How Money Works or Why our society can NEVER be debt free.

In today’s edition of The Daily Skinny, we will be discussing money. I had another topic planned, but let’s face it. This one is more useful. After a significant number of classes and study, I think there may be things about money that an average person may not know.

I’ll try not get too academic about this, but let’s start with some definitions.

1. Real Currency – money with intrinsic value that can be exchanged for something else of value (ie a gold nugget is traded for a pair of levis during the gold rush)
2. Fiat Currency- Money that has no intrinsic value, other than what the government say it has.

All of our U.S. bills are fiat currency. Notice that a $20 bill is not more valuable than a $1 bill, except that it has a 20 instead of a 1 on it. In fact, they have no value other than the government backing it. It even states on our bills that “This note is legal tender…”. It has value because the government says it does, and basically everyone on the planet accepts their word. Both kinds of currency (fiat & real) have their pros and cons, but let’s keep this simple.

Our government has the power to print our money themselves, but they don’t. I won’t conjecture why they don’t, but they don’t. I guess this point is moot (what kind of word is “moot”?) since it would be a huge task to change our whole system. Anyway, the government doesn’t print our money, they hire it out. The Federal Reserve prints it. I hope most people know that the Federal Reserve is NOT part of or controlled by the government. It is a business. It’s about as governmental as Federal Express. In fact, if you look at the top of our bills, they are owned by the Federal Reserve, NOT the U.S. government. Let’s follow the process of you buying a house, from the reserve to you.

"The actual process of money creation takes place in the banks." (Modern Money Mechanics, Federal Reserve Bank of Chicago)

1. The Federal Reserve creates/prints $150,000.

2. The U.S. government accepts the $150,000 and agrees to pay it back with interest. (Just like a loan) Let’s pretend the government agrees to pay back $160,000.

3. The $150,000 is deposited in your local bank, “Steve’s Bank & tackle Store”.
When “Steve’s Bank & Tackle Store” gets that $150,000, the Federal Reserve says they can’t loan it all out but they have to keep some of it in reserve. One reason for this is that during the depression when banks ran out of cash, people wanting to make withdrawals were not happy. For simplicity, let’s say the rate is a flat 3%. So the bank can loan out $145,500.

4. You get a loan for $145,500, buy your house, and the bank pays the person who owned your house previously $145,000

5. That bank takes out the reserve and gives person B a loan for $141,135
6. Person B’s bank takes out the reserve and loans Person C $136,900
7. Person C’s bank takes out the reserve and loans Person D $132,793
8. This continues for a long long time.

9. When it’s all over, there will be $5,000,000 in loans created (multiplier=1/reserve RATE). And how much money is in the economy to pay it back? $150,000. As you can see, it is for this reason, impossible to pay off the national debt (under the current system). In fact, the only time we have not had a national debt was when President Jackson got rid of their version of the Federal Reserve.

So what keeps the whole house of cards from falling down? Mainly two things. Other countries investing their money in the U.S., the Federal Reserve printing more money, and inflation. You can see that this is a self sustaining cycle. This system guarantees that there will periodically be cycles of bankruptcies, company failures, and banking assets being written off as worthless. Our current economy is not broken. It is functioning as it was designed to function. So why do we put up with it? Because in the good times things are really good. Money is cheap, easy, and we can buy whatever we want. But it is unavoidable that we must sometime pay the piper.

We are using debt (loans) to create money out of thin air. This is the reason that one Federal Reserve Chairmen said, “If there were no debts in our money system, there wouldn’t be any money.”

Want to hear something funny/sad? Because we will always owe more in loans, than there is money to pay it off, there will ALWAYS be bankruptcies and foreclosures. And when the bank takes your house, they have basically bought your house with money that never existed. In one lawsuit, Martin v Mahoney, a bank was trying to foreclose on a man. The man showed that the bank did not actually have the money for his loan, but created it after the loan was signed (by the above process). The jury denied the banks claim to foreclose and held the contract unenforceable. I must admit though that this was a small bank, and they basically admitted everything. If you tried this with a big bank they are not going to do you any such favors.

We are in a period of inflation, and the level of inflation is going to increase. This means we are in a period of time when the system will be working against you.

Inflation is an increase in the money supply; no matter what anyone tells you, it is not an increase in prices. Saying inflation is rising prices, is like saying a runny nose is a cold. Rising prices is just one symptom of inflation just like a runny nose is only one symptom of a cold.
$1 in 1913 was worth 21.60 in 2007 that is a 96% devaluation since the Federal Reserve began.
When the Federal Reserve chairmen say they are going to lower interest rates, what they really mean is that they want to increase inflation, and make the dollar worth less. This makes old loans easier to pay off with new money, and delays the inevitable.

The bottom line is that people who cannot control their debt and spending habits will increasingly become prisoners of their debt which they will have a harder time repaying. This process will push people into lower and lower income classes until they cannot extricate themselves. So what can be done?

Don’t buy ANYTHING with debt if you can help it. The only debt that the prepared person should have is debt that is related to producing income. That means school loans, car loans (for getting to work), and eventually maybe a home loan. Anything that will not enable you to produce income should NOT be financed. Emergencies will happen, and we should have 3 to 6 months of income saved to prevent emergencies from forcing us into debt.

The more your income exceeds your expenses, the less inflation will impact you negatively. If you can’t increase your income, decrease your expenses.

Society can’t be debt free, but you can. Anyone who doesn’t do the above will eventually sorely wish they had. I'm not forecasting this, I am promising it. The system is working how it is designed to work. The less we are part of that system, the better off financially we will be.