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Crash Course - Chapter 7 - Money Creation

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If we want to have any hope of understanding all of the things that are going on in the financial world right now we really have to start with understanding money and how it´s created. So here we will explore the process by which money is created. Let me introduce you to John Kenneth Galbraith. He taught at Harvard University for many years and was active in politics, serving in the administrations of Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy, and Lyndon B. Johnson; he was one of a few two-time recipients of the Presidential Medal of Freedom. Clearly a pretty accomplished and stand-up kind of guy. About money, he famously said: “The process by which money is created is so simple that the mind is repelled.” We’re about to discuss that very thing. If you don’t get this segment on the first pass, don’t worry, because money creation is truly a bizarre thing to ponder, let alone accept. It’s actually a very simple process, but really difficult to accept. First, let’s look at how money is created by banks. Leaving aside for now where this money comes from, suppose a person walks into town with $1000, and, luckily, a brand new bank with no deposits has just opened up. The $1000 is deposited in the bank, and now the person has a $1000 asset (their bank account) and the bank has a $1000 liability (the very same bank account). Now, there’s a rule on the books, a federal rule, that allows banks to loan out a proportion, a fraction, of the money they have on deposit to others. In theory, banks are allowed to loan out up to 90% of what people have on deposit with them, although, as we’ll see later on, the actual proportion is much closer to 100%. Nonetheless, because banks retain only a fraction of their deposits in reserve, the term for this process is “fractional reserve banking.” Now back to our example. We now have a bank with $1000 on deposit, and banks do not make money or make a living by holding on to it - rather, they make their living by borrowing at one rate and loaning at a higher rate. Since any bank can loan out up to 90% on what they have on deposit, in our example our bank wants to find somebody who wants to borrow $900. Suppose this borrower then spends that money by giving it to another person, in this case his accountant, who, in turn, deposits it in a bank. Now it could be the same bank, or a different bank, but that really doesn’t change how this story gets told at all. With this new deposit, this same bank now has a fresh $900 to work with, and so it gets busy finding somebody who wants to borrow 90% of that amount, or $810. And so another loan gets made, and it gets spend and redeposited in the bank and the 90% of this new deposit is $729 which can get loaned out. and so it goes, until we finally discover that the original $1000 deposit has mushroomed into a total of $10,000. Is this all real money? You bet it is, especially if it’s in your bank account. You might also notice here that if everybody who had money at the bank, all $10,000 dollars of them, tried to take their money out at once, the bank would not be able to pay it out, because, well, they wouldn’t have it. The bank would only have $1000 hanging around in reserve. Period. You might also notice that this mechanism of creating new money out of new deposits works great… …as long as nobody defaults on their loan. If and when that happens, things get tricky. But that’s another story for later. For now, I want you to understand that money is loaned into existence. Conversely, when loans are paid back, money ‘disappears.’ This is how money is created, and I invite you to verify this for yourself. One place would be the Federal Reserve itself, which has published a handy comic book from which I actually drew this fine example. You can find a link to that on the website under Essential Articles. You may have noticed that I left out something very important here, and that is interest. Where does the money come from to pay the interest on all the loans? If all the loans are paid back without interest, we can undo the entire string of transactions in this example, but when we factor in interest, we would suddenly discover that there isn’t enough money here in this example to pay back all the loans. Clearly that is a big hole in this story, and so we’ll need to find out where that comes from. In doing so, we’ll also clear up the mystery of where the original $1000 came from. So why did we spend these past few minutes studying the mechanism of money creation? Because in order to appreciate the implications of our massive levels of debt, you have to understand how that debt came into being. That’s one reason. And the more important reason is tied to all those exponential graphs we viewed earlier in Section 3. But we’re not quite there yet. Let’s continue.

Video Details

Duration: 4 minutes and 19 seconds
Country: United States
Language: English
Producer: Chris Martenson
Director: Chris Martenson
Views: 130
Posted by: pscigulinsky on Dec 6, 2010

The Crash Course seeks to provide you with a baseline understanding of the economy so that you can better appreciate the risks that we all face.
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