This is your Money and Financial Management Series…but with a twist. My name is Smithy, I’m from the land of Oz.
Introduction
In response to the growth in business and personal finance shows at most media outlets, including so-called public media, such as NPR and PBS, we bring you this new series on money but “with a twist”. In this series we will look beyond the latest DOW and NASDAQ ups and downs, and past the hot stock tips, and see just how peculiar and undemocratic our monetary system really is. The Wizards of Money will take a critical look at the mechanics of the capital and debt markets, who makes the critical decisions that drive them, and how these markets then effect everybody’s lives.
Humans have inherited a monetary system that fueled the industrial revolution, lost its commodity backing during the Vietnam War and now travels by the trillions, over millions of miles in a matter of nano-seconds. Physical currency notes are almost irrelevant having been replaced by a system of bits and bytes accounting in complex networks. While money is just a highly abstract measure and a medium of exchange our lives revolve around it and its disappearance can bring trade to a grinding halt, collapsing whole communities. This ridiculous situation is akin to a carpenter stopping work because he has run out of inches! Or a musician calling it quits because she’s run out of decibels!
Today, in part one, we’ll examine that most peculiar activity known as “making money”; how money is made and who makes it. We’ll explore the mysterious money making process by first exploring the origin, and role of, one of the most secretive bodies in the world, the Federal Reserve System. We will also look at the role of the commercial banking system, and why it is that the money origination process is quite unfair and undemocratic.
In future editions of Wizards we will look further into the workings of the Federal Reserve, and its sole shareholders, the private banking industry. We will also investigate similarly secretive bodies such as the Bank for International Settlements in Switzerland, the World Bank, the International Monetary Fund, Central Banks in other countries, and most importantly how these institutions interact with the stock markets.
Recent decades have brought with them a growing public awareness of the long-term costs of the short-term profiteering legacy of the industrial revolution. Global Warming, Ozone Depletion, and Acid Rain are now all household names. The current monetary system – the one inherited from this same industrial revolution and the one in which we always “discount the future” – has played a large role in such destruction of the environment. Many are asking the question – Can we design monetary and economic systems that encourage preservation of the environment and sustainable economies?
Along these lines, in later editions of Wizards we’ll examine some of the fundamental flaws of contemporary mainstream economic theory, that led to such environmental destruction. Then we’ll explore how emerging fields of economics, such as Ecological Economics, are addressing some of these flaws and challenging the underpinnings of traditional theory.
Why this Name for the Series?
The explanation of this will provide a good historical framework for this series, and remind us of a time a hundred years ago when the American citizenry had a much better understanding of their national monetary system and demanded active participation in it.
Today, however, for reasons that can only be speculated on, the majority of world citizens have very little understanding of how the international monetary system works. Yet in this day and age our lives are largely determined by our relationship to, and we are highly dependent on, the international monetary system.
When you live and work amongst something day in, day out, you take it for granted. Just like fish surrounded by water, many people seem to have stopped questioning the foundations of the monetary system and go through life unaware that these foundations may be on very shaky ground. Additionally those of us who work in finance have been “trained” to understand economics and finance in a certain way, often blinding us to new ways of looking at money. Many activists request reform and more economic fairness within the existing monetary system. However there is evidence to support the position that problems of economic inequity are rooted within the monetary system itself.
The name of this series, the “Wizards of Money” is derived from the title of a book written just over 100 years ago, called “The Wonderful Wizard of Oz”, by a journalist named L. Frank Baum. Many believe this book to be a social commentary of the times. One of the most contested issues of the era was the monetary system and whether America should stay on the gold standard or move to a bi-metallic standard (meaning gold and silver). Gold would benefit the already rich and powerful financiers of the northeast, who owned most of the gold, such as JP Morgan and others. The bimetallic standard would make money more available to farmers and regular workers and was backed by the Populist movement of the time. The monetary system was such a popular public discussion item that talks on this issue drew crowds of ten of thousands from across the country. Interpreters of the “Wizard of Oz” have suggested the following meanings of characters and places in Oz:
- Oz, short for Gold Ounces, is probably short for the Gold Standard.
- The Wizardry in Oz may refer to the mysterious money making process itself.
- The YELLOW brick road to Oz, is probably the way to the gold standard.
- Emerald City is likely another word for WALL STREET, where the wealthy financiers who owned most of the gold were based, and where green glasses (green for money) were worn.
- Dorothy’s shoes in the original book were SILVER, not red as in the movie, and likely represented the other component of the bimetallic standard.
- The man operating the Wizard possibly represents the financiers behind the presidential candidate at the time who favored the Gold Standard. This candidate was William McKinley.
“Wizards” of Money, as in Oz, is a most appropriate name for those who are responsible for the mysterious money making process today. In this process, as we shall see, money is essentially created “out of thin air”. It is only the Wizards who get to practice this art, and they do so in the absence public scrutiny which might ruin the magic.
The other main characters of Oz also have counterparts in US society at that time, that is, at the start of the 20th century. Books such as “The History of Money” by Jack Weatherford (which incidentally received rave reviews from Charles Schwab) cover this interpretation of Oz in more detail. As it turned out, the Populist movement lost, McKinley was elected president and the Gold standard defined the monetary system. But the US still did not have an effective central bank system. At the instigation of financiers like JP Morgan and his right hand men, but most of all from the sheer energy and genius of one Mr. Paul M. Warburg, that was all about to change.
The Birth of the Federal Reserve
The birthplace of the Federal Reserve System was not Wall Street or Washington as people might think. The founders wouldn’t dare hold a monetary design meeting in a place where public scrutiny might threaten the handiwork of the first Wizards. Rather the monetary system designers chose to go to a state with a proven track record of loyalty to wealth accumulation as a priority over the rights of the people. This was evident from the state’s long history of slavery, coupled with such a remarkable devotion to gold that it uprooted its indigenous inhabitants and marched them off to Oklahoma at the first smell of gold. What better place to design an undemocratic monetary system based on the gold standard? This state was Georgia, and in 1910, a special Wizard convention took place there on Jekyll Island. Duck-hunting was the excuse given for having to go there. But numerous historical accounts of this event reveal that the duck population remained fully intact and, instead, the Federal Reserve System was designed. (Examples of this account are in Frank Vanderlip’s Autobiography. Mr. Vanderlip attended the secret meeting and was President of National City Bank, which is now known as Citigroup today. Another account was written by Bertie Forbes, in a publication called Current Opinion in 1916. He went on to found Forbes Magazine. Interestingly, today the Federal Reserve Bank of Minneapolis also has this same account on its web site, so it is “Official History”).
Three years later, during the week before Christmas 1913 when several representatives were already on vacation, the US Congress slid through the Federal Reserve Act, thereby giving birth to the Federal Reserve System. Today, though the gold standard is “no more”, we still live with the legacy of that Jekyll Island meeting and some of history’s real monetary wizards, particularly Mr. Warburg. Needless to say, the system they designed had little (well, effectively no) room for public input. It has survived fairly well, with the exception of the 1929 crash and subsequent depression, because the general public trusts it. However, they do so mostly without understanding it. This is a very interesting situation to have in a so-called democracy.
In later editions of the Wizards of Money we will look more closely at the founding of the Federal Reserve System, its governance, and its relationship to congress, to the markets and to the public in general. We will just note here a fact about Federal Reserve ownership that is largely misunderstood by the general public. That is that the Federal Reserve is not a government body. It is 100% owned by the private banking system. While its governors are appointed by the President, their terms are for 14 years and the structure of appointments guarantees they represent the very best interests of the wealthy.
Misconceptions About Money
Lets start with some common misconceptions about money, and why they are not true:
Misconception 1: You make money by going to work, or by selling something.
FALSE: Nobody can make money except commercial banks (also called depository institutions) and the Federal Reserve, which is owned by the commercial banking industry. When you get paid for work it is merely a transfer of money that already exists. It was, at some time in the past, created by the banking industry for a purpose for which they saw fit to create (or really lend) money. The main reason people get a job is to get a transfer of money from people who already have some.
When we talk about money here we mean money that can be used in all transactions and in the repayment of all debts. This is what we are calling bank-money. However many non-bank types of so-called “money” raising instruments are increasingly being used by non-bank corporations to avoid direct contact with the bank money creating process. This includes things like corporate bonds and shareholder equity, which expand on the bank money supply, but all are completely dependent on, and rely on the confidence that they can be liquidated for, “bank money”. We might call this other stuff “near money”. Since, in our society, it is really bank money people seem to need for the basics of life, and these other near monies are luxuries for people that have excess, we will focus just on bank money in this edition of Wizards.
Misconception 2: Money has something to do with gold and Fort Knox.
FALSE: The monetary system used to be backed by the gold standard until President Nixon abolished the Gold Standard in 1971 during the Vietnam War. He did this because there was not enough gold at Fort Knox, KY to back all the money that needed to be created to fund the massive wartime expenditures. The axing of the gold standard backing the US dollar led to the “floating” of most national currencies, which were no longer pegged to a gold conversion standard.
This led to phenomenal growth in speculation against international currencies, which later led to massive economic and social crises in various countries that were speculated against. Examples include the Mexican Peso crisis of 1994-95, the Asian financial crisis of the late 1990s, followed by the Russian ruble crisis. Since the death of the gold standard and the floating of most major currencies we have seen currency speculation increase to an astonishing 98% of all international transactions. This means that “real economic” transactions account for a mere 2% of international transactions, and we truly live in the midst of a global casino. This data on currency speculation is derived from data from by the Bank for International Settlements and summarized in the book “The Future of Money” by Bernard Lietaer, Century Press.
Money supply and debt have exploded in the absence of gold convertibility and it is hard to make sense of what money really means anymore. Money is no longer a store of value. It is only a measure, an electronic accounting system of credits and debits, that has come to be accepted world over as the only way of conducting trade. Each day several trillion dollars travels the globe trying to attract more electronic credits for its owners.
Today’s money is not backed by gold. It is now backed by nothing at all, except our trust in the monetary system. This is ultimately a trust in those that create and control money – the commercial banking system, and its major shareholders. The statement on all Federal Reserve Notes “In God we Trust”, is perhaps the most telling statement of this trust. For, who would not trust something that appears to be so close to God?
Misconception 3: Money is Created by the Government Printing it.
FALSE: Today almost NO money is created by the government. Most of the total money supply is created by banks making loans to the non-bank public. Almost all money (more than 95% at any time) is created by the creation of a corresponding amount of debt. Currency in circulation is just a very small proportion of the total money supply and it is created by the Federal Reserve System, not the government. In truth, money is actually created “out of thin air” by the commercial banks and their Federal Reserve System.
The Money Creation Process
Having gotten some of these misconceptions out of the way lets talk briefly about the actual mechanics of money creation. Money creation happens in two main ways; First the creation of base money, which is mostly physical currency notes, created by the Federal Reserve. The second money creation process involves checking account or deposit money created by the commercial banks, and which makes up most of the money supply.
Base money, also called high powered money, is created when the Federal Reserve performs what are known as Open Market Operations. In this process the Federal Reserve injects money by buying Government Securities, which then become debt owed by the government (that is the American Taxpayer) to the Federal Reserve. And where does the Federal Reserve get this money to buy the government securities? Well, it just makes it up “out of thin air”. The Federal Reserve has no budget, quite simply because it doesn’t need one – it invents money whenever it needs it. In fact, almost all money we come by has its basis in high powered money that the Federal Reserve invented at some time in the past. Most of this base money is currency in the form of Federal Reserve Notes. The Federal Reserve then creates a spurious “liability” on its balance sheet called Federal Reserve Notes outstanding, and in return gets an asset in the form of government securities, which the public must repay through the efforts of real work. Every time the Federal Reserve creates or extinguishes base money the financial press and other mainstream media reports it as a Greenspan interest rate announcement. This is not technically correct but it does sound more palatable than saying that the Federal Reserve just made some money up or just made some money disappear.
Once this base money is created, banks can create around 10 times this amount in checking accounts and other deposits. They do this by making loans to the non-bank public. A corresponding amount of checking account money is created for each new loan. So most money is created just by bankers writing some new numbers on a piece of paper, or these days, entering some new bits and bytes in computers, since money is really now just a bunch of computer records. This means that when you go to borrow money to buy a house or car, the money is really being created “out of thin air” by the bank, and being credited to the checking account of the seller.
The bank has a distinct advantage in all this just by being a bank. For if you can’t pay the loan through your hard work, they automatically get the house, and all they did was write some numbers into the computer! From the bank’s perspective however, if you don’t pay off the loan, they would have to write down their asset (i.e. your loan) and this would effect the earnings they report. If lots of people did this the bank could go “belly up”. So you can see why they want to keep the house if you don’t pay your loan – they are taking a financial risk too, albeit one created completely out of “thin air”.
Why Money is Undemocratic
Much of the unfairness to the non-bank public of this magical money creating process – creating money out of thin air – really comes about because the general public has no input into decisions about money creation. It is only bank managers and the Open Markets Committee of the Federal Reserve Board that decide how much money gets created, and importantly, for what purposes money should be created. These decisions are all entirely closed to public input. Decisions on making new money will be based on whether a lender can repay and how much interest the lender can bring in, which is what creates bank profits. This means most money will be created to lend to people that already have lots of previously created money, and lots of advantages in life. Disadvantaged people will often be denied access to the money creating process, except under exploitative circumstances which are likely to see high interest rates and/or ultimate possession of their assets and resources by the bank. Alternatively the more disadvantaged will have to seek money from non-bank entities that have already accumulated lots of money, and this often also leads to exploitation.
What this also means is that money is not created for things most desired by society as a whole. In fact it is often created for exactly the things that society does not want at all. This includes projects that involve excessive destruction of natural resources like logging, building power plants, mining, and so forth, because the bank realizes that such projects are likely to bring back the money that will pay off the loans. It is also interesting to note that money is almost NEVER created for the purpose of providing public goods, such as education and healthcare, for such services will not pay the bank back. Rather these services depend on recycled money through the tax system. Hence it is not surprising that we have reached a situation where monetary value and social value are inversely correlated. By this I mean that a good or service with a high monetary value in the private property markets generally has a low social value. Conversely high social value goods and services generally return a low monetary value. This is illustrated in the example where public goods providers such as teachers are some of the lowest paid workers, yet currency trading is perhaps the most lucrative profession there is, and has also become one of the most socially destructive. It is reasonable to expect that this situation would be largely reversed by taking social factors and public input into consideration at the point of money origination.
It is clear that origination of money at commercial banks is undemocratic and so encourages the creation of money (or loans) for many undesirable activities. But often overlooked is the unchecked power of the Fed, the creator of Base Money. One of the best reminders of this power is then Federal Reserve Governor Paul Volcker’s hike in interest rates in 1979 that triggered the Latin America debt crisis. This came at tremendous cost to the people of Latin American countries. While the activities of OPEC, the commercial banks and various dictators, played a major role in laying the foundations of this crisis, the final push was decided at one committee meeting conducted behind closed doors. The FOMC meetings have never been open to public input or scrutiny. While summaries of meetings are posted almost immediately, the full transcripts of FOMC are not even available until 5 YEARS after the event!
It’s important to be concerned that the money origination process is not subject to democratic accountability. Many of these problems could be remedied if the public had more input into the decisions surrounding the origination of money. This requires an entirely different paradigm for thinking about money than we have today. It is a very complex problem and there are no simple answers. But at the very least it should be high on the list of topics for public debate. In addition, once you understand the process for creating money out of thin air, you begin to see that what banks and the Federal Reserve do is not so difficult after all. Some hope for better money is starting to materialize from the local and alternative monetary systems such as LETS and Ithaca Hours. These will be discussed in later editions of “Wizards”.
The “Zero Sum Game”
What is often overlooked about the monetary system, particularly by advocates of the “trickle down” hypothesis, is that it is a zero sum game, because our money is entirely debt based. The more of a positive net money balance I have, the more of a negative balance someone else has. I can put my positive balance to work earning more money, while I either sit around and do nothing, or go and work for more money. So the most likely situation for a positive balance person is that their positive balance will keep growing. Also, in the zero sum game, this means that someone else’s balance gets more negative. The negative sum person would be unlikely to get a loan to start their own business, and so would have to go work for someone that already has money. Under current wage structures and interest rates for “high risk” customers it would be difficult for many negative balance people to ever get to a positive balance position no matter how hard they work. They have the added disadvantage that they can’t put a positive balance to work earning more money. Most likely their balances will get more negative, while the people that already have money will get more money to balance out the zero sum game.
With positive money balances always earning a positive return on capital, combined with no requirement for redistribution of wealth, which is implicitly prohibited by neo-liberal policy because it eases such governmental intervention, the results are clear. The rich will keep getting richer and the poor will keep getting poorer, and the more interest bearing debt-money you “invest” in developing nations the worse (not better) the situation gets. Those that believe that the “trickle down” effect will result from investment in poorer (more negative balance) countries and neighborhoods demonstrate a very poor understanding of the monetary system. In fact they believe in something that cannot possibly materialize, and is evidenced by the consequences of investment in developing nations.
This situation is compounded by the fact that the banking system must not fail. What this really means is that the major section of the world banking sector – namely the Western financial institutions – must not fail. This would actually be disastrous for rich and poor alike, as in the great depression. To reduce risk of banking system failure (which ultimately comes from sudden loss of confidence or trust in the system) institutions such as the IMF and World Bank have evolved into mechanisms for preventing banking system collapse. Unfortunately, however, what these mechanisms amount to is transferring the cost that could collapse the banking system outside of the banking system. And these costs end up being borne by those who have the least say in the financial system. This actually distorts free markets where, ideally, investors take personal responsibility for the risks they assume. Those that support so-called free market ideology and think that today’s markets are actually consistent with this ideology are seriously misguided. They overlook the biases and distortions built into today’s markets, making them very inefficient and highly volatile.
Along these lines, it could be argued that much of the hardships forced upon the people of Indonesia and other Asian countries after the Asian financial crisis were the result of excessive risks taken by Western financial institutions in search of large returns or profits. It turned out that if these institutions were to bear the full costs of the risks they took leading up to the crisis then the whole financial system may have faced collapse. Through the IMF bailouts they effectively passed these otherwise bankrupting costs to parts of society that would not threaten the financial system, because they are not costed in its accounts. This, as usual, meant the poor, workers and Mother Nature, who form the balancing item of the biases built into today’s unfree and inefficient markets.
Ancient Monetary Wisdom
What is surprising is that this knowledge is ancient wisdom and has been recorded in the primary texts of the world’s major religions. The Old Testament of the Bible speaks of the sin of usury and the concept of Jubilee, the period eradication of all debts. Most likely this is from very similar realizations thousands of years ago.
It is ironic that the Federal Reserve Note bearing the statement “In God we Trust” is the symbol of the system that so blatantly violates the key principles of this ancient wisdom claiming to be God’s word itself.
If money is so abstract and does not store value, nor correlate with social value, couldn’t we change it to better satisfy our needs? This is what democratizing money really means – and like all movements to further democracy it will no doubt meet with serious resistance.
That’s all for Wizards of Money #1.
