the industry don’t understand it either! Ask any banker the same question about money creation and they’ll likely give you the same answer as the economists. So how does our current monetary system, the Dollar Standard, really work? I’m glad you asked…

When the government wants to spend more credit than it gathers in taxes, it sells “Treasury Securities”. A Treasury Security is essentially debt: a promise to repay the lender the amount borrowed, plus interest. So when you “buy” a Treasury Security, you’re not actually buying anything but rather lending credit to the government. So, who lends all this credit to the government? The Central Bank. And where does the Central Bank get all the credit? Computers. Yes, that’s correct, the Central Bank buys Treasuries, from their constituent banks, with credit they literally type into existence on their computer systems:

“When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money.” – Boston Federal Reserve.

Now think about this: if the Central Bank “buys” a Treasury Security with credit it created out of thin air, and that Treasury Security represents an obligation for the government to repay the credit borrowed PLUS interest. Where does the credit to repay the interest component come from? Answer: more credit! In order to repay interest on old loans, new loans must be created so there is enough credit sloshing around the economy to cover the difference. This is no different to a Ponzi Scheme in which new investors are used to fund returns to old investors.

This can easily be confirmed with a quick look at the “money” supply since 1900:

US MOney Supply Since 1900

As new debt is perpetually created to service old debt, the money supply increases exponentially. This isn’t sustainable, even in an almost purely electronic monetary (credit) system.

Sooner or later, the house of cards will tumble. It almost did in 2008, but instead of recognizing that the fundamental problem was the banking system, politicians and their economic advisors were misdirected into believing a “sub-prime” lending crisis was at fault, and were conned into resuscitating a broken system with a band-aid solution – more credit – instead of addressing the fundamental problem: the monetary system itself.

Now if it isn’t bad enough that our monetary system isn’t a monetary system at all, but rather a ponzi credit system, what’s worse is that credit creation isn’t confined solely to the Treasury and Central Bank: retail and commercial banks also create credit by typing numbers into the computer system. This is the part that most economists (particularly MMT proponents) either ignore or simply don’t understand. It is also the most crucial element of our monetary system in the sense that it explains virtually all the anomalies of the economy today, such as why inflation remains below 2.5% despite doubling the credit supply in the last 10 years, why wages have remained stagnant for decades, and why the economy is bloated with asset bubbles. This will be addressed in Part 3.

To understand how banks create credit, let’s rewind to the bit where the Central Bank buys Treasuries to fund the government. When a Central Bank buys Treasuries, it doesn’t typically buy them directly from the government. Banks and other financial institutions buy Treasuries from the government, and the Central Bank buys them from these banks and financial institutions.

Since the Central Bank uses computer generated credit to purchase Treasuries, what’s really happening is that Banks and other financial institutions are handing the government existing credit they’ve accumulated through deposits, in exchange for Treasury Securities, which they then swap for new credit created by the Central Bank. This new credit can then be used to buy more Treasuries to keep the ponzi system going.

Now, banks don’t buy Treasuries for the returns. The interest rate on Treasury Securities is about the same rate you’d get depositing your cash in a bank, so banks can’t earn profits by investing their deposits in Treasury Securities. They invest in Treasury Securities to maintain reserves. In the old days of notes and coins, banks kept reserves as a matter of necessity as they needed to have enough physical currency to redeem withdrawals. These days, reserves merely dictate the amount of additional credit the Central Bank allows its constituent retail and commercial banks to create in the same way they do: by typing numbers into a computer system.

This is best demonstrated with an example: A brand new bank, Scambank, is established under a Central Banking system that requires a 10% reserve ratio (e.g. 10% of its deposits must be kept aside as reserves). If Scambank receives $1 million in deposits, how much can it lend? The answer may shock you: at least $9 million. How is this possible? First, Scambank buys Treasuries with its $1 million. Next, it deposits the Treasuries at the Central Bank in its reserve account. It now has $1 million in reserve, so it can lend $9 million and maintain the required reserve ratio. But how can it lend $9 million when it doesn’t have any deposits available to make loans? Computer credit!

In order for Scambank to loan $9 million, it simply records a $9 million receivable on its balance sheet. The recipient of the $9 million deposits the credit in their account, so now Scambank has a $9 million deposit (a liability) offsetting the receivable (asset), and just like that, Scambank has effectively created $9 million of new credit. But what if the recipient deposits the $9 million in another bank, Shambank? No problem, Scambank can simply borrow $9 million from Shambank in the “money market” and both banks’ balance sheets square up.

Taking things one step further, I said earlier that Scambank could lend at least $9 million. What if it wanted to lend $10 million? It can, simply by using the same process as above, and borrowing the reserves it needs: For example, if Shambank also had $1 million in reserves but had only made loans totalling $4.5 million, it has excess reserves of $0.5 million. Scambank can borrow the additional $0.1m of reserves it needs from Shambank to cover its $10 million loan, and the system remains in balance.

This “system” is the foundation of our entire economy. The Central Bank and its constituent retail and commercial banks create credit out of thin air and charge interest for it, requiring perpetually more credit to be injected, in the same way a ponzi scheme requires perpetually more investors to keep rolling. The system needs everyone to be succumb to perpetually more debt as there is never enough credit in circulation to repay outstanding loans:

If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible – but there it is.”  – Robert W. Hemphill

Just as a ponzi scheme inevitably runs out of investors, a ponzi credit system will also run out of creditors. It’s a ticking time bomb that will eventually explode, and it’s likely to happen very soon as we’re on the brink of credit saturation right now – consumers are crippled by record levels of mortgage debt, student debt, auto debt and credit card debt, and defaults are on the rise…

When a customer defaults on a loan, the bank writes off an asset (the receivable) but is still stuck with the corresponding liability (the deposit). Banks typically issue thousands of loans so a few defaults can be absorbed by earnings retained from its interest income. But when too many loans default, as occurred in 2008, the system collapses with catastrophic consequences: since banks are constantly borrowing credit and reserves from each other, defaults are a systemic problem.

Under a quasi-gold standard – where money and credit co-existing in a system that distributes new credit bottom-up rather than top down – the systemic weaknesses of the dollar standard are eliminated.

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