Ever thought about how money works or what it is ? £ – “Pound Sterling” – it used to be a pound of sterling silver and you could have gone to a bank and asked for your silver. You may remember or been taught about the Gold Standard and how this was abandoned.

In order to fully understand the crisis humanity is facing it’s critical to understand how money works. I’ve long had an interest in economics, I have an economics a-level, a maths degree, qualified as an accountant and spent 15 years working in an investment bank in Interest Rate Derivatives and still the way money works sometimes messes with my mind. So here’s an attempt at explaining how money works.

There are three major features of our money are:

• Fractional Reserve Banking;
• Compound Interest; and
• Fiat currency

To explore the implications of money I spent a lot of time thinking through a scenario which I called “Lordy World”. I originally included it in this post but my sister felt it got a little complicated so I’ve separated it out. I will provide links to it rather than include directly here.

LORDY WORLD – introduction

Fractional Reserve Banking

When banks take a deposit they only have to keep so much of it (the reserve amount) the rest can be leant out. So say you deposit £100 with your bank they can lend out £90 (given a reserve requirement of 10%). They are reliant on all depositors not wanting their money back at the same time as they will only ever have about 10% of total deposit available. This is how runs on banks happen – if depositors start to worry about the solvency of a bank they may start withdrawing money. After a certain length of time the cash deposits at branches will be gone further fuelling the panic and more people will try and get money out. The bank will get more cash but at some point they will run out of reserves and not be able to pay any more.

The full implications of Fractional Reserve Banking are not immediately obvious. Say Bank A gets a deposit of £100 and lends out £90 keeping £10 in reserve. The person borrowing the money is clearly going to spend it (why else borrow) so the money ends up in someone else’s hands and ultimately as a deposit in a bank, say Bank B. Now Bank B has got £90 so they loan out £81 and keep £9 in reserves. Now note that there is still only £100 total money but Bank A has £100 deposit and Bank B has £90 deposit. The owners of deposits have £100 and £90 each. If they both go to withdraw that money from their banks there is clearly a problem – they demand £190 in cash but only £100 exists in total. This table above illustrates how this works.

Given £100 pound initial deposit and a 10% reserve requirement (I believe this is approximately what most western economies require) this can result in £1,000 of deposits existing via this process. Crazy stuff right !

Note that this can be backed out if a nice orderly repayment of loans happens. There is enough money in the system for all this to work.

Imagine what this means for our banking system as a whole. Imagine what happens if even a small proportion of total deposits are demanded in short order (say more than 10%). One way to tackle this comes as a result of moving to FIAT currency, which we will come to later, but that has it’s own set of implications.

This is already pretty scary before I even add in Compound Interest.

Back to “Lordy World”

Compound Interest

This is something we’re all brought up with and just take for granted. Logically you would think you would pay a bank to safeguard your money. In the times of gold (no paper currency) you can imagine that would be reasonable – pay a bank a monthly fee to protect your money. Once you introduce FIAT currency (see below) and fractional reserve banking it becomes a little less important, in fact if a bank is only holding 10% of your money most of it isn’t available to steal. In todays world where it’s just a bit on a computer even less so. With Fractional Reserve Banking you can see why you get interest – the bank is paying you because they can then lend your money out. They lend it out and earn interest meaning those borrowing must make a profit (either through a business venture or working to pay off the loan plus interest). Hopefully you see that implicit in this is the need for growth. Perhaps they also paying you to take the risk that your money won’t be available when you want it, though this is certainly not made clear to the average depositor.

I want to make this clear. Once you charge interest that is creating money and at any one time there isn’t enough money to pay it all back. Look back at Fractional reserve banking – £100 deposit with 10% reserve could create £1,000 of loans. Say interest is 5% (lets ignore compounding – it just makes it worse anyway) which means £50 of interest. Now without interest all those loans can be repaid with only £100 money in circulation but where will the £50 comes from – we need continued growth for this to work.

Think about it you deposit money and it just keeps creating more money. Money grows infinitely. Whats even better everytime a borrower pays interest the bank can lend 90% of it out and via fractional reserve banking the increase in money is 10 times the interest.

For example if we deposit (of course it works just the same for a loan it’s just banks unlike depositors won’t just wait and let it accumulate without getting some of it paid) £1 at 2% interest:

• After 1 year we have £1.02
• After 10 years we have £1.22
• After 100 years we have £7.24
• After 1,000 years we have £398,264,652

And after 10,000 years we have about £100 Sextillion Vigintillion (thats 100 with a further 84 zeros).

There’s that crazy exponential growth again. You may say well thats daft you won’t keep it deposited for that long. If you think I won’t then why wouldn’t I ? Or are you thinking well the banks won’t be around that long. If so I agree … but if you think that do you assume it will happen in some far distant future and not tomorrow?

If we think back to when money had some physical meaning to it (say gold) then compound interest would mean depositing gold created gold ! Well, at least from the depositors perspective. Whats happening in the background is that the bank loans it out and charges interest (ie more gold) so it’s all reliant on the borrower producing something that will result in more gold to pay back the loan plus interest or gold would have to increase in value.

Back to “Lordy World”

FIAT CURRENCY

The best definition I can come up with is “money without intrinsic value”. Though the pound in your pocket may have historically represented a pound of sterling silver and you could have gone to a bank and redeemed it for the silver that is no longer the case. The £1 in your pocket represents nothing other than a promise that you can exchange it for some good or service. The value of money is completely based on trust. There’s trust that at the time you chose to spend it that the seller will accept it. This trust can fade or disappear. Take countries that experience hyperinflation – the value of the money in your pocket decreases rapidly, people lose faith in it and fewer and fewer people accept it reverting to barter or other currencies.

The key thing with FIAT currency is that without any link to something physical there is, in theory, no limit to the amount of money that can be printed. In fact, economists that believe in infinite growth (which really is all you hear in the mainstream media since every expert tells us we need to have economic growth) are reliant on being able to have as much money as required. It’s also one of the reasons government debt is so secure because they could just print money to pay it off. Heard of “Quantative Easing” ? Well, thats printing money which is used to pay off govt debt. By buying back govt bonds from banks they inject more money in to circulation as it allows banks to lend out. The problem here is that printing more money has not increased wealth at all, it’s merely devalued all money – it is inflationary.

Back to “Lordy World”Back to “Lordy World”

Now lets put this all together. We have individuals, businesses and governments borrowing money. Due to compound interest they all have to add value to pay back the interest. This requires an ever expanding economy. On top of this we have Fractional Reserve Banking – it means any interest paid on loans is multiplied up to create even more money to loan out and charge interest on. For this to keep working economies have to keep growing. If you’ve ever heard of banking as a huge Ponzi (pyramid) scheme you can now perhaps see why. What happens if individuals can’t pay their interest or debt ? Or governments for that matter. What could cause that ? Lack of economic growth over an extended period ? Whats happening now ?

Growth is something I will blog about shortly but for now just look at those numbers above which demonstrate how growth progresses at 2%. I picked that percentage because thats the target growth rate regularly touted by economists and politicians. Surely I don’t need to site Peak Oil for you to realise growth cannot go on endlessly. Anything in nature has a period of growth and then becomes stable. Why do we not believe this is the case with economic growth. IT MUST STOP. Unfortunately the way money currently works has endless growth as implicit within it. Conventional economic thought believes this can continue due to efficiency & substitution which means they believe we will get ever more efficient in our use of resources (The Faith In Technology) and also as something gets more expensive we will find or make a substitute. Unless the substitute is sustainable it will, of course, also have a limit.

This post hopefully gives you something to think about in terms of what will happen to our current financial system when it growth does stop. Think about the current EURO crisis. Don’t observe that and think ah poor them. We (UK) are in no better state, neither is the US or China (who Europe are turning to to bail us out!)