Money explained, for seventh graders

russian-roulette
This below is far worse than Russian Roulette – it’s an odds on certainty.  Hold onto your seats.

Fiat money

A nation’s currency used to be backed with something, e.g. gold or silver. That is, you could redeem your paper dollar for one dollar in the national commodity. Now you have a bit of paper backed by Obama’s or Gordo’s word that it is good.

That’s fiat money.

Full reserve banking

All deposits in commodities or cash are kept in a vault on the premises and therefore there is never a problem in a run on the bank. The deposits can always be returned. The way the bank then pays its staff and running costs is to charge the customer a fee for holding the money. It’s little different to left luggage at airports.

The bank cannot give you a loan because reserves must be 100%. The only advantage in this is that your deposits are safe. Essentially, this scheme is neither inflationary nor deflationary and does not involve booms and busts. It also means that people live within their means.

If you wish for a loan for a purchase, e.g. for a car, you need to go to some financial intermediary and you take the risk on repayments as they take a risk lending to you.

No western country uses this system.

Fractional reserve banking

This is the system used by all western countries.

Only 10% of deposits [on current figures] need be held at the bank for issuance to depositors. The bank plays the odds that you will not withdraw the lot at one time. The other 90% is lent out or invested to make profits for the bank.

One upside is that the bank becomes strong and your chances of getting out however much you’d like is quite good – in good times. The downside is that in a run, the bank closes its doors or else costs the government, meaning you, big to prop it up.

Another upside is that money is freely available in the community at reasonable rates of interest – normally. The downside is inflationary pressure, which affects everything from commodity prices to wages. It’s unstable and is only justified for two reasons:

1. You are greedy. You see a bank paying you 5% or whatever on the money you’ve deposited, instead of having to pay fees – plus you see it as being secure.

2. You want that bank to lend you money you don’t have, on the strength of the little you deposited. This is actually a criminal act because the bank is lending you mainly someone else’s deposits, without asking him/her.

In an uncontrolled environment, it goes like this

My First Bank issues me a loan, say £1000 to buy a product, say a motorbike. The Second Bank, the bike firm’s bank, wants all that money transferred from the First and is not interested in delay because it has its own business to conduct.

The trouble is that because of a rail strike and clogged roads, many First Bank depositors want bikes at this time and the banks of the firms they bought the bikes from all want their money at once. Because First Bank has issued loans, it doesn’t hold this money as deposits and defaults. It goes bust.

Solution

The solution is to cartelize the banks and create a Central Bank, a bank for the bankers, which would regulate how much can be demanded and which can print money to cover any run on the banks through, say, an FDIC deposit insurance group. Not only that but the CB, in having the power to issue money, can regulate the economy, say by increasing the money supply.

Let’s say it wishes to do this. It goes to an open market source and buys £10m in securities. The issuer pockets the cheque and deposits it in its own account at a bank. That bank deposits this amount in its own account at the CB, thereby increasing its reserves and therefore its ability to create new deposits by a factor of 10.

This happens right across the country and thus, from the CB’s initial purchase of £10m in securities, it has effectively increased money 10 fold nationwide. And where did it manage to get the £10m in the first place?

It created it from thin air, as a bookkeeping entry.

The problem is that there is nothing backing that money – no commodities, no gold, nothing tangible. That money does not exist, except in the CB’s declaration that the deposits are valid and legal. It survives in this swindle because most people take the government’s word that its money is rock solid, which it is anything but.

However, as long as these notes are the only currency going, it stays afloat. If someone is to create real money, e.g. Liberty Dollars, backed by a commodity, it could bring the whole house down and thus people who try this die or are incarcerated and these operations are closed down. This is gangsterism by the state, which is both kept afloat by and in thrall to the CB.

Apocalypse, 30s style

Let’s say the people get wind of this [and thus it is necessary to control the media], then there would be an almighty run on deposits which, as the banks each only hold 10% of what they were given, means they cannot repay.

Ah but now there is a modern solution – the FDIC. The CB merely prints enough money to pay out depositors and depositors, happy again, reinvest the non-money, causing, as Murray Rothbard said:

Runaway inflation and total destruction of the currency [which] would quickly follow.

Derivatives

Wiki describes them simply:

Derivatives can be thought of as bets on the price of something. Suppose you bet with your friend on the price of a bushel of corn. If the price in one year is less than $3 your friend pays you $1. If the price is more than $3 you pay your friend $1. Thus, the underlying in the agreement is the price of corn and the value of the agreement to you depends on that underlying.

Hedging

Hedging is a technique that attempts to reduce risk. In this respect, derivatives can be considered a form of insurance.

Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, like the weather, or that one party will renege on the contract.

Over the counter derivatives

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.

The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds.

Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. The potential for scamming is immense.

Credit Default Swaps [courtesy Roosh]

Virgle Kent borrows $50 from me. I want to get insurance on his debt in case he goes broke. I go to Roissy and say, “Hey, Virgle Kent owes me $50. Can you insure that debt?”

“I’ll insure it if you pay me a premium of $4 a year,” Roissy says.

“Done!”

Roissy is betting that VK will pay me back, especially since he did his homework by looking at VK’s credit rating and saw it was superb. Roissy just wrote me a credit default swap, an unregulated derivative invented in 1995 by JP Morgan.

Unfortunately Roissy has some problems with his business, and he no longer even has $50 to pay me in case VK goes broke. The premiums I gave him are long gone. Credit agencies notice this and tell Roissy to find some cash or his credit rating goes down.

Roissy is f—ed because if his credit rating goes down then he won’t be able to raise cash at good rates to keep his business open (today’s large businesses need a constant flow of credit to maintain operations). Sure enough his rating gets killed and Roissy goes bankrupt.

Now I’m in trouble. The debt I had on my books that was insured is now uninsured. The agencies look at my books and see I have this exposed debt and they downgrade my ass. I have no choice but to enter bankruptcy as well. But I happened to be knee deep in the CDS game too. I wrote a ton of them for Arjewtino, insuring the debt owed to him by other parties. When I go down it puts pressure on him. Like dominoes we fall.

In the carnage it turned out that the ratings we used to judge each other’s debt worthiness was bogus from the start. Essentially we all gambled like we would at a blackjack table, but we did it while drunk. And blind.

The insurance company AIG wrote $78 billion worth of swaps.

All of these things above were not only allowed to go on, not only did they involve the housing market and people’s jobs with firms, they were positively encouraged by the regulatory bodies.

Now everyone is lying in an attempt to prop up the system.

The missing gold

Jim Rickard explains.  His bona fides. The big question is – if the gold has almost gone from the vaults:

WHO HAS THE GOLD?  WHO IS ACTUALLY HOLDING IT?

How to pay debt

Q:  If you have a huge debt and it has gone past the point of no return, how do you repay it?

A:  Simple.  Cause hyperinflation and inflate it away.

Q:  Doesn’t that crash the economy?

A:  Who cares, as long as we’re covered.

Incredulity

The greatest single factor which protects the system of boom and bust is the ignorance of the people as to what is actually going on and the second factor is incredulity that such an obvious scam, such an obvious ponzi scheme could exist.

This is our government, people would say, this is the Fed, the BofE, the most learned economists in the country. It’s too big to go bust. The government of the day can wave a magic wand and say, “Well we got that wrong but we’ve artificially kept everything afloat for you.”

Works for a time but what it does not take into account is that this government does not operate in isolation – it has debts to outside interests, e.g. the IMF, World Bank, Club of Paris etc. These bodies can call in their money. They wouldn’t do so if it were not politically expedient because the government would crash and they’d get nothing.

If, however, the IMF was getting money from drugs, prostitution, gun running, the old money of Europe and so on and if they shared the globalists’ politics, namely the end of the nation state and the substitution of the continental bloc in a new socialized financial system which would guarantee their money, then the temptation would be huge to go along with it and pull the plug on UKplc.

Things would go pear shaped for a while and then what would emerge would be the new system, planned all along.

10 comments for “Money explained, for seventh graders

  1. April 20, 2010 at 07:52

    So, you read Roissy….

  2. April 20, 2010 at 11:25

    Your definition of derivatives is wrong- it is a bet from one side yes but on the other side what a derivatvie does is take away uncertainty. Imagine I’m a supermarket, by buying a derivative in grain I can be certain that I will be able to balance any loss or gain I make in the grain market in a year’s time with a loss or gain in the derivative market then. Therefore I have certainty about what the price of grain effectively will be then and therefore I can plan with certainty.

    On a second point, its not fiat currency or fractional reserve banking that causes economic crises: both happened before either were invented. What causes economic crises is complex- it is sometimes dearth and famine, war othertimes- but most often it is movements of demand. You are basically saying that all movements of demand are caused by lending and if there was no lending there would be no problem: but that’s not actually true- a movement upwards in the savings rate also causes a fall in demand and therefore a recession or depression, a boom or bust. There are other things too- indeed there is a whole economic literature you seem to be ignoring on these problems.

    The 30s or now were not neccessarily caused primarily by the run on the banks: that may have been the symptom for something else that your policies would not control.

  3. April 20, 2010 at 11:44

    its not fiat currency or fractional reserve banking that causes economic crises: both happened before either were invented

    Yes it very much is and we’re headed towards the biggest one of all now, aided and abetted by the globalists. Only the blind would ignore the sheer weight of evidence – either the blind or someone with an agenda.

    I do wish you’d read the material before commenting. Try this one, for example:

    http://www.kingworldnews.com/kingworldnews/Broadcast_Gold+/Entries/2010/4/14_Jim_Rickards.html

    or this one:

    http://www.nytimes.com/2010/04/17/business/17nocera.html?src=busln

    The subprime crisis alone was directly attributable to the actions of OTCs and CDSs which were known of but not regulated by the Fed. Directly, Tiberius – not even any room for speculation.

  4. JD
    April 20, 2010 at 13:55

    You wonder who has the gold?
    It doesn’t matter, they can’t do anything with it.
    It is not edible and is of little practical use.
    It derives its value from other people’s belief that it has a value. Just another fiat currency in other words.

    If you want to understand the financial system, and the markets in particular, just go into your nearest betting shop and ask the first ‘benefit scrounging chavscum’ you see. He will explain it all to you in great detail (but only after ascertaining that you are not a spy from the DWP)

  5. April 20, 2010 at 16:16

    JD is right that all value is about a consensus that x is valuable- hence gold is a fiat currency too James, it depends on our common belief that it has a value.

    You didn’t take on my statement about derivatives: they are ways of trading risk not creating it. The problem with derivatives is that information did not flow along side the derivative in some cases- but where derivatives work they allow you to divide the risk from the product you are selling. I’m not sure from your statements you understand that.

    Of course I read some of the stuff behind what you write- I can’t read all of it- but equally do you read the stuff you disagree with. Martin Wolf of the FT for instance puts forward the argument about China that I detailed above and you seem very ignorant of the economic literature about the crisis- you don’t seem to have quoted a single peer reviewed source in all of this just journalistic articles (which are more often wrong than right). Paul Krugman is another who would disagree with your interpretation of the crisis.

    I’m not saying you are neccessarily wrong but that this is more complicated than you are saying.

  6. April 20, 2010 at 17:10

    Tiberius, I despair. The import of what you say is that it is not happening.

    It-simply-is.

    Read Denninger, read Keiser. Did you listen to Jim Rickards? Did you listen to Janet Tavakoli? These are people in there, not theorists. Have you looked at Xxxl – he’s in the game and knows. Did you look at Jesse’s Cafe Americain?

    But you won’t read them, will you? The reason is your agenda – to counteract in people’s minds what is actually going on.

    Sigh.

  7. April 20, 2010 at 17:44

    you seem very ignorant of the economic literature about the crisis

    You’re doing your reputation no favours coming out with this guff. I quoted you two sources above which you should have immediately looked at. You didn’t even effing bother. I quoted you six more jsut now. Ditto. Then you have the gall to say I’m ignorant of the literature?

    Look at this:

    http://market-ticker.denninger.net/archives/2221-On-The-Goldman-Complaint-Janet-Tavakoli.html

    Paul Krugman is another who would disagree with your interpretation of the crisis.

    Of course he would – he’s a Keynesian and well in with the globalists, of which you also are part. Now, here’s your precious Krugman, rejected by every economist who is not Marxist:

    http://market-ticker.denninger.net/archives/2178-Trichet-Speaks-Is-The-US-Listening.html

    Krugman’s claim is especially odious:

    What worries me most about the U.S. situation right now is the rising clamor from inflation hawks, who want the Fed to raise rates (and the federal government to pull back from stimulus) even though employment has barely started to recover. If they get their way, they’ll perpetuate mass unemployment. But that’s not all. America’s public debt will be manageable if we eventually return to vigorous growth and moderate inflation. But if the tight-money people prevail, that won’t happen — and all bets will be off.

    What growth Paul?

    Go look at that graph up above again. We never exceeded 2% GDP growth coming out of the 2001 recession in real terms.

    Krugman is well known as a stooge. Here’s someone who actually likes Krugman but when Krugman starts talking depression – he hasn’t a clue:

    http://jessescrossroadscafe.blogspot.com/2008/11/educating-paul-krugman-about-money.html

    We like Paul Krugman and enjoy reading his columns. But every so often he writes a column that is so off his normal standards that it makes us wonder if he is on vacation and the task of producing the column has been delegated to a graduate assistant.

    That’s from a Krugman fan!

    Have you any others? Bernanke perhaps? Paulson? Tucker?

    Am I ignorant of the literature when you fail to address even one point in these many posts on this blog, let alone what is at the end of the links.

    Instead you come in with the personal insult again. How much more data would you like? Now start effing fisking it, Tiberius, point by point – show me that there is factual error in what the economists say or else go and do your reading.

  8. April 20, 2010 at 17:57

    Try this:

    http://jessescrossroadscafe.blogspot.com/2010/04/reich-levels-broadside-at-greenspan.html

    In 1999 I started wondering what Robert Rubin might have said to Alan Greenspan in a private meeting in 1997 to cause him to reverse his policy bias shortly after his famous “irrational exuberance” speech. Greenspan embraced the monetary easing that led to the tech bubble, and joined the fight against regulation of derivatives, and the repeal of Glass-Steagall, in which the Fed was absolutely instrumental.

    PBS Frontline – The Warning: The Roots of the Financial Crisis
    http://jessescrossroadscafe.blogspot.com/2009/10/pbs-frontline-presents-warning-roots-of.html

    Please fisk that for me. Or this:

    http://market-ticker.denninger.net/archives/2218-The-Valukas-Report-on-Lehman-My-Questions.html

    Again, from Mr. Valukas:

    The SEC knew that Lehman was reporting sums in its reported liquidity pool that the SEC did not believe were in fact liquid; the SEC knew that Lehman was exceeding its risk control limits; and the SEC should have known that Lehman was manipulating its balance sheet to make its leverage appear better than it was. Yet even in the face of actual knowledge of critical shortcomings, and after Bear Stearns’ near collapse in March 2008 following a liquidity crisis, the SEC did not take decisive action.

    Me [Denninger]:

    This is not a unique failure. The OTS has been fingered by its own Inspector General for having an employee who was an OTS inspector during the S&L crisis and during that crisis allowed an S&L to fraudulently backdate deposits perform the exact same outrageous action with IndyMac bank. The bank subsequently failed and a significant part of the FDIC loss was taken as a consequence of its delayed action.

    Now tell me, Tiberius, that no one knew anything and everything was done by the book. Could you also possibly reply to this?

    http://www.gata.org/node/8557

    By Adrian Douglas Monday, April 19, 2010

    At the public hearing on the metals markets held by the U.S. Commodity Futures Trading Commission on March 25, I was able to introduce testimony on the record that the London Bullion Market Association is operating a massive fractional reserve gold market that I called a Ponzi scheme.

    In your wisdom, tiberius, would you say that Adrian Douglas is talking through his backside and there is no such thing going on, nothing whatever? would you say that it doesn’t matter anyway? Which economists are you using to back up that assertion? Could you quote them?

  9. April 21, 2010 at 04:43

    Much of the post James reminded me of principles of macroeconomics which I took last year. I forgot most of it but remembered some of it, including the 10% reserves rule. Now that the FDIC bumped up the insurance level of accounts to $250,000 from $100,000, there’s been rumors afoot they’re planning to require a higher reserve percentage, possibly 15-20% with this new financial nationalization they’re planning.

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