Our Debt Money System Explained
by Michael Nystrom
August 23, 2007
Regular reader Rich writes:
I've read in a couple of places on the internet that if all outstanding debt was repaid, there would be no 'money' left in our debt money system. Is this true? If so, what happens to the interest that the bankers earn?
This is unbelievable to most people, but it is absolutely true. If all outstanding debts were repaid under our current debt-based monetary system, there would be no money left in existence. I stress our current debt-based monetary system because other types of monetary systems are possible. Most people never stop to think about this (usually because they're too worried about paying their bills), but our current system (which is controlled by the Federal Reserve) is just one of many possible money systems. There are in fact a variety of different kinds of monetary systems. The following illustration of a simple commodity-based monetary system will help us understand just exactly what money is.
I. The Commodity-based Money System of Prison X
It is well known that in prison, cigarettes often take on the role of what we traditionally think of as 'money.' In fact, given the circumstances, they are money. Inmates may not be free, but free markets can spontaneously arise in prison.
Imagine that the warden gives all prisoners at Prison X a ration of one pack of cigarettes per week. Many prisoners don't smoke, but the cigarettes they receive are not worthless. This is because many more prisoners do smoke, and they value those excess cigarettes. This gives the cigarettes an intrinsic value. Even if you don't smoke, you will still value the cigarette because it has value to someone else. Furthermore, cigarettes are small, uniform, easily stored, hidden and traded. In the absence of what we traditionally think of as 'money,' they become money. As a commodity in constant demand, they make a perfect medium of exchange. In fact, this is one part of the definition of money: Money is a medium of exchange.
Money is also a unit of measure: If you find yourself in Prison X, you might discover that a large metal file (a vital tool in your plan to escape) will cost you 500 cigarettes. At a pack a week, it will take you 25 weeks to save enough to get your file (assuming you don't smoke). Whatever you're looking to obtain in Prison X, you'll find that its value can be measured - i.e. priced - in cigarettes.
It is also worthwhile to note that different kinds and brands of cigarettes would undoubtedly have different values, because they taste different (as a smoker for over 10 years, I know this to be true!). American Spirits might be worth the most, and menthols might be worth more or less, depending on the preference of the smoking population. The raspy generic brands would no doubt be worth the least. An internal exchange rate between the different kinds of cigarettes would spontaneously arise, based on their intrinsic qualities (taste), and how those qualities were subjectively valued. This exchange rate would be equivalent to the different denominations of bills that we have in our system.
Finally - money is a store of value. As long as the number of cigarettes in circulation remains stable, the monetary value of each cigarette should remain stable over time. If the ration of cigarettes were to suddenly jump - say the warden increased rations from a pack a week to two packs a week - each cigarette would now be worth less. This is inflation. Simply put, inflation means more money in the system. As a result of this sudden inflation, that big metal file you were saving up for would now cost twice as much. As should be clear from this example, higher prices are not the cause of inflation they are the result.
Conversely, if prisoners suddenly began smoking cigarettes faster than they were being issued, the cigarettes that remained in circulation would increase in value. This is the definition of deflation. Deflation just means less money in the system.
II. Our Debt Based Monetary System
The purpose of the brief illustration above is to outline the essence of money. Some key points are: 1) Nearly anything can serve money, as long as it has intrinsic value and is therefore in demand by some members of the population. 2) Money doesn't have to be issued by the government - it will arise spontaneously as it is needed. 3) Sound money must serve three basic functions. It must be: a unit of measurement (serve a pricing function), a medium of exchange, and a reliable store of value. With this in mind, we can now take a fresh look at our Federal Reserve controlled debt-based monetary system.
Under our debt based monetary system, money is backed not by a commodity that is in demand like cigarettes or gold, but by debt. Ultimately it is the debt of the United States government that backs our currency. Since we are the government in the United States, or at least that is how it is supposed to work, it is our own debts that back our currency. Our paper currency has no intrinsic value other than that we need it to pay back our own debts.
Confused? This is how it works:
If you look at the green bills in your wallet, you'll notice two things. First, across the top, they all say 'Federal Reserve Note.' These are FRNs. Also, somewhere on the right side - depending on the bill - it says in small print, 'This note is legal tender for all debts, public and private.' In other words, this is the government's way of telling you that FRNs must be respected as a medium of exchange. If someone says he wants his debt to be paid off in FRNs, you must comply. This is the law, by fiat decree. This is what is meant by 'fiat' money. This is extremely important, as we shall see later.
Where do FRNs Come From?
FRNs are created in an exceedingly simple transaction between the US Treasury and the Federal Reserve. The US Treasury (the government) creates a bond, and the Federal Reserve (a private bank) creates some money. The Fed loans the Treasury the money it just created and the Treasury gives the Fed the T-bond it just created as collateral. The bond is an IOU that serves as backing for the money that was just created.
I know. It sounds circular, confusing and insane, because it is. It is meant to be so that you don't understand it. It was this understanding that led Henry Ford to proclaim, 'It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.' The great economist John Kenneth Galbraith put is even more succinctly: 'The process by which banks create money is so simple that the mind is repelled.'
The Similarities and Differences
At this point, lets take a moment to examine the similarities and differences between our debt money and the prison's commodity-based cigarette money.
First, the prison warden did not stamp 'this cigarette is legal tender for all prison debts' on each cigarette. He didn't have to, because under the circumstances, cigarettes had intrinsic value. People could smoke them. There is always demand. The reason the fiat declaration is stamped on each FRN is because these pieces of paper are otherwise worthless. Who would want this crap? They were created from thin air, there is an unlimited supply, and they don't hold their value.
But given that this is true, why do people continue to use them? Why doesn't another monetary system spontaneously arise, the way it did in Prison X?
Here is the rub: Since there is no intrinsic demand for worthless FRNs, the government - specifically the Treasury, which is on the hook to pay the interest back to the Fed on those bonds - created one. You have to pay your taxes in FRNs. Nothing else is accepted.
The income tax is the mechanism by which the government creates artificial demand for an otherwise worthless currency. Is it a coincidence that the income tax and the Federal Reserve were both created in the same year - 1913? Emphatically I say, it is not. As Ron Paul says, '1913 was a bad year. We need to repeal that entire year!' (see the video)
So, to get back to the questions that began this piece: In Prison X, if all the cigarettes were smoked, there would be no more cigarette money. Likewise, if all debts were repaid under our current monetary system - all the credit card debt, auto loans, and mortgages, all the way up to the national debt - there would be no more debt money, either. I have explained how the Fed and Treasury create money from thin air. It is by this same process that money is created by the banking system throughout the economy. Your debt is the bank's asset. The interest you pay them is their income stream. The more assets it has, the more loans it can make. More loans means and increase in the money supply, and therefore inflation.
Our Competitive World
As for the interest that the bankers earn...first, the bankers don't 'earn' it. They collect it. There is a huge difference. 'Earning' refers to obtaining money by doing useful work. The banks, like the Fed, create money from thin air and 'loan' it to you. However, in creating the principal amount to loan you (from thin air), they never create the interest that you are to repay. So where are you supposed to get this extra interest amount to pay them back?
The answer is that you have to get it from someone else's principal that they borrowed. This is why it is such a competitive, dog-eat-dog world out there - not because of human nature. It is because the monetary system requires it of us. Everyone is scratching and clawing at one another, collectively trying to get their hands on more money than exists in the system. The system itself ensures that a certain number of people will go broke and lose everything. They have to so that others can repay their loans to the bankers.
The final thought that I would like to leave you with is this: If we change our money system, we will change the world. Are you ready for a revolution?
Sign up here to be notified of future articles.
Comments welcome below. No need to register to post.
What is going on with the markets? Get complete access to the U.S. portion of EWI's Stock Market Specialty Service, including labeled price charts, detailed analysis and intraday forecasts for the S&P, DJIA, and NASDAQ - Free. Click here for free access.
Back to the Archive
All contents © Michael Nystrom