How Is Your Money Made?

    Have you ever wondered how money is actually created? In honor of Rothbard's birthday, today's post is about how messed up our banking system is.

    When we're dealing with commodities, like gold or salt, the reasoning is pretty intuitive. People like to trade one thing for another, yet direct trade requires a very particular coincidence of needs. If I want to trade 5 chickens for a cow, I need to find someone who wants to trade a cow for 5 chickens, which might get pretty tricky. If I can find a good that doesn't spoil, is easily divisible, and people use all the time, like salt, I can "split the trade" into two - chicken for salt, salt for cow - making my life a lot easier. Just mine salt, and you've created money.

    But what about money we use right now, like the Dollar? How is that made? To understand how it works, we need to know how it came about.
Paper money started out as a claim on metal. Instead of carrying heavy, shiny pieces of gold around, it is much easier to leave it in a trustworthy bank, and use paper notes that can be redeemed for gold on demand. Put yourself in the banker's shoes: you have a lot of gold, and your word is worth so much that people just leave their gold with you, using your notes to trade with one another. If you're honest, you'd realize that the essence of your business is honesty and trust. If you're dishonest, however, you can think "since people only collect a little bit of gold at a time, and use my paper to trade, why don't I make myself richer by issuing more paper?". 

    That's the birth of debt-based “money". Sounds shady right? It gets worse.

    Instead of allowing dishonest banks to eventually go bankrupt, politicians institutionalized this type of fraud through central banks, like the Fed. Instead of multiple banks issuing notes at will, subject to the "danger" of debt collection; only the Fed can do so, keeping a predefined paper-to-gold ratio, while being legally protected from "bank runs". At this point, the currency is government debt - a piece of paper issued by the government that can be redeemed for gold.

    Politicians, however, love easy money. Over time, they realized they could get their hands on more money by increasing the paper-to-gold ratio. By changing the reserve from 50% to 25% - 2/1 to 4/1 paper-to-gold ratio - the government allows itself to incur in twice as much debt, effectively doubling the public budget, at the expense of the individual's right over his money, but without the political cost of raising taxes.

    Eventually, the entire situation becomes ridiculous - even by government standards. You can't expect people to trust your capacity to pay what you owe, if you only own 0.1% of your debt. The "solution" was to sever the tie between paper and gold altogether - paper is now only paper. What can you buy with it? Government debt. Why would you want to buy government debt? Because it yields paper. The system is now circular.

    So, in concrete terms, how is money "printed"? There are a group of banks called "primary dealers", which are legally allowed to deal directly to the central bank. Those banks are allowed to use the paper dollars they have to buy treasury bonds, and to sell or redeem those treasury bonds for paper dollars, at a particular interest rate. By changing the interest rates, central planners can make it more profitable to trade bonds for paper, increasing the amount of currency in circulation, or the other way around, decreasing it.

    Yes, money used to belong to individuals, who used it to store value, and trade honestly and efficiently with one another. Now your money belongs to the government - it's a Ponzi scheme, in which corrupt politicians negotiate, with corrupt bankers, the best way to control the individual. 

    It's messed up, but at least you know how it works now.

  -  March 3rd, 2020