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  We’ll begin with a simple U.S. $1 bill. What is it good for? Well, it can be exchanged for real goods, say, anything in the 99 cent store. It can also be deposited into a bank savings account to receive interest over time. Its value will derive from these functions as a medium of exchange and a store of value. (Aside from these functions, a piece of green paper, as opposed to a gold coin, has no intrinsic, or real, value. Some may argue a hunk of shiny metal has no intrinsic value either, but that argument is unconvincing to at least the female half of the population.) A fiat currency’s true value is determined by what it can be exchanged for, either now or later. The theoretical value of one U.S. dollar is the total of all dollar assets divided by the total supply of dollars. So value = sum of assets divided by sum of currency supply. Let’s unravel these concepts.

  We consider dollar value as an asset when it’s in our wallet or savings account. This is because a dollar represents a claim on real assets—we can buy something with it. An interesting question is: since a dollar is a claim, who bears the liability for this claim?

  Prior to 1933, one could take a U.S. dollar bill and redeem gold from the U.S. Treasury. The liability of the dollar bill was then borne by the U.S. government, backed by its gold supply. The saying that once described the US$ was, “Good as gold.” In 1933, the U.S. government, by executive order of President Roosevelt, outlawed the private ownership of gold coin and bullion, demanding that gold held by U.S. citizens be redeemed for dollars at the rate of $35 per ounce. Foreign governments, not subject to U.S. laws, could continue to hold and redeem dollars for gold from the U.S. Treasury at the rate of $35 per ounce. By 1971, foreign gold redemptions threatened to clean out the U.S. gold supply (we’ll discuss how later), forcing President Nixon to close the Treasury’s “gold window.” From that point on, the U.S. government has repudiated any redemption liability for U.S. paper currency, merely designating the dollar as legal tender for payment of goods and services, backed by “the full faith and credit” of the U.S. government. In 1974, President Ford lifted the private ban on gold coins and bullion. This history demonstrates how the U.S. dollar monetary system was transformed from a commodity exchange standard (dollars to gold) to a pure fiat standard.

  So, where did the liability go?

  Actually, the liability stayed right where it was, it was just transformed. The gold reserves held by the U.S. Treasury were always technically the property of the U.S. citizenry. It was our gold stored there in Fort Knox, supposedly held in trust and guarded by our political institutions. Under a fiat currency, the liability for the U.S. dollar is still borne by the citizenry through the value of their assets and their productivity. Every citizen of the U.S. backs up the full faith and credit of the U.S. dollar with our ability to pay off all dollar debts incurred, either now or in the future. A foreigner holding a U.S. dollar has a claim to exchange it for U.S. goods and services—he can buy a house, a business, or even Rockefeller Center. (As of 2011, the Chinese government holds roughly $1.1 trillion of claims on the U.S. Treasury.)

  We may think the supply of dollars is represented by the quantity of dollar bills and coins floating around the economy—in our wallets, cash registers, and piggy banks. But this is not really true. The bills in our wallets are just for the convenience of small purchases. We pay for most purchases not with physical paper money, but with checks drawn on bank demand deposits (a fancy word for a checking account). Paper bills and coins only represent a small fraction of our actual money, the bulk is in the form of electronic credits on bank statements. For those unfamiliar with banking, perhaps the next disclosure will be the eye-opener: the commercial banking system, regulated by the Federal Reserve, creates the money supply by issuing new credits in the form of loans. Let’s see how this works.

  When you deposit $1000 in your bank checking or savings account, your bank is permitted to take that money and lend it out again to borrowers. The bank is only required by Federal Reserve regulations to keep 10% as a capital reserve in case depositors should want their money. Since most people leave their money safely in the bank, 10% is considered an adequate reserve on hand under normal circumstances. Keeping $100 in reserve, the bank makes a $900 loan. But as that loan money is spent, where does it go? Right back to the bank in somebody else’s account. The bank can the lend out 90% of that new deposit, or $810. If we keep reiterating this process we see that the banking system creates ten times more in money credits as the original $1000 deposit, increasing the money supply by $10,000. It keeps $1000 in reserve and lends out $10,000, which is represented by deposits in the bank. The bank’s accounting balance sheet shows $10,000 in assets (the loans) and $10,000 in liabilities (deposits), only $1000 of which is held in reserve. The 10 to 1 reserve ratio is called the money, or credit, multiplier.

  The danger is that, under abnormal circumstances, depositors might demand all their money at once, all $10,000, while the bank has only $1000 in its vaults. The loans they extended cannot quickly be recalled. All depositors withdrawing their money at once is called a bank run or panic, and the result is insolvency, or bankruptcy of the bank. Bank runs used to happen frequently during economic downturns, as people grew fearful for their life’s savings. Today, the danger of banking panics is mitigated by the Federal Reserve, which provides emergency money as the “lender of last resort.” To do this, the Fed merely creates credits and lends them to any bank in need of capital reserves. A federal agency, the Federal Deposit Insurance Corporation (FDIC), also guarantees deposits up to $250,000. The banking system outlined above is called fractional reserve banking. It may sound crazy, and it can be, but not necessarily.

  If you think about this illustration deeply enough, you may ask, “Okay, but the first $1000 I deposited came from another transaction and loan. This money creation seems circular. Where does it all start?” It starts with the Federal Reserve System, a consortium of private banks ostensibly under government control, which has the power to create new credits and lend them to the commercial banking system.[22] The Fed does this in several ways (which are not crucial to our discussion), but essentially they lend reserves to commercial banks by crediting their accounts at the Federal Reserve. Banks then commence the credit creation process by making loans to customers. This expands the money supply. The Fed can also reduce the number of loans by calling in these credits, which shrinks the loan portfolios of the banks as they scramble to maintain the 10% capital reserve-to-loan ratio. This contracts the money supply.[23]

  The logic of fractional reserve banking is to make the money supply responsive to the demand for money. The demand for money is a function of economic expansion and the need for exchange payments. If the money supply is too tight or fixed, new investment and production is impeded because capital resources must be reallocated from old investments and recycled into new ones. This requires price changes to separate the good investments from the bad. It’s a difficult and time-consuming reallocation process. Imagine your loan officer saying, “I’d like to lend you the money, but first I have to recall all these old loans from these deadbeats.” The net result of an inelastic currency is slow growth and price deflation. An elastic currency, however, empowers new investment and production. Credit creation is a net positive IF the investments made by new loans earn a return sufficient to pay for the loan with additional profit (a big “IF,” as we’ll see). The management of the money supply through fractional reserve banking is the primary mission of the Federal Reserve.

  2.3 Financial Alchemy

  Still with us? Please hang in there as we explore the next stage of financial alchemy. If we understand fractional reserve banking, we see that our fiat money supply is not actually created by printing presses, but by credit creation, denominated in debt outstanding. (When a bank issues a loan, it creates the credit that the borrower assumes as a debt.) It’s time to introduce the other major player on the stage: the U.S. Federal government.

  Conventionally, the government claims its share of our dollars’ value by co
llecting taxes and using those to pay its (our!) bills. Or it can borrow. (This is where the money shell game begins, and the path of the hidden “pea” becomes increasingly hard to follow.)

  When the Federal government spends more than it collects in taxes (creating a budget deficit), it borrows the additional money it needs by issuing new Treasury bonds, or debt. The sale and purchase of these bonds soaks up private savings—when you buy a $1000 Treasury bond, you lend your private savings to the government. In return you receive a promise of an interest payment over the life of the bond, and then repayment of the original $1000 principal. The interest rate the government offers depends on the available supply of savings and the buying demand for government bonds. The actual rate is determined by auction – so every couple of weeks the Treasury has a bond sale auction. These bond sales are participated in worldwide; so many buyers are foreigners who exchange the dollars they received for their exports for U.S. government-guaranteed debt. If savings supply or demand is inadequate, the Treasury must raise the interest rate to attract more buyers. Remember, U.S. citizens back up government debt with tax revenues, so technically, taxpayers are the ones who must pay more interest on the borrowing. Some of our fellow citizens will buy the bonds and receive these payments. Other payments will be sent to European or Chinese buyers. The government is constantly issuing new bonds to pay back, or roll over, the maturing principal on bonds issued in past years. In addition, under a fiat currency, the Treasury can just issue new debt to pay that interest, putting the financial reckoning farther off into the future.[24]

  So far we have two major players in the credit creation and debt markets—the banking system and the government. The banking system creates credits that are held in the form of private debt (whoever borrows, owes the bank) and the government creates debt through deficit spending in the form of privately held credits (the government owes whoever buys the bonds). The commercial banks’ credit creation, under the regulation of the Fed, is what increases or decreases the money supply.

  Now, what happens if the Fed buys the government bonds directly from the Treasury? Recall that the Fed has the power to create credit from thin air and can use these credits to buy bonds. Now the Fed holds assets in the form of government bonds. This transaction has two important consequences. Since the Fed provided funds to the Treasury by buying the bonds, private savings were not reduced, but the spending of these credits by the government has increased the supply of money. In addition, these bonds are now reserve assets of the Federal Reserve, increasing the available reserves to the banking system. If the Fed allows commercial banks to borrow these reserves, it increases the supply of credits to the banking system that can be loaned out ten times over to new borrowers.

  When the Fed buys bonds directly from the Treasury, we call this “monetizing” the government debt because it can drastically increase the money supply.[25] An increase in the money supply has been the traditional source of price inflation, which is just another way of saying the supply of money rises faster than the supply of goods and services it represents, causing all prices to rise. After the 2008 financial crisis, the Fed became a major buyer of Treasury bonds and now holds a greater share of Treasury debt than any other entity— more than $1.2 trillion, roughly 14% of the total Treasury debt outstanding. (China holds $1.1 trillion.)

  At this point we might hope that the money supply is somewhat under the control of the Federal Reserve and that the supply can be controlled by virtue of enforcing the right central bank policies. Unfortunately, that’s not quite the case. The game gets more complex.

  Commercial banks are not the only institutions that lend money. In fact, because banks earn a nice return by extending credit and creating new money backed up by the full faith and credit of the American people, everybody wants to get in on the action. The new players include mortgage lenders, investment banks, large corporations, insurance companies, hedge funds, credit unions; the list goes on. These various players make up what is called the “shadow banking” industry. Supposedly, the U.S. taxpayer is not on the hook for the liabilities of these shadow bank credits. Supposedly.

  After the high inflation of the late 1970s, the Fed turned to these shadow banks to deploy a different strategy for funding the government debt without direct monetization. They encouraged these private financial institutions to buy the debt rather than the commercial banking system. Government debt held by the shadow banking system was used for capital reserves and collateral to create more credit. The excess liquidity poured into financial assets, leading to a sustained boom in stock, bond, and derivatives markets. This strategy enjoyed the advantage of funding the government debt without stoking price inflation in the goods markets.[26] However, this has come at the cost of complicating the Fed’s control over the money supply.

  The Fed closely regulates commercial banks, while commercial bank deposits are insured by the FDIC. The shadow banking system, however, is outside the regulatory arms of the Fed and mostly subject to regulatory oversight from various other agencies, such as the Securities and Exchange Commission. Foreign financial institutions outside U.S. jurisdiction are completely unregulated by U.S. laws. Thus, the credit controls exercised by the Fed can only weakly constrain the credit creation of the private shadow banking system. The leverage used by shadow banks may far exceed the 10% reserves of the commercial banks, sometimes up to 30 to 40 times. This credit creation takes many forms, from margin debt offered by investment brokers to highly leveraged financial derivatives. For example, you can open a stock brokerage margin account, put in $100,000 in cash, and the brokerage house will allow you to margin that to $200,000 of buying power. They have simply created $100,000 of new credit from nothing, Investment banks increased leverage ratios to create $40 of credits in derivatives for every $1 in capital reserves. This means that a 3% decline in market prices would completely wipe out the bank’s equity. This explosion of new credit creation introduced another dangerous wild card into the monetary system.

  This discussion of money may be esoteric and somewhat confusing the first time through. The most important fact to understand is that, through the processes outlined above, the U.S. money supply is wholly based on credit and debt creation that is backed by the full faith and credit of the U.S. government and guaranteed by U.S. taxpayers through the productive capacity of the US economy. Every dollar of purchasing power represents a debt on which interest is paid to the creditors who created the loans that represent that debt. These creditors include the privately-held Federal Reserve System, all the commercial banks, and the entire shadow-banking system. All these financial institutions are receiving a return by creating money from debt. We can see that the incentive for the bank creditors is to create more money and earn more interest on the debt they issue. This continues until foolish lending turns into bad debt. Then it all comes crashing down. (In Chapter Four we will analyze how this happened in 2008.) In general, the consequence of a credit or debt creation fiat currency system is that nobody has clear control over the money supply. There are few constraints on the system, or even the correct incentives, to ensure a sound monetary system. The ultimate risk to the US economy, the nation, and its citizens is not the bankruptcy of the government, but the gradual erosion of our standard of living through misguided policies. This is difficult to understand unless one can see the big picture. It is also much more difficult to discern in short time frames as it is more like the frog being slowly boiled in a pot of water. By the time he realizes it, he’s already cooked.

  Lastly, we must consider the political interests of the government as the presumed regulator of this system. We know that politicians get elected by promising lower taxes and higher benefits to voters (I address politics in Chapter Three). These political incentives result in deficits funded by excessive government borrowing. The creditors of the fiat currency system, with its incentives to create more debt, have found a ready partner in a government that desires endless borrowing. Eventually, the entire bill must
be paid by distracted taxpayers. In simple terms, the financial liability comes down to you and me—only our capability to work will create the necessary wealth to pay back a massive national borrowing spree. Is it any wonder that obfuscation and public confusion favor the architects of this system?

  As for the U.S. dollar, its value has been left to depend on the productive capacity of the U.S. economy, which, in turn, will depend on the successful management of economic policy. The deeper personal implication is that the ultimate value of your life’s hard work, saved as accumulated capital, will depend not only on your own prudent financial judgment, but also on the collective financial behavior of the nation. It’s not a comforting thought. (For a flowchart of the credit-debt cycle outlined above see Appendix C.)

  2.4 Capital and Financial Markets

  Some of the financial assets that trade in world capital markets include stocks (or equities), bonds, commodities, loans, mortgages, real estate trusts, currencies, precious metals, commercial paper, and financial derivatives. New products, which, like those above, help to manage risk and provide capital, are being innovated every day. As this book is not an investment guide, we will not examine these various securities except in terms of how they may affect the macroeconomy. The point I wish to raise here is that these financial asset markets behave differently than the markets for goods and services. To understand this we must first investigate the nature of capital.

  The idea of capital is fundamental to understanding our capitalist society. (There's actually a good reason why we call our system Capitalism and not Laborism.) Many people may think capital is just another name for money, but there are crucial differences. Money, as we mentioned previously, is defined by its three functional uses: as a store of value, a unit of account, and a medium of exchange.