How Currency Is Created

Most of us understand that currency is being created ex nihilo by governments around the world. The question I always had was how were they able to do it? How do you create something that has no foundation to it, and seemingly uphold a castle in mid-air?

We are going to explore the nitty gritty of how currency comes into existence. The governments of the world create currency in much the same way. Since the US dollar is the reserve currency of the world, we are going to look at how the US generates its currency.

Government Issues Glorified I.O.U.'s

Our first lesson is that government does not produce anything of value. When a politician promises to give us more free stuff than his opponent, he is igniting the engine of deficit spending. There is no such thing as a free lunch. Since there is no such thing as a free lunch, a politician must vote for the government to spend more than its income from taxes.

When a new bill is ratified that requires more currency, the Treasury borrows currency by issuing a bond. What is a bond you ask? A bond is little more than a glorified I.O.U. It is a piece of paper that says, "Lend me a billion dollars, and over a 10-year period I promise to pay you that billion dollars back, plus interest." The important thing for us to understand is that Treasury bonds are our national debt. These bonds are to be paid back by our descendants via future taxation. When a government issues a bond, it is stealing prosperity from the future, to pay for items in the present.

Banks Purchase Bonds from the Government

Once the Treasury issues a bond, it holds an auction for those bonds. The clients at this auction are the big banks. Each one competes to buy the freshly minted bonds, and earn an interest on our national debt over the lifetime of that bond.

Then, through an elaborate game called Open Market Operations, the banks are able to sell some of those bonds at a profit to the Federal Reserve. The Federal Reserve opens its checkbook that has a zero balance, and writes a check to the banks for the bonds. This is how currency springs into existence.

"When you or I write a check there must be sufficient funds in our account to cover that check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check it is creating money."
-Boston Federal Reserve

What do the banks do with this new cash? The banks go back to the Treasury auction, and buy more bonds. This is crazy right? Before we go any further, let's review a bit.

The government and politicians need funding for new projects. They vote for new money to be made. The Treasury issues I.O.U.'s (bonds) that then go to auction, where banks purchase them to collect interest on the national debt. Banks sell these I.O.U.'s to the Federal Reserve, who writes another I.O.U. (check), that the banks receive and go buy more I.O.U.'s with. So what's really happening is the Federal Reserve and the Treasury are just swapping I.O.U.s, using the banks as middlemen.

Government Spends the Currency from the Treasury Auction

Now that the Treasury has funds from their auction, they distribute the fresh currency into the various departments of the federal government. The politicians smile, and go spend the new currency in their states and provinces where the population sees that they kept their campaign promises. The re-election cycle is off to a good start.

The new currency flows into the hands of government employees, contractors and soldiers like water from a faucet. They in turn deposit their paychecks into a bank, and then the currency creation engine truly kicks into gear.

Fractional Reserve Banking

This may come as a surprise. When we deposit our currency in the bank, we are not depositing our funds to be held in trust with the bank - we are loaning our currency to the bank. Since we are loaning our currency to the bank, they can, within certain legal limits, do with this currency almost as they please. This includes gambling in the stock market, and loaning it out at a profit. This is where Fractional Reserve Lending begins.

Fractional Reserve Lending is exactly what it sounds like. The bank is allowed to lend out a portion of the funds that are deposited with them. The reserve ration each bank is required to keep varies, but is usually around 10%. What does this look like?

If you loan $100 dollars to your bank, they can legally keep $10 on deposit to pay you back, while they lend out the other $90. The $10 that are held at the bank are what we know as "Vault Cash." How can you pull up your banking app and it still show $100 you ask? The bank creates bank credit in the place of the dollars they are loaning from your account. Here is a quote from the Federal Reserve on the matter.

"Commercial banks create checkbook money when they grant a loan simply by adding new deposit dollars in accounts on their books in exchange for a borrower's I.O.U."

This checkbook money is currency on the bank's balance sheet. Now there is $190 in existence for the bank to use. What will the bank do with these $190? They will loan it out to each one of us looking for a new house, car, or whatever else we fancy at the moment.

When we pay the home owner or car dealership, they deposit those dollars into their bank. The process continues over and over again until an initial $100 deposit can turn into thousands of dollars on a bank's deposit sheet. This is of course assuming the reserve ratio at the bank is 10%. There are some banks that are not required to keep any dollars on deposit.

This currency creation is a massive one. It is estimated that as much as 92 to 96 percent of all currency in existence is created through fractional reserve banking.

Now, it could be a fun thing to have our own money tree as it where - granted this is a much faster means of growing money than waiting for it to grow on a tree. Any student of economics will tell you though, a surplus of currency always leads to an increase of prices for goods and services. The goods and services act as a sponge for the currency supply. This is inflation.

The Government Taxes Us for the Currency They Create

This is the point where the system becomes criminal. We work to earn the currency that the government created out of thin air. Our hard earned dollars are taxed by the IRS, which gives them to the Treasury where the original I.O.U was created. The criminal part of it is, each dollar we earn is being diluted and losing value with each cycle of this system.

The truth of the matter is, the taxes we pay are not being used to fund schools and public roads, they are being used to pay interest on loans. The government has borrowed so much prosperity from the future, that we are now only able to pay the interest on our loans, and not the loans themselves.

This system is a failed one. If we would stop paying on these loans, then trillions of dollars worth of wealth would disappear. There is nothing backing the dollars that have been created. This is the essence of a deflation, and it is what happened in 1929 with the Great Depression. The only way the system continues is to keep borrowing from the future.

Conclusion

On the subject of inflation, the economist John Maynard Keynes once wrote: "By this means government may secretly and unobserved confiscate the wealth of the people and not one man in a million will detect the theft."

The system we currently live in is designed to kick the can down the road. This simply means that for any president who does not wish to preside over the next Great Depression, he must allow currency to continue being created.

"No generation has the right to contract debts greater than can be paid off during the course of its own existence." -Thomas Jefferson

We owe it to ourselves and our children to learn what is going on in our monetary system. It is pure theft. This is not a system that can last forever, and we must come to the realization that easy money will not be so easy soon. The hope is that enough people learn what it going on that when the system does crash, people know why it did. A misinformed people, is an easily controlled people. We are to be about the business of sharing the truth with others.

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Image Sources: 1-2-3
Sources: Boston Federal Reserve quote
Commercial Banks I.O.U quote
Keynes quote
Jefferson quote