Chapter 4: The Greatest Magic Trick Ever
This post is Chapter 4 of the book I’m writing. You can read the Introduction here
In Chapter 2, we learn how our money became a money that can be printed. Chapter 3 shows us how government creates Fiat Money.
Fiat Money is created when government issues debt or what we call government bonds
Governments have no choice but to issue more debt in order to pay for their old debts.
The government is like a shopaholic with $100,000 worth of debt but earns $50,000. To make end meets, he needs borrow $50,000.
The original debt of $100,000 + $50,000 will also have interest making his debts bigger.
With fiat money, new money is created through debt.
This is counterintuitive to think at first, but in this chapter, I will show you how is that possible.
Governments are not the only ones who can create more money. Banks can also create more money. Banks can create more money because what we call fractional reserve banking.
Fractional Reserve Banking
In a fractional reserve banking system, banks are only required to maintain a portion of customers' deposits.
If JPMorgan bank has deposits of $100,000 that belongs to a depositor named Bob. And assuming the fractional reserve requirement is 10%, only $10,000 is required to be maintained in JPMorgan bank.
$90,000 can be lent to those who want to borrow money from the bank.
Let's say that Alice obtained a loan of $90,000 from JPMorgan bank. Then Alice buys a car from Peter using this $90,000
Peter happens to also banks with JPMorgan. He deposited the money he received from selling the car ($90,000) to JPMorgan bank.
Now, if you ask JP Morgan bank how much money they have in the bank, their answer will be 100,000:
$10,000.00 - the fractional reserve requirement that was left in the bank.
$90,000.00 - the amount borrowed by Alice then paid to Peter which you then also deposited into JPMorgan.
Now here’s the interesting part, if you ask the depositors how much money they have in the bank, their answer will be $190,000.00
Bob - $100,000.00
Peter - $90,000.00
If you ask all the depositors, the total amount of money they have in the bank is $190,000.00 but the bank has only $100,000 money in their vault.
How is that possible? Because only a fraction of the deposits is required to be maintained at the bank, the rest can be lent out.
That’s fine as long as Bob and Peter don’t withdraw their money at the same time.But what will happen if Bob & Peter withdraw their money at the same time? Bob believe he has $100,000 and Peter believe he has $90,000 but the bank only has $100,000
If Bob & Peter decided to withdraw at the same, that will cause a bank run and the bank will collapse.
How new money is created when debt is issued.
Suppose that the reserve requirement is only 10%. This means that banks are only required to hold 10% of every deposit they get, they can lend out the rest.
Because of this fractional reserve banking, new money is created when debt is issued. Here is an example on how that is possible.
Initial Deposit:
You deposit $1,000 in Bank A.
Bank A keeps $100 as reserves (10%) and lends out $900.
First Loan and Redeposit:
The $900 loan is spent and deposited in Bank B.
Bank B keeps $90 as reserves and lends out $810.
Second Loan and Redeposit:
The $810 loan is spent and deposited in Bank C.
Bank C keeps $81 as reserves and lends out $729.
This process continues, and the total amount of money created in the banking system is much larger than the initial deposit.
The only money is $1,000, but because of fractional reserve banking, that $1,000 can be multiplied because of issuing loans.
That’s how new money is created when debts are issued.
This process continues with each round of loans and deposits becoming significantly smaller.
This means that the initial $1,000 deposit can theoretically result in up to $10,000 of total deposits in the banking system through successive rounds of lending and depositing.
Of course this is an oversimplification example, not all money deposited in a bank will be loaned out over and over again. Banks are also regulated by the government to have some regulatory requirements that prevent them from over-expanding their reserves. Central banks also have tools in their disposal to prevent this from happening.
But the key and important thing to understand here is that our money is not physically backed by something anymore, that is why we are able to create more money out of thin air.
HOW ISSUING DEBT PRINTS MORE MONEY
Whenever the government issues debt by issuing government bonds or banks issues loans, they increase the money supply. This result to inflation or to be exact, currency debasement.
It doesn’t decrease the nominal value of your money. The $100 you have won’t become $90 when government and banks prints money, it will still be $100 but that $100 bill will buy you less, because again, they print more money that will result to increase in prices.
If your salary decreases in nominal value whenever the government prints money, for example if your $100 bills become $90 every time they print money, you probably will start a revolution or rally to overthrow the government, or you will post a lot of hateful comments towards the government in social media.
But since inflation is theft hiding in plain sight and not obvious, most people just accept inflation as if it is a natural phenomenon like the sun rising or like gravity.
Maybe inflation doesn’t happen in your country in a fast rate like in Argentina, Zimbabwe, Lebanon, Venezuela etc.
But inflation will still hurt you, that is why it gets harder and harder to survive, especially for those earning just minimum wage.
Once you understand that:
they print more money by issuing debt > supply of money increases > prices of goods increases > your salary devalues> you need more work or higher pay to buy less
Once you’ve understood that, you will understand that money printing is theft.
This is not just problem our money has, it is a problem in our daily lives, because remember, money is not just a currency.
Money is tool we use to measure our work or value.
And because of this bug of fiat money that can be printed out of thin air, it lessens the value of our work.
It’s devaluation of the work we do, our time and energy.
To recap what we’ve learned:
Chapter 1: Inflation is a result of printing more money.
Chapter 2: Our money evolved to money that can be printed. We went from gold as money, to paper money backed by gold to fiat money that is backed by nothing.
Chapter 3: Government prints money through issuance of debt called government bonds. Government spends more than what they earn. They will need more debt to pay for more debt.
Chapter 4: Banks can also increase the money supply when they issue loans because of Fractional reserve banking.
As an everyday pleb and worker, I hope that I have establish to you the problems of our fiat money.
Before reading this, you may not know what the problem is, but you feel it, you feel that every day is becoming harder to get by. Everything cost more. We work harder and longer hours but earns and save a little, we work 5 days a week and rest 2 days a week. Almost most of our waking life is spent on work. We have little time left to relax and spend time with family after our work. We spent 20 years in school 50 years in work then retire to have 5 or 10 years left before we die if we’re lucky. Something is not right. All of these can be trace to how our money works.
I can’t stress this enough, money is not a paper, money is a representation of our time and energy. Imagine it that every time you work, you store those work or energy or time into your money. Whenever they print more money, it’s like your money is being drained or stolen of its energy.
Printing more money not only leads to higher prices, but it also steals our time and energy, two of the most precious assets that we won’t ever get back.