1955Design left a comment on Exploiting Ignorance: Money for Nothing,which I feel deserves a stand-alone reply.  In response to my assertion that in the event of credit default, “Nobody has lost anything … on the contrary, whosoever he purchased goods from has already received and has likely spent the money that was created out of nothing.”

OK, this is all pretty confusing to me. Hasn’t the credit card company lost in this case? After all, they paid money to Best Buy for that flat screen HD television that you acquired by using your credit card.

The source of this confusion is that most people simply have no idea how money is lent into existence by the Federal Reserve and its member banks. Most people have a very hard time comprehending the fact that most of the money ever lent to you never existed until you signed the note.  That’s why I included the Galbraith quote,

The process by which banks create money is so simple that the mind is repelled.

I feel like I have a pretty good handle on the concept, and it often still challenges me.

If I had a printing press in my basement, and could print perfect copies of $100 bills at a cost of zero, you would rightly call me an extortionist if I offered to “loan” you some of that money at 5% per annum. In the event that you accepted the “loan” anyways, and you failed to repay me, would I be any worse for wear? It is preposterous to assume that I would be in any way damaged by your failure to repay me.

The Federal Reserve has a printing press in its basement. It prints perfect copies of $100 bills at a cost of (essentially) zero. Through its member banks and institutions, it offers to “loan” you that money at 5%, 10%, 25% annually. What’s the difference? The government says that it’s OK for the Federal Reserve to create money out of thin air, and to loan it out to you or me, at a profit.

Under these circumstances, any interest rate charged is usurious, because there is no time value, nor is there an opportunity cost for the money allegedly “lent.” Anyone else who wants to loan money must make an immediate sacrifice, and bear real risk, in hopes of earning a modest return on capital lent.

I really like the explanation given in I want the Earth, Plus 5%, but it’s a tad on the lengthy side. In The Compound Interest Paradox, blogger FSK summarizes the flaw in debt-based money:

Money is only created when someone takes out a loan. However, only the principal is created and not the interest payments. For example, suppose a bank borrows $1B from the Federal Reserve at 5% interest for 1 year, either directly at the Discount Rate or via the Federal Reserve “monetizing the debt”. In a year, the bank must repay $1.05B. The $50M required interest was never created or put into circulation. Therefore, there’s a permanent money supply shortfall. Everyone is enslaved under a crushing debt burden.

The key step in the money creation process is when banks borrow from the Federal Reserve to create new reserves. Only the Federal Reserve can create new money, and all the money it creates has debt strings are attached … Total debt is always greater than total money.

You’re not going back far enough if you presume that the credit card is giving money to Best Buy. Where did that money come from? That money likely did not come from some investors’ accumulated savings, ultimately that money was created out of thin air; it is a pure debt obligation which exists only insofar as it is backed by the full force of law. If I loan you money to buy a house, I actually have to part with thousands of dollars of accumulated savings. When a bank extends credit for you to buy a house (or a television, or a car), they are not taking money from a pool of accumulated funds, they are quite literally creating the money with a few keystrokes and bookkeeping entries with the Federal Reserve.

Think about why prices rise. Prices are nominally rising not because the goods are becoming more scarce, but as a rule, because the currency is continually debased.

The important consideration is that goods and services cannot be created out of thin air.

No amount of printed money is capable of creating wealth, and to the extent that the new money “stimulates” investment and productivity, it can only do so with the hidden costs of malinvestment, that is, a falsified price sigal (an interest rate is really an intertemporal price) is sent to the market, inducing entrepreneurs to borrow money when otherwise they would not have, to embark upon productive processes the lengths of which are unsustainable given the existing time preference, the stock of complementary goods or factor inputs, and which also permits them to bid away resources from their most efficient allocations.

The resultant rising prices silently and secretly destroy everyone else’s purchasing power, stealing from everyone else’s savings, bit by bit.

By political favor, banks have become uniquely empowered with the special privilege, a privilege which no individual could claim by rights, and which no man would honor otherwise.  This privilege is the permission to loan  into existence, money representing wealth which has not yet been created. In doing so, they are effectively mortgaging the borrowers’  productivity, while risking nothing of their own.

Gresham’s Law (i.e., bad money drives out good money) is often and peculiarly cited by opponents of specie-backed currency. According to Gresham’s law, the existence of a competing yet inferior currency will ultimately result in widespread use of the inferior currency as people hoard the superior currency. The subtle point which is overlooked in this argument is the institutional framework of the economy under observation.

This is the framework they assume:

With the press of a button, a bolt of cloth (in the right hands) can become Federal Reserve Notes, which someone will then be able to use to buy things which already existed prior to the miraculous transmogrification. So long as you can get the new money before anyone else, you can spend it before prices rise, and expropriate real wealth from the rest of a productive society.

Turning simple cloth into greenbacks does not and cannot create wealth. This argument cannot be made about gold, since so long as people continue to desire it (for whatever purposes), the production of gold does constitute the production of real wealth, and the resources allocated towards its procurment are not malinvested.  On the contrary, paper money cannot conjure up the abundance of goods and services which indicate wealth, from nothingness.

Under a gold standard, the amount of credit that an economy can support is determined by the economy’s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government’s promise to pay out of future tax revenues…

Greenbacks are only accepted by people in exchange for real wealth (i.e., goods and services), because people are bound by the full force of the government, to accept them.

When a government, says that bad money = good money, and any refusal to accept this fiat will be met with violence, the results are predictable: bad money drives out good money.

Gresham’s law can only have its prophesied effect when governments distort the market for money, forbidding by one means or another, several currencies from being accurately valued in terms of one another.  In a free market, “bad money” would properly be discounted in proportion to its “badness,” so long as that quality could be reasonably ascertained (a risk that many people might not be willing to bear) and if allowed to trade at a discount relative to the good money, the “bad” money would not drive out the good money, because only an idiot would accept the bad money at face value.