"Why is fiat money a scam? Because it is grounded in the notion that it is proper to allow the U.S.  Treasury and the Federal Reserve to issue liabilities which they have neither the means nor the intention to meet. Nobody has ever offered a valid argument showing that there are defensible grounds for these privileges without counter-wailing responsibilities. There are none. Here we come up against a double standard: if an individual or a private firm tried to issue liabilities which they have neither the means nor the intention to meet, then they would be facing criminal prosecution. Fiat money is a gigantic legalized Ponzi-scheme." Professor A Fekete

If you want to better understand this fiat money scam we offer individual and group workshops on financial awareness, including monetary economics. The workshops are specifically developed to meet your particular interests. Our focus is on developing your self-directed learning. We will try not to indoctrinate you with our views, but instead we aim to boost your financial awareness.

Our focus is on teaching you to understand the fundamental concepts of wealth accumulation and then wealth decumulation.

We deal with money every day, but the process of money creation is understood by only a few. Under a regime of government money, commonly known as fiat money, there are two ways in which new money is brought into the system. The first way is money created through ‘Quantitative Easing’. The second, and more dominant, is the creation of bank deposits through the process of commercial banks borrowing short and lending long.

Fiat money creation - 'Quantitative easing'

‘Quantitative Easing’ is generally defined as the central bank purchasing government bonds without sterilising the money supply. But does it really matter when the central bank is effectively the government, so on a consolidated basis it is just buying back the bonds that it has previously issued? The answer is yes, and we will try to explain why in this article.

Firstly, the Treasury of the government issues bonds and raises dollars from the public for government spending programs.

Secondly, the central bank purchases the government bonds in exchange for the issue of new dollars. The central bank has the monopoly on the creation of new dollars. The new dollars (in the US they are known as Federal Reserve notes; in Australia they are known as Australian notes) that it creates are held as liabilities on the central bank’s balance sheet. The corresponding asset, matching the new liability, is the government bond it has purchased.

As is shown in the diagram above, the cashflows involved in ‘Quantitative Easing’ are essentially a reversal of the initial government bond issue. The dollars that the public paid to the government in exchange for the government bond are then returned to the public through ‘Quantitative Easing’ and the issued bond is eliminated on consolidation – if you assume the central bank and the government are effectively one entity. It is worth noting that these cashflows, depending on interest rates, may well not be identical. Central bank buying of bonds is likely to push down interest rates, pushing up the prices of bonds. The public is likely to receive more ‘dollars’ in the sale of the bond than they paid for the purchase of the bonds. The bond holders are effectively front-running the known future purchases of the central bank. As such, there is likely to be some increase in the dollars held by the public.

It can be argued therefore that the ‘Quantitative Easing’ in and of itself is not ‘money printing’, instead it can be argued that ‘money printing’ actually arises from government spending of the dollars that it has raised from the public through bond issuances in order to fund spending that is in excess of its revenues (including taxation).

So why do we bother with a central bank, and instead we could just allow the government to issue dollars when spending is in excess of revenues? The reason why this is not possible is that all the veneer from the dollar would be removed. It would be seen for what it is - a fiat currency. Throughout history fiat currencies have a short life time. Authorities know the history of fiat currencies such as the Continental, the Greenback, the Assignat, the Mandat, and the Reichmark. Instead, with the support of a so called ‘independent’ central bank, the dollars issued by the central bank are seen to be backed by assets held by the central bank. What we currently have is an irredeemable currency. Although it is not possible to redeem your Australian notes or Federal Reserve Notes for government bonds, there is an asset backing the note issue. This gives the irredeemable currency an aura of respectability.

However, the assets backing the note issue are highly unlikely to ever be paid back. That would require government expenditure to be less than revenues. ‘Austerity’ is not popular. When government can effectively print money, the incentives to spend in excess of revenues are too great for most.

As such, the current arrangement between the Treasury of government and the central bank is essentially a cheque kiting scheme. As explained by Professor Fekete “The Treasury issues debt which it has neither the intention nor the means ever to repay. This debt is used as backing for Federal Reserve notes and deposits, which the Fed has neither the intention nor the means ever to redeem. When the Treasury debt matures, it is paid in Federal Reserve credit issued on the collateral security of new Treasury debt. When Federal Reserve credit is presented for redemption, the Fed offers interest-bearing Treasury debt in exchange. This is a shell game and it exhausts the definition of check-kiting. Neither the Treasury debt, nor the Federal Reserve credit is issued in good faith. Neither is redeemable any more than Charles Ponzi's tickets were. They are both issued in order to mesmerize a gullible public, much the same way as Ponzi did.” Source: http://www.safehaven.com/article/19693/there-is-no-business-like-bond-business

Eventually the public will realise that Quantitative Easing is just the government printing money. Public confidence in ability of the dollar, and all other irredeemable currencies, to maintain long-term purchasing power will be lost. This is variously known as the flight into real goods, Flucht in die Sachwerte, the crack-up boom, Katastrophenhausse.

It is worth noting that to date the Reserve Bank of Australia has not undertaken a Quantitative Easing program.

Bank deposit creation - 'Borrowing short and lending long'

In its First Quarterly Bulletin of 2014, the Bank of England (BOE) released an article titled ‘Money Creation in the Modern Economy’. The paper debunks some popular misconceptions – that banks just act as intermediaries, and that banks ‘multiply up’ central bank money.

The paper puts forward the case that the majority of money in the economy is created through the process of the banking sector making loans. It argues that whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The paper says although commercial banks create money though lending, they cannot do so freely without limit. They argue prudential regulation acts as a constraint, and that households and companies who receive the money can quickly ‘destroy’ money by using it to repay their existing debt, for instance.

In the UK, bank deposits make up the vast majority (97%) of broad money, and as the BOE points out “in the modern economy, those bank deposits are mostly created by commercial banks themselves”.

The BOE report points out that “Bank deposits are simply a record of how much the bank owes its customers. So they are a liability of the bank, not an asset that could be lent out”.

The BOE also argues that “Money can be destroyed though the issuance of long-term debt and equity instruments by banks”.

The following diagram shows how the BOE understands the money creation process to work. Money is created as the buyer’s bank lends money to the house buyer. After the sale, the new deposit is held in the account of the house seller. The size of the balance sheet of the buyer’s bank is unchanged, but the size of the balance sheet of the seller’s bank is increased by the amount of the loan. This process is continued by the seller’s bank making a loan to the next person. The new deposits created from that loan may find their way back into original bank, replenishing that bank’s reserves, and so on.

IMG BOE MC.png

While we commend the BOE for bringing forward the discussion of money creation, we believe that they have not correctly identified the underlying process by which banks create money. Instead, it is our view that commercial banks don't directly create money, but they create bank deposits (liabilities to the bank) through the so-called ‘maturity transformation’ function of banks, by borrowing short-term and lending long-term. These bank deposits are then exchangeable into fiat money through the use of repurchase agreements between the commercial banks and the central bank.

The BOE example of money creation is a result of the bank creating short-term deposits (bank liabilities) backed by a long-term housing loan (bank asset). As new long-term loans accumulate on the bank’s balance sheet the bank can no longer meet its short-term deposit liabilities. The bank relies upon the short-term liabilities to be rolled-over. The bank becomes insolvent as it is unable to pay its liabilities when they fall due. The bank then becomes reliant on a central bank to provide ‘lender of last resort’ facilities in the scenario that the depositors do not wish to roll over their short-term deposits. This is commonly called a ‘bank run’, but it is really just the depositors deciding to not roll over their short-term deposits with the bank.

It remains in the back of people’s minds that a ‘run’ can destroy a bank and this probably explains why banks have traditionally traded on low price to earnings ratios (i.e. high earnings yields).

In the BOE example, but with matched maturities, the bank would issue a long-term debt instrument to finance the new loan to purchase the house. This long-term debt instrument would then be transferred to the seller of the house. The seller could then exchange the long-term debt instrument in the market with a person holding cash on deposit. Under this arrangement there would not be an increase in the money supply. Yes, there would be an increase in the assets and liabilities of the banks, but as the maturity of the house loan would match the maturity of the long-term debt instrument, there would not be any ‘money creation’.

Another simple thought experiment is if you lend money to the bank for 3-months and then the bank lends that money out for 3 months, there is no new money created. The loan is created and then repaid, and in the meantime the lender does not think he has money, but rather he has a 90-day loan to the bank. It is really the maturity mis-match that creates bank liabilities, rather than any ‘fractional reserves’ component.

This maturity mismatch of ‘modern’ banks creates risk. While the ability to create bank liabilities which are exchangeable into fiat money makes the banks an attractive place to go along for the ride, the risk is in the timing of when this mismatch plays itself out. Of course, the institutional imperative is for the authorities to protect the banks against the maturity mismatch risk – central banks, deposit guarantees, special borrowing facilities during GFC, ‘too big to fail’ etc, so that makes the ride much longer (but with a steeper final decline?)

It doesn’t seem quite right when you understand that banks create bank deposits through borrowing short and lending long, and then those bank deposits can be exchanged into new fiat money. This new money is identical to the existing money in the system. The purchasing power of existing money declines over time as the new money enters into society’s transactions. Once you understand this process, you can start to understand why housing prices in Australia have risen so sharply in our ‘modern economy’. Back in 1971, the median price for a house in Sydney was only $21,200 (source: Abelson & Chung). Now that amount might hardly cover the stamp duty!

Of course, the ‘money’ we talk about is government fiat. As fiat is just numbers (mostly generated by electronic journal entries), it is much easier for the ride to continue on. If we were dealing with gold coin, the banks would quickly be recognised as acting fraudulently, by lending out gold bank notes on gold coin/bills that doesn’t exist.