How Money is Created through Debt in our Fiat Economy -- Starting from Scratch

Alright, there are so many misconceptions on how our economy works. And I think the majority of those misconceptions come from the misunderstanding of how the economy works now compared to under the gold standard. A lot of what is taught in text books revolves around how are processes worked under the gold standard.

We have a completely new economic system. First off, let's understand there are 5 actors in our economy.

1) The Country (represented by the Govt... aka Congress, etc)
2) The Treasury (the country's bank)
3) The Fed (The Govt's bank and the bankers bank)
4) The Banks (including Primary Dealers)
5) The Private Sector

Now, under the gold standard, money came from finding gold. Originally the country did not know how much gold was in circulation and the private sector basically had ownership in the currency. The second we left the gold standard, everything changed. The private sector now has absolutely zero control over how much money exists or the creation of money.

It is completely dependent on numbers 1-4 above. A complex system of reserves, debt, and money... that come together to create our system. And the catalyst for our entire system is Govt Debt. Everything revolves around the Govt going in to debt. Think of Government Debt as the amount of "gold" we had in the gold standard. Banks are reliant on Government debt, the Fed's are reliant on Government debt, and the private sector is reliant on Government debt.

When you reduce Government debt, you reduce private sector assets. As in, you and I get poorer. Eliminating Government debt would eliminate all money from our system... and the private sector would be left with nothing.

Let me go through the process of how Govt Debt is essentially the starting point for how our economy works.

Start of a New America
Alright, so we have a hypothetical country with a Government, the Fed, a bank, and the private sector.

First thing is the Government wants something for the country. Let's say, they want to build roads. So what do they do? They go to the private sector and say we will pay you, say, $10,000 if you start building roads.

But now what? There is no money in the economy in which the Govt can pay to build roads. So the Govt then has to borrow money. But wait a second, no one has any money to lend to the Govt because it hasn't been created yet. So the Govt goes to Bank A (Let's assume they are a Primary Dealer)... and says, hey lend us $10,000 and we will give you this piece of paper, saying we will pay you back with interest.

This is how money is created in our current system. The transaction between the initial sale of Government debt to the banking system. The banks essentially "loan" $10,000 to the Government. In return the banks get a piece of paper as their asset and a Treasury account as it's liability.

Bank A Balance Sheet
A | L
Treasury $10,000 | TT&L Account $10,000

But wait a second, now we need actual cash so that the private sector can withdraw money from their account. Here comes the Fed. The Fed says, hey we will give you $5,000 in Federal Reserve Notes and $5,000 in reserves in return for your Treasury.

Banks A Balance Sheet
A | L
Reserves $5,000 | TT&L Account $10,000
Currency $5,000

Fed's Balance Sheet
A | L
Treasury $10,000 | Reserves $5,000
-----------------| Currency $5,000

So now the Govt finally has cash to give. So they credit the private sectors accounts. Say Bank A is the only bank in town. Now they credit the account.

Bank A Balance Sheet
A | L
Reserves $5,000 | Deposits $10,000
Currency $5,000

Now you and I magically have money!!! However let's look at the country's balance sheet

Country Balance Sheet
A | L
Neg Equity $10,000 | Treasury $10,000

As you can see the Govt needs to go in to debt in order for the private sector to have money. To pay off debt, the Govt can either take back the money it gave to the private sector, or it can go through the same process to create more debt.

Now a common fallacy here is that the Fed is responsible for creating money. Which in our system is true... they are given the responsibility of creating Federal Reserve Notes and maintaining reserves in the banking system. BUT, there ultimate role is to make sure the private sector has money to take out of the banks from the money the Govt credited them. If the Fed did not create the cash, then Govt spending money would just be stuck in a computer and the private sector would not be able to get their money.

The money is already given to the private sector before the Fed purchases debt. As you can see through the diagram, the private sector would have $10,000 in deposits and the bank would just have $10,000 in Govt debt... meaning they couldn't give the private sector currency from their deposit.

The other thing to note from this... is you notice now the private sector has $10,000 in which to pay taxes. That the private sector did not have to fund Govt spending. In fact Govt spending has to occur before the private sector has the means in which to pay taxes. That is critical to understand when you are complaining about Govt spending. The private sector DOES NOT FUND deficit spending. In fact the private sector gets deficit spending... we all get richer and there is more money to purchase goods and services.

You can argue with the system all you want, but at least understand the role Govt spending and Govt debt play in our economy. When you are advocating to eliminate Govt debt, you are advocating to make the private sector poorer and make us all worse off.

Serious responses only please... if you see any holes or have any questions, let me know.

 

We might get 'poorer' in the sense that we would have fewer pieces of green paper in our pockets, but due to increased scarcity their value would increase.

 

Only if we are reaching our maximum capacity. If there are people willing to produce more, people willing to work, people willing to consume more... and the only thing that is missing is a medium of exchange. Then no, the value would not increase.

 

Interesting post, thanks for your attention to detail and seriousness. I have but one question:

What is the role of the creation of real intrinsic wealth in the system you envision? Examples of real intrinsic wealth would be :

1) petroleum and natural gas production
2) other types of mineral production
3) improved land use, such as turning scrub land into farm land
4) harvested crops or timber

none of these types of wealth involved the refning or processing of raw materials, these are the raw materials which build society.

Doesn't wealth in the economy actually start with primary materials, such as iron, or natural gas?

Isn't it then the role of the economy to pay the owners of those materials for their use, in order to build something else which individuals can actually use?

The Fed or Central Banks in other countries exist to enable this transaction and subsequent transactions to take place in an orderly fashion. But the Fed or Govt itself creates no wealth, the wealth chain is started by the producers of raw materials and then developed by the refiners of those materials.

 

You are very correct. And my example was just a basic simplistic view of how money is created in our system and the relationship between Government debt and the amount of money the private sector is able to attain. In reality, our system evolved in the way you are describing in to what I am describing. I'm describing how it would of started from scratch if we wanted to build a country like ours.

The only reason we were able to do this and the only reason why the Government can spend so much money is because of all the reasons you listed. We have the resources, technology, and productivity to create an atmosphere where people want this "fiat money". We use more petroleum than the next 6 countries combined. We have more billionaires than the next 9 countries combined. We are a wealthy society that consumes and produces a lot of stuff.

Last year we had $15 trillion in real output. That is over a quarter of the world's output.

Is that sort of the question you were asking, or was it more specific?

 

thanks, you answered my question directly. I appreciate a simple clear analysis as to how the economy in a vast complex nation actually works.

a preindustrial society creates wealth almost entirely thru its primary producers (agricultural, minerals, etc). In societies such as these, a gold or silver currency can easily be used a reflection of the actual wealth produced in the society.

A basic industrial economy (steel and railroads) takes those primary products and transforms them for an enhanced use. paper currencies and banks become a necessity.

our economy is several steps beyond a primary producer, and a complex banking system is necessary in order to determine the wealth of the economy.

however, it is important to remind ourselves that the foundation of wealth in the economy is the primary production of raw materials.

 

If people just understood the relationship between the Govt and the private sector in our system, we would be much better off. Technology and mass production is so advanced these days that the amount of labor needed to produce all these goods is no longer necessary.

We can produce all the basic materials and resources we need with out near the amount of labor that it took in the past. The Govt in our system essentially supplements the demand of the private producers. You gotta think when the Govt employs 22 million people, they are creating almost 1/5th of our demand for labor. They are creating 22 million new consumers.

And if you understand that Govt spending doesn't have to come from the private sector and that the money you have comes from the Govt... then you can start putting two and two together.

If we have tons of room for more production, tons of consumers, tons of people looking for work... and the only thing missing is the medium of exchange... then you have a problem. We are killing ourselves by not utilizing the system we have like we have in the past.

Govt deficit spending is essentially private sector savings. And when you export so much of our labor and money overseas, the Govt has to spend THAT much more in order to give the private sector enough money to save.

 

Delusional.

 

So, if what I'm saying is 100% correct, and you consider me "delusional"... then what does that make you?

 

Just callin it like it is. Money is just the medium of exchange. Until you get that you wont understand your mistakes.

 

No, that's specifically what I understand. The medium of exchange has to come from somewhere though doesn't it?

 

And it failed. end of thread

 

one question about your flawed system here.......your model is based on debt.....so what happens when a handfull of those debtors default? Does the whole house of cards come crashing down?

 

Everything has to come from somewhere. And?

 

You can't default in this system. You can either tax the citizens to get the money back or issue new debt.

There is no defaulting in a system in which you control the currency unless you choose to default.

 

Make a point or leave the thread. I put my position out there, just saying your "delusional" and making weird questions isn't going to help anyone out.

 

I did make my point. You don't understand that currency is just the medium of exchange. There it is again.

 

most if not all nations are on a fiat system right? Yet look at how many have failed? Poland, Argentina, Yugoslavia, Iceland, the USSR and the list goes on.....by your logic they should of never gone under as they control the currency as you put it!

 

he also doesn't understand that money replaced the barter system so in order for people to accept money it needs to be sound!

 

If it were legal, people would create their own medium of exchange.

 

I'm not saying America can not fail. I'm just showing how the system works operationally. Over a 1/3rd of our debt held by the public comes due every single year. We don't need to tax our citizens to pay it back. We just continuously roll the debt over.

The reason why deficit spending is such a big deal, is because that money doesn't exist in our system. We can not physically pay for deficit spending, with out creating new assets. Because there is no money in existence account-wise that can fund our deficits.

Countries don't fail because of their currency systems... they fail because they are unproductive and no one wants their currency anymore. As long as people want American labor and American goods, people will want American currency.

 

People already do create their own medium of exchanges. But because no one wants them outside of their little militia groups, it doesn't matter. I want USD because I can essentially use it any where in the world. I can't use your militia dollars for squat.

 

you are also overlooking that alot of that debt refinancing comes from abroad......if they are not buying then interest rates must rise.....or the fed steps in and monetizes it....and we all know the consequences of that!

 

That is completely false. The only reason foreigners purchase so much of our debt is because that is their most viable option to invest their money. We don't need them to invest in America. If they spent that money back in to America, then America would issue less debt.

And interest rates are controlled by the Fed. Yields on treasuries are controlled by demand. The thing people don't understand is people purchase treasuries in order to invest/save. They do not do it to fund Govt spending. If they didn't invest in treasuries and spent the money elsewhere, then the Govt would issue less treasuries, since their would be more revenue.

As long as people continue to save money more than the previous year, then the Govt is going to have to issue more debt.

This is why Japan runs 200% debt to GDP's. Because not only are they a net exporter... but they also save tons of money.

 

Absolutely. I dont think OP knows what barter is either. He thinks somehow the paper money is the source of the wealth, not the real goods and services being produced and consumed.