I just finished reading another excellent book: Web of Debt. This will not be a post about personal finance; instead I want to talk about money in general. I have always had a lot of misconceptions about where money comes from and how it flows, and this book did a great job of disabusing me of what in retrospect I now recognize to be some rather ignorant notions. The fact that these rather simple lessons either aren’t taught by our educational system or are intentionally obfuscated is suspicious, but at the end of the day I had nobody to blame for my ignorance but myself, and want to make up for it by sharing what I’ve learned with all of you. These are not the book’s conclusions; Instead they are the commonly misunderstood axioms.
Where does money come from? If you are like me, you may have an image in your mind of the government running a series of giant printing presses. In reality, less than 3% of the national money supply is in the form of physical cash. The 97% of the money supply not represented by physical cash is instead represented by numbers on a computer screen (or entries in a ledger).
So where does THAT money come from? It is created when a bank lends it. For example: the bank agrees that you owe them $500, and in return $500 appears in your checking account. All money is created this way, in the form of debt.
It is interesting that the bank does not really have the money it is lending out. The bank usually keeps on hand, in cash, a fraction of the amounts in its accounts (this is called “fractional reserve banking”) to accommodate withdrawals, but most of the money really doesn’t exist except in the ledger.
So let’s say you want to pay off the $500 loan you took out. You return the debt-money and it eliminates the debt, in much the same way that matter and anti-matter annihilate each other on contact. The ledger balances, and the total money supply of the simple closed system in this example contracts by $500, which is to say that $500 simply disappears, because money only exists in the form of debt.
But the bank doesn’t lend out money for free (even though it doesn’t really have the money to begin with). The bank charges interest on its loans. So when you pay back the $500, you also pay back $50 in interest. Where did that $50 come from? It must have been created by being borrowed somewhere else in the system. Where does the money come from to pay the interest on THAT loan? Good question.
On a national scale the bank is the Federal Reserve Bank, and the astronomical number we call the “national debt” is actually a measure of the money supply (money in circulation) plus interest owed. Congress has the legal power to create money but delegated it a long time ago to a private institution called the Federal Reserve Bank (also known as “The Fed”). The Fed is neither owned nor controlled by the government (i.e. the public) despite its name. The Fed creates money by lending it to the government, which spends it on public works, putting the debt-money into circulation. Every dollar (or “Federal Reserve Note”, as they are marked) in your pocket is a small part of the national debt.
So that is how your money works, if you live in the United States today. Hopefully you found my brief explanation enlightening. If you’re interested in learning more about the history of this system and/or alternative systems I highly recommend a trip to your local public library to check out Web of Debt.