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The world economy is in a state of coma. Despite what the media would have us believe, and ironically, despite undeniable progress in reducing absolute poverty, hunger and illiteracy. We have been living with an economy in a vegetative state for more than 10 years. An economy that never recovered from the 2008 crisis, but has been worsening to the point where it only needed a small shake-up to give it the final blow.
Well, the shake-up came and it was not a small one, but the worst economic crisis in history, at the hand of the Coronavirus and our capitalist system is doomed but refuses to die. What we see today in the news are the last spasms of the future corpse clinging to life.
I know this sounds bleak but it is important that we prepare ourselves because in the next few years we are going to experience a fundamental transformation of the economy around the world. Perhaps a change in the predominant currency and certainly several versions of a new capitalism.
But let’s start by finding out how we got to this point. This episode is mostly an adaptation of the excellent work of youtuber Dagogo Aldrige, which I share on my page, which explains very well all the concepts of economics that we need to understand to understand the irrationality of the situation we are living.
We are going to see the three ways in which money is created and some of the consequences that are going to happen. I am also going to show you the true origins of wealth inequality.
Government money
The first form of money is that which is created by the government. in practice, it is outsourced to the central bank but the government is who controls the issuance of currency. Physical money comes in two forms: bills and coins. But physical money is only a small fraction of the economy. In most economies, physical money accounts for only about 3 to 8 percent. Physical money is created primarily to meet the obligations of private banks when customers go to an ATM and try to withdraw cash. Banks need to make sure they have enough cash to meet those obligations.
Take a $10 bill, for example. It costs about 3 cents to print that bill. This means that there is approximately nine dollars and 97 cents profit in making a ten dollar bill. This $9.97 can be added to government revenue. This income is called seigniorage.
Since the government is the beneficiary of printing and minting currency, we might think why don’t governments just always print physical money instead of taxing? The main reason governments do not create most money is because of politicians. If a sitting politician could create money at will, there would be a tremendous conflict of interest. He might be tempted to hold the printing to fulfill his campaign promises or to finance wars. This would, in theory, cause the destruction of the currency by excessive printing causing a massive devaluation.
The more money in circulation, the less it is worth and that is a key point. For example, if massive inflation occurs and the average citizen has a million dollars, but that million dollars is only good for buying an apple, how much is a million dollars really worth? The loss in purchasing power of money over time is called inflation and when inflation gets out of control, money becomes worthless. Why does this happen? Well, because money must represent existing wealth or wealth that will exist in the future. I will explain this in a moment, but for the moment, the important thing to know is that when a trader loses faith that money really represents the wealth of the country and it is simply paper created by the politician in office, he begins to fear that this money will lose value in the future and to protect himself he will raise prices. If many traders do this, it becomes a self-fulfilling prophecy because effectively the buyers start to have less money, so the next day they raise prices again to protect themselves. This vicious circle, when it shoots up exponentially, is called hyperinflation.
Some recent examples of hyperinflation include Argentina , Zimbabwe or Venezuela . Inflation can happen in a very short time. And no one sees it coming.
We can think of money as a yardstick of value, a yardstick that is highly elastic and can change depending on how much there is. For thousands of years, gold was the standard measure of value, as a kind of physical anchor that kept the money supply in balance and governments accountable. Not that gold has any intrinsic value. It is ultimately stone, just as paper money is paper. But it has the advantage that it cannot be created out of thin air, it is difficult to mine and there are limited stocks of gold in the world. But in 1971, US President Richard Nixon announced that the United States would no longer convert dollars into gold at a fixed value. As we know most countries followed suit and from that moment on, money became disconnected from gold and the yardstick of value became elastic.
Moreover, since the US dollar backs all other currencies as a reserve currency, Nixon’s decision changed the world. With this you can see that, even though politicians supposedly cannot influence the creation of money, it is happening anyway. This is certainly causing problems, as we will see later.
To summarize so far:
- The government creates the physical forms of money such as bills and coins.
- Only 3 to 8 percent of money is obtained in this way.
- Seigniorage is the revenue from the creation of that physical money. This revenue is both a benefit to the government and the taxpayer: it reduces the debt for the government and reduces the tax burden on the individual taxpayer.
- The reason governments do not create more of this money is because of the risk of inflation, caused by the decisions of politicians.
Now let’s look at the second way of creating money:
Private banks and debt-based money.
The vast majority of money created today is created by the private banking sector. In most of the world’s most developed economies, approximately 97 percent of the entire money supply is created digitally by banks and therefore, most of the money in the world is privatized.
Banks invented digital money when they succeeded in convincing legislators, shortly after the first bank runs. A bank stampede is an event in which most depositors try to withdraw most of their money at the same time and the banks run out of cash. From these events, banks argued that they should be legally allowed to create more deposits than actually exist, but based on debt, and this is how governments outsourced the creation of digital money.
The idea of using debt as money started much earlier than this. English innovators set the stage for banks to become the creators of money around the world. In 1704, the English Parliament passed the Promissory Note Act. A promissory note is a written promise that someone will pay back money borrowed. According to the law, a promissory note in the amount of $20 was fully equivalent to a $20 bill. Today we digitize this agreement and call it a debt.
For reference, every time I mention the word debt in this episode, you can think of an IOU and you’ll remember that it’s just as valid as money. Well, then the banks were authorized to use these promissory notes as if they were money. From this point on, the banks were effectively free to create and destroy debt and therefore money.
In the modern world, as we shall see, the entire world economy is based on these IOUs. Let’s take an example of how this works. When you go to a bank and ask for a loan, the banking license gives that bank the ability to create money every time they issue a loan. They do this through a system called double counting. For example, if you buy a $500,000 house, the bank creates $500,000 in its account and you receive $500,000 in debt; that is, the promise to pay it back with interest. this $500,000 debt can enter the economy of the country, because when the house was bought, the seller of that house can use that new debt money that was created by the bank, that it gave to you and that you gave to the seller, to buy other things in commerce or the financial market.
This means that in the system we have, if we want to achieve more economic growth, we need more debt. The key point here is that debt is actually new money, just viewed from a different point of view. for the lender, it is a money asset. For the debtor, it is a debt liability, but they are one and the same. It sounds a bit complicated, but all you need to know is that when a bank issues a loan, the money it lends is not someone else’s savings as many believe, it is not money that the bank had. It is essentially new money that the bank has created. They simply type it into a computer and it appears as a digital representation of money that belongs to the state.
Let me repeat this in another way: If you lend money to a friend, you have to work long hours, collect your salary and save it in order to do so. A bank instead simply enters the amount that the client needs and automatically appears the amount on which the client will have to pay interest, in some cases for many years.
Now, the beneficiary of this new money is actually the bank, not the State, because they can charge interest on that money and that is how they make a profit. Later, when this loan is repaid, the debt disappears and the money disappears too, but the profits that the bank earned from the interest remain.
The origin of today’s economic bubbles
Real estate and financial markets are the most important tools for creating digital money. This is because banks decided that they are the safest and most profitable ways to invest the debt money they create. This is because if the customer cannot repay the loan, the banks simply take the house from them, auction it off and get all their money back, including the interest owed.
In developed nations, the mortgage market is backed by large amounts of money. In Canada, the United States and Colombia, for example, this has been spiraling out of control in recent years. For decades, banks have stopped investing in the productive economy and have shifted their focus to investments in housing and stock market shares. This has caused housing prices to skyrocket. People take on more and more debt to buy properties they could not otherwise afford and at the same time the banks make more and more money. This cycle over many decades has caused all those real estate bubbles we see around the planet. Here in Toronto for example, a 100 m2 apartment in a residential area can be worth on average about $500,000 Canadian dollars.
So those are the loans, but then what about deposits? When you deposit money in a bank, you no longer have legal ownership of that money, the banks become the owners. They keep 10% of the deposits they receive as a reserve and they can lend the remaining 90% of that money to other people and those other people can deposit that money in another bank and then that bank can lend 90% and so on. This is known as fractional reserve lending.
After the chain of fractional lending we just saw, an initial deposit of $100 with a 10% reserve requirement can lead to a total of a thousand dollars outstanding. Well, at least that’s how it used to work until March 26, 2020. Now, at least in the United States, there is a zero percent reserve requirement. As the Federal Reserve website says, “This action eliminated reserve requirements for all depository institutions.” That means banks can now create infinite amounts of money without having to hold reserves, but it doesn’t stop there. When a bank receives your deposit, it can – along with investment funds – gamble with your money through financial instruments such as derivatives and securities. They do this in order to make even bigger profits. Most of the time, these instruments are ultimately simply bets on whether the price of an asset will rise or fall, but this gambling taken to the extreme can be truly ridiculous.
Enron, for example, the famous American company that went bankrupt due to corruption in 2001 used financial instruments to bet on the weather.
The banks’ gambling
Weather derivatives, as they are technically called, are financial instruments that can be used by companies that have some operation that may be affected or dependent on the weather. They are used as part of a risk management strategy to reduce the risk associated with adverse or unexpected weather conditions.
Weather derivatives are index-based instruments that generally use data observed at a weather station to create an index that can be used as a basis for the calculation of a risk management strategy to reduce the risk associated with adverse or unexpected weather conditions.
These kinds of eccentric financial instruments are part of what caused the housing market crash and the subsequent collapse of the global economy in 2008. But the problem today is that banks are playing with many more derivatives, often stacked multiple times on top of each other, rather, intertwined in such a way that no one really knows how much money is invested in this game. Some estimates put the derivatives market at over a quadrillion dollars, which is more than ten times the size of the world economy.
When there are fat cows, everyone goes into debt, i.e., they borrow from banks and spend it on things they normally could not afford, but this causes economic growth. Eventually, people can’t afford to take on more debt and can’t pay it back. Banks stop lending, many debtors begin to default, and the economy suffers a recession. This cycle is natural and has happened many times over the centuries. But in 2008, everything changed. The world did not want to go through the pain of a recession and some analysts point to that point as the moment when the real economy died.
By 2008, banks had become so large, intertwined and integral to the money supply that when they were about to collapse, governments had to use central banks to bail them out. Remember that banks are creating 97% of all money circulating in debt form and if that money cannot be recovered, the economy may suffer a systemic failure, a risk of collapse of the entire global monetary system.
In 2008, the global economy was dead, but it has been on life support ever since. A decade of super-low interest rates in developed countries, which basically made the cost of borrowing money almost free, has caused market distortions so large that they have compounded the whole original problem. There were short-term gains, but at the cost of long-term pain.
When private banks make risky bets and incur losses, central banks can bail them out with their infinite wallet. I will talk about central banks in the next section, but as you will soon see, in the end it will be the citizens who will have to pay for these debts. All this money that is being created is like that promissory note we talked about at the beginning, except that it is signed by all of us and we sign that we are going to pay this debt through taxes; us and our future generations.
It is important to keep in mind that governments do not actually support the citizens, it is the citizens who support the government through taxes. Taxes and foreign trade are the two main ways that governments can raise money. This collected money is used to pay back central bank loans with interest. Then, when governments use central banks to bail out private banks for their irresponsible behavior, governments are left with debt that will eventually have to be paid by taxpayers in the future.
So in summary:
- Private banks create the vast majority of the money in circulation, about 97% and they do it by creating loans, which is debt money.
- The process is as simple as typing numbers into a computer.
- To some extent, banks can spend and gamble on consumer deposits because legally, they own that money.
- Too-big-to-fail banks are backed by the central bank, creating a moral hazard. Which brings us to the final and craziest form of money creation:
Central Bank Digital Money.
The third form of money creation is called “quantitative easing” or QE. Quantitative easing is a new way of creating money that was invented by the Japanese central bank in 1989. It was then popularized by the Federal Reserve in the United States during the 2008 crisis. QE is when a central bank creates money to issue loans directly to the banking sector, large corporations and as seen in the United States with the pandemic financial stimulus, to the public as well. It is a way of injecting money into the economy in situations of extreme events, as was the 2008 financial crisis or the COVID crisis in 2020.
As a result, central bank balance sheets have gotten completely out of control, trying to keep the economy alive a little longer. In 2008, during the mortgage crisis it was the first time QE was attempted outside of Japan, the $700 billion QE bailout was quite controversial.
The plan that President Bush executed that year allowed the Treasury to buy up to seven hundred billion dollars of those bad loans that banks had irresponsibly given to people with no income and no money,
but those bad debts then became the responsibility of U.S. citizens. Congress had to raise the legal limit of the national debt from $10.6 trillion to $11.3 trillion. We are talking about billions in English, i.e. millions of millions, not billions.
It was initially thought to be a one-time emergency measure, but over the next decade, the Federal Reserve was unable to reverse it. To give you an idea of the magnitude of it all, it took from the founding of the United States in 1776 to 2008 for the nation to reach $1 trillion in debt. By 2014, that number had expanded to $4.4 trillion and since the onset of the COVID pandemic, another three trillion was added in the span of three months. Now, the U.S. central bank is creating hundreds of billions in a matter of hours. A few months ago, I saw the news that the Central Bank of Canada is also in the process of injecting $250 billion into the economy using quantitative easing. The problem is that this measure seems to be having less and less effect as it continues to be implemented.
So how do central banks use their magic money? What they do is buy the equivalent amount of government bonds through the bond market, which is a kind of exchange that exists to lend money to corporations or governments. Although the stock market gets more press, the bond market is actually bigger. But what is a bond? For the purposes of this episode, it is basically the same as a promisory note, except that it is issued by a government or a corporation. Central banks, which have no savings, can create money to buy these bonds. In this way, the money that central banks create becomes a debt that the government will later have to pay back by collecting taxes or tariffs.
So here an important question arises: can a central bank go bankrupt? Well according to the European Central Bank, according to a paper it published in 2016, central banks are protected against insolvency because of their ability to create more money. In other words, they can’t go bankrupt because when they need to, they can just print more money and that’s it. If this sounds a bit unfair to you, wait until you hear the following.
Governments in this current sticky situation are caught between a rock and a hard place: they can’t raise money except by raising taxes, but they owe billions to central banks. The hope is that the money they have borrowed can be used to kick-start the economy, but there is a small problem: the central banks go on a buying spree.
When central banks buy bonds (i.e. debt securities), generated by government or corporations, they can end up owning many of the world’s assets. For example, the Japanese central bank’s balance sheet is larger than Japan’s entire GDP: They own 80 percent of its entire stock market. That’s right, Japan’s central bank is the largest shareholder in Japan’s stock market. The Swiss central bank owns $90 billion in U.S. stocks, including shares of Apple, Microsoft, Google and Amazon. Dagogo, the author of the original video said that when he heard about this, he had to investigate because he could not believe it was legal. This means that central banks are creating money out of thin air, they can’t go bankrupt so they can take any risk they want, but instead they are buying and owning real assets.
But this creating money out of nothing and buying things has some consequences: this kind of central bank intervention disconnects the stock markets from reality. Throughout the 20th century, the stock market was used to reflect the real state of the economy, but in recent years that is completely out of control. So much so that the U.S. stock market has become almost twice as large as the GDP of the entire nation, which literally makes no sense.
So we see the fact that today, in the midst of the worst economic crisis since the Great Depression, with many industries grinding to a complete halt and more than 30 million people unemployed in the U.S. alone, the stock market continues to grow as if nothing has happened.
The central bank printed millions of millions, gave them to banks and investment funds at almost zero percent interest, supposedly to reactivate the economy, but this money went directly to the stock market and to a lesser extent the real estate market, while the real economy was left with just the crumbs. We are seeing exactly this in Colombia, where the government is bailing out large corporations and banks and little or no help is reaching the small businesses that are the main beneficiaries.
Earlier we discussed that printing money leads to inflation as happened in Venezuela when the Chavist government engaged in printing money to compensate for the lack of tax and tariff revenues. So why haven’t we seen inflation in the US yet? Well, the reality is that we have. That exaggerated rise we have seen in housing prices and stock markets is the inflation that has caused this fever of printing money. the money created ends up in all these assets, which drives up stock and property prices, so that the few people who own large amounts of stocks and real estate become ridiculously wealthy while there is no growth in the real economy. the rich get richer and the poor get poorer.
Many people can feel and see wealth inequality, but very few have any idea where this phenomenon comes from.
Wealth inequality
Since the 1980s the wealth of the top of society has been tied to the stock market. Since 2008, when the economy went into a life-support coma, the stock market became Siamese to the Federal Reserve. The more money is printed, the more the value of the stock market rises and the richer the rich become. Since 1980, the wealth of that elite has grown by 420%. When the central bank prints money, the primary recipients of that newly printed money enjoy higher and higher standards of living at the expense of the secondary recipients of that money, when inflation has already taken hold.
This phenomenon is known as the Cantillon effect. Experts believe that when the rich finally start selling their stocks and real estate to buy other assets in times of distress, the velocity of money, i.e., the rate at which money changes hands in the economy will start to pick up and that is when we will start to see real inflation in the overall economy. Therefore, money is going to be worth less and less than it was when it was held by the wealthiest.
To recap:
- Central banks have no savings, they can’t go bankrupt but they can create infinite amounts of money to buy government bonds.
- A bond is an exchange of money for a promise that the government will eventually pay it back with interest. this money must eventually be paid back by future citizens of the country, either through taxes or inflation. so what can be done?
It is clear that people who have lost their jobs need help. Printing money is just a warm water handkerchief. Decades ago, societies and nations should have focused on wealth creation instead of exclusively financing real estate, the stock market and those speculative instruments such as derivatives, futures and options. In other words, banks should have lent to productive areas of society: small and medium enterprises, entrepreneurs, education, manufacturing, innovation, research and development. Imagine what our world would be like today if banks invested hundreds of billions of dollars in these kinds of things, instead of property and betting on whether the price of something goes up or down.
Sure, this is riskier for the banks, but the benefits lead to more jobs, innovation, better competition and better living standards in the long run. In addition, governments could raise more taxes through these new revenues without raising existing taxes. You can print money but you cannot print wealth.
The problem is that focusing on wealth creation and productivity takes time, effort and hard work, and apparently, people these days don’t have the patience for that and, truth be told, it is already too late for this option. As I stated at the beginning, the economy is moribund and we are left to deal with the consequences of a fragile system.
What will happen next? I share the view of the author of the video, that all this will lead to something very big and nasty in the next decade. No one knows what it will look like, but it may involve runaway inflation in many economies around the world and much slower economic growth. This situation is known as stagflation. This happened in the 1970s in the US, but this time it could be much worse, because of the excessive amounts of debt held by both governments and individuals, compounded by the additional effect of social instability and pandemic.
The conventional wisdom seems to be that over time, the world will lose faith in the US dollar, although some macroeconomists believe that the US dollar may even increase in value as other nations try to sell their products or exchange falling currencies for the US dollar because, for better or worse, it is the strongest economy in a world of collapsing economies.
This theory is called the Dollar Milkshake Theory. What happens is also going to depend on the monetary management of China and the European Union and suddenly on how many people begin to trust cryptocurrencies as a safe haven for securities.
There are other economists who argue that nations can simply print infinite amounts of money, as long as enough goods production is maintained to pay the interest on the debt owed to central banks by the government. The argument here is that the debt never actually has to be repaid, only the interest. This is called modern monetary theory.
This is something that has never been proven before but seems like another facile solution. Instead small communities in Venezuela and a small town in Italy have taken the initiative to regain control and have just issued their own currencies. We are starting to see many solutions appear of which most will fail and perhaps a few will succeed.
On the positive side, all the events to come could generate massive reform. They say that from the worst circumstances, the best innovations emerge. So what can you do on a personal level? This is my personal opinion, but I think most ordinary people have more debt than savings. If you are fortunate enough to be a happy exception and have good savings, maybe it is time to diversify, perhaps buying gold, cryptocurrencies if it is something you understand well or if not, suddenly a part in local currency, another part in dollars and another part in euros.
I personally, if I had significant savings I think I would invest in real estate but in areas with future growth projection, not in overvalued places.
But if you belong to the majority that lives more or less to the day, I think the best investment is education: a postgraduate degree, a master’s degree, a certification or job training in arts and crafts that you like and that have good projection will undoubtedly be the best way to be prepared for what is coming, which will not be pretty but I think it is going to be necessary.