## How Money Works: The Problems of Our Current Monetary System

One of the traders who I know and respect the most said once to me that if people truly knew and understood how money worked there would certainly be a bloody revolution. After a several years living as a trader and getting deeper and deeper into issues dealing with our monetary system it becomes evident that the way in which money works is not only “dark” but utterly unsustainable in the modern world. On today’s post I want to talk a little bit about how money works and what I believe the biggest problems of the current monetary systems are. Once you read this post you’ll be able to understand a little bit more – or at least a different point of view – of why our current monetary system needs to be changed (I will also talk about my proposed solutions tomorrow).

What is money? That is perhaps the first question we need to answer. Many people would define money as a “means of exchange” or as a “representation of value” but those are merely definitions of money through function (which – in my opinion – are not explanatory enough). To be clear, money is simply an agreement. Money is the agreement we make as a society to grant something the power to become a means of exchange. For example a dollar bill on its own is practically useless (it has no intrinsic value, unlike something like a pound of rice) but it becomes “money” when we make a collective agreement that says that we will all accept it as a means of exchange. Money is then simply an agreement which can give any physical (bill or coin) or abstract (electronic) means the capacity to exchange goods.

Traditionally the status of money was given to something which was a universal store of value in itself. For example in roman times everybody needed salt so salt became a good way to exchange goods universally as almost anyone would be willing to give you something for salt. Up until the last century gold was used as a universal store of value. This is when the first large problem of having money became apparent : the money supply. If everyone is expected to exchange things for a determinant store of value then the availability of that store determines the capacity of people to exchange goods. This is very important as when you have a low money supply then people cannot exchange goods or hire people and economic problems start to arise. However if you have “too much” then the economy “over heats” and the value of your supply lowers (as in inflation).

In our current economic system money is not tied to any sort of specific type of value but it is merely – as I mentioned before – an agreement we make to assign something the status of “means of exchange”. In our current monetary system central banks – which are private institutions (yes, the federal reserve is a PRIVATE bank, nothing to do with the federal government) – create money from thin air as debt to some particular lender. Every dollar bill used by the federal government in the USA as well as money used by the EU and almost all countries comes from private banks in the form of debt. However – interestingly enough – this debt carries an inherent interest which is not “created from thin air” but which must be competed for within the market amongst the “debt-created” money.

Certainly when people compete for this money and pay the banks the banks now have the original money plus the interest they earned. If the banks move this interest money back into the system by spending it (not by lending it) then the money goes back and can be reused by other people to earn the interest of their debt created money. If banks spend all the interest which is repaid to them then the system “works” as you have a system in which all money is originally created as debt but interest which people compete for is reinjected into the market outside loans.

There is a very large and inherent danger with this system which is that how banks spend money becomes primordial in determining the health of the monetary system. If banks keep the money they have earned as interest then it becomes obvious that a percentage of people won’t be able to pay their debts as there isn’t enough money supply to do so. The evil thing about the current monetary system is the large amount of control banks have over the health of the economy. Why should the ability to exchange goods depend on the way in which interest is spent? Should the control of the system fall in the hands of a few? If banks decide not to spend a penny of all the interest they are paid and also reduce the amount of new loans then the economy crashes as there is simply not enough money supply available.

It is absurd how banks (especially central banks) have evolved from a “piggy bank” role to become the corner stone around which our whole capacity to exchange goods is based. Of course the solution to this problem is to have a way of supplying money which is both unlimited and self-regulatory, a means of exchange that depends solely on our need to exchange (the original objective of money) and not on anyone’s particular control of the monetary supply. In other words we need a way to have money which is controlled by all of us and not by either a very few (banks), a larger few (government) or another few (gold or silver producers). Basing our monetary system on some hard-asset, like gold or silver is absurd as we need a monetary supply which doesn’t depend on the availability of any limited resource. Commodities like gold and silver have a LOT of intrinsic value but their supply CAN be limited by the few who produce them. We need a money supply which is strictly tied to our capacity for production and exchange, a self-regulatory debt-free monetary system.

### 10 Responses to “How Money Works: The Problems of Our Current Monetary System”

1. Franco says:

Hey Daniel,

Thanks for the excellent post, I have wached some documentaries a while ago on this issue, but I have not really thought about a solution to the problem. A good documentary that explained this was Zeitgeist2, although I don’t agree with the religion part of the documentary the monetary part was excellent :)

My view at the moment is that the current way banks control the world’s currencies and economies cannot go on forver. Interest is the ultimate killer and will destory an economy sooner or later.

Interesting future ahead of us :)

2. Rimas says:

Very interesting post. I think the problem is that we use the money for wrong purposes. With the help of money we can excange good and that should be the only and one reason we use it. The problem arises when we invest in money hoping to earn more money(money makes money), take loans to buy things we cant afford. This is where we need supply only, i think. If we used money only for exchange things we wouldnt need more supply. The system to work in this way we need to become less materialist and dont think about the money nesesity. Money is a tool not what we should reach for. But we want the future now and we take loans to buy things we cant afford. Very complicated. But finally we still need to pay for that.
I am not completely sure there are not some holes in my thinking about this, just I wish we wouldn` need it(money). I gess, if we used the money in right way we would became angels and begun to fly very soon.

3. xyz says:

“Basing our monetary system on some hard-asset, like gold or silver is absurd as we need a monetary supply which doesn’t depend on the availability of any limited resource.”

I like your blog but reading this sentence makes me think that you should read a bit more before commenting on our monetary system.

Why is it a problem that gold is a limited resource? On the contrary, “real” money is money that cannot be printed or created from thin air. Gold coins could always be made smaller, or contain fewer grams of gold (for example, by mixing them with another metal), so the supply is not a problem. On the contrary, the fact that we have a stable, limited supply is a huge advantage compared to paper/digital money.

If you think that gold is not a store of value anymore, then why do you think central banks hold hundreds or thousands of tonnes of the stuff in their vaults? Central bankers are in a good position to know that their paper is practically worthless for other central bankers (the US dollar is an exception due to Bretton-Woods and the current domination of the planet by the US military, which basically forces other countries to use US dollars to pay for oil). Indeed, if you are a central banker, the only real and durable asset that is not created out of debt and that you can conveniently store without depriving anyone of an essential commodity is gold (cf. the famous passage on why gold is a better store of value than other commodities by the English philosopher John Locke).

I’d like to draw your attention to this famous quote by J.P. Morgan, who was probably in a good position to know what is money:

“Gold is money and nothing else”. Yes, this quote is 100 years old and things may look different on the surface nowadays, but it contains a deep truth that it still valid.

Hi xyz,

Thank you for your comment :o) Oh well, you seem to have misinterpreted my phrase a little bit! I am not saying that gold is not a store of value, on the contrary it is the store of value by excellence and therefore it is what most people buy when paper money loses its exchange capacity (devaluates) and this – as you point out – is why central bankers use it. However when you base your money supply in gold you run into the problem of limiting your capacity to carry out exchanges as the supply of gold (or any other metal for that matter) is limited. The problem you have when you make metals or any other commodity a store of value is that you give power over the money supply to either those who produce the metal or those who mint the metal into “coinage”. You run into a problem of supply in which you give power to control supply over to a few people. The objective of money is to carry out exchanges and money needs to be available in the proportion in which these exchanges are necessary, therefore the money supply should be controlled by our ability to produce and our need to exchange and NOT by any single group of people (not the government, metal producers, etc). I am not saying that gold or metals are not a store of value! What I argue against is the fact that basing money on any hard commodity makes the money supply limited and controllable by a few. I give you another quote that talks about the great power you give anyone when you base the money supply on anything which can be limited by a group of people :

“Permit me to issue and control the money of a nation and I care not who makes its laws.” (Mayer Amschel Rothschild)

Thank you very much for commenting :o)

Best Regards,

Daniel

4. Samkronin says:

Solution to monetary system problem #1: feed the banksters to the poor!

Seriously though, this a very real problem that I have thought about a lot and look forward to hearing your ideas. I’ll be here at my computer hitting the refresh button until your next post ;-)

5. josh says:

Awesome post, I, like Samkronin, can’t wait for tomorrow’s post……..Have thought about this one a lot, but never once thought of a way around the problem….

6. Vitor says:

Nice post I never thought from this perspective. There is too much poverty in my country(Brazil) and the Central Bank has one of the highest reserves of US dollar in the world, it increased in 35 Bi only these first trimester/2011. I Guess in China is the same(the poverty and the USD reserves).

7. xyz says:

Hi Daniel,

Thanks for your reply. Well, I appreciate your explanation but I do not completely agree with it.

First, one fundamental reason why gold is a good store of value is precisely because the supply is stable: almost all gold mined since Antiquity has been preserved, therefore the new gold mined every year represents only 1 to 2% of the total quantity of gold already mined. Essentially, this represents a “controlled inflation” of 1-2%. Contrast this with paper/digital money where inflation is potentially unlimited (of course, you get a practical limit when people stop using a worthless currency). So, although I agree with you that miners/coin minters would have the power to control the new annual influx of gold, this new influx still represents a small proportion of the existing supply. This is obviously different from the situation with central banks and paper/digital money, where there are no “natural” limits to inflation as there is with a hard commodity.

Second, I do not see why having a limited currency supply would limit our capacity to carry exchanges. If the economical activity/productivity of a country increases while the currency supply remains stable, then prices should go down. This would be absolutely normal (i.e., not the dreaded “deflation”), it is simply that we are not used to seeing it in our environment of inflating fiat currencies… Actually, you can see it in the case of computers, where the price generally decreased over the last twenty years as production coasts were decreasing faster (and technology was progressing faster) than the inflation rate. Also, as I said in my earlier comment, you can always make smaller gold coins or coins containing fewer grams of gold, so this is a non-issue (the fact that gold and other precious metals are divisible in such a manner is actually an advantage over other commodities and is probably one reason why they were historically selected as stores of value).

Third, although gold mining can be very profitable, it is risky and involves a lot of work, which means that “gold money” cannot be created at will and without effort. Again, please contrast this with paper/digital money. Also, gold mining is not generally a monopoly, while central banking represents an absolute monopoly on money creation, enforced by law.

And, last but not least, gold represents value in its own right, i.e., it is not a debt owed by/to someone else. As you pointed out in your post, under the current system, fiat money is actually debt. I will admit, however, that this last point could be changed by giving governments the right to issue their own currency (that is, not as a debt to a central bank), something that Abraham Lincoln did when he started printing “greenbacks” during the Civil War in the USA. But, even if that were to happen, the main problem remains for me that, under a fiat money system, there is no limit to money creation, therefore the central banks have unlimited power over the currency (as I said, the only practical limit is that people will stop using an hyperinflated currency), something that is not the case when a “hard” commodity is used as money.

Hi xyz,

Thank you for your post :o) Ok, my main argument against this continues to be the issue of supply. As you say the amount of gold is limited and whenever you base the supply of money on a limited hard commodity the issue to control supply becomes a problem. Let us forget a little bit about miners and minters and let us concentrate on the willingness of some entity (like the government) to control supply. Anyone which can have enough power could control the supply of gold by restraining its circulation, the capacity of the population to carry out exchanges becomes dependent of the willingness of people to use this to carry exchanges and if powerful entities wish to restrain gold then they can effectively control the money supply with potentially devastating consequences. What if China or the UK decided to accumulate more gold? It would become an effective way to restrict other country’s money supply. The problem becomes the same, you give powerful people potential control over your supply.

Regarding the current system, having the potential to create unlimited amounts of money is not problematic if such money creation is only tied to the needs to exchange, the problem under the current system is that the money created is less than the money owed (debt creation without interest as I mentioned) and that money can be printed even if the need of exchange isn’t there. Government can create money without debt and still does to some extent (all US coins are issued by the government free of debt) but you again create the problem of giving government the power to control money supply. My main point is that the power to create money should not belong to anyone in particular but it should be simply generated upon the need to exchange. When you give someone the ability to eventually restrict the money supply you cause a problem which will eventually materialize. Gold poses the problem of a limited supply which can be controlled by accumulation/restriction of powerful entities while government issued currency makes the government very powerful (something unwise as power breeds corruption). Our money supply must NOT depend on anyone and no one can have the ability to restrict it, it must be a natural consequence of exchange with production being its only natural limit (not the availability of any metal).

I hope this gives further insight into my views :o) Thanks again for commenting,

Best Regards,

Daniel

8. […] my “how money works” posts last week (one and two) we discussed some of the problems of our current monetary system and some of my ideas of […]