Curried Wealth Building
Finding an Edge

If you want help with your finances, give me a call at 703-791-3243.
June 16, 2009
Issue 50  -  In Debt We Trust
 
This week I'd like to go a little deeper into our financial system and how it works.  I've went over this before but I still find most people don't completely get how our money comes into existence.  First, realize there are three main types of exchange systems:  barter, hard money (like a gold standard) and fiat money.
 
Barter is the oldest system and is still used in many parts of the world and in limited circumstances, here, in the United States.  Barter involves exchanging one good or service for another.  This is very workable when exchanging my corn for your green beans, but runs into extreme trouble when a house builder wants to exchange with someone like a barber.  No one really wants a "free haircuts for life" card, so the house builder would have a hard time trading in this scenario.  This led to the need for money.
 
Money which can be used in lieu of a barter.  Now, if a barber accrues enough money, he can trade with the house builder.  Money has consisted of many things over the ages including sea shells, rocks, metals and cattle.  If money is too large or fragile, it becomes unmanageable so over the years people naturally migrated to precious metals.  It was rare, durable, hard to find, and easily formed into coins.  Since moving gold around can be difficult in that it is very heavy, gold certificates were made that represented the actual gold.  These certs could be used for trade and actually brought into existence the phrase "as good as gold".  
 
People handing out these certs soon discovered that they were never pressed to provide more than a small percentage of the gold they had on hand and decided to lend out gold to make some extra profit.  This was completely in contradiction with what they were supposed to be doing but no one ever called them on it.  Over the years they lent out more and more until they had very little metal on hand at all and gold certificates far outnumbered the gold that was on hand.
 
Eventually the government entered the game and starting printing money based on the amount of gold they held.  They also eventually printed more money than was actually backed by gold.  Governments just can't help themselves as the only sure way to garner votes is with giveaways.  Central banks eventually saw that gold backing was limiting (to their profits anyways) and starting the propaganda battle against a gold back currency.  This consisted of bogus arguments including, "there's not enough gold" or "gold is a barbaric relic".    
 
Eventually, central banks can't help themselves and switch to a fiat money system.  Fiat means "by edict".   Basically the government makes a law, "legal tender" laws, which state that you MUST take the paper money in exchange for goods or services.  If something has value, why do you have to have a law that one must accept it?  You wouldn't.  Therefore it has no value.
 
So a central bank prints up money with no backing and the government passes a law that says you must treat it as money.  Nice scam, huh?  It gets worse.  They can print as much money as they want.  Now here is where it gets tricky.  There would be no fiat money at all unless there was debt.  Read that again.  Without debt, we have NO money.
 
This is how it works.  The central bank couldn't just print money and hand it out like the beginning of a monopoly game.  That wouldn't work at all.  So what was the answer?  Debt.  Someone goes to the bank and borrows some money.  The bank calls the Federal Reserve and says we will borrow some money from you for say 2%.  The bank gives the "money" to the sucker...err I mean borrower and issues a contract that he is to pay the money back.  The loan may call for 6% interest.  The bank now makes 4% (if he pays it back) on this "money" which was created out of thin air.  Again, a nice con job.  (why does the banker get to make a profit on something that has no intrinsic value?)  It gets worse.
 
The borrower takes the money and spends it with someone who then deposits it in another bank.  That bank can then turn around and lend it out again.  This can continue ad infinitum because there really aren't any hard and fast rules for reserves.  (although this has been tightened up recently due to bank calamities)  This is called the multiplier effect and as long as more and more people continue to borrow, the game continues and the banks make their "cut", enriching themselves for really doing nothing at all.
 
Now, however the game is in trouble as people are increasing savings, and reducing their debt.  This does the opposite of borrowing.  Instead of increasing the money supply, now it decreases.  As it decreases and debts are paid off, the banks must, by definition make less in profits and pay back the central bank.  If this continues for too long, game over.  This is the reason for the TARP and the breakneck spending by the feds.  They are borrowing to replace the lack of borrowing from the general populace.  Businesses have also stopped borrowing.
 
Look at this chart from contraryinvestor.com:
  
 
 
 
The consumer is retracting and rebuilding his balance sheet.  To do this they must pay off their debt.  This leads to lower spending and more importantly for the banks, less borrowing.  They can't have that!  It means death.  NO profits without loans.  However, they can't just lend to everyone (we tried that and it didn't work, no documentation loans anyone?) so they are tightening their requirements which is even further reducing their credit balances.  This is a nightmare scenario for them and they are in trouble.  Unless the government can kick start the economy with all this spending we will have major bank failures.  This is why Obama is spending so much.
 
Speaking of Obama, he is hardly what was promised.  Change.  A new direction.  Yes we can.  All lies.  His latest proposal is to give the Federal Reserve more powers!  You see, they didn't have the "tools" to properly react and contain the roil ups.  Now with new legislation they will.  The Federal Reserve CAUSED the mess!  Now we should give them MORE powers?  That's like the owner of a country club walking down to the marina and finding that half the boats have been stolen or vandalized and the solution he comes up with is to put the manager of the marina in charge of the parking lot too!  NO, we need to fire the manager.  We need to rip the Federal Reserve off its foundation and throw it into the ocean.  Give them more power!?!!??  You can't make this stuff up.
 
Until we give the money making authority back to where it belongs (congress) there is NO chance of exiting this crisis without significantly more damage and misery.  The Federal Reserve is the problem, not the solution.  The people are rightly balancing their personal books and paying down debt.  The government is trying to borrow money to make up the difference instead of taking our medicine and going through a brutal contraction.  Putting off the day of reckoning doesn't prevent the reckoning.  Follow the lead of the people and pay off your debts and right your financial ship.  Next week I'm trying finish my battle plan for living off the grid for over one month.  Have a great week!