A comparatively short explanation that even members of Congress can understand.

Officials in our government assure us that they are working hard to fix our broken banking and credit systems. Do they know, though, what a properly functioning system looks like? If there was a user’s manual for our system, would they even bother to read the troubleshooting section before taking their monkey wrenches to the machine?

Unfortunately, most explanations of how banking and credit markets work are confusing. We are assured by the experts that we are working with a complex system. Brief reviews are loaded up with technical jargon. Attempts at producing user manuals usually become tomes running into several hundred pages. Even those who have spent careers studying the subject cannot say they understand how it all works with confidence.  And, there lies the key word to unlocking the secrets of banking and credit: confidence.

What our banking and credit system comes down to is a confidence game. Official explanations of how the game works are confusing by design. In the absence of imparted confusion, participants in the system would too quickly understand our modern banking and credit system for what it primarily is: a grand fraud.

Like all con games involving money, however, the fraud eventually becomes mathematically unsustainable — too apparent to cover up. The numbers don’t work. The whole system collapses as angry players figure out they’ve been duped.

A harsh conclusion? Let’s take a look at how our banking and credit system would work in a simple economy small enough to grasp. Simple means we scale down the billion ($1,000,000,000) and trillion ($1,000,000,000,000) figures and work with numbers we can comprehend. For our Austrian School economics friends we also ban the use of fractional reserve banking, which is one of the great artifices of confusion in our current system.

Our model economy has one saver, one banker, one governor, one lawyer and six producers. A total of ten people. The total money supply in the economy is $200. (For those who want to scale back-up add all the zeros you want to these numbers later.)

As our demonstration opens, our simple economy is momentarily stable (bankers and economists on their payroll would paint things bleaker and say that it is stagnant). The amount of goods and services available are constant, as is the total money supply of $200. The $200 of money (the medium of exchange for the economy) is divided up as $100 of savings in the hands of the one saver who is about to enter retirement after a successful career in business and $100 in constant circulation between the other nine members of the economy. 

At the moment our one banker has yet to open for business. He has no depositors. Remarkably, but not impossibly, like all the other members of the economy at the moment, our one governor is not in debt. He is not running a budget deficit. Note: While no debt exists, there has been an ample amount of money risked as capital investments in the economy.

Total money in our model economy can still be explained as stated above. Confusing definitions of M0, M1, M2, and M3 money supply are not required. We have simply $100 held in savings and $100 in constant circulation. The $100 in circulation buys all the currently available goods and services in the economy. Prices have been adjusted by market players to meet this reality.

If our one saver decided to live a life of leisure in retirement and simply spend money out of his $100 of savings, our stable economy has a theoretical chance to remain stable. As our saver (turned 100% consumer) introduced more money into circulation prices could remain stable if the other players perceived this new money coming into circulation as their opportunity to begin saving for their own retirements. Savings and money in circulation in the economy could remain constant. Our happy little economy has the potential to continue on in a stable, steady-state condition.

However, there is a snake in our economic garden. Our one banker is lining up his first depositor. Here is his pitch to our one saver: “Why just hold on to your $100 of savings and slowly spend it down to nothing? If you deposit your savings into my bank as a one-year certificate of deposit, I will pay you 2% annual interest on your money. You can use the $2 a year I pay you for the use of your money to live quite comfortably without having to spend away any of your $100. You can live a life of leisure and still have your $100 of hard earned savings to pass on to your heirs or favorite charity when you move on to better a better world.”

Though our hard working saver’s first reaction of, “this sounds too good to be true,” is absolutely correct, he eventually succumbs to the temptation of being able to get something for nothing. He deposits his $100 with our one banker. Our model economy has taken its first step down the path to destruction.

Remember, we started this model by eliminating the ability of our one banker to use fractional reserve banking. That is, our banker cannot create money out of thin air by lending money he does not have. However, to make our calculations simple, we do allow the banker to go all in on his loans.  He can loan 100 percent of the funds he has on deposit. No fractional reserve banking allowed, but no reserve requirements to worry about either.

To make things even simpler, we are going to take the case where in a single stroke our banker immediately lends the full $100 on deposit at his bank to a single debtor — the one lawyer in our economy. Our one lawyer has a brilliant business plan. He is going to lobby our one governor to introduce a new tax. The resulting new tax proceeds will be transfered to the lawyer as a subsidy to support additional lobbying efforts on behalf of making more laws to help our model stable economy prosper and grow.

The deal our one banker cuts with our one lawyer is that he will charge 4% annual interest on the $100 loan to the lawyer. That is, our one banker contracts to get $4 of interest a year from our one lawyer from which he can take $2 to pay the interest he contracted to pay our one saver. For a little bit of paperwork our banker has set himself up to live almost as comfortably as our one saver in retirement, or so it seems.

Over the course of the year, our one lawyer turned lobbyist consumer lives it up entertaining and influencing our one governor. He spends $96 of his loan directly into the economy and uses the other $4 to cover his interest charges to our banker.  At the end of the first year in our banking era economy, $100 of savings has been spent into our model economy with no net increase in goods and services available. Our one saver has been in retirement, our one banker, one lawyer, and one governor have created no new capital. Our six producers had another year of production just like the ones before it.

However, our economy has experienced a significant change. There is now $200 of money in circulation where before there was only $100 in circulation. More money chasing the same amount of goods and services means producers eventually figure out they have to raise prices to receive the equivalent compensation.

Because our model economy was small and understandable, the price adjustments to cover the doubling of the money in circulation are made within the same year the new money flooded into the system. As the second year opens, prices have doubled for everyone. Rather than being able to live off his $2 of interest payments as planned, our one saver discovers that he has to pull $2 out of his savings on deposit with our one banker, if he wishes to live at the original standard of living he had planned for himself. That is, it now takes $4 to buy what $2 used to. Important note: Though our banker has lent out the full $100 of the saver’s deposit, he has received $4 in interest payments from the lawyer. The banker can pay the $2 interest to the saver and still have $2 available to cover the saver’s withdrawal of $2.

Our one saver discovers he is no farther ahead than if he simply kept his $100 under his mattress and spent $2 from his savings like he originally planned before he was enticed by our one banker’s offer to pay $2 of interest for holding on to his $100 for him. Worse, our saver’s remaining $98 on deposit (now circulating in the economy) will currently only buy about half of what it used to.

Things are just about as bad for our one lawyer. It turns out that our one banker was also spending some time talking to our one governor.  As a team, our one banker and one governor are even better schemers than our one lawyer.

In spite of our lawyer’s best efforts, the most he was able to negotiate out of the governor was a new 2 percent tax on all money circulating in the economy. Even though the governor agrees that the full amount of annual revenues collected from this new tax will be transfered to the lawyer as a subsidy, 2 percent of the $200 of money now in circulation comes to $4. This is only enough for the lawyer to make his interest payment to the banker.

Over the course of the second year, our one saver is picking up 2% interest on his remaining principle of $98 and our governor is collecting $4 of taxes that are being transfered through the lawyer to the banker. While the interest the banker has to pay on the saver’s dwindling deposit goes down each year, the interest the banker collects from the lawyer each year remains constant as long as the lawyer is unable to pay against the principle of his loan.

If nothing changes, here is what is going to happen to our model stable economy that was modified by the single change of having our one banker successfully solicit our one depositor and then lend the depositor’s money out; our one banker ends up acquiring all the money in the system.

This is not an exaggeration. There were no sleight-of-hand assumptions used in building our example model economy. Take the time and run the numbers. If the saver maintains his standard of living by pulling money out of his savings, each year the banker will pay less and less interest to the saver. At the same time, the money being paid to the banker by the lawyer can either be saved, spent or lent out by the banker. Note: In the real world, the $100 lent to the lawyer could have just as easily been lent to a municipal government as a bond to support a money losing mass transit system, or to a floundering automobile manufacturer who was unable to turn a profit in its failing operation.  

If the banker saves his interest gain he is receiving from the loan made to the lawyer, money will be pulled from circulation and prices will begin to fall to compensate. This will tend to slow the speed the saver has to draw down his savings on deposit at the bank, but it will make it more difficult (or impossible) for the lawyer to keep up with the payments on his loan. Remember, the lawyer’s lobbying income comes from the tax collected on money in circulation. If the banker spends the gain on interest he is receiving, he can acquire greater ownership of the capital assets in the economy. If he lends it out on additional interest bearing contacts he can increase his interest revenues without a concomitant requirement to transfer interest payments to a depositor. 

Overall, the banker has created a win, win, win situation for himself.

The major difference between our example model economy and what happens in the real world is that in the real world the banker(s) and governor(s) make great effort towards convincing people they are working hard to fix and improve the economic system to help others. Here are two prominent explanations that have been have promoted to obscure the fundamentally fraudulent nature of banking and credit:

• Because bankers do due diligence on who they lend money to, over time, the net result of banking activity is positive. The service bankers provide helps to grow the economy and meet the needs of society.


• No new money has to be created to meet the interest payments demanded in the contracts written by bankers. The interest can be paid from money already in circulation or bankers can spend the interest back into circulation. Therefore, no harm occurs from charging interest.

Here are the problems with these two explanations. You are not going to see these in today’s college textbook on banking and credit:

Over time, it is the service to society provided by successful risk taking investors and entrepreneurs that help expand the availability of goods and services in the economy. Bankers are not investors. They are money managers along for the ride. They require payment on their interest bearing contracts regardless of the economic outcomes of the monetary capital they offer for deployment. That is, they require funds over-and-above the principal loan amount, even when the economic activity tied to their loans does not result in an increase of available goods and services in the economy. Other economic players, not direct parties to the loans, must work to create or transfer the wealth required to cover the interest payments of lagging ventures.    

While it is true that money does not have to be created to cover the interest payments on lent money, in the real world it does not happen the way bankers and their apologists suggest.

If interest payments come out of money in circulation, money in circulation will decrease and prices will drop in classic deflation fashion — unless production also drops to reduce the amount of available goods and services. If prices are dropping, even savers who keep their money under their mattresses benefit without having to call on the services of a bank. Not surprisingly, even though it should be most often a good thing, central bankers claim that deflation is as much or more damaging to an economy than inflation. Try to find cases where central bankers talk of a “target deflation rate.

The concept of bankers spending money into circulation is also not viable. In a world with an annual economy of only $40 trillion or so, it is not realistically possible to spend the amount of notional interest payments written into hundreds of trillions of dollars worth of interest bearing contracts.  Additionally, the rare banker with excess cash on hand is far more inclined to lend it into the economy than spend it into the economy.

Should we be surprised then, if the bankers' preferred method of covering interest payments is to simply create more money out of thin air? This is close to how our system is currently set up, with a major exception: most of the new money in our system is created through fractional reserve banking. 

Money created in this process is debt based money that also has an interest bearing obligation attached to it. Old interest in the system is paid off with new money that also has an interest obligation on it. Under the fractional reserve system, it is extremely difficult to ever pay off the outstanding interest. Banks receiving interest payments would have to spend the bulk of their received interest payments back into the economy and avoid the more profitable temptation of lending it back into the economy. 

This is one reason why we see today interest rates near zero and theoretically below zero. The only way to pay off old interest with new interest bearing money, that doesn’t create an even bigger interest payment time bomb, is if the new money created is at zero or negative interest rates.

If one takes the time to research the history of banking and credit thoroughly, it is difficult to escape the conclusion that the creation of new money out of thin air through fractional reserves banking is not as much a stand alone criminal act as it is a cover-up for the greater criminal act of promising people that money can magically beget money under a system of charging interest for it. It does not matter if the money lent on interest is a fiat federal reserve note or an ounce of pure gold. The day of financial reckoning just tends to occur faster in the former case.

The fixes politicians and bankers are proposing to solve our banking and credit crisis will not work. They are just buying time for the bagmen in the crime syndicate that is our banking and credit system to flee the scene of a crime and escape the wrath of the vast numbers of people who are realizing they are the victims of a grand swindle.

There is no easy way out. We have to move forward with the understanding that we simply can’t get something for nothing, at least not without eventually paying the consequences of our attempts.  

We have to work and risk our way to prosperity, not lend and spend our way to prosperity. 

Eliminating the powers held by the crime syndicates in charge of our banking and credit systems is a good first step forward.

2-23-09 clarification update...