Fractional Reserve Banking: Engine for Economic Growth or Fraud?

The cornerstone of our monetary is based on fractional banking. This, along with the Federal Reserve (I will discuss the Federal Reserve in another article) play an important role in the value of our money, the dollar. It also has a significant impact our wealth (both personal and as a nation). To make better investment and business decisions, and to steer our nation to prosperity, we really need to know how both of those systems work.

  

Fractional Reserve Banking

The way a bank operates is like this: You deposit your money into a checking account, say $1,000.00. The bank then shows the deposit on the asset side of the balance sheet (I'll go into how a balance sheet works in another article. Suffice it to say here that it means the bank views your money as their money. You can read about it here: Murray Rothbard: The Mystery of Banking, page 92.). This is the bank's reserves. The bank then can (and does) take that deposit and lends 90% of it to businesses, individuals, and whoever the bank deems credit worthy. In the process the bank charges interest on the money lent, and it is usually a very long term note, such as 15 or 30 years in length. Below is an example:

                                                                              Bank

Deposit: $1,000.00                                                                  Loans: $900.00
                 

Because the bank has $1,000.00 of hard money (money earned by the depositor through the sweat of his brow or his investments. In the beginning and to a certain extent now, it is gold...hard money), and will then lend out up to $900.00, leaving $100.00 in reserves. So far, so good. There is still $1,000.00 in the banking system. What happens next? The borrowers of the $900.00 will then deposit it in a bank and spend the money they borrowed into the economy to buy items for their business (or if it is a consumer loan, to buy a car, vacation, etc..). The deposits made into these banking institutions will then be lent out as well leaving 10% in reserves, whereby these loans are then deposited as well. So following the line of money a little bit looks like this:

• First deposit:                                $1,000.00               Loans: $900.00
• Next set of deposits:                     $900.00                  Loans: $810.00
• Next set of deposits:                     $810.00                  Loans: $729.00
• Next set of deposits:                     $729.00                  Loans: $656.10      

This can go on for quite a while. Here is what happened. After the initial $1,000.00 deposit, the banks added another $2,439.00 in the system. How? It created money out of thin air. The banks created "notes"  to represent a claim. On what? That is a good question. It used to represent a claim on gold or other precious metals (although the gold above a certain amount does not exist from fractional banking), but now that we are off the gold standard (Thank you Richard Nixon. He took us off of the last remnant of that in 1971), it is simply a claim by the U.S government that it has value. At close view, the money system seems a little funny. After all, essentially creating money out of thin air just because a bank has some hard assets to back it up? Doesn't make a lot of sense, does it? How did it come into being?

A Little History

I will come back to modern fractional banking and the pros and cons of it below. But let's first take a look at how it developed in the first place.

Fractional reserve banking started around the 17th century in both Britain and the Netherlands. People during that time used the goldsmiths to store their precious metals, and in return would be issued a receipt for the metals they had deposited. Over time, these receipts would be used literally as money itself, for it was easier than having to go to the goldsmith to get the gold, then go and pay for items with said gold. After all, the receipt represented the actual gold itself. The goldsmiths observed that, at most, 10 to 20% of the receipts were ever redeemed at one time, so they started printing more receipts than they had in gold. This they used for lending out to people as loans whereby they would charge interest. Thus was the beginning of fractional reserve banking. It would seem to be an illegal operation because by printing more receipts for gold than they had in gold is fraud. The receipts are basically worthless. So how did it become the legalized institution it is today? By court order. There was a case called Foley v Hill and Others in England in 1848 that actually legalized it. Here Murray Rothbard lists the exact verbiage:

Money, when paid into a bank, ceases altogether to be the

money of the principal; it is then the money of the banker,

who is bound to an equivalent by paying a similar sum to

that deposited with him when he is asked for it. . . . The

money placed in the custody of a banker is, to all intents and

purposes, the money of the banker, to do with it as he

pleases; he is guilty of no breach of trust in employing it; he

is not answerable to the principal if he puts it into jeopardy,

if he engages in a hazardous speculation; he is not bound to

keep it or deal with it as the property of his principal; but

he is, of course, answerable for the amount, because he has

contracted.

So there you have it. The general origins of fractional reserve banking and the legacy of our monetary system. There is quite a lot of controversy as to whether it is or isn't a good system for economic growth. Let us examine the pros and cons.

The Case for Fractional Reserve Banking

The main argument for the use of fractional reserve banking is the multiplier effect. This, in essence, means that by increases in the money base above the stated reserves, the overall wealth of a country increases. The rational is that by adding more money or credit to the system, more loans can be made to businesses and new start ups that can create more and better products. As an example, a farmer can approach a bank and get a loan to buy a machine that can harvest 1000 plums as compared to the farmer only able to pick 100 plums in the same amount of time. By increasing the plum output, we as a nation are better off...more wealthy. By persuading individuals to store their earnings in a bank (as mentioned above, it first meant the the storage of gold and later on, dollars), the banks are now able to use it to increase wealth. This argument also states that if someone holds onto their gold (say that the person is a hoarder and buries it), it is not wealth. That it really represents nothing, and it certainly is not put to good use.

The Cons of Fractional Reserve Banking

There are, however, some serious issues one must consider in relation to fractional reserve banking. First of all, it is fraud. If you deposit your money into an account, it is a demand deposit, meaning that you should be able to withdraw all or part of it whenever you want. After all, it is your money. But in reality only 10 or 20% on average is actually in your account. The rest is loaned out. It is not there. Second, it is inflationary. Arguments go back and forth as to whether inflation is good for economic growth or not (I'll address this another time), but suffice it to say that inflation in and of itself eats into your savings. Your savings will lose value over time, thus lowering your personal wealth. Third, the banks almost from the moment they open their doors are insolvent because of fractional reserve banking. If everybody decides that they want their money at the same time, the banks will go out of business. The depositors will lose their money. This is known as a bank run. It happened very often before the advent of the Federal Reserve. Why doesn't it happen today? Because the Federal Reserve will lend banks money to pay depositor demands. How? Printing money out of thin air. This in an of itself seems a bit funny to me. It certainly makes one question the real value of the dollars they are holding on to. Fifth, the banks are taking your deposits and using it for loans on their books. They are putting your money at risk, but you get no return. In other words, your money is working for the bank. It gains profits, and if they lose money they get bailed out by the federal reserve. You do not. Sixth, it creates distortions between economic growth and actual wealth. Increasing the money supply will inspire entrepreneurs to take on more risk to grow businesses, but if the individual's savings and personal wealth doesn't keep up, it eventually leads to excess businesses closing and a contraction of the money supply (in a nutshell, a recession and potential depression).

The Alternative

Economic growth can happen in a sustainable way without fractional reserve banking. For one thing, demand deposits should be treated as demand deposits. They should not be lent out. The banks can make money by charging a monthly fee for the checking account. In truth, it is similar to an institution that stores gold for an investor. They store it for safe keeping and charge the appropriate fees to run at a profit. Now what banks can do to get investment capital for loans is offer investment vehicles for customers whereby the customer will lend their money for a given period of time to a bank for rate of return. This way a bank can lend out that money and make a profit for itself and the the individual that lent his money to the bank. This is what a CD is for. Banks and investment institutions can design any number of investment vehicles to suit market needs.

Denouement 

There are many other aspects of our monetary system that must be addressed for our prosperity. For example, it would be very beneficial if we allow free banking and get back to a gold standard for our money supply, but the fractional reserve money system needs to be changed as well. As explained above, there are many problems with fractional reserve banking. Left unchecked it plays a major role with inflation, recessions and depressions.
On a personal level, we can keep most of our wealth out of the banking system. At the very least, one can keep low balances in their checking accounts. This makes it harder for the banks to leverage up their balance sheets. We can also store our wealth in precious metals. The value of gold and silver will not go down due to inflation like the dollar will. I believe that if the majority of people get into gold and silver, the money system will have to be changed. It can bring back a gold standard. And finally, if we all do a better job of researching investment vehicles and other opportunities, we will be better off as a nation.

Nobody Understands Debt?

Paul Krugman is a well known economist that writes for the New York Times. He has recently written an article about how nobody really understands debt, and that the leaders of the United States may well make bad policy decisions because of it. Common sense tells us that when we take on debt, we have an obligation to pay it back. Furthermore, making payments on that debt takes money away from something else we can spend it on. Makes sense, doesn't it? If I buy a car and take on payments of $300.00 a month for 5 years, that is $300.00 less a month I could allocate elsewhere. If I take on too many loans, my monthly obligations can get very hard to make. By servicing these loans, I cannot spend that money elsewhere, or more importantly, save a good portion for a rainy day. I would be treading on thin water. Would it be any different for a government? Paul Krugman says yes. Here he explains it:
    

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.
Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.

Point 1. Families have to pay back their debt, but government does not? Why not? The people holding those bonds...those pieces of paper saying the government will pay them back are expecting to get paid back. The real difference is that the government has tools, nay trickery to pay back the debt instruments that a family does not, mainly the printing press. If worse comes to worse, they can print up more money to pay the debt. If a family tried to do that, they would get arrested and thrown in jail for fraud (BTW, the government printing money without backing and using it to buy things is also practicing fraud...the difference is it is legal for them to do it). So, in essence, the lenders to our beloved government will get paid back in dollars that are worth less than they bargained for.  
Point 2. An over borrowed family owes money to someone else, but the U.S. debt we owe to ourselves. Boy, to this day I have a hard time wrapping my head around that. How can you "owe it to yourself"? Let's say a family decides to borrow $10,00.00 from itself to buy a car. How would the family do it? The only way it can be done is if the family had the $10,00.00 in the first place. In essence, from it's savings and investments. Then the family could "borrow" the money from itself by writing a promissory note for the amount, monthly payments and interest over a given period of time. How is it different with the government? It isn't. The government borrows from individuals (you and me and whoever buys the bonds). It borrows from people who saved their money. These people expect to get it back, plus interest. Otherwise they would not have lent it to the government. What is important to make clear is that "we" do not owe it to ourselves. The government owes it to individuals and other institutional investors. There is no "we" in that mix. 
Paul Krugman is a Keynesian (an economist in the 1930's that basically says the government needs to go into debt to "prime the pump" when the economy is in recession, and that national debts do not really matter). Keynesians think that you can get something for nothing. All it takes is for the government to step in go into debt or print money to keep things going. This is flawed thinking. It does not matter if we are talking about an individual, family, business, or government. Economic fundamentals still apply. Debts do matter. They are easy to understand both on a micro and macro sense. Do not let someone like Paul Krugman talk you out of your common sense.

His full article is here. Nobody Understands Debt. 

What will it take to see real wage increases?

Here we are in 2011. Unemployment is high. Real wages are down. Way down. According to Bill Bonner and Addison Wiggin, the average man earns less per hour worked now than he did in the Carter years. You add inflation and taxes to that and it is no wonder people have a hard time making ends meet. To fuel our nation's woes even more, we have the highest unemployment rate since the great depression. Things are not looking good. Workers are are wanting, nay, demanding higher wages. The call for more unions and higher taxes on the rich are now in vogue. Many people like the idea of the "stimulus" programs implemented by the government, a la work programs of the last depression. Can it work? Will all of this prevent us from another depression? What really leads to higher real wages?
Bill Bonner and Addison Wiggin address this issue in their book, "The New Empire of Debt, second edition".

Real wage increases require three things: First, the society must save money so that it has the capital to invest. Second, it must invest the savings into profitable businesses. Third, these capital investments must result in increased productivity.

So how are we doing on these three fronts? Again, Bill and Addison explain:

Alas, none of these things happened. Instead, these three critical things began trending in the wrong direction. National savings-including public savings-fell from 7.7 percent in the 1970s to only 3 percent by 1990. Business investment fell from 18.6 percent of GDP in the 1970s to 17.4 in the 1980s. And productivity? In the 25 years after World War II, output per employee had risen at average rate of 2.8 percent a year. During the 1980s, this rate fell to less than 1 percent.

I want to add more to these insights. By the 2000s, the savings rate went into the negative. Obama and the current administration put into play the stimulus package that cost over $700 billion so far, and he has plans for more. Setting aside why this happened (a lot had to do with manipulated interest rates, the federal reserve, and government policies; all of these topics are for other blogs), we have made poor decisions regarding our finances.
So where does that leave us? In trouble, that's where. Before we can even consider increasing wages, we have to increase production. Before we can increase production, we have to increase savings.
Right now our GDP is made up of only 30% production (making more "stuff") and 70% consumption. 70%! How can we do this if we have lower real wages and high unemployment? We can't...unless we go into debt to pay for it. This we have done. Since we went off the gold standard in 1971, we have been living beyond our means (once again, we did this both individually and as a nation). This lavish living caught up to us. We are starting  to see it in lower real wages and the loss of employment.
Debt doesn't build wealth. It does not build capital. It ultimately acts as an anchor on any individual, business or nation that wants to increase growth.
As near as I can tell, the policies we need to follow to get us out of this slump are not being done. We are still spending way too much. We are not saving. The United States is looking for a quick fix to solve the problems, when what we really need is to get back to work, even if it means accepting lower wages for now, save, reinvest the savings into capital goods (manufacturing), and work toward the future. If we do what is required, we will head the right direction...but it will take time. It will take years if we start now. Every month or year we put it off, the longer and harder it will be.
       

   



            

Moral Hazard and the Taxpayer

Moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.                        Wikipedia

In a free market capitalist economy, greed is counterbalanced by fear. Everybody is greedy (we all want to improve the quality of life for ourselves, our family, and close friends), and most of us do it by working for an income, getting an education in a trade or skill to get better pay, by starting a business that produces what people want to buy, or investing in an enterprise that can pay back interest. All of these endeavors ultimately improve the quality of life for everybody. The problem arises when this greed is not counterbalanced with fear. It would lead individuals to take on riskier, often fraudulent activities. Let me use an example to explain my point. Suppose an individual had $10,000.00 to invest. He would be cautious who he would lend it for he could be devastated financially by losing all of his investment. He would do his due diligence to see if the borrower had a good business plan, reserve cash or assets for collateral, was credit worthy, and the lender would charge an appropriate amount of interest associated with the risk he would be taking on by lending his money to this individual. He most likely would invest in a pretty sure thing, and will most likely get a conservative rate of return for his investment. Now let's add another factor. Let us assume that the investor has a rich uncle who tells him "If you lose the money you invest, don't worry about it. I will pay you back the $10,000.00 you lost".  How would the investor behave now? He would most likely take a bigger risk chasing a bigger reward. He would be less likely to do his due diligence on the creditor. He would increase his probability to lose all of his investment. After all, it doesn't matter if he loses it. He still has his $10,00.00 one way or another. His uncle, on the other hand, will most likely lose his money (that crazy uncle). The fear of loss is taken out of the equation for the investor, and greed plays a bigger role in his decision. The scale of greed/fear is out of balance. Greed goes on a tear.
So what does this have to do with the recession (great correction) and the wealth inequality unfolding in the United States today? Plenty. It is giving capitalism a bad name. It is privatising the big gains made by financial companies while socializing the losses to the taxpayer. What is worse, it is happening to the tax payer without him having any say about it. Unlike the rich uncle in the above example, the taxpayer is not rich, nor did he choose to have his money used through moral Hazard.
The New American has a story on how it happened in 2008.

The Federal Reserve Bank committed some $7.77 trillion in funds to major Wall Street banks during the height of the 2008 financial crisis, according to a report published by Bloomberg News November 28 through a Freedom of Information Act request.

Got that? 7.77 trillion loaned to Wall Street, courtesy of the Federal Reserve. Why? Because these big institutions made risky loans and needed to be bailed out or the whole financial system will fail (so they say). Where does the Federal Reserve get the money? It prints it (more on that in another blog). Who ultimately pays? The tax payer, both through inflation and taxes. This is moral hazard. The article goes on:

Bloomberg noted that most of the major banks receiving the below-market-rate loans made billions in profit from the Federal Reserve policies. The Federal Reserve Bank loaned funds to major Wall Street banks at rates of between 0.10 percent and 0.25 percent and at the same time banks were encouraged  to purchase U.S. Treasury bills. Two-year Treasury bills the federal government was selling were fetching more than one percent interest. The deal — borrowing at a discounted rate from one agency of the federal government and taking loans earning interest at a higher rate from another agency of government — amounted to a cash transfer from the federal government to the big banks that Bloomberg estimated netted the banks some $13 billion in profit.

So, not only did the banks get bailed out from making risky bets through moral hazard, they then turned around and bought Treasury Bills from the same government for profits of 13 billion plus. It sure is a nice gig if you can get it, but it is fraud, pure and simple. The precedent for this type of moral hazard, in which the government bails out financial institutions can be traced back to at least the Savings and Loan scandal in the 1980's. The came along Long Term Capital Management in the 90's, and finally sub prime mess. Another factor that loosened up the purse strings for big bankers is the fact that the big wigs alternate between working for the big banks and working for the government, kind of a revolving door policy. A very clear conflict of interest.
One of the problems I have with big government is exactly this. Moral hazard that cannot be kept in check. When we get taxed, we lose control of what we want to do with that money. It no longer is ours. We have no say. We are supposed to live in a representative democracy, and with that people assume taxes collected upon the citizenry will be used for the "public good". The call for more taxes because we need them for social programs, to protect our country, etc...pull on our heartstrings, but is it really for our best interest? Can it ever be for our best interest? What if, instead, we were only taxed 5% of our income and that is all we can be taxed? What if we had a sound money system that did not allow for the printing of money out of thin air? Well, we would be able to say no to the big banks. I do not want to bail you out. You are financially insolvent, and I don't want my money to be wasted to keep you alive. The banks then would have to behave differently. They would have to be more fiscally responsible with the money they do get. They need to have a positive cash flow statement and strong balance sheet, or they would go out of business.
This is sound business. Everybody would benefit. The banks would practice sound money storage and lending, our money would retain it's value, and more importantly, big bankers could not fraudulently make profits hand over fist on our dime with us taking on the risk. The greed/fear scale would be in balance.
Moral Hazard is pervasive, both in the public and private sector. The difference lies in the fact that in the private sector, moral hazard can be detected sooner and rectified easier. The investor simply can stop investing with the organization in question (as a matter of fact, this is the primary reason for bank runs. Bank runs, or the threat thereof are actually a good thing. It keeps bankers honest more so than regulations ever can). In the public sector, not so much. The politicians can override the wants of the majority (and often do).
The Occupy Wall Street movement is right in that the bankers are to blame for the mess. They did get the bailouts. But the solution they want is for more regulation and taxes. The OWS don't realize that the government played a big role in this form of moral hazard, and that the solutions they propose will not change that. The best thing we can do is fight for sound money (getting rid of the Federal Reserve), free competition with banking (for example, we can have state banks and private banks that offer their services on the open market along with the federal banks and other financial institutions), and roll back taxes to a reasonable level. This gives people more freedom to choose where to store their wealth. These measures, although will not completely eliminate moral hazard (nothing can), will keep it in check. There would be better prosperity for all.
For reference, here is the article in The New American.

The Cash Flow Statement: An Examination

     The example above is a basic cash flow statement. All businesses have one. It reveals the bottom line. In essence, what works...and what does not (as a side note, a state, nation, and individual has a cash flow statement and balance sheet that follows them wherever they go...whether they realize it or not). So let's take a close look at what the businessman uses as a tool to guide his decisions, shall we?

1. The sales. This is money coming in from the selling of the product or service that the business offers. This is where the individual (read consumer) has the most power. If he or she does not buy the product, the company goes out of business. In a free market, this company has to woo the customer to buy...and keep buying. The organization has to keep improving it's product or service to stay in business. Many factors come into play. A competitive price, quality, better service, a specialty serving a niche, etc... They all play a role in better sales.
2. Expenses. As you can see, there is a laundry list of expenses. The common term is "the cost of doing business". Expenses add up. A little here, a little there. The next thing you know, there is not much left. I'll break these down a little later.
3. The profit...the bottom line. This is what is left after income minus expenses. This example shows a profit of 5% for the month, and a profit of 10% for the year. The profit is what goes to the owner(s) of the business as dividends. 

     For starters, a business has to run at a profit. If it does not, it has to close the doors. This is so important, I'll say it again. A business has to run at a profit. If it does not, it goes out of business. If it has a cash reserve or a line of credit, it can run in the negative for a while. But it cannot do that forever. Sooner or later, it has to run at a profit. Most businesses in most industries run between 5% to 10% profit over a long period of time. In other words, for every dollar a business brings in, 10 cents is what the owner(s) keep. So let's play with the balance sheet above to see what a business owner has to do faced with certain situations.
     Let us start with payroll. This cash flow statement shows wages paid out for $10,000 of sales at $2,500.00. Along with that, the business had to pay payroll taxes of $600.00. This makes it a grand total of $3,100.00 for the business owner to pay for labor on $10,000.00 of business. Let us assume that the owner has 2 employees working for him. The numbers will break down as follows:

• Monthly take home pay  $1,250.00 per employee.
• Taxes.
• Social Security taxes paid by employee: $87.50.
• Social Security taxes paid by employee on behalf of employee: $87.50.
• Other employee taxes: $112.50.

     I want to point something out here. The total taxes paid per employee is $462.50. This total comes from the sales brought in by the company. It does not come from the profits of the business. Remember, it is part of the expenses of doing business. So in this case, taxes taken out from the business could have gone somewhere else if, say, he did not have to pay Social Security taxes. He could have (and most likely would have) paid his employees more in wages for the labor performed. If you add in the 15% total the employer had to pay SS to bottom line wages, the business owner could pay his employee an extra $350.00 a month. Let me ask you, would you make better decisions with what you would do with your money than the government with the S.S. mess we have today? Would it be easier for you to save for your own retirement than what S.S. is doing with your "retirement?

     Let's take the tax situation further. Progressives call for more taxes on corporations. They think businesses are "too greedy", so they need to pay. Well, let's look at the cash flow statement again. This particular example does not show the business paying corporate taxes, but they do. Right now, the corporate tax rate in the United States is 35% (by the way, that is the second highest corporate tax rate in the world. Japan is the first). To veer off course a little bit, I need to clarify between a sub S corporation and a C corporation. A sub S corporation is usually used for a small business in that both the personal and business taxes run straight through to the bottom line. A C corp is set up to where you have share holders, and because of the arrangement (a C corp is usually formed for a big business), the corporation pays it's taxes, and then the shareholders get taxed on dividends. In essence, the owners get taxed twice. Now let's take a look at what happens to the cash flow statement. After all the expenses it takes to run a business, the company now has to pay 35% from the profits. In this case, the bottom line profit is $500.00, so 35% of that is $175.00. This leaves a total profit of $325.00. In this example, after all expenses are paid...and taxes...and working to bring in sales (and most likely the owner working long hours), he gets to keep $325.00. Tell me, how motivating is that?

     Now let's examine minimum wage requirements on the cash flow statement. Once again, progressives make a strong case that a business must pay a "living wage", whatever that is (mostly determined by bureaucrats that have no business sense). In this example, the 2 employees are earning $12.91 an hour (assuming they work a 30 hour week). Admittedly, this is a reasonable wage, but let us say that the powers that be decide that each worker now must be paid $15.00 an hour. What would happen? This:

• Total wages paid would be $3,600.00.
• Total Social Security paid would be $540.00. 7.5% from the employee, 7.5% from the employer.
• Total taxes now paid would be $765.00.

     With the new, higher wages added to the expenses, the total expenses now paid is $10,000 for the month. Since the increased wages did nothing to improve the bottom line (in essence, the workers get paid more for the same amount of production), the owner now makes no profit at all. He breaks even for the month. Suppose that the following month he only sells $9,500.00 worth of goods. He will lose money, but because of the new law he still has to pay his employees the same wage. It becomes very evident that this cannot continue. What are the choices for the business owner? He can fire a worker and try to get by with less help. He can try to increase sales, but that would come with extra costs associated with it. He can try to raise prices on his product. That's about it. If he raises prices too high, consumers will go somewhere else or stop buying the product altogether (or cut back on the amount he or she buys). If he cannot make the necessary adjustments and run again at a profit, he will close up shop. After all, nobody wants to work for free, and just as importantly, investors do not want to lose money or take big risks to break even.     

      Next let us examine the effects of government regulations on the cash flow statement. We'll use just one example. Let's say the EPA (Environmental Protection Agency) determines that to produce the widget this company sells causes a lot of pollution. The cash flow statement above shows purchases made, meaning this organization sells the final product. It does not make it. The EPA then imposes strong pollution requirements on the company that produces the widgets that it has to meet. By doing so, the cost to produce the widget goes up from 20 cents to 50 cents. Here is what would happen. Since this particular company buys the finished product to sell at the retail level, the outcome will be as follows:

• Before the price increase the company can buy 15,000 widgets for $3,000.00
• After the price increase, the company must pay $7,500.00 for 15,000 widgets.

     Back to the cash flow statement. If it now costs $7,500.00 (up from $3,000.00) for the same amount of widgets and the total income sales is still $10,000, then the company will run at a loss of $2,500.00.
As noted above, how long can a company run at a loss? Who would want to invest in a company that runs at a loss? The only thing the company can do (and hope to still  have customers), is to raise the price. It is passed onto the consumers. 
     These are just a few examples. A real business has to deal with much more, such as workman's comp, unemployment insurance, occupational "privilege" tax, and so on. Every time the government adds more regulations, taxes, and any other such demands, it makes it more difficult for the enterprise to keep going. If these restrictions get too strong, the business cannot continue. That means jobs are lost. That means there are less products or services offered. It means a lower standard of living for everybody. Personally, I believe that this is the main reason the United States is losing it's manufacturing base. The labor unions, although they did much good initially, pushed for too many benefits for the employees. The United States government in an effort to improve working conditions and lower pollution output went too far. Both of these actions over time has changed the employment landscape in the United States. I am also afraid that it would be difficult to reverse it. It would take concessions in wages and benefits, along with a roll back on regulations to bring it about. In short, people are going to have to be willing to roll up their sleeves, accept that they will have to be paid lower wages for work performed, work hard and save more than they spend to rebuild our nation's capital base. Our manufacturing base can then be rebuilt and we can finally see an improvement in wages and our quality of life. This will take time. A lot of time.

Fiat Money: A Critique

Now let's examine Fiat Money. Let us compare it to the five traits of sound money:

1. Divisible. Yes. It is denominated in pennies, nickels, dollars, 5 dollars, etc..
2. Portable. Got that too. Mostly paper and light.
3. Durability. Sketchy there. Made of paper. It can easily get torn, burned, etc.. 
4. Recognizable. Absolutely. The dollar is known around the world.
5. Scarcity. Oops. Not here. The government can print as much as it wants, or lately just hit a button on a computer.

Fiat is a Latin word meaning "let it be so". In other words, by government decree. This is not free market money (more on that below). By law (legal tender law), the dollar is supposed to be used for trade and to pay taxes (in other words, the government does not accept, say, gold or silver for payment), nor can there be competing monies. By doing so, the government actually has, by decree, created a money monopoly. From this monopoly, the Federal Reserve (which is privately owned, by the way), creates dollars and charges interest to the government. Say what? I know. It sounds crazy, but it is true. For the most part, the system seems to work well. After all, the United States is the wealthiest country in the world, right? That is debatable (and a blog for another day), but here I want to focus on the unintended consequences of Fiat Money. What does Fiat money do?

• Increase the welfare, warfare state. Since fiat money is created out of thin air, the government can have as much produced as it wants (it claims it needs). Government representatives get elected on promises to it's constituents, who always want something from the government. Be it big military contracts or social programs, they all want something from their congressman.
• No accountability. These programs cannot come into being, or if they do, get out of hand if we had to pay from them from the collective labor and wealth of the citizenry. In other words, the government would have to prioritize where to spend it's limited funds.
• An increase in the rich/poor gap. The people and organizations that are closely connected to the money supply get first dibs before the new money circulates in the economy. They get to buy the goods and services before the prices go up to reflect the new money. The ones further down the money spigot have to pay higher prices before they get the increased money. In many cases, wages do not keep up with the inflation. And those on fixed incomes? They are the worst off. Their incomes do not go up, but prices do. This leads to a lower quality of life for all except the well connected. Who are they? Bankers, big corporations, politicians, and big contractors that bid for government work among others.    
• The business cycle. The "elastic" money we have is the primary reason for our booms, recessions, and depressions. It is called "the business cycle". I will devote a full blog on this in the future. 
• Ultimately, I believe, we will see a collapse of the financial system, dragging the economy (and the middle class) with it. 

Every single one of these problems are the cause of inflation from the fiat money system we have now. Fiat money, since in my opinion it does not store value, is not money, nor should it be called money. It is a currency. It works as a medium of exchange, but it is so flexible you cannot count on it to store your wealth long term.

The use of fiat money has problems. Big problems. So far the powers that be have been able to kick the problems created by fiat money down the road. The problems did not disappear. They are bigger. They are like a wave that keeps getting bigger and bigger. Eventually it will it us, and there is nothing that can stop it.


What do I mean about "free market" money? easy. It is money that comes into use organically by people in the market. In other words, the state does not create nor own it. It is what we choose is money. It would show the five traits listed above, and most importantly, it cannot be created out of thin air. It would represent the true value of stored labor that can be used for capital formation (more factories and better tools for use in production), and sustainable economic growth.

Here is a 5 minute video that explains what fiat money is very well. I encourage you to watch it.

FIAT MONEY

What is sound money?

Sound (or honest) money have 5 characteristics. They are;

1. Divisibility
2. Portability
3. Durability
4. Recognizability
5. Scarcity (high value in relation to volume and weight)

The first one, divisibility, is important as a unit of account. You need to count things. "It takes 5 of these to get one of that, etc". Portability is for convenience. If it too big or hard to carry, it loses some of it's appeal. Durability is also a necessity. It if wears out or rots, for example, you would have to keep replacing it. Recognizability plays a role in that it is something usable that everybody understands. Let's say someone wants to pay you for your service in a special colored stone from Russia, how much value does it have? Would somebody be willing to trade you his car for it? It needs to be recognizable. The final feature that money needs is scarcity. Why? Quite simply due to supply and demand. The more there is of an item, the less it is worth. As an example, if we as a society decide to use rocks for money, anybody can just pick up a bunch of rocks whenever he wants to buy something from someone else. It does not have value. It is easy to find and use. It would disrupt trade. These are the five characteristics make up sound money.
Why is this important? Because free trade, the division of labor, personal wealth accumulation and higher standards of living count on it.


A little history:


Primitive society started more or less on a barter system. If a hunter landed a buffalo and had more meat than he needed, he could trade a portion of it for some fruit another tribe member collected. Other members may have been better at building housing or clothes, or maybe performed the function of collecting berries. They would trade with each other and with other tribes. This is the beginning of specialization of labor. Some would be better than others at certain tasks. While trade and bartering took place, there were certain items that began to be used as a medium of exchange, thus the first forms of money. The more successful forms of money displayed the 5 traits listed above. An important intrinsic feature of sound money is it's value. It is a way for an individual to save more than he produces for his own use either now or in the future. What was used? Money took many forms. Sea shells, salt, cattle, bear claw are some examples. The most common and enduring forms of money have been gold and silver. These precious metals best displayed the aforementioned five traits of sound money.


And Now?


Now we have what is called a fiat currency. It is paper notes printed by the government and decreed by the government that it is money. At one point, paper money used to represent sound money in that at any time, you can turn in the note to a bank and get the note's  value paid to you in gold or silver. In other words, it was backed by something other than the good word of the issuing government. Is a fiat currency good? No. It has plenty of flaws that lead to big economic problems. That, however, is a blog for another day...