Monday, October 20, 2008


(Week 11 - Monday, Oct. 20)

We the People of the United States need a public money supply with which to conduct our commerce. Under the current Federal Reserve System, our money is issued via loans from a private banking system.

When a private person, corporate entity or government body borrows money from a bank, the banker creates the money he is loaning when he writes the check for the loan or credits the account of the borrower. That is the rule upon which the Federal Reserve System is founded. In a booklet published by the Fed, "Everyday Economics", the section titled "How Banks Create Money" states as its opening sentence -"Banks actually create money when they lend it."

The borrower then goes out and spends that money for whatever purpose he took out the loan to fulfill. The money from the loan (principal proceeds) thereby enters into general circulation.

Over time, the borrower will be required to pay back the loan. The terms of the loan contract, however, will state that he will be required, not only to pay back the money he borrowed, but also pay a compounding fee described as "interest on the loan". A problem arises because the money from the loan entered into circulation and is therefore available to be paid back, but the money to make the interest payments was never created and issued. It can only be obtained by taking it out of the money from other loans that are still in circulation.

This means that there will not be enough money in circulation for others to pay their loans. The only way this shortfall can be coped with in practice is for people to borrow more-and-more money into circulation on a continuously increasing basis, both to service the principal and interest payments on old loans, plus bring enough newly borrowed money into circulation to maintain an adequate money supply. People almost certainly will not think of what they are doing as being motivated by maintaining an adequate money supply, but as the amount of money in circulation drops, people are progressively less able to pay their bills, and so will tend to resort to borrowing from banks to make their financial ends meet, which, in turn, has the effect of filling up the monetary pool.

Eventually, the amount of outstanding indebtedness becomes so great that people are simply not able to pay it, and a wave of financial defaults results. This temporarily relieves pressure on the money supply relative to the amount of "debt" it is being called upon to service, but at great cost in personal trauma to those who are obliged to bear the resultant bankruptcies.

As a domino-like default phenomenon gains momentum, a psychological state takes over whereby people become more prone to consolidate their financial position by paying off old "debts" (as opposed to taking on new "debts"), and even banks become reluctant to create and lend more money. The net effect is that the money supply goes into a contraction, which, if not arrested, can lead to economic depression.

One further effect is that the "investments" (bonds, mortgages and other "debt" contracts) bought up by financial speculators are in jeopardy of becoming worthless paper. Technically this is not really a danger to the economy, as the collapse of such paper would relieve pressure on the existing money supply to service "debt", but it does create a great disorder and confusion of interests because many ordinary people also are significantly invested in "debt" paper (as held in money-market accounts, retirement portfolios and the like). In any case there will be voices from the academic, political and financial arenas that will try to convince the public that their distress can only be relieved by rescuing the "investments" of the "speculative industry".

Complicating the whole picture is the fact that the "fractional reserve formula" that governs the banking system will start to break down, sending the banks themselves into technical "bankruptcy".

The upshot of all this financial mayhem is that there arises a general fear in the populace that the monetary system is in danger of "collapsing" if it is not "rescued" with a massive injection of freshly-borrow private-bank money. In truth there is such a danger, but mainly because widespread belief in such a scenario makes it self-fulfilling. This fear, plus the lack of realization concerning what to do about the situation, is precisely what is driving the headlines announcing a general monetary meltdown at present, and the promulgation of a $700 billion "bailout" plan.

Such a plan may (or may not, if a degree of confidence and order cannot be restored) stave off near total disruption of the economy in the short run, but it will inevitably result in the citizenry taking on an ever greater amount of "debt", in this case indirectly through government borrowing. An increasing portion of tax receipts will be diverted into making more hundreds-of-billions of dollars of "interest" payments on a ballooning "national debt", until even the Federal government will not be able to borrow enough new money into circulation to meet its operating expenses.

The churning of the monetary system will continue amidst increasingly unbearable complications. We live in unprecedented times, and where this all may lead is difficult to envision, but the end thereof, and the rough ride getting there, can only be catastrophic in the extreme.

Turning the leaf over, the remedy to the crisis is simple, straightforward and quintessentially American; that is to restore the authority to create our money to the public sector (as stipulated in Art. 1, Sec. 8, Par. 5 of the U.S. Constitution). Money is created "out of thin air", whether this function is performed by a public body that serves the people as a whole (the U.S. Treasury), or a corporation that serves the interests of private gain at the expense of the whole (the Federal Reserve).

If the public's money is borrowed at "interest" from a private corporation, the social order as a whole cannot help but fall increasingly into "debt" to the financial interests that that corporate entity serves.

If, on the other hand, our money supply is issued publicly out of the U.S. Treasury, We the People issue it to ourselves, and no "debt" of the economy as a whole to private financial interests can result.

This was the very monetary principle the Founding Fathers incorporated into the U.S. Constitution, which would, if reinstated, resolve the crisis of crushing "debt" that is today plaguing individuals, the nation, and the world.

Richard Kotlarz

The complete set of columns from this series is posted at the following websites:

Postscript: I have attached to this column a note from a colleague, Stuart Weeks, who has in many ways played a vital role in helping me to produce these columns. It introduces the matter of possible audience participation in the greater ongoing effort of which the columns are but one part. For my part, I thank you for your considerate interest in the journey through this most critical subject of money so far. (second link listed)