A Reader Asks About His Checking Account and Bernie Madoff

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Ronnie writes in:

I’m curious what your thoughts are on fractional reserve banking. It seems to me that this method of banking is a high risk form of financial management on the part of the banks. The difference (sort of) between Maddoff and FRB seems only different by institution: as long as there is more money coming in it doesn’t matter that a small percentage is going out. This system seems based entirely on debt, which is not ideal for a country, I wouldn’t think.

What Ronnie is really asking about is fractional reserve banking, which is the standard practice of pretty much every bank in the modern world.

What’s fractional reserve banking? It’s easiest to illustrate fractional reserve banking by giving an example.

Let’s say a new bank opens up in town and you’re the first person to open an account there. You deposit $100. Then, another person stops in seeking a loan of $80. The bank gives the person that loan, leaving only $20 in their reserves. Of course, the interest rate they’re paying you on your account is low – say, 2% – and the interest rate they’re charging on the loan is likely higher – say, 6%. At the end of the year, they’ll earn $4.80 in interest on their loan to the customer, and then pay you $2 in interest on your deposit, keeping $2.80 for themselves.

Now, if you were to decide that you wanted your full balance back, the bank would obviously be in trouble. They wouldn’t have the money to give back to you, and thus they’d go bankrupt (and you’d have to rely on FDIC insurance).

What actually happens is that a bank has a lot of depositors. Let’s say 1,000 people all deposit $100 in the account, then the bank lends out $80 to a different group of 1,000 people. This would leave $20,000 in their coffers. Thus, even if 150 of the original depositors came in and asked for their money back, the bank would be completely fine.

Fractional reserve banking simply means that a bank is only required to keep a fraction of their deposits on hand – they’re allowed to lend out the rest to people who want to borrow money.

The benefits Without this system, it would be almost impossible to borrow money for any purpose. Loans would basically only exist between individuals – you wouldn’t be able to just go to a bank to borrow money for a car, a home, or to start a business.

At the same time, the idea of a checking or savings account as we know them would go away. We would have to pay a sharp fee for such services – or else keep all of our money at home.

The risks The biggest risk in such a system is the potential for bank runs. If the bank is making poor decisions with the money they’re lending out (or investing), then people who hold accounts at that bank might get nervous and start demanding their money in droves. If enough people tried to withdraw their money at once, the bank would eventually not have enough to pay the depositors and would go out of business. This happened with the Northern Rock bank in 2007 and with IndyMac and Washington Mutual in 2008 – in both cases, the bank showed signs of holding a lot of bad investments, causing depositors to start clearing out their accounts very quickly, driving the banks out of business.

My take On one level, I do understand Ronnie’s comparison of fractional reserve banking to the Ponzi scheme perpetuated by Bernie Madoff – both of them relied on a continual flow of deposits and both collapse if the deposits stop flowing.

The difference between the two is simple, though: Madoff’s scheme could not earn money without new depositors constantly entering the system. He needed new investors so that he could keep paying old ones – and that meant that it was inevitably going to fail.

This system, though, can work forever provided that a large number of depositors don’t demand all of their money at once. Since the rate of interest the banks pay to checking and savings accounts is lower than the rate of interest the banks charge borrowers, the system also earns money in perpetuity, something that Madoff’s scheme doesn’t do.

In short, I think fractional reserve banking is something of a necessary evil, given the benefits (individuals are able to borrow money, banking services are free and often earn depositors some interest).

If this still concerns you… Some people are still left feeling pretty uncomfortable when they learn about fractional reserve banking. If you’re left feeling this way, keep two things in mind:

Your checking and savings accounts are insured by the FDIC. Currently, that insurance is for up to $250,000 – it’s scheduled to drop back to $100,000 at the end of 2009, but that may change. Make sure your account is insured (if it’s in an American bank, it probably is) and hold on to your bank statements, as those may be the proof you need to get your money if your bank were to fail.

You shouldn’t have all of your eggs in one basket. I would personally feel concerned if my account balances were pushing the FDIC limit. Instead, I would be investing some of that money in real estate, stocks, government bonds, or other things – the money will work much better for you there.

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41 thoughts on “A Reader Asks About His Checking Account and Bernie Madoff

  1. Fractional reserve banking creates the debt out of thin air. What it doesn’t do is create the interest on the loan that must be paid back. That is why money systems under fractional reserve are bound to go bust. Watch the google video “Money as Debt” for a simple cartoon video that explains it nicely. Or watch the first part of the zeitgeist addeendum for a better explaination. In that Video it shows that the GAO predicts the U.S. will exceed its ability for borrowing under our fractional reserve system by 2013. Maybe sooner as this was before the 2008 financial crisis.

  2. Hi Trent… love your blog. I may be way off base here, but since most of our money is issued this way, from the fed on down thru our banking system, using this system seems to guarantee that you may never be able to get out of debt, in total.

    In other words, if all your money is issued this way, the current supply of money could not repay the outsttanding loans (principal + interest). So, if everyone, including the Federal governement, decided to repay all debt and try to become debt free, it would be impossible, and maybe that’s where the Ponzi scheme analogy comes in. You need to continue to issue money in the form of debt (issued at interest) to keep this thing going… someon is ALWAYS in debt here.

    Maybe I’m missing something!!

  3. I disagree that the two are similar. FRB is not like a Ponzi scheme.

    You state that “both of them relied on a continual flow of deposits and both collapse if the deposits stop flowing.”

    But FRB does not rely on a continual stream of deposits. If no new customers opened accounts at your local bank (no new depositors), the bank would still be able to make loans (as long as they did not deplete the required reserve). As interest payments are made, and as loans are paid off, the bank can make new loans. The bank does rely on a continual stream of interest payments from loans to continue paying interest to depositors and earn income for shareholders, but does not need a continual stream of new depositors. If deposits stop flowing the bank does not collapse.

    A Ponzi Scheme, on the other hand, does rely on a continual stream of new depositors to pay off older depositors. If new depositors stop investing in the Ponzi scheme, it does collapse.

    For FRB, even if some loans go into default, the bank is not necessarily in trouble, because they have the collateral behind the loan as an asset. A bank that properly evaluates risk expects a small percentage of loans to default, and these loans are backed by additional reserves at the bank (http://www.fool.com/investing/beginning/2007/04/09/whats-the-deal-with-bank-reserves.aspx). As long as they properly accounted for the asset behind the loan, and did not make too many bad loans, their balance sheet would show that bank had enough assets to meet the required reserve.

    The banks caught in the current crisis got into trouble because they had an excessive amount of loan defaults backed by (in the case of mortgages) houses that were highly overvalued. And because they did not properly understand the risks of their loan portfolio, they did not have enough reserves to cover the losses that occurred.

  4. Isn’t the major difference the fact that the banks are actually “investing” the money (through making loans) and can be reasonably expected to see a rate of return close to the expected 6% (less the small portion of defaults), whereas a Ponzi schemer simply pays old investors out of new investors without ever actually investing the money, and simply pockets the cash when the system becomes unsustainable?

  5. Treasuries are a better example of a Ponzi scheme: debt interest paid for by more debt and dependent upon increasing demand.

  6. Nice summary. It might be interesting to note a few other things:

    #1 Most people have a bank account and loans at the same time. Therefore the bank is making a spread lending you your own money! Dirty trick.

    #2 Lots of banks went under recently. How poor does management have to be at these banks to loose money given the fractional reserve system. They get free money! The law allows them to loan out money that isn’t even theirs!

    #3 Banks create almost all the money in the world, not the government. In you example there is a person with $100 in depost and another person with $80 in cash = $180 in “money” available to spend. This gives banks as a group control over how much money there is, and consequently how much inflation, interest rates, and general “sizing” or the economy.

    #4 Think of how the interest flows. There is only $100 of “real” money in your example and $80 of fake money. The depositor gets $2 per year, which the banks pays by taking $4.80 from the borrower. Where does that $4.80 come from? The only other money that exists is the $100 in the bank. The answer is that the depositor either withdraws some money to give to the borrower, say in payment for something, or the borrower takes more loans. Either way, “real” money gravitates to the bank away from individuals.

    It’s good be a shareholder of banks. A gig at which it’s hard to lose.

  7. You should read The Creature from Jeckyll Island by G. Edward Griffin for a great understanding of fractional reserve banking. For a Simplified version, i like George Bailey’s explanation in Its a wonderful Life.
    Also, i would never put much faith in the FDIC. They don’t have enough money either!

    Kevin

  8. Ugh… Sounds like my brother… Conspiracy alarmists.

    FRB is NOT the same as a Ponzi scheme as some of your more astute readers have already pointed out. People need to realize the difference between good debt and bad debt, not ALL debt is bad. Actually, not having any debt can be seen as a negative to investors because it could be construed as a poor use of capital.

    I submit an alternative comparison to Madoff’s Ponzi Scheme… SOCIAL SECURITY.. Now THAT, is a Ponzi Scheme.

  9. Kevin @ 2.59, I am familiar with the creature from…book. I believe like the comment by Ken above yours that it is a ponzi scheme because the only way to sustain the system is by ever increasind debt. Most of the money owed to the FRB is from our federal government that must borrow more and more to sustain the government’s obligations/debt. Prior to Bush II, some were speculating that the projected (next decade’s) surplus could repay the federal debt. But if that had been done the system would have collapsed. Our system relies on ever increasing debt to sustain it.

    “If there were no debts in our money system, there wouldn’t be any money” -Marriner Eccles – Governor of the Federal Reserve 1941 house Committee on Banking and Currency

    “When the government borrows money from the Fed, or when a person borrows money from the bank, it almost always has to be paid back with accrued interest. In other words, almost every single dollar that exists must be eventually returned to a bank with interest paid as well. But if all money is borrowed from the central bank, and is expanded by commercial banks through loans, only what would be referred to as the principal is being created in the money supply. So then where is the money to cover all of the interest that is charged? Nowhere; It doesn’t exist. The ramifications for this are staggering for the amount of money owed back to the banks will always exceed the amount of money available in circulation. This is why inflation is a constant in the economy, for new money is always needed to help cover the perpetual deficit built in to the system caused by the need to pay the interest. What this also means is that mathematically defaults and bankruptcy are literally built into the system, and there will always be poor pockets of society that get the short end of the stick.”
    (quoted from the video zeitgeist addendum)

    So when our government is unable to repay the interest to the FRB, the system crashes.

  10. As soon as I saw the comparison to Madoff’s Ponzi scheme I wanted to mention that Social Security is the biggest Ponzi scheme but Chris beat me to it.

    Both take money from current investors to pay investors that are cashing out and both require a constant stream of new investors to keep the scheme going. Social Security doesn’t even invest your money. Madoff must have made at least some investments.

  11. For folks earning higher incomes, accounts at or above the FDIC insurance limits are not uncommon. If you are fortunate enough to be saddled with such a dilema, simply open an account with another bank and transfer about half the money into the new account. I would assume the money is for emergencies only and needs to be readily available for such, real estate or stocks or bonds are not easily converted to cash in emergencies.

  12. Note that, under at 10% reserve, a $1000 deposit can create $9000 in new money, not only $900 as you suggest. That’s because the borrowed money is generally deposited.

    So..

    Initial Deposit $1000
    Loan & Deposit $900
    Loan & Deposit $810 (90% of $900)
    Loan & Deposit $729
    .. $656
    .. $590
    .. $531
    …. and so on.

    Like others have stated, this is not a Ponzi scheme. This is fractional reserve banking.

    The problem with FRB is that it creates new money out of thin air. Our fiat currency is essential to the survival of the FRB system. On one hand it can create new money very easily, on the other, it can destroy money very easily.

    Switching to a 100% reserve system would be a drastic change from today, although many think ideal. This would shrink the money by a massive amount (deflation), and completely change the face of banking. I don’t imagine it’ll happen in any of our lifetimes.

  13. Your last paragraph states: I would personally feel concerned if my account balances were pushing the FDIC limit. Instead, I would be investing some of that money in real estate, stocks, government bonds, or other things – the money will work much better for you there.

    It might be worth clarifying that the limit is per banking institution, so if you’re pushing the limits, another option is simply to split up your deposits between two unrelated banks. As written, I think it could be interpreted to mean you only ever get that $250K limit, period.

  14. Trent:

    As I understand it, banks would still be able to make loans as most of the money from time deposits, such as certificates of deposit, would be lendable. Even now the banks keep a portion of your interest if you withdraw the funds early.

    It’s only the money from on-demand accounts, such as checking and savings, that would be kept at full reserve. Although that might come at a price, banks would also be able to offer different forms of savings accounts, say ones with limited withdrawals, that offered interest and an agreed percentage of that money could be lent. Banks actually have a form of that now with accounts that have mandatory minimum balances.

  15. Stephen, I don’t argue for a 100% reserve system. But to have the FRB controlling the money (private bankers) and letting the Federal government borrow the funds it needs with interest is beyond stupid. It is perpetual slavery for the US taxpayer. Now, if with the stroke of a pen (as the FRB was created) the President dissolved the federal reserve with a U.S. Reserve bank that was able to mint, print and loan money to the government without interest would go a long way in strengthing our money supply. Kinda strange: On June 4th, 1963 President Kennedy signed executive order 11110 which allowed the US government to make its own money and bypass the Federal Reserve. The 4+ billion dollars of United States Notes (backed by US gold and silver) were put into circulation in denominations of $2 and $5. The $10′s and $20′s were printed but never released as he was assassinated and the program was shut down and notes taken out of circulation by another executive order by Pres. Johnson.

  16. So, why can’t the Treasury simply issue money interest free – it’s been done before… I remember Silver Certificates (backed by Silver, although I’m not saying you have to do it that way) around 1962 or 1963… Treasury issued currency.. why can’t that be done with all money that goes into circulation? Why have a Fed at all?

  17. Ken, like Kevin said above, go to Google video and watch the Creature from Jekyll Island. All is explained. Of course people will comment on your tinfoil hat but you will know the truth. Or, read the book.

  18. .
    Stephen (comment #14), you are right on and Trent does not understand FRB, let alone explaining it!
    This post is plainly misguiding!

    George Bailey’s explanation in Its a wonderful Life is outdated. Banks don’t operate that way any more, issued loans are now sold as tradeable securities (MBS, CDO & the like) against cash that replenishes the reserves and can be leveraged into new loans at once.

    MONEY IS DEBT – it is borne into existence by your (or the USTresaury) signing of loan documents (Mortgage or TBonds).
    The irony is that 99.99% of the people spend MOST OF THEIR LIVES working for money, without knowing what it is.

    Obama is betting on “The Character” of the American people, drawn from a history of hardships… We’ll see!

  19. Actually, Fractional Reserve Banking does work, provided that it is implemented properly. When the system is running properly, the bank takes most of the deposited funds and loans them out to people that are deemed credit-worthy. The debt is loaned at a higher interest rate than the bank is paying for the deposits. The difference between the interest paid to the depositor (who loaned his money to the bank) and the interest paid on the loan represents two things: The bank’s profit and a hedge against a loss due to a default.

    Example: 10,000 people deposit an average of $1,000 at 1% (above what most banks pay, sadly). The bank now has $10,000,000 in available capital, around 80 to 90% of which it can loan. Assuming the bank loans “only” 80% at 5%, after one year the bank has earned $400,000 in interest on the loans and paid $100,000 in interest to the depositors. The remaining $300,000 is the bank’s gross profit, assuming no defaults. If a debtor does default, the bank takes possession of any collateral and attempts to sell it to recover some of their loss. The rest is taken from the $300,000 gross profit, leaving the net profit for the bank.

    For years banks had very careful guidelines on who they considered creditworthy, based upon a number of criteria. By following those guidelines, the banks were usually able to make loans with relatively few defaults, which meant that relatively little of the banks’ gross profits were eatten up by bad loans.

    But over the last decade or so, the banks have been encouraged to ease their lending criteria, both by the government who wanted to increase home ownership and by the bank’s investors who wanted the banks to earn high profit margins. The banks made riskier (sub-prime) loans that tended to have a higher interest rate. At first this increased the banks’ profit margins because the relatively few borrowers who had problems repaying their loans could usually just resell their house at a profit and pay off the loan.

    Then the bubble on house prices “popped” and borrowers who ran into trouble found they couldn’t simply sell their houses to repay loans they couldn’t afford. At that point default rates started to increase until the losses from defaults surpassed the banks’ gross profits, leading to losses. Making the situation harder is the fact that the loans had been bundled to be resold to investors. The investors know that a significant portion of the loans in these bundles are going to default, but no one really knows just how many – 2%? 5%? 20%? No one knows. So investors stopped buying the bundled loans.

    But again, even this wouldn’t have necessarily forced the banks to their knees. They could have written down the lost value in these assets over number of quarters or years until the situation stabilised, but for a rules change passed in 2007 called “Financial Accounting Standards Board (FASB) Statement No. 157″, also known as “Mark to Market”. What this federal rule did was force all financial institutions (such as banks, insurance companies, etc.) to have to restate the value of their assets based upon the current market value. A reasonable requirement, and one that wouldn’t be a big problem *if* those assets could be valued. But with investors refusing to purchase these huge loan bundles, their market value has plunged from hundreds of billions of dollars to zero, literally overnight.

    As a result, banks that would have been able to weather even a couple years of higher defaults were suddenly forced to write down hundreds of billions of dollars in assets. As these banks suddenly reported massive paper losses it led to a freeze on even lending between banks (since Bank A can’t tell for sure if Bank B really has enough assets to pay back an inter-bank loan). Don’t forget, most of the loans in these bundles are NOT defaulting, so the bundles really do have some value, but no one is able to say exactly how much, so the banks have to treat them as essentially worthless.

    Banks also stopped loaning money to individuals and companies because they needed to preserve what remaining working capital they had left, so car loans, credit cards and lines of credit to individuals and companies all ground to a halt, spreading the problem outside of the banks and igniting a recession that’s pretty much hit every country in the world as the effects of the sudden halt in credit spreads.

    None of this was necessarily the fault of Fractional Reserve Banking. Instead we’ve got a series of changes that has fed one into the next:

    1. The housing price bubble finally burst and house prices started to drop.
    2. The higher than normal number of risky loans outstanding led to more defaults
    3. Thanks to the combination of FASB 157 and the bundling of these loans, banks had to write off huge losses than faster they would have otherwise, often before many of the loans even went into default.
    4. Lending almost completely dried up as the banks tried to preserve their remaining cash
    5. And as loans stopped flowing the rest of the economy stalled into world-wide recession.

  20. When you say in your article that people could not get loans, etc without fractional reserve lending, this is just absolutely false. Maybe I misunderstand what you mean, but the way banks are *supposed* to work is that they offer CD’s, in 1-month all the way up to 30 year increments and beyond. Banks can then only lend money that has been given to them by some saver into a CD. This guarantees that the saver cannot access his money before the CD expires, and thus the bank knows how long of a loan term it can loan that money out for. This system creates no new money. Only savings can create real “capital”, so when new money is created out of thin air in the FRB system, it gets its value by stealing value from all of the other money out there in the system. No new real capital is created this way, and yet everyone’s dollars become worth a little bit less every time. With regards to the FRB system allowing you to earn interest, it is actually the FRB system that makes it *necessary* for you to earn interest because of inflation. If we had no FRB system, and you got 0 interest, you would be preserving more buying power than you would getting 2% during 3% of inflation caused by FRB. In addition, FRB is fraud, and I do believe it to be a ponzi scheme. In my ideal system where savers deposit money into CD’s with the banks, the banks are telling the depositor that they cannot get their money out for that period of time. With checking and savings accounts, you are basically using the bank as a warehouse for your money that you can access at any time. With FRB, however, not everyone can access all of their money at any one given time, and this is essentially fraud. FRB is government-approved fraud and is, indeed, a ponzi scheme.

    I also wanted to thank you for the very thought-provoking article, very well done. Keep up the good work.

  21. The following definitions are oversimplified, but they may help clarify some of the confusion surrounding FRB.

    Money

    – A societies most liquid (easy to trade / in high demand) asset (an object of value).

    Historically this was gold or silver, but today it is usually some type of government bond. Keep in mind government bonds have value because a government has the ability to seize (tax) almost any asset.

    Currency

    – A piece of paper that represents a claim on a store of money.

    Fiat Currency (e.g. a Federal Reserve Note)

    – A type of currency issued by a government.

    By law, usually the only type of currency allowed in a given country.

    In response to Stephen Waits comment:

    “The problem with FRB is that it creates new money out of thin air.”

    This is a common way of explaining FRB (I’ve even had economics teachers describe it this way) but it is a little misleading. The term “money” here really has a different definition than the way most people use the term. What Stephen is talking about here is just the sum total of all the deposits that different banks are obligated to pay.

    Instead of thinking of dollars in an abstract sense, think of something physical like gold coins.

    So..

    Bob Deposits 1000 coins in Bank A. Bank A holds 100 coins, and lends 900 coins to Mary.
    Mary Deposits 900 coins in Bank B. Bank B holds 90 coins and lends 810 coins to Tom.
    Tom Deposits 810 coins in Bank C. Bank C holds 81 coins and lends 729 coins to Sue.

    …. and so on.

    At the end of the day, there are still only 1000 coins. However the sum total of all the bank deposits (e.g. checking accounts, saving accounts, CD’s etc.) is often 10 times that amount.

    Economists call the initial 1000 coins the “monetary base”.

    The total of all the bank deposits is called the “money stock”

    If you want to know these amounts for the US FRB system, you can find them here:

    http://www.federalreserve.gov/releases/

    The monetary base is in the report entitled “Aggregate Reserves of Depository Institutions and the Monetary Base” – H.3

    Look for a column entitled “monetary base” under Table 1.

    The money stock totals is in a report entitled “Money Stock Measures – H.6″

    Look for a column entitled “M2″ under Table 1.

    See footnote 2 in Table 1 for a technical definition of the term “M2″.

  22. @almost there (#3):
    That is ridiculous: The bank is paid back more money than it loans out; that doesn’t mean that it is claiming to create money out of thin air. The extra money that is paid back *does* come from a real source: it must be earned by the borrower, who either makes something, sells something, or provides some service to earn money through his labor.

    Lenders do earn their profits, because they provide money ahead of time, and people are often willing to accept having less money now rather than more money later–especially when starting out and the ‘seed money’ is necessary to get one’s start. Anyone who borrows accepts to pay the lender for the service he provides (although not all borrowers realise this as clearly as they should).

    Obviously the system can and has been abused, but in itself it is a sound and legitimate system–which would operate the same way independently of whether you have a fiat or gold-based, or even a bartering economy.

  23. Watch it’s a wonderful life. “You’re thinking of this all wrong. It’s not like I’ve got the money back there in the safe. Your money’s not here – it’s in Joe’s house right next to yours – or in Mr. Kennedy’s house or Mrs. Mecklin’s or a hundred others…”

    These banks take deposits and invest the money. They use a portion of the returns on these investments to pay your interest dividends.

    Ponzi scheme – he didn’t invest the money. He pretended he did and hid that fact by sending “false” dividends earned back to his investors.

  24. JonFrance, It may be ridiculous but that is how the system works. Watch the links mentioned or do your own research but when debt(money) is created via loans the interest to pay it comes from somewhere else, so there is always less money in circulation cash and electronic than the debt + interest. Read the Federal Reserve’s Modern Money Management.

  25. @JonFrance. You are misinformed. Nearly every dollar in the US is created via debt.

    If, a bank can loan $9000 against a $1000 deposit, what are they doing besides creating money out of thin air?

    [Note: Trent has misstated that banks lend only $900 against a $1000 deposit. He should correct that at once!]

    If every dollar is debt, there can never be enough dollars to service the debt and its usury.

    FRB can work in a truly free market (which we’ve not had for at least a century now). But, in a centrally planned and overregulated market, such as ours, FRB is prone to failure due to government manipulation of risk and excessive malinvestment. In a free market, lenders would be forced to aggressively estimate and manage risk. So called “stated income” loans for half a million dollars (or any amount) could never exist in a free market!

    @almost there (17) and @Fred (21), I agree with both of you.

  26. Sooo the FRB haters would rather all our “debt” notes that we “created” by our labor sit in a big pile in the bank gathering dust?

    No, actually you would rather us get paid in silver/gold coins, bags of salt, cow chips, or whatever other commodity you deem worthy. I vote for the silver/gold coins, cow chips really start to stink sitting in a vault.

    What an absolute load of crap. If you had any courage in your convictions you would take all your worthless paper money, buy commodities, and stick them in your basement (which I know some people have).

    Fiat currency is not the problem. It is the SUPPLY of fiat currency that is the problem. Whether you use dollars, wood chips, gold, salt, or dirt, currency (means of exchange) is really nothing more than PERCEIVED VALUE. I agree we can’t let our government debase the value of our currency, but let’s not get crazy. I LIKE paying my bills via online banking. I DON’T WANT to pay my mortgage by wheelbarrowing 100 lbs of salt.

  27. @Jon (post #27)
    You do a good job explaining things – may I try to elaborate on the “not enough money”?

    1- ALL “money” is debt – take a dollar bill and read: FEDERAL RESERVE NOTE… yes, note! a debt.

    2- How is it created: there are two mechanisms; the first is between Treasury and FED – the Treasury (ex King Henry now replaced by BigLiar Geithner) writes a bond on a nice piece of paper & gives it to the FED in exchange of a check for the principal of the bond written on other nice pieces of paper, the aforementioned FRNs.
    Second, Treasury gives the notes (dollars) to congress that does what it does best: it spends it (say on military equipment to invade foreign lands), while the FED writes the treasury issued bond in their reserves.
    The FED turns around, sees it now has “reserves” (the Bond – debt from treasure, congress and in the end, you!) and decides to write another check to the commercial banks. The check is 10x the value of the reserves (remember, that is the fractional part of it) this is the high power money part of the FRB.
    Now to the second stage of FRB: The commercial banks receive the check from the FED and write it in their “reserves”, turn around, see that they have reserves and decide to write more checks to you – this is called a LOAN – at that moment, the bank can lend 90% of the money in “reserve”.

    …But it does not stop there:

    While the Fed was writing checks, congress paid for its tanks (remember, the war against cavemen in Afghanistan?) and the tank manufacturer deposited the proceeds to its bank that wrote it in its reserves… At the same time, you were using the new loan from the bank to purchase a house (or whatever stuff to fill up your garage!); the house seller received “your” money, deposited it in the bank that – you know now – wrote it in its reserves… Reserves that can be lent out for 90%, go in the economy, come back to the bank and hop again for another turn…
    This is low power money – it can still be lent up to 9 or 10x the reserves, but needs several turns to get there…

    All the while, ONLY the PRINCIPAL of the loans have been created (loan to BigLiar Geithner, loan to buy your house, etc…) No amount of the money needed to repay the interest exist…

    So how do you pay the interest?
    Interesting question: It is called competition – the system is designed so IT IS YOU OR ME! Either through wits, cunning or skill, I outsmart you and take enough of your money to service my loans, in which case you cannot repay and you go bust; or it is you that outsmart me and then I go bust.

    - BY DESIGN, ONE OF US MUST GO BUST! –

    …that is precisely where we are now in the cycle… The precise moment where the masters of the bankers harvest 25 to 30 years of planning, before we start again on a new cycle!

  28. Comments on post 29:

    1- sometimes congress pays the teachers instead of buying tanks and bullets.

    2- King Henry is now retired and BigLiar Geithner (not quite his real name) is in charge of the IRS that will put you in prison if you don’t pay your taxes.

    3- Inflation is always a monetary phenomenon, price fluctuations are only a consequence of an increase of the quantity of money – if you heard of Quantitative Easing recently, that is it – an increase of the quantity of money.
    Inflation is VERY REAL and it is only a matter of time before it hits you! Are you prepared?

    4- If the above (post 29) does not make sense, it is because IT DOES NOT!
    The monetary system is an awful joke, a maze of smoke and mirrors and obfuscation where the serfs (read citizens) are by designed being smoked and dumbed down… Don’t believe me?
    Okay, what did you learn at (the Government’s) school about money? …not much, right? But you are expected to spend most of your life working FOR MONEY, right?

    5- Agreed, teachers are not well qualified to teach about money – if they were, they would have some… sounds plausible this time. Still, NOTHING YOU ARE TOLD ABOUT MONEY IS TRUE, at least not at school or mainstream media, or your bank or your financial planner (that likely does not have a clue himself… he learned what he knows from… school!)…

    6- Don’t worry, everything will turn out fine, no need to understand how these things work, it is toooo much very much complicated and better leave all these difficult things to the professionals…
    …if you understood, it would be a lot more difficult to pick your pockets, plunder and rape you!

    7- Above point 6 is… ironic, don’t believe it and start educating yourself RIGHT NOW!

    8- Tar, feathers and pitchforks will soon be in a raging bull market!

    That’s it, I’m done!

  29. After reading the post and most of the comments I went searching for a little clarity. While I agree with the Fed causing a lot of problems. It isn’t necessary to bring them into the conversation. I will also be ignoring interest because it doesn’t matter.

    Here’s my source…
    http://mises.org/books/desoto.pdf
    page 182

    The distinction I don’t think any one has made is that there are two forms of deposits. A deposit LENT to the bank for a period of time and a deposit given for safe keeping. Some examples would be a Certificate of Deposit and a Checking account respectively.

    Now If I get a $1000 CD I am lending that money to my bank for say 1yr. They know when I will be asking for this money so they can do what ever they want with it as long as they have it when the year is up. In this situation there is only $1000. It trades hands a couple of times but no money is created.

    The issue of money creation comes into play with the second form of deposit. A deposit for safe keeping.

    Lets say I go to my bank and open a checking account with my $1000 instead of a CD. The bank tells me that I have $1000 setting in my checking account. According to fractional reserve banking they only need to have 10% on hand. They take the extra $900 that they aren’t required to keep on hand and loan it out to some one. My bank tells they guy getting the loan that he has $900 more than he had before, but my bank is still tell me that I have $1000 in my account. The bank now tells us that there is $1900. I only gave them $1000 so they created $900 out of thin air.

    Here’s the line from the pdf. (m.u.= monetary units)
    “there has been an increase in the amount of money in circulation in the market, due to beliefs held simultaneously and with good reason by two different economic agents: one thinks he has 1,000,000 m.u. at his disposal, and the other believes he has 900,000 m.u. at his disposal. In other words, the bank’s appropriation of 900,000 m.u. from a demand deposit results in an increase equal to 900,000 m.u. in the aggregate balances of money existing in the market. In contrast, the loan or mutuum contract covered earlier involves no such occurrence.” – Jesus Juerta De Soto

    I thought I knew how frb worked but this discussion prompted me to check it out for myself. Thanks!

    My apologies for the long reply but this is the easiest way I could think to explain it.

  30. @Chris: I have eliminated all of my cash and I have accumulated some commodities.

    FRB is a dirty business, but I’m not saying it should be outlawed or regulated. I’m saying it should be unregulated, and the government should get out of the business of massively reducing risk for these financial institutions.

    If the banks were less protected (or unprotected!), they would be forced to aggressively manage risk. FM/FM? Everyone in the industry knew they’d never fail. Reserves? That’s what the FDIC is for. Wait a minute, NO RISK! LOAN TO ANYONE WOOHOO!

    The Austrian Economists have this one right guys.

  31. .
    Understanding the new rules of money is essential: from Trent’s post and several comments, it seems that it is badly needed, RIGHT NOW!

    You can try these resources:
    1- The GRUNCH of Giants by R. Buckminster Fuller.
    2- The Creature From Jekyll Island by G. Edward Griffin.
    and (3), the Robert Kiyosaki new book, free on internet at this address: http://www.conspiracyoftherich.com/ where RK skillfully simplifies and clarifies a complex subject.

    Hope that helps
    Fred

  32. @ Stephen

    Amen, brother. Laissez fair and libertarianism CAN work if we don’t let the government bastardize the whole principle.

  33. @Stephen Waits

    “If, a bank can loan $9000 against a $1000 deposit, what are they doing besides creating money out of thin air?”

    If a baker can buy $100 worth of flour and sell $1000 worth of bread, I suppose you think he’s creating money out of thin air too?

    Not at all: the banker, like the baker, are only setting the prices at which they value their work (turning the flour into bread or giving you some money now in return for more money later).

    I’m not talking about the Fed inflating the monetary supply by lending to institutions at low rates; that *is* creating dollars out of thin air in a sense, but it has nothing to do with fractional reserve banking. It’s simply a special case because the Fed is ‘lending’ something that is not finite–exactly as if I were to lend you one million JonFranceBucks, US dollars exist by pure government fiat.

    And yet, as I said above, even under a gold standard, even under bartering, people get paid for their labor, be it producing goods or providing services. What form they get paid in is ultimately up to them, but society tends to form a consensus on these matters, and we’re currently using dollars (for better or worse). But the baker’s business model, and the banker’s, would not have to change if we had a finite currency.

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