Money and banking: A story of values

There will be near-universal adoption of the crypto system in the next decade, and other predictions. 

“I know of only three people who really understand money.” 

– JM Keynes1

What will you get out of this paper? 

This paper is designed to help you understand money. You need to understand what money is before you can understand the banking system. You need to understand the banking system before you can compare it to an alternative, the crypto system. Money is fundamental to life; you need to compare the two systems based on your values. 

Who should read this paper? 

People who want their money to work harder for them, rather than for big banks. People who want to know the reason why there are booms and busts in the economic cycle. People who want to make the world a better place.


Understanding money and banking will help you solve the greatest mystery in modern economics: why does our economy suffer catastrophic breakdowns, causing significant human misery, every few decades? This paper has some clues.

The development of money was a natural part of human evolution: it was driven by our biology and our values. Money arose as an extension of our memory and represented something valuable created through specialised effort, which was used by the group and then, later, exchanged with others through trade. We acquired the concept of stored memory to shift value across time periods. As we specialised further and repeated exchanges across time, this gradually led to the concept of a standard of value, the first step towards money.

Money allowed us to specialise and exchange items of value. Money is often defined using complex language, but it only has two simple, common-sense characteristics:

(1)  Money needs to be scarce.

(2)  Money needs to be accepted by others as having purchasing power.

Money co-evolved with our ancestors’ discovery of sacrifice. Seeds planted today, rather than eaten with a crop, could mean more next season. Borrowers could repay lenders from what was brought forth by their efforts: when the grain harvest was brought in, a certain percentage was given to those who had sacrificed. Loans and interest due were recorded on tablets and quoted in money. Sacrifice, a form of savings, and the productive use of this savings, benefitted both parties and led to a better existence for humanity.

1 John Maynard Keynes, British economist, cited by several contemporary sources.  Unfortunately, for him, Keynes does not appear to be one of these three. 

Money itself is only a symbol, a representation of purchasing power; it is not valuable in itself. Gold, US dollars, bitcoin, etc. have value only to the extent that they are scare and are commonly accepted to purchase goods and services. Since money has no intrinsic value, it must be trusted. The basis of all good money is trust, just as it is the basis for all good human relationships.

Where precious metals were present geologically most societies adopted them as money; they did this because precious metals are scarce. This allowed something that has no intrinsic value to act as a symbol that retains purchasing power over time. The global acceptance of precious metals meant that they could be exchanged for goods and services in ever distant trade and that their value was not tied to the actions of a specific nation state.

As carrying gold and silver around was somewhat inconvenient and risky, the precious metal depositories that emerged issued paper IOUs to customers, like merchants. These paper IOUs, backed by the value of precious metal, could be used for making purchases and the IOUs themselves began to circulate as a form of money. The depositories learned that not all customers demanded access to their deposit at the same time. This presented an opportunity to make loans using paper receipts for more than the total amount of precious metal that they physically held. In this way a “fraction” of the value was kept in reserve and the rest could be lent out. Precious metal depositories led to the creation of banks. Modern banks use exactly the same model today as the depositories from history.

Money: a tale of two time periods

Money and banking are inextricably linked. The history of money can be broadly divided into two periods, as set out below.

Time period



From the time early humans began to specialise, sacrifice, and to exchange value, until the rise of precious metal depositories. All money represented value already created, by productive effort in the real economy. This is present value (PV) money. The banking function matched surplus capital (e.g. grain, gold) to productive opportunities in the economy.
From the establishment of these depositories (eventually called banks) until the present day. Two forms of money begin to exist, side by side:

(1) PV money.

For example, gold coins.

(2) Future value (FV) money, where the value was linked to an expected future cashflow stream, which didn’t exist currently (at the time that the FV money was created).

An example is paper IOUs or promise to pay bearer notes.

Banking matched PV money (e.g. gold) to productive opportunities.

It also began to evolve into issuing paper IOUs in return for future cashflows from productive opportunities, in the form of loans.

As both gold and IOUs were relatively scarce and were accepted as having purchasing power, two types of money existed side by side: PV money (value already created; no credit risk in exchange) and FV money (value expected to be created in the future; those who accept it take credit risk on the issuer).

Although this evolved over time, it led to a decisive change in what money meant to humanity:

The rise of modern banking broke the historic link where money represented the memory of something valuable created. 

Modern, fractional-reserve banking is characterised as set out below.

  • Banks create the vast majority (about 90%) of the “money” that exists in an economy. Through bank charters, society grants the exclusive right to banks to create most of the money supply.
  • Banks create money by granting loans to borrowers; these loans are funded mainly by creating matching deposit accounts based on confidence in the bank. This provides purchasing power today in return for future (and greater) cashflows owed to the bank.
  • Bank-created money (FV money) is explicitly linked to an asset (the bank loan), which depends on an expected future value.
  • This FV money can be used for purchases today in three broad ways:
    (1) for productive investment in the economy (e.g. buying equipment or hiring people)
    (2) to bring forward expected cashflows (e.g. credit card finance or mortgages)2

    (3) to finance asset purchases (stocks, real estate)
  • The repayment for (1) and (2) are dependent on future cashflow generation. Number (3), for asset purchases, is based on the expectation of selling the asset to someone else in the future at a higher price.
  • This third use of funds, for asset purchases, is the main cause of excess variance in the business cycle.   
  • Banks accept other banks’ newly created money. These create inter-links between banks, globally. Payments between customers cause the recipient bank to retain a fraction of the transferred (deposited) money and lend out the rest, contributing further to money creation.
  • If a bank’s loan value is destroyed (e.g. when asset values decline significantly), then the related FV money – originally created by the loan – is also destroyed.
  • FV money destruction from the original loan leads to backward, recursive money destruction between linked banks, similar to the money multiplier process for creation on the upswing. This greatly exacerbates economic downturns.
The fractional-reserve banking system

Here is the best way to understand our current fractional-reserve banking system.

Fractional reserve banking is an inherently risky activity. The core philosophy of fractional reserve banking is based on dishonesty. The bank tells depositors that it is their money, sitting in their account, and they can have it back at any time. At the same time, the bank lends most of the money to borrowers or uses it themselves, including as an input to their own credit money creation.

If future cashflows needed to support bank loans (and the FV money that they create) do not materialise, recursive credit money destruction causes economic crises and means that the bank may not have enough reserves to cover the lie that they told depositors: that they could have their money back anytime. This is what happened in the 2008 financial crisis, prompting the bail-out of the fractional reserve banking system.   

The risk structure of fractional reserve banking:

2The repayment for which is based on future salary expectations.

Here are the top 3 things that banks don’t want you to know.

  1. Legally, you don’t deposit your money with a bank. It becomes their money; it is no longer yours when you make a “deposit”. They account for this money as an asset (since it is legally their property now). In return, you get an IOU, which they call a deposit account. An honest name for the account would be “Unsecured Loan to Us Account” but Deposit Account sounds a bit better.
  2. There is no such thing as deposit insurance. Unlike real insurance, the government doesn’t have a pot of money sitting somewhere to cover your deposit unsecured loan to the bank. What the government will do is print additional money to cover your loan to the bank, if the bank goes bankrupt. This would cause inflation, of course.
  3. Inflation is simply a way of measuring a reduction in your purchasing power. It is better called a Theft Index and is essentially a transfer of value from bank account holders to debtors. Usually, this happens just a little bit at a time, so you don’t notice the missing money. Debtors benefit from inflation because it means that they have to repay less value, in real terms. Who are, by far, the largest debtors in an economy? The government and the banking sector (remember those IOUs?). And, who is mainly in charge of determining the amount of inflation in an economy? The government and the banking sector.

Don’t feel silly if you don’t know this; banks are intentionally opaque. There is a reason you are made to feel stupid or uncomfortable when your mind wanders to thinking about how banks work, or to define what money really is. In fact, in economics textbooks and at business school, they don’t teach you that banks create money; they keep up the deception that banks are just helpful financial intermediaries, the Walt Disney version of how banks operate.

“It is well enough that people of the nation do not understand our banking and money system, for if they did, I believe there would be a revolution before tomorrow morning.”  – Henry Ford

Bank regulation, a success story

Let’s look at the role of bank regulation, which is principally in the hands of central banks. The main objectives for a central banker are price stability and employment. Well, here is a chart of the purchasing power of the US dollar since the inception of the Federal Reserve to the end of 2017.

Value of US Dollar Since Inception of the Federal Reserve

Explains why you don’t see too many “Five & Dime” stores in the US anymore. Great work, Fed. It looks like Zimbabwe, just over a longer timeframe.

OK, so the product has lost 95% of its value and you wanted it to be stable. That isn’t so great on the CV. But, it has outperformed almost every other nation state currency and that is why it is the global reserve currency today. So, maybe you could argue in your defence, if you were a US central banker, that your performance has sucked, but it has sucked a little less than most of the others.55 So, maybe you deserve to stand up a little taller, as your relative performance has been ok. Oh, except against gold. Which somehow has held its value since Neolithic times, even without the benefit of an economics degree. So, central bankers can go home at the end of the day and feel pretty good about their performance. Except against that rock.

What about managing economic variance? Well, here is a chart that shows money creation and recessions over the past 100 years in the United States.

St. Louis Adjusted Monetary Base

OK, so 18 recessions and about 18 booms; that isn’t so great either. Let’s imagine that being a central banker was a real job, like being an engineer and let’s be generous and say that about once in every 10 years there is a system failure. What if we built dams and every 10 years or so they burst? You think people might complain? So, is it impolite to ask: why do we just accept it from bankers?

Here is the key take-away from the graph:

Under a fractional reserve banking system, recessions are a regular occurrence; they are an inherent part of fractional reserve banking. Recessions are the norm, not the exception.

In most important aspects, the impact of banks on the economy is almost completely unregulated. Here is why, in one image.

Monetary policy through the lens of a punch bowl

Regulators’ main tool is called monetary policy, which is where a small committee of government economists with a crystal ball sets the price of money in a (supposedly free-market, capitalistic) economy. Monetary policy mainly and indirectly affects only one of the four main sources of funds for a bank: borrowing from the central bank. This is a small minority of a bank’s cost of funds. The largest source of funds is a bank’s own internal, credit money creation. The cost of this money is not set by the central bank. Banks create this FV money based on their own estimate of the profit potential for creating assets (making loans), based on their own risk-return metrics.

Alan Greenspan remarked that the role of the central bank was to take the punch bowl away just when the party gets going (by which he meant the central bank would raise interest rates when the crystal ball predicts a future upswing in the business cycle; this is using monetary policy to manage the economy). We all know how well that turned out. However, it was his intellectual point that was incorrect, because he doesn’t understand how banks actually operate (or isn’t telling the truth). It isn’t simply an issue of timing. It isn’t simply that the Federal Reserve waits too long to raise interest rates, to pop an asset bubble (or, like 18 of them in the past century).

The correct point to understand about regulating banks is that:

They are not drinking your punch, man.

They have their own punch bowl. And, it is 10x the size of your punch bowl. And, the mix in their punch is a lot more intoxicating than your punch.

Yeah, of course, the bankers come over and drink out of your punch bowl. And, out of the depositors’ punch bowl. But, that is not where the party is.

Your problem, Alan, is WYSIATI. What you see is all there is. You see the bankers drinking out of your punch bowl and you assume that is all they have to drink. Well, if banks only got money from the central bank, then taking the punch bowl away would, indeed, have put a damper on the party. But, this is a relatively small part of what is fueling their activities.

The proof can be seen in the empirical results. These results are not in favour of a reserve requirement/money multiplier theory of banking, nor the idea that banks only act as helpful financial intermediaries. Nor do the results support the effectiveness of monetary policy in managing economic variances. Raising rates doesn’t end the party.58 Cutting rates doesn’t bring the party back to life.

This is our modern fractional reserve banking system. It is not at all based on capitalism; it is more like a closed, medieval guild system and it will always exclude out-groups by its very nature. It is as destructive as it is dishonest. It is about as far away from the concept of value, and from our better human values, as you can get.

The crypto system

In 2009 Satoshi Nakamoto created a system of money that corresponds to how humanity has exchanged value for most of our history. Technologically, this system is based on mathematical formulae and a straight-forward verification and record system. The implications are spectacular: you can now trust exchanging value with another person or institution directly, even if you don’t know them.

In terms of values, the crypto system is profoundly natural, a very human invention, based on the concepts of freedom and fairness. It is the most authentic form of money humanity has had since value was based on memory. It is characterised as set out below.

  • Based only on PV money (i.e. value that exists today, not tied to any required future value creation).
  • Allows value to be exchanged directly between two parties without any bank middlemen, almost instantaneously and at extremely low cost.

A better description than the term crypto currencies is honest money. This money system is about more than just exchanging value; it is also about our values. The crypto system is digital technology to banking and paper money’s analogue technology. The potential, the combination of value and values, that this new (old really) system unlocks for humanity is hard to overstate.

The crypto system is an existential threat to nation state currency as well as to the fractional reserve banking system and to their enablers. It is incompatible with fractional reserve banking. The crypto system is based on a transparent record of truth, captured forever in a giant record book, and on value that exists today.

The fractional reserve banking system is intrinsically dishonest: bankers will tell you that your money is both safely in the bank and, at the same time, they are lending it out to others. They will tell you that it is your money while, legally, it belongs to the bank and they can do what they want with it.

Only one of these two systems can survive. They cannot co-exist together in the long-term. They are not going to be best friends, give each other warm hugs, and talk about a win-win paradigm. Their values are completely contradictory. Expect the banks and their enablers to continue to be relentless and underhanded when attacking the crypto system.

The biggest issue for the crypto system is its lack of connection to the real economy. This comes from the fact that there is no crypto banking system yet. This is illustrated in the form of a puzzle.

Obviously, a link to the real economy is fundamental to any financial system and this is the main impediment holding back the entire crypto industry.

By bank system, I mean that holders of crypto assets need to have the option to link their savings, a store of their value, to productive opportunities in the real economy.

When this issue is resolved, it will significantly spur crypto adoption. Real crypto banking will be the Netflix moment for the entire crypto space. This will drive the future value of crypto currencies and many existing crypto firms.

If the crypto system can link to the real economy and challenge the core banking of deposits and lending, it will replace fractional reserve banking and benefit all crypto firms. If not, it will remain a niche movement. Banks, and their enablers, will do everything they can to prevent a link to the real economy.

Twenty predictions for the next decade
  1. A new banking model will emerge, in accordance with our better human values. Fractional reserve banking sucks. Putting the fractional reserve banking model onto the blockchain does not make it suck less. Whether it is traditional banking, challenger banks, neo banks, fintechs, crypto banks: if it uses fractional reserve banking, it is dishonest and dangerous to the economy. Fractional reserve banking is antithetical to the crypto system and the movement of people who support it. A new banking model will emerge, for the crypto era.
  2. Fractional reserve banking will be reformed. The government charter to commercial banks that allows them to create credit money will become regulated. Internal credit money creation will be subject to regulatory limits. The free government deposit guarantee to commercial banks, which encourages speculation on future asset prices and is the cause of economic booms and busts, will be reformed.
  3. But it won’t matter: the fractional reserve banking system will almost completely die out over the next decade. The crypto system will offer higher returns for less risk and depositors will increasingly vote with their feet. Over the next decade, the crypto system will expand and the fractional reserve banking system will decline. An inflection point will be reached where the rate of change for both accelerates rapidly. The fractional reserve system is intrinsically structured like an inverted house of cards. Once enough deposits are pulled out of the bottom, the house will collapse.
  4. International trade will increasingly be priced in a standard of value that is global and not tied to the currency of any particular country. The US dollar will slowly decline as a standard of value in trade. It will be replaced by the Special Drawing Rights basket (USD, EUR, GBP, JPY, CNY) + BTC.
  5. Bitcoin, once linked to productive use in the real economy, will emerge as the ultimate global store of value, mainly because its supply is fixed and because of wide adoption.Bitcoin will increase significantly in price as adoption spreads. The price a decade from now will be in excess of $410,250 per BTC.
  6. With greater adoption of the crypto system, excess economic variance in the economy will become like some diseases that human ingenuity has confronted: a distant memory. The crypto system will reduce business cycle variance in two ways:a. Through the elimination of credit money creation by commercial banks. Crypto money supply is fixed; it cannot be arbitrarily created.b. By endowing money ownership rights in its proper holders: those who created the value in the first place. This will tap into distributed knowledge in society and will naturally introduce greater prudence in use of funds, particularly lending in the hope of future asset price appreciation.
  7. Crypto currencies will be valued more like currencies in the future, rather than like assets, as the sector achieves greater financial depth. There are two main problems with crypto currencies at the moment: there is little market depth and there is not much of a link to the real economy. In the future, as greater links are established to the real economy, leading to greater market depth, crypto currencies will be priced more like currencies and less like assets.
  8. Most utility tokens will convert into equity tokens or companies will set the price for their product in relation to a stable standard of value, rather than in the token price. The utility token value is often treated as a representation of the value of the issuing company. Many companies have encouraged this impression, which is economically to the long-term detriment of product adoption. There are two simple solutions: issue securities tokens and/or pricing usage based on a stable standard of value.
  9. Stablecoins will be a very niche part of the crypto space, without much value. Most stablecoins seek to provide price stability for crypto users, in relation to old standards of value, like the US dollar. While there are some use cases for such tokens, most participants will seek to achieve price stability through more efficient or financially rewarding means. Sellers and buyers of many internationally traded goods, for example, can achieve future price certainty by reference to a stable standard of value and/or using crypto derivatives markets, which will grow in importance in the future.
  10. The future “unwinding” of money created over the past decade will lead to an accelerated decline of nation state currencies over the next decade and drive savers to adopt crypto currencies. The unbounded and continuing money creation of the past decade, to bail-out the fractional reserve banking system from asset mal investment, is historically unprecedented. Foresighted savers, particularly asset managers in advanced economies, will seek value preservation in the emerging crypto system at a level greatly in excess of today’s levels.
  11. Enterprise “blockchains” will cease to exist. Their very name is an oxymoron. Enterprises only adopt blockchain as a defensive measure, but they won’t be able to hold off the value that arises within global ecosystems from truly decentralised blockchains. The benefit of blockchains is to cut out the middleman. Enterprises are the middleman. As soon as a real crypto bank is in place, to link the crypto system to the real economy, industry ecosystem blockchains will arise to disintermediate these middlemen.
  12. Centralised trading exchanges will cease to exist. These exchanges are nothing more than SQL databases and have nothing to do with crypto except the assets that trade on them. Decentralised exchanges will arise.
  13. Money transfer companies like Western Union will go bankrupt and cease to exist. Western Union transfers money mainly amongst the poorest people in the world. They do this for up to 30% of the amount transferred. The crypto system will soon be able to do this for fixed fees of less than a dollar per transfer. Over the next decade, those institutions that have ethical investing guidelines will disinvest from Western Union, based how it preys on the poor.
  14. Low income people everywhere will do their banking using the crypto system. The fractional reserve banking system has completely failed low income people. Of course, most poor people are not even accepted by these banks. The crypto system has significantly lower fixed costs than the traditional banking system and, consequently, allows everyone to benefit from financial inclusion. The poor will be able to make transfers at extremely low cost. Emerging crypto banks will allow them the benefits of the savings function, giving them the first opportunity ever to climb out of poverty. The effects for poor communities globally will be transformational.
  15. Micro-everything will explode in use. The crypto system allows extremely small amounts to be used in the financial system. For example, transfers for only a few dollars can be made. Emerging crypto banks will allow savers to put very small amounts of value to work, on which people can earn interest. The poor will be able to hold just a few satoshis worth of global stocks. Even the yield curve will be able to be constructed on a micro-level, for example the lending function could happen based on a day basis, rather than on wide fixed dates with interpolation between such dates for pricing at the moment. It will revolutionise finance. These are problems for which the only technology solution is the crypto system. As in so many improvements, the traditional banking system simply cannot offer such solutions; they are stuck in an analogue world.
  16. Constraints due to “repugnance” (for legal activities) will cease to exist. Economists use the term “repugnance” to describe activities that have a moral element to them. Many banks and financial intermediaries do not allow their customers to make purchases they deem repugnant, even if they are legal. In the future, people will decide what is morally repugnant to them and what is not. The crypto system allows users to decide how they spend their money, not middlemen.
  17. The various financial companies in the credit card processing chain will go bankrupt and cease to exist a decade from now. The various financial companies in the credit card processing chain will go bankrupt and cease to exist a decade from now. The existing cards – banking system is based on pull technology, which is complex, costly and prone to fraud. The crypto payment system, based on push technology, is simpler than and will replace the old system. A decade from now no one will use the pull-based system; it will completely disappear. The main impetus for switching from credit cards to crypto system payments will come from merchants.
  18. Criminals will continue to use the crypto system. Sadly, criminality is just a fact of life and most criminals use financial systems, including crypto. The crypto system will put safeguards in place to protect against criminal activity, which is possible in a high-tech environment and less possible with traditional banks.
  19. Gold will decline significantly in value, to the price level set by jewelry. Crypto currencies are superior to gold in all respects and gold’s use as a store of value will be reduced as the crypto system increases in adoption and the fractional reserve banking system and national currency use declines. Eventually, both gold and nation state currencies will be seen as barbarous relics.
  20. Until the crypto system matures, it will continue to attract some bad actors. The exuberance related to the crypto system’s potential for humanity will continue to attract those who do not have the best interests of others at heart, those who seek only personal gain. This cannot be avoided and all new technologies, from railroads to the internet, attract such characters; it seems it is only human. For those who want to make the world a better place, we need to ignore critics’ attacks against the small number of these bad actors, weed out the opportunists, and focus on providing services that improve people’s lives.

End of TL;DR. You should read the rest, though; it will change your life.

The story of money is the story of human evolution

Our ancestors’ development of money was driven by our biology and our values; the future of money will be no different. The history of money can be separated into two parts:

(1)  A period where money had an explicit link to value. This period existed from the dawn of money in Neolithic times, as humans started to cultivate crops and domesticate animals, and lasted for most of the rest of human history.

(2)  A recent period, where this explicit link has been broken. This period followed the rise of precious metal depositories (the forerunners of modern banks).

Technology has allowed us the ability to re-establish this explicit tie to value, through a direct trust relationship between people. This technology removes the need to have trust in the intermediaries that have arisen, the banks. The upside is that it would remove most of the negative side effects of banking, exhibited through excess variance in business cycles, which are a significant net cost to society. This new system (old system, actually) will be vigorously resisted by those with the most to lose: the banks and their enablers. This paper will give you an insight into how future humans will likely interact with each other financially and as well as a choice of values we all make today, whether we realise it or not.   

Money arose, essentially, as an extension of memory.

As our ancestors evolved, they assumed increasingly specialised roles in society. Some might concentrate on making footwear, others to tending livestock, others in raising crops. Money represented the concept of value created through specialised effort, which was used by the group and then, later, exchanged with others through trade. Small groups remembered that the makers of footwear had done their part earlier, when the meat came in from a hunt. We acquired the concept of stored memory to shift value across time periods. Between groups we learned to exchange valuable items, either at the same time or with one group giving food now in return for a promise to receive food in the future from the other group. As we specialised further and repeated exchanges across time, this gradually led to the concept of a standard of value, as barter exchange become too complex for us to remember. This was the first step towards money and a standard of value for exchange existed amongst communities in Mesopotamia and along the Nile River by ~3,000 BC. 

A standard of value was necessary before any other aspects of money could emerge.

Exchanges of valuable items needed to be comparable and many societies used what was most available, such as wheat or barley. In Ancient Rome, cattle (pecus) become a standard of value, from which we get the word pecuniary. These standards of value also had other rudimentary, secondary characteristics useful for money: they are (somewhat) divisible, portable, durable, etc. and also their supply is naturally limited.

Due to the rarity of double coincidence of wants, barter probably never really existed outside of small groups that didn’t want for much. As human groups became larger, people conceived of value in relation to a common standard (like barley); this allowed the emergence of a medium of exchange. So, a goat herder could sell a goat to a shoemaker, even if he already had enough shoes; the shoemaker could simply pay in barley. The goat would be valued according to a standard of value, measured in barley. Even if the goat herder didn’t want barley he could accept it as payment, as knew that he could use the barley as a way to buy something else he wanted. Barley also allowed him to buy a variety of items or to spend some now and keep the rest for future purchases.

Any medium of exchange implies that the item is also a store of value, otherwise it would not be accepted in exchange. Barley is a store of value, as no one can magically create a huge supply of barley. A paper currency that is subject to inflation is a poor store of value, as it is worth less every day; therefore, it is a poor medium of exchange (because who would really choose it, if it is constantly declining in value?).

Through a process of evolution, our ancestors developed the concept of money.

Essentially, money reflects the memory of something valuable that was created by our efforts, like raising livestock or making shoes. It allowed us to specialise and exchange items of value, so we were all better off. Money is often defined using complex language, but it only has two simple, common-sense characteristics:

(1)  Money needs to be scarce.

(2)  Money needs to be accepted by others as having purchasing power.

3 P. Einzig, Primitive Money: In its Ethnological, Historical and Economic Aspects, 2nd edn., London, Pergamon Press, 1966. M. Powell, ‘Money in Mesopotamia’, Journal of the Economic and Social History of the Orient, vol. 39, no. 3, 1996, pp. 224-242.
4Amongst the earliest recorded civilisations to use money were the Sumerians. By the time they codified a standard of value, this was still expressed in barley, although silver had become the main medium of exchange. R.F. Harper, The Code of Hammurabi, Chicago, 1904, p. 37. S. Homer and R. Sylla, A History of Interest Rates, 4th edn., Hoboken, John Wiley & Sons, 2005.

Money co-evolved with our understanding of sacrifice.

Humans gradually learned that sacrifice today could mean more of something tomorrow. Some of our earliest writing dealt with loans from those who had surplus grains to those who presumably had the ability and inclination to put the grains to productive use. Seeds planted today, rather than eaten with a crop, could mean more next season. Borrowers could repay lenders from what was brought forth by their efforts: when the grain harvest was brought in, a certain percentage was given to those who had sacrificed. Loans and interest due were recorded on tablets and quoted in money5; this usually happened at temples, which were principal meeting places for the community. Many societies set limits on interest rates, had rules for times when the harvest failed, etc.6 Sacrifice, a form of savings, and productive use of the savings, benefitted both parties. A primitive economy grew bigger: more land was brought under cultivation, more animals were raised. Savings (sacrifice), recorded as a form of money, led to a better existence for humanity.

Money itself has no intrinsic value.

Gold, US dollars, bitcoin, etc. have value only to the extent that they are scare and are commonly accepted to purchase goods and services. Money is a symbol, a representation of purchasing power; it is not valuable in itself.7  If aliens show up tomorrow and want to sell us a cure for cancer, they are unlikely to take gold bars in payment. Undoubtedly, their home planet also has the element Au (gold), caused by the explosion of neutron stars a few billion years ago, and they are not likely to value it very much. Probably they would find it amusing that we spend time digging up, refining and then guarding gold. They might think that if we didn’t waste our time like this we might have discovered a cure for cancer ourselves.

Since money has no intrinsic value, it must be trusted.

When you create something of value (for example, by making shoes, or selling your time to your employer), you need to trust the money you get in return for your effort. You need to trust that what you are getting in exchange will give you the ability to purchase things, now or in the future. The basis of all good money is trust, just as it is the basis for all good human relationships.

Precious metals emerged as the global money in many places.

Where precious metals were present geologically most societies adopted them as money.8 Why did this happen, in an uncoordinated manner, around the world? Most importantly, because precious metals are scarce. This allows something that has no intrinsic value to act as a symbol that retains purchasing power over time.9 This led to groups of people accepting that precious metals represented a store of value, which could be used as exchange for goods or services in ever distant trade. So, by definition, they had purchasing power; their common acceptance was a benefit for the real economy. The global acceptance of precious metals meant that their value was not tied to the actions of specific nation states.

Precious metals had other, common-sense characteristics as a representation of value: they lasted a long time, were hard to damage, could be divided into smaller units, each unit had the same value as any other, etc. Their value was based on their weight.

5Einzig, op. cit.,p. 206.
6Homer and Sylla, op. cit.
7Some items were used as money that have value in themselves, like barley or cigarettes, but, when used for an exchange purpose, their value was their scarcity and purchasing power, not because you could eat or smoke them. If the goat seller, for example, just wanted to buy barley, he probably would not have gone to the shoemaker.
8The earliest form of precious metal money in Mesopotamia was originally copper. In Ancient Rome it was the aes rude, which was copper or bronze. In Indonesia, tin was used in trade and Sparta used iron. Eventually, gold and silver became more prominent. Einzig, op. cit.
9Precious metals did not have consistent global pricing until the emergence of modern logistics, but acceptance of precious metals by diverse civilisations facilitated exchange amongst groups and, eventually, nations. In many ways, gold and silver were a global money for most of human history: they were scarce and they were accepted as having purchasing power.   

Eventually, probably in Lydia10, precious metals were made into standard units called coins, to facilitate commerce. Since they come from distant, exploded stars they were rather hard to counterfeit. In addition, primitive humans, unlike us today, probably used gold and silver because they liked shiny things with a bit of bling to them.

Precious metal depositories led to the creation of modern banks. It was the end of an era for what our ancestors would have considered “money”.

Gold and silver were concentrated in the hands of governments and guilds, who acted as producers, issuers, and depositories. As carrying gold and silver around was sometimes inconvenient and risky, precious metal depositories issued paper IOUs to their customers, depositors like merchants. These paper IOUs, backed by the value of precious metal, could be used as a more convenient form of making purchases; the IOUs themselves began to circulate as a form of money. The depositories learned that not all customers demanded access to their gold or silver at the same time. This presented an opportunity to make loans using paper receipts for more than the total amount of precious metal that they physically held. In this way a “fraction” of the value was kept in reserve and the rest could be lent out to borrowers.11 

Borrowers, doing something productive in the real economy, had an obligation to repay the lender a greater amount than was lent to them, secured against their real economy assets. This allowed the depository to earn a significant lending profit from each reserve amount. Of course, there was a risk as well: what if all customers came in and wanted their gold back? However, the real risk to the depository was relatively low: obligations were covered either by gold in storage or by real asset collateral. As further security, loans were also backed by the expected future cashflows of the productive use of the lent “money”.

What became crucial was not the gold on deposit, but rather the confidence that users had in the depository. This confidence made the difference between a successful and an unsuccessful depository, not the ability of users to see how much gold really existed behind the scenes. Modern banks use exactly the same model as the depositories from history.

If you want to solve the greatest mystery in modern economics, and help remove the cancer that is the extreme variance12 in the business cycle that metastasises every 1-2 decades, here is the question to ask yourself: are the gold and the IOUs the same thing?

We know that no money has any intrinsic value. The gold is a symbolic representation, a token, that represents value. The IOU is a token on a token. They both have purchasing power. So, is there any difference between them? Let’s see if we can solve this mystery once and for all.

10From the Greek historian, Herodotus, The Histories. R. Cook, ‘Speculations on the Origin of Coinage’, Historia, vol. 7, no. 3, 1958, pp. 257-262.
11This is double spending: the depository had gold on deposit from the customer and, at the same time, lent some of this gold to a borrower. The original gold is the only representation of value created in the real economy. Actually, depositories (banks) spend much more than twice. A 10% fractional reserve ratio means that ~9x the original “value” deposit is created in paper IOU money, in purchasing power.
12Of course, some volatility is to be expected and at certain amount does, in fact, provide valuable information to participants in the economy. A natural amount of volatility is beneficial to the economy, as it gets rid of dead wood and makes the overall system stronger. Here, we refer to excess variance, the exponential effect of bank credit money on a natural process and also its abnormal impact on asset pricing.

Money and banking are inextricably linked.

The history of money can be broadly divided into two periods, as set out below.

Although this was an evolution, it led to a decisive change in what money meant to humanity:

The rise of modern banking broke the historic link where money represented the memory of something valuable created. 

Here is a clue to the mystery we are going to solve:

You cannot put new money into old banking.

How banks make loans

Banks are simply investment companies. They evaluate a potential investment (the loan) based on risk and return, the basis of modern finance theory since Markowitz in the 1950s, just like other actors in the economy. There is something special about banks, though; if you keep reading you will be in the 1% of people who really understand banks and money.

This is a necessary condition if you want to understand the crypto system or take action to make the world a better place.

First, here is how bank lending works.

What is the key number to pay attention to? CFADS. That stands for Cash Flow Available for Debt Service. The calculation is set out below.

Operating profit
add back non-cash expenses (e.g. accounting depreciation)
minus cash taxes to be paid13
adjust for changes in net working capital
minus capital expenditure (basic, or maintenance, capex)
equals  CFADS

Banks forecast CFADS using qualitative factors (like the competitive position of a company in its industry) and quantitative factors (like historical performance, expected growth of the economy).

The example above shows an actual commercial bank lending model. It illustrates how a bank estimates the principal amount a company could borrow for a 5-year senior debt loan with a bullet repayment (meaning, the amount borrowed is repaid at the end of year 5; in the meantime, the borrower only pays interest, on a quarterly basis)14. These kind of models are one of many internal processes that banks don’t want you to know about.

13Even though CFADS is before debt interest tax shields, which impact on tax payable, banks adjust for taxes to be paid. It is a bit of a circularity, but this is the standard approach.
14The other repayment option is a declining balance (mortgage) style loan, where some of the principal amount gets repaid each period. Bullet repayment loans may have a sinking fund attached to them. The type of loan and these mechanics are not important for our thesis.

The loan officer selects a debt service coverage ratio (DSCR), which is the amount of “headroom” the expected cashflow will cover the amount that the company needs to repay each period. The loan officer also selects the interest rate on the loan. Both are set in relation to the perceived credit risk of the borrower. Based on the amount of expected cashflow, the interest rate and the amount of headroom, the principal amount of the loan is calculated.15  In this example, the maximum principal amount that could be borrowed is $10,625. Total repayments (principal and interest) are $14,875. The difference is interest (profit) to the bank, for using “their” “money”: $4,250.

Sophisticated banks don’t just use a single input in the CFADS formula. Instead, they use a statistical model for forecasting, based on a distribution range of potential inputs.16 

If you are cynical, you might think that your average loan officer probably doesn’t do this. It is true that loan officers are human and humans are sometimes lazy. This kind of loan evaluation is complex and is only done, by definition, for loans that are expected to bring in future cashflows.17 There are other options for loan officers who want to be on the golf course by 3 pm: they can make consumer loans or asset loans, which are simpler. They also, consciously or subconsciously, use heuristics in decision-making.

A few biases in the lending process are set out below.

  1. Banking, like money, is all about trust. Humans, including bank loan officers, instinctively have greater trust in people who are similar to them. Consequently, banks are more likely to make loans (especially with attractive terms) to in-groups, rather than out-groups, based on similarity between lender and borrower.
  2. Employees of large organisations, like banks, are mainly motivated by preserving their jobs. Consequently, they are more likely to make loans to low perceived controversy borrowers (e.g. based on name recognition, history with the bank, people their boss likes) than higher perceived controversy borrowers (e.g. smaller, newer borrowers or borrowers that may be lower risk, but require individual reputational risk from the loan officer).

There are three broad uses of funds from a bank loan. Two have to do with future cashflows. The third is the cause of most business cycle excess variance.

In general, there are three areas to which banks make loans, which are set out below.

Loan use Example Effort level for the bank loan officer Risk to the bank loan officer of getting fired if things go wrong Repayment
1. Productive economic activities Buy new equipment, hire people to expand output. High. God, I have to come up with all of those numbers to input into the financial model again. Then, I have to go to the credit committee. Medium.

A lot of model inputs could turn out to be wrong. “It is tough to make predictions, especially about the future.”  Yogi Berra. 

Company sells stuff that people want to buy.

Future cashflow stream.

2. Time shifting of income/

Consumer consumption

A mortgage, or you want to “bring forward” some of your future salary to go on a vacation now. Low. Check salary statements, get asset valuation from third party, if needed.    Low.

Run standard bank policies.   

Customer keeps getting a salary.

Future cashflow stream.

3. Asset purchases Someone uses a bank loan to finance a real estate investment or to buy stocks. Low. Get asset valuation (usually a market price, from a third party, or check bank policy). Very low.

Bank policy on securities lending. Or, bricks and mortar lending; what could go wrong?

Future sale of the asset, at a higher price that it was purchased for.

No/little future cashflow stream.

15This is a simplified example. There are a few other considerations, but they don’t have much impact and don’t change the thesis. The calculation of the principal amount is done by an algorithm written in computer code; the output is shown here.
16This model uses @Risk statistical modelling software to apply a distribution shape to inputs; you just see the expected output for CFADS. 
17This includes balance sheet loans, where a bank lends against a general corporate obligation to repay. In this case, sometimes banks may not explicitly control the use of funds. However, good bank loan documents are detailed, with covenant tests, and they usually don’t allow you to use the money to go to the casino and put it all on black.

For asset lending, you may be thinking to yourself, “wow, some banks use poor suckers’ money in the hope that asset prices will go up. Glad that isn’t what my money is being used for.”18 If this is what you are thinking, now would be a good point for you to stop reading.19

Where did the “money” come from for the loan?

The sources of funds (the money) for the bank to make loans are set out below.

  1. Savings (i.e. deposits or rather, technically, loans, from people like you).
  2. Their own funds (i.e. profits that they make and retain in the bank).
  3. Borrowings (either from the central bank, interbank market, or bond issues).
  4. Their own, internal credit money creation.

The first three sources (savings, own funds, borrowings) are lent out in part, but they make up a minority of bank lending.20 The majority comes from creating “credit money”. How it works is simple and is set out below.

Let’s use our example from above. Say that the bank decides to go ahead and loan a company the principal amount that they calculated: $10,625. The risk and return characteristics seem acceptable. The bank will give you $10,625 today, in return for $14,875 in the future (over the next 5 years). That is an 8% per year return. What is their cost of funds? Well, for the first three sources, it is pretty low. As the saver (unsecured lender to the bank, really, but let’s keep up the charade for the example), what do you get in interest on your bank account? What do you think the central bank charges them? Right, not very much.

OK, but if most of these funds come from their own internal money creation, what is the cost of this? The answer is almost zero. The main costs to the bank are related to having other banks accept your newly created credit money. As with everything in banking and money, the key issue is confidence. In a fractional reserve banking system, it is obvious that if everyone loses trust in your bank, it will fail. There are not enough reserves (real, PV money) to pay back all depositors. Confidence-related economic costs are: advertising (to create brand image), payments to central banks, transfers to the political sector, etc. The biggest economic cost to any bank is related to the confidence amongst users that it will be there tomorrow. More confidence = lower cost of funding. Modern banking, like the precious metal depositories, is all about the illusion.

18Or, at least hope that the asset won’t decline in value.
19You also need to stop lying to yourself and accept: it isn’t your money. The money you have in your deposit account isn’t yours and isn’t a deposit. Legally, it is an unsecured loan from you to the bank. Recall that our modern banks grew out of precious metal depositories. Calling it a Deposit Account is also a little better marketing than calling it an Unsecured Loan to Us Account. If your bank gets into trouble, then you are an unsecured creditor of the bank; you have no other claim to your money. Probably there is some bank insurance in your country, so maybe the government will pay you back, since they can just print “money” (who cares if it doesn’t purchase the same amount of stuff?). These fears are what led to bank runs in the past. Don’t think that bank runs exist anymore? Maybe you are not old enough to remember the 2008 financial crisis. That was a modern bank run, cleverly disguised. Don’t worry if you have forgotten, it will happen again.
20Most of these funds are used for the banks own reserve capital, sometimes held with the central bank; some also supports correspondent bank accounts (the bank’s own accounts with other banks). Correspondent accounts are how banks and national banking systems link to each other. This is how payments happen. Another way to think of correspondent accounts amongst banks is how excess business cycle variance is transmitted throughout the financial system. If you are scientifically minded, you can think of these inter-linked bank accounts as similar to how viruses spread.

You have to give the impression that the gold is all there. Your money is sitting here in your account with your name on it, don’t worry. One way to preserve the illusion is to attack any questioners as too ignorant, too stupid to understand banking.

Internally, banks work out their cost of funding for loans using the following simple formula:

= wt savingst + wt own fundst + wt borrowingst + wt credit moneyt

This is just the weighted average of the sources of funds. In the example, the weighted cost of funds for the bank is just less than 2%. So, the expected economic profit for the bank is about 6%, or 3/4ths of the interest rate charged. This profit percentage is typical for corporate lending; it is lower for larger borrowers and higher for smaller borrowers. For consumer lending, the profit percentages are typically higher than corporate.

The accounting for this newly created credit money is based on double-entry (matched) bookkeeping, like all accounting, and is as set out below.

The loan of $10,625 is an asset to the bank, since the company will pay them $10,625 in future cashflows (hopefully). This is entered on their ledger, their balance sheet, in the assets column. The bank now has to give the loan money to the company. They do this by creating a deposit account in the amount of $10,625.21 This is FV money; its value is matched to the loan, which is (hopefully) going to come in via future cashflows. There is no real-world value created today, as our ancestors in the Liberty Tribe in the cartoon above knew. There is an asset (the loan), which is based on an obligation for future payments by the company, but this asset isn’t “real” yet; its value hasn’t materialised at the time that the asset is created.   

Note that the money in the borrower’s deposit account looks exactly the same as a PV deposit of value, but there are some differences. For one, the use of funds is restricted. The borrower needs to use it for the purposes that they declared to get the loan. This falls into the three categories that we discussed: (1) to invest in productive purposes to make stuff that people want to buy, (2) to time-shift consumption, and (3) to invest in an asset in the belief that it will increase in value.

Banks are intentionally opaque and hard to understand. If you were an outsider, not part of the guild (for example, if you were an economist or a consultant living in your ivory tower), and you looked at the balance sheet or read aggregated national statistics, you might think that the deposit is just money from savers that has been matched to a loan. You wouldn’t be totally wrong, just almost totally wrong. A small portion of the weighted sources of funds does come from savings on average and the cost of savings does factor into the cost of lending. This what banks and their enablers want you to believe: that they just helpfully match savings with borrowings.   

Don’t believe that commercial banks create money? Well, how about asking the central banks themselves? In the United Kingdom, according to the Bank of England, 97% of the money supply comes from credit money creation by commercial banks.22 

21This is a liability of the bank to the company (i.e. to pay them “money”) and is exactly the same as the deposit account that you have at a bank. Your deposit account is where your salary is paid into each month. Wait a minute, you might be thinking, I have already worked for this money in my deposit account; I sold my time to my employer. So, “my” “money” should be seen as PV money. Value has already been created in the economy. Hmmm, maybe this has something to do with the greatest mystery in economics thing ….
22M. McLeay et al., ‘Money Creation in the Modern Economy’, Bank of England Quarterly Bulletin, Q1, 2014. The BoE actually hedges its bets: it has other papers that state that banks are financial intermediaries and also some papers that make reference to the money multiplier effect.

In Germany, according to the Bundesbank, the vast majority of money is created by commercial banks.23 In Switzerland, it is about 90%.24  Guess what it is in the United States?25 The percentage varies over time, but it is broadly above 90% across advanced economies.

Is this news to you, that banks create most of the “money” in an economy? Well, don’t feel silly; the banks don’t want you to know this. Switzerland is one of the most financially literate countries in the world, with one of the highest GDPs per capita, home to one-third of global offshore wealth.26  Yet, even here only 13% of respondents in a recent poll knew that banks created most of the money in Switzerland. This seems strange, as we all use money every day and it is so central to our lives. If you asked Swiss people where cheese comes from, 100% could probably identify cows as the main source. In earlier eras of our history, humans could probably tell you where, say, coins came from. Why so different today? Why such a mystery?

In the event that you ever took a course in economics at university, there is a reason why you don’t know that commercial banks create the vast majority of the money supply: you have been lied to. As an example, Gregory Mankiw’s Macroeconomics, the most widely used introductory textbook in the United States, continues a falsehood first perpetrated by Samuelson’s textbook in 1948. These textbooks teach that the national government creates money, as well as the money multiplier theory of money creation; they do not reveal that banks create credit money themselves, through their own loan process.27  Standard economics textbooks teach that banks lend out existing deposits of savings. They state that the collective actions of the banking system then can create additional money supply, as loans from one bank then become deposits of other banks, up until a ceiling imposed by a central bank (called the reserve requirement). So, in textbooks, the reserve requirement is crucial to the amount of money in an economy and banks don’t create money themselves.

Here is a little science experiment. Textbooks teach that money is created collectively by the banking system, controlled by a money multiplier, imposed by the central bank’s reserve requirement. So, a reserve requirement is a necessary component of money creation, right? Well, what about countries like Canada, Australia, the United Kingdom, Sweden, etc. where there is no reserve requirement? How do the textbooks explain that? Well, they can’t. Regardless, empirically, there is a weak correlation between reserve requirements (where they do exist, like in the United States) and money creation in an economy. Similarly, there is a weak correlation between savings and money creation.28 

You may be asking yourself: if changes in the money supply (which impact inflation and cause excess variance in the business cycle, both bad news) don’t really come from savings or from this money multiplier concept, then how does this impact bank regulation? If banks create the vast majority of money in an economy and they do it by themselves, based mainly on their own estimates of future value, how are they regulated? We are going to get to that in a minute. As advance warning, you probably don’t want to know.

23‘The role of banks, non-banks and the central bank in the money creation process’. Deutsche Bundesbank Publications, vol. 69, no. 4, 2017, pp. 13-34.
24Dr Emma Dawnay, Vollgeld Initiative, 2016.
25Just joking. In the United States, the land of the free, their government and banks do not reveal this information to their citizens. In fact, their education system teaches that banks are simple intermediaries between savers and borrowers and do not create money.
26BCG Global Wealth Report, 2018.
27So, it is a little embarrassing when other central banks, like the Bank of England, actually state clearly that, no, central banks don’t create most of the money supply. Most of the money supply comes from commercial banks in an economy by making loans. But, the textbooks never change, never reveal the truth about money creation, even when central banks themselves state it clearly. Why could that be?
28You can measure total savings (which would be incorrect) or available savings depending on changes in the interest rate paid on savings deposits; it doesn’t matter. Both correlations are weak.

An even more ridiculous theory taught in economics classes is that banks are just financial intermediaries and that they don’t create money; this theory states that only the national government creates money. This theory is taught alongside the money multiplier/fractional reserve model mentioned above. Banks are just simply channelling savings to productive use. So nice and helpful of them.

Here is an interesting quote about why this quite misleading information is taught to the public, from an economist who wasn’t afraid of telling the truth.

“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent.” – John Kenneth Galbraith29

The only significant living economist who has actually done an honest, empirical investigation into the mechanics of bank money creation, who has really gotten his hands dirty doing actual banking work, is Dr Richard Werner, a professor in the UK with a doctorate from Oxford.30 He has compared scientifically the three main theories of money creation (money multiplier, banks as intermediaries, and credit money creation).31 He is able to disprove the two standard theories taught in economics: the money multiplier and banks as intermediaries. They are demonstrably false. The credit money creation theory matches with what banks actually do in the real economy and cannot be disproved.

Yet, despite this, most well-known economists still continue to support theories that are disproved by evidence and by admissions from central banks themselves. Why is that? There are a few reasons, including: mainstream economists don’t include banks and money very much in their explanations for how the overall economy works; they are so wedded to their axioms of banks as neutral agents in an economy, simply allocating capital, that, intellectually, it requires an exceptionally strong effort to be genuinely self-critical of what you have learned; not a single one of them has actually worked as a banker, as far as I can find32; and, the vast majority, directly or indirectly, benefit financially from continuing to support the party line and avoiding biting the hand that feeds them. For others, in a world where you can see that the emperor has no clothes on, it takes a lot of guts to speak up and tell the truth. Guilds and their enablers don’t change from the inside.

In fact, like most things to do with modern banking, the situation isn’t black and white. There is a (small) element of the truth in banks acting as financial intermediaries and fractional reserve/the money multiplier does play a role in money creation. However, the vast majority of money creation comes from the banks’ own credit processes. What the banking industry and their enablers do, however, is point to the (relatively) less harmful theories (intermediaries, money multiplier effect of the system), while intentionally remaining silent about the largest contributor: that individual banks create FV money through the lending process, which is then co-mingled with PV money (money where the value has already been created) so that the two “monies” are indistinguishable from each other.

29J. Galbraith, Money: Whence it came, where it went, Princeton, Princeton University Press, 1975, p.22.
30He isn’t a banker and he doesn’t fully seem to understand the workings that you would know if you were an insider, but he actually did field research!!  It is incredible, as the biggest sin in being an economics professor seems to be actually applying your trade, getting your hands dirty with commerce. You won’t find that with any Nobel prize winners.
31R. Werner, ‘A Lost century in economics: Three theories of banking and the conclusive evidence’, International Review of Financial Analysis, vol. 46, pp. 361-379.
32Economics is one of the few professions where you can be an expert without actually ever having worked in your area of expertise. I mean, if you want to be a golf pro, it helps if you have swung a golf club. Not so with economists who “teach” about banking. Yet, when these same economists go to the doctor, you can be pretty sure that they select someone who has real experience, not just someone who has read about how medicine works and has developed grand theories.

Does bank credit money come from nothing? Is it created by the stroke of a pen?

It is sometimes suggested that banks can create credit money out of thin air. This idea can, perhaps, be dated to a comment from one of the founders of the Bank of England. “The bank hath benefit of interest on all moneys which it creates out of nothing.”33  The phrase “out of nothing” sounds very common, so economists translate it into Latin to make it sound better: ex nihilo.

Some brilliant minds have repeated this. Niall Ferguson mentions this in Ascent of Money. Ray Daglio does the same in his video How the Economic Machine works.

However, this isn’t correct. Banks don’t create credit money from nothing, with the stoke of a pen. It is quite close to being true, though. The reason that most people cannot believe it, and why most economists therefore have not been able to accept the credit money creation theory, is that it sounds silly. Probably, instinctively, something based on common-sense inside you says: something from nothing isn’t very likely. You cannot create gold from nothing.

However, what banks create isn’t gold.

It is the IOU.

Formerly, this IOU was linked to gold, to a memory of value created by effort in the past. Today, it is linked to a loan asset, which is expected to bring in a future revenue stream. Really, banks are monetisation entities. By granting loans/deposit accounts to borrowers, they give them purchasing power today in return for repayment tomorrow. The ratio of:

deposit money created today (equal to the loan amount)

to the expected future cashflows to be received by the bank (adjusted for funding cost, use of funds risk and expected economic performance)

is the most appropriate way of evaluating the risk of bank lending, similar to the Sharpe ratio.34 

There is a noticeable difference in this ratio depending on the use of funds for the loan. The two loan categories related to future cashflows (productive investment, time shifting) are significantly less risky than asset loans (which are not, or weakly, supported by expected future cashflows).

Commercial banks today create credit money. This credit money has purchasing power and is indistinguishable from a real deposit of value into a bank account. This use of funds for loans isn’t created out of thin air; it is created by using the confidence capital of the bank, their reputation. Of course, you have to be a bank as well; other actors in the economy cannot just create credit money. It requires a banking license. This license from the government essentially grants power from the nation state to a commercial bank to create credit money. Most of the money supply creation power in an economy is granted to the private banking sector, which creates money based on their views of their own profit potential. In no country is this power to create money directly regulated. Nor is the use of these created funds regulated at all.

33William Paterson, founder of the Bank of England, from contemporary sources, 1694.
34This is how central banks or regulators should evaluate the genuine riskiness of banks. Not a single regulator currently does this. Why not? What a mystery. It would require banks individually to reveal how much money they create. Do you think the banks want you to know this information?   Can you imagine the regulatory filing? Like: here at JP Morgan we created $x billion of money last quarter, of which x% went into the financing of speculative asset purchases. Henry Ford knew what the public reaction would be, as we will see.

Most people don’t see the reality of how money is created. Others see, but seek to mislead. A few see clearly. Here are some quotes from those who see.

“If the American people ever allow private banks to control the issue of their currency … the banks … will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered …. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.” – Thomas Jefferson35

“A great industrial nation is controlled by its system of credit. Our system of credit is concentrated in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated governments in the world – no longer a government of free opinion, no longer a government by conviction and vote of the majority, but a government by the opinion and duress of small groups of dominant men.” – Woodrow Wilson36

“It is well enough that people of the nation do not understand our banking and money system, for if they did, I believe there would be a revolution before tomorrow morning.” – Henry Ford37

“Thus, our national circulating medium is now at the mercy of loan transactions of banks, which lend, not money, but promises to supply money they do not possess.” – Irving Fisher38

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. Deficit spending is simply a scheme for the ‘hidden’ confiscation of wealth.” – Alan Greenspan

The Gulf Investor Deception

Nothing illustrates the fact that banks can create their own credit money better than the “investment” in Credit Suisse and Barclays Bank by Gulf investors during the 2008 financial crisis.

In 2008, like many banks, Credit Suisse and Barclays were technically bankrupt by the financial crisis: their liabilities exceeded their reserves. In the crisis, insolvent banks had three options: get an explicit government bail-out (take government money, which is what many banks did); raise capital from private investors (which is what a few, mainly better capitalised banks did); or receive an implicit bail-out (the government offers some guarantees, the central bank buys your not-so-good assets for cash, etc. This is what the rest received).

Credit Suisse and Barclays came up with a better plan: they created their own money and “loaned” it to “investors” from the Gulf. As with normal credit money creation, on the banks’ books there was an asset (a loan, based on expected future cashflows) and a deposit (of the loan amount, for the use of the investors; this is FV money). The investors then used this newly created FV money to purchase newly issued preference shares in the banks. So, on the liabilities side of the balance sheet, the banks no longer had a deposit obligation; instead, they had brand new capital in the bank. What collateral did the Gulf investors put up as security for the “loan”? Well, they put up their newly received preference shares. Does anyone else see this as an illusion or is it just me?

35Quoted by contemporaries. Letter to John Taylor, 1816. Letter to John Wayles Eppes, 1813.
36W. Wilson, The New Freedom, New York, Doubleday, Page & Co., 1913. Also quoted by contemporaries.
37H. Ford and S. Crowther, My Life and Work, New York, Doubleday, Page & Co., 1922. Also quoted by contemporaries.   
38I. Fischer, ‘100% Money and the Public Debt’, Economic Forum, April – June 1936, pp. 406-420.
39A. Greenspan, ‘Gold and Economic Freedom’, Objectivist newsletter, 1966. 

Try not to laugh, but there is an entire regulatory regime for calculating “capital adequacy ratios” for banks.40 The same banks that can create their own money and their own capital. To make sure that the banks have sufficient “tiers” of capital for the risk they undertake. So, don’t worry, the regulators have it all under control.

Wait a minute, you may be asking: even if these Gulf investors didn’t put up a penny of the billions of new “capital” that was created, they still have to pay the interest on the billions in loan “money” they received, right? The answer is no. Don’t worry for the Gulf investors. Barclays made a transfer to the investors of £322 million as part of the “investment”. You read that right: the only physical cash transfer in relation to the investment of £3 billion in Barclays went from Barclays to the Gulf investors. What was the £322 million for? Well, Barclays doesn’t need to tell you that. For Credit Suisse, there were convertible elements to the loan too complex for you to understand, gentle reader.41 

The bail-out of UBS during the financial used up almost all of the funds available to the Federal treasury in Switzerland, at a significant cost to every single Swiss taxpayer. When it came to Credit Suisse’s deception, the regulator allowed it to pass. If Swiss citizens knew how their two global banks actually functioned and the risk that is borne by the Swiss people, they would never support these banks.

In the United Kingdom something strange happened: the Serious Fraud Office called it a fraud. The SFO is a minor regulator and doesn’t usually get involved in such matters. The main British bank regulator is the Financial Conduct Authority, which did nothing. Undoubtedly, it found Barclays conduct to be just fine. Eventually, the British courts examined the “loan”, found nothing wrong with it, and dismissed the SFO’s case. The traditional British sense of fair play prevailed.

Why did this “loan” for capital injection work? Because of confidence. Because people believed in this self-created “money”. To make it believable, you need believable investors, of course. When you want to arrange something like this, you are better off calling people from the Gulf rather than from, say, Mauritania. Actually, in some ways, you could say that the Gulf investors provided an extremely valuable service. Just not in cash. They provided confidence capital. For Barclays and Credit Suisse, rational actors in the economy, this confidence capital was obviously more valuable than a government bail-out. Whether you want to call it a con game, an illusion, or a fraud, it is on confidence that the fractional reserve banking system exists and nothing else. It makes people dishonest, in a way, because Barclays and Credit Suisse cannot just come out and tell the truth about why it was really done: to encourage depositors to believe that the banks were solid, that their money is there and safe, to prevent a bank run. It is the intrinsic nature of “fractional” reserve banking. Your money cannot be “there” and also lent out. No bank is “solid”. If you lose the confidence of depositors, any fractional reserve bank would just collapse.

40Capital adequacy standards are overseen by the Bank for International Settlements in Basel, Switzerland.
41The heart of the loan – investment in bank capital are summarised here. Of course, if you do something so plain vanilla, it is obvious to many, even those who are not financial specialists. So, naturally, the overall dealings between these two banks and the Gulf investors was made much more complex, involving: offshore companies; other, complex financing instruments; detailed legal documents, etc. The core issue is that the banks created their own money to facilitate believable “investors” to purchase shares, so that the banks’ capital adequacy ratios could be reported at higher, adequate levels but with no true change in value.

What if the borrower transfers his deposit to another bank? Why would Bank B accept Bank A’s newly created credit money?

Now we are really starting to get somewhere in solving the mystery.

To return to our example: our borrower gets $10,625 in a deposit account that the bank creates for them. Remember that deposit accounts are liabilities for a bank; it is something that the bank owes to the borrower. Now suppose that the borrower uses these funds to pay a supplier, for a piece of equipment, and the money is transferred to the supplier’s bank, Bank B. As the customer, you just transferred “money” but what happens between these two banks?

Now, Bank B would have an IOU to the supplier, which they will have to pay out of their future earnings. But, how does this balance, as they don’t have an asset? (i.e. they didn’t make a loan to the supplier, so they don’t expect a future income stream from them). It isn’t PV money (meaning, it isn’t money representing value already created, with no loan attached to it). It is FV money, but the future cashflows are going to Bank A, not to Bank B!  Do you think that Bank B is going to accept a liability without a corresponding asset?42 So, how is this solved?  This is part of the mystery. When you solve it, you will be one of the few people in the world that really understands money and banking.

Well, to keep it simple, let’s assume that the two banks have a direct relationship with each other, which means that each bank has an account at the other bank.43 This allows Bank A to “transfer” $10,625 to the supplier’s bank, Bank B. There are two main aspects to the transfer: a message system (like SWIFT), for notifications, and reciprocal bank accounts, where money is exchanged between banks. Bank A would credit $10,625 into the account that Bank B holds at Bank A. This is how banks settle transfers. In most cases, it is a long, complex process that takes at least several days to reconcile. It is also a transfer of risk from Bank A to Bank B. Bank B takes on an obligation to pay the supplier, in return for “money” from Bank A. The supplier’s bank is receiving FV credit money from Bank A, so they now have exposure to Bank A’s credit risk (like, do they make good lending decisions?), their future performance.44 When you multiply that by millions of transfers each day in the banking system, you begin to understand why almost all fractional reserve banks are inter-linked globally via credit money creation. You begin to understand how credit crises are transmitted around the world. 

You might argue that you can create credit money just between two entities, without needing a bank. This is somewhat true. If a purchaser gives a supplier a year to pay, the supplier has additional purchasing power, with no bank involved. However, this isn’t really money creation. This grant of a year to pay isn’t very liquid. It is unlikely you can buy a cup of coffee with it. To be accepted as “money” you need an entire system. Other entities (like other banks) need to accept credit between entities as money.45 

42This is another reason why it doesn’t make sense to say that banks create credit money out of “nothing”. When you get into the technical details, what happens when the deposit that corresponds to credit money is transferred to another bank? The other bank likely wants to have something to back the new deposit liability they are taking on. Probably they won’t accept it if you say you created it out of “nothing”, so you will give them a little bit of that “nothing” as security.
43This is a simplification, but the main point is the same regardless of the intermediary system. It is also possible that the banks don’t have a direct relationship, so they use a middleman, a correspondent bank. They could also use some intermediary system or they could both have accounts at the central bank that could be used for offsets. Most involve pure FV money, but some have a mix of PV and FV money.
44Again, this is a simplification. Many transfers between banks are netted out and calculated at some future period, either intra-day or at the end of the day or later. In some circumstances, settlement is via holdings at a central bank. However, the main point is the same: commercial banks create the vast amount of “money” in our economy, through the deposit (IOU) process. These IOUs are backed by only about 10% of your deposited cash. Most of the repayment obligation is linked to expected FV profits. This credit money, in deposit accounts, is accepted by other banks as “money”, which creates the link between banks.
45An example is Switzerland. The Swiss, being a free people, do not allow their government to restrict their right to create money. There is a second currency in Switzerland, called the WIR, that is used mainly amongst small and medium size enterprises and has been in place for almost 100 years. Perhaps that is why bitcoin is also accepted for many transactions, like on Swiss trains, to pay taxes in some places, etc. In contrast, in the United States, citizens have wide freedoms but have no right to create their own money, even amongst consenting adults, so to speak. You can say what you want, bear arms, vote, etc., but if you try to create your own money, armed government agents will show up pretty quickly to stop you. Now you have touched a nerve. Now you see what is really important to the establishment.

Acceptance of other banks’ credit money (either as bank issued paper or in the form of deposit accounts) was always one of the key issues in the formation of central banks and, in particular, in the debate over their role as lender of last resort.46 In fact, in the United States, many smaller banks, particularly the ones that dealt with “the little guy” type of borrowers (farmers, blue collar labourers, small businesses in the Western states), were originally excluded from the Federal Reserve System.

How credit money grows over time

A single bank can create credit money on its own. As this money moves through the financial system, deposits into other banks have two important effects: 

  1. The deposit money into other banks leads to further lending, after these banks set a certain amount aside (the “fractional reserve”).
  2. The inter-links between banks are mainly credit risk.47 

In our example, a borrower started with nothing in their account and then received a loan of $10,625. With a 10% reserve ratio decided on by the banks in the system and after 5 iterations, $43,510 of “money” has been created. All of this money is FV money: the purchasing power created today is dependent on expected future cashflows from the real economy.

46The economics profession is second only to the funeral business in using euphemisms. Lender of last resort actually means that you have driven your bank into the ground and it is about to go bankrupt. No one will lend to you, because they suspect your loans (needed to support the FV credit money you have created) are not very good. The government can lend to you because it can just print more money into existence. That means that the rest of us are all worse off, because inflation takes value (purchasing power) away from us. But, just a little bit for each of us, so most of us don’t notice the theft.
47A small element of value exchanged between banks is PV money, but the majority is FV money, which intrinsically includes credit risk.
How banks make profit

Banks make a profit by lending money at an interest rate that is much higher than their costs of funds. They mainly create their own credit money, which has purchasing power today, in return for the promise of future cashflows from borrowers in the future.

Of course, diversified banks also have other revenue streams. For example, they take your money and use it in “proprietary” activities (you’ll appreciate the irony of the name), like sales and trading, market making, wealth management, direct investments, etc.

How banks don’t make profit

Banks are not simply intermediaries, charging for connecting surplus capital with productive opportunities. They are not neutral actors in the economy. That is the Walt Disney version of helpful, friendly banks and it is almost completely a lie.

How do you value banks?

Here is an illustration from one of the industry standard books on valuation.48 

So, the textbooks tell you not to value a bank like a normal firm that makes profit-seeking investments based on risk and return. How should you value a bank? You should imagine the bank as separate profit units and then value each of them separately since, unlike normal firms, they create value on the liabilities side. In your imagination, you should artificially assume that each unit has its own imaginary cost of capital that it charges internally to other units. In their example for “ABC Bank”, the “Wholesale bank” makes a spread of 12 – 8% (the 8% is completely fictitious) borrowing from the “Treasury and trading” unit (the numbers for which, conveniently, are never, ever revealed by banks) and the “Retail bank” takes in deposits from the public and their profit, from lending to the internal Treasury, is 8 – 5% (which is also completely fictitious). Just banks as financial intermediaries. Sure, maybe this is how ABC Bank works. Maybe ABC Bank is also where the Tooth Fairy does her banking.

Here is some text from a typical business school class on valuing financial services companies.49   

Unlike manufacturing firms that invest in plant, equipment and other fixed assets, financial service firms invest primarily in intangible assets such as brand name and human capital. Consequently, their investments for future growth often are categorized as operating expenses in accounting statements. Not surprisingly, the statement of cash flows to a bank show little or no capital expenditures and correspondingly low depreciation.

With working capital, we run into a different problem. If we define working capital as the difference between current assets and current liabilities, a large proportion of a bank’s balance sheet would fall into one or the other of these categories. Changes in this number can be both large and volatile and may have no relationship to reinvestment for future growth.

As a result of this difficulty in measuring reinvestment, we run into two practical problems in valuing these firms.

The first is that we cannot estimate cash flows without estimating reinvestment. In other words, if we cannot identify how much a bank is reinvesting for future growth, we cannot identify cash flows either.

The second is that estimating expected future growth becomes more difficult, if the reinvestment rate cannot be measured. 

Yeah. Raise your hand if you can spot the circularity here.

Other than these little problems, valuing banks is easy.

48T. Copeland et al., Valuation: Measuring and Managing the Value of Companies, 2nd edn., Hoboken, John Wiley & Sons, 1994, pp. 498 – 499, 503.
49Class handout, London Business School, MSc degree in Finance programme, from a visiting professor from a US business school. [Editor’s note: Ernst & Young publication]

Economists, consultants, professors, “industry experts”, etc. mostly have three things in common when it comes to banks:

  1. They have never worked in core banking, never made a loan, never written code for loan algorithms, never done the internal, management loan accounting.
  2. They never mention in their work that banks create money (credit money, FV money) through the loan process.
  3. They break out in a cold sweat when confronted with the reality of bank processes, as it is so counter to the imaginary view of how banks operate that they read about themselves, in textbooks when they were students.

Banks are intentionally opaque. Intentionally hard for outsiders to understand. There is a reason you are made to feel stupid or uncomfortable when your mind wanders to thinking about how banks work, or to define what money really is. It is the same reason that the precious metal depositories and guilds from the Middle Ages were impenetrable. What could that reason be? What a mystery.

What happens if someone cannot repay a loan?

When a borrower cannot repay a loan, it means that the asset that the bank has created (the loan) is worth less than expected; potentially, it is worth zero. That is a problem, because the bank has already created money and put it in a deposit account for the borrower. This is FV money; it is dependent on the future cashflows from the loan. If there are no future cashflows coming in from the borrower then this created money, theoretically, has no value.

However, it is a bit tricky. Your borrower has taken this money and paid their supplier, which is annoying. So, the worthless FV money is now in the supplier’s bank (technically, you, the bank, put FV money into an account for the supplier’s bank, to make it all balance in the system). So, now that money isn’t any good; it doesn’t just disappear, like loan. Worse, the deposit leads the other bank to think they have more “money”. So, they create more loans (and more money), on the basis of this deposit of “money” that they have received.

Loan failures cause the recursive destruction of credit money in the same way that credit money creation leads to more credit money creation. When borrowers cannot repay loans, it destroys an asset to the bank. The asset is mainly matched to FV credit money that was created. This FV money is now also worthless and the bank has to find other assets to support the FV money that they created. These other assets can be from reserves, deposits of PV money, and/or borrowings.

This causes banks to reduce their lending, as their assets have been reduced, resulting in an impact on the real economy. When this process happens at scale, when it is inter-linked amongst banks and the recursive destruction of credit money is significant for the fractional reserve banking industry, it causes an excessive downward variance in the business cycle.

How it works is set out below.

Let’s imagine that your initial loan is expected to be ok. So, you expect to get in $14,875 over the next five years, of which you created FV money today of $10,675 and gave it to the borrower. However, the other 4 loans that were made all go bust. That is a problem, as they are linked to a further $32,885 of FV money that was created in the system as a result of your initial loan. (Actually, based on typical multipliers, much more money would be created, but let’s be conservative for our illustration). So, $10,675 + $32,885 = $43,510 of FV money has been created, but the expected cashflow to be received in the future is only $14,875, which comes in over the next 5 years. If you are not a math whiz, just know that these numbers are bad for the economy.

Now you understand the 2008 financial crisis a bit better.

How do banks value themselves?

Well, they don’t tell you. They don’t really want you to know. Of all of the industries covered by research analysts in investment banks, financial services firms are the most difficult to evaluate and then forecast. Banks just don’t make the necessary details available. None of them do. It is a “trade secret”.

You now know most of the important aspects of how banks operate. It isn’t so important to know many of the remaining details. You are not going to go set up a fractional reserve banking operation, I hope. We are going to end fractional reserve banking and reduce the booms and busts in the business cycle.

The main thing to understand about banks is that while most of their assets (loans) have a finite life, like, say 5 years, the bank itself is correctly conceived of internally as a perpetuity. It is basically an on-going bundle of expected future loans, converting future cashflow streams into purchasing power today. This is its monetisation role.

So, you can think of valuing a bank, or a business unit of a bank, using a perpetuity formula, as below.50


CF is the expected cashflow in the period (either t0 or at the start of some Terminal Value period)

r is a discount rate, the cost of capital

g is the expected future growth rate

If the perpetuity is for a future period, then the derived value needs to be discounted back to a present value.

50This is a simplification and you can add many different valuation considerations. The main point here is: keep your eyes focused on “g”.

Banks have a perception of their own value and adjust their actions accordingly. People are the same. If you feel good about future economic prospects, feel secure, feel positive about the potential for a raise or bonus, you are more likely to loosen the purse strings and spend now. If you feel insecure about the future, you are likely to conserve your funds.

For the bank, what drives their actions is “g” in the formula. That is their perception of the future. The term “g” has significantly greater influence on bank lending volumes than the term “r”. This is one of the reasons why typical central bank policy action is so ineffective when it comes to aggregate lending in an economy. The correlation between r and aggregate lending is low. The correlation between banks’ perception of g and aggregate lending is high.

How the banking system works, globally

Credit money creation by commercial banks and the fact that most commercial banks accept deposit account transfers from other banks lead to the inter-linking of credit risk.

Here are some lessons from this global inter-linking of credit.

  • One, small bank undertaking fractional reserve banking is high risk. Banks know that bigger is better and that scale is important to mitigate the risks inherent in this banking model. If you are a bank, you want to be too big to fail.
  • Or, you want to be as connected as possible to other banks, like through correspondent banking. Everyone needs to be in on it. Globally. Success in fractional reserve banking requires coordination and enablers. Over the centuries, a vast infrastructure has grown up to enforce the system (legal, police, debt collection, prisons, etc.). It is the same in almost every country, regardless of political leanings.
How financial crises are caused

The vast majority of financial crises are caused when there is a recursive destruction of bank credit money that was used for the third lending area: against asset prices.

Recall that lending to the first two areas (productive investments, like extending the plant or hiring more workers; and time shifting of consumption) are both based on expected future cashflows. Maybe those cashflows will materialise, maybe they will be a little higher or lower. In extreme cases, maybe they will be zero.

Financing assets is different, though. It assumes that an asset will increase in value in the future, which is how the loan gets paid off. Maybe you sell the stock to someone else at a higher price, or you hold the real estate expecting prices to rise and then you will sell it to someone else.

If future, higher prices for that asset do not materialise, however, there are two problems for the bank, on each side of the balance sheet. On the asset side, well, your asset has gone down. The stock or real estate tied to your loan is worth less. That is a problem because your loan is only backed by the asset value; there is no (or little) cashflows that can be used to repay the loan. Your other problem is on the liabilities side. You created credit money and gave it to the borrower, which is now gone. This is FV money; it is tied to the expected future value of the loan, your asset (which is now underwater). It isn’t PV money, which has no link to future cashflows, since it represents value already created.

If, as is typical, the borrower used this credit money to pay their own suppliers, then this will have involved transferring money from the account at your bank to accounts at other banks. As we saw with how transfers work, this means that the suppliers received a deposit from their bank. The way that this works in the banking system, you will have credited the other bank’s account. So, you owe money to the other bank, which allowed this other bank to credit the deposit account of the person receiving the money, the supplier.

But, now, the asset (the loan) you were counting on to bring in money isn’t there. Sadly, however, the money you credited into this other bank’s account is still there. You still owe them the money. You wish you didn’t make the loan in the first place: the value of the asset in the market is uncertain and it doesn’t produce cashflow. At the same time, the other bank, the bank of the supplier, has received the deposit, put some aside in reserve, and lent out 90% of what they received. You want to call them and say, hey, maybe best to just hold on to that “money” until we can figure out the value of the asset, linked to the original loan. Now, this decline in asset prices has caused a problem for you. It has also transmitted some of that problem to the supplier’s bank. It doesn’t stop there, though, as the supplier’s bank has also lent out some of this money, so some other bank also now has a credit problem. Isn’t fractional reserve banking a great system?   

The graph illustrates the effect of increasing asset valuations over the economic cycle. In this case, they increase from 100 to 305, which is a 25% uplift per transaction for the asset.

The bank finances the asset at a prudent 80% loan to value ratio. The key issue is: what is the value level? Suppose the value is set by the market (like for stocks or real estate) and you mechanically apply your 80% LTV ratio, as is standard in banks. The problem occurs when value resets in the market and the price falls.

The result of a decline in value of the asset should be obvious:

  • The bank debt doesn’t also automatically reset; the bank has already made the loan, based on the (now too high) valuation. All of a sudden, LTV is way too high.
  • In creating the loan, the bank created a deposit and FV credit money. This is what was lent to the borrower. It also doesn’t reset. This is also based on a valuation that was too high. So, too high LTV = creation of high risk FV credit money in the economy.
  • There are no (or little) cashflows to support the loan (and the FV credit money created).
  • This leads to FV credit money destruction.
  • Banks’ inter-linked accounts transmit this value destruction in a recursive manner throughout the economy.

Oh, but wait: the textbooks tell me that banks don’t create money!  And, that I should not value banks as if there are making investments, like normal firms!  Here is the truth: banks create the vast majority of “money” in the economy and they make investments (called loans, the assets on their balance sheet) with the objective of making a profit. Don’t be deceived.

This combination (FV credit money creation + use of this money to finance asset purchases + inter-links amongst banks) is what caused the 1929 Great Depression (stock value declines) and the 2008 Great Recession (housing value declines). Essentially, long-run natural valuation levels became distorted (too elevated) by credit money creation, which caused a concomitant series of further distortions to natural asset valuation levels. Natural asset valuation levels are those valuation levels that would be set by supply and demand for an asset (based on risk and return metrics) in the absence of bank credit money.

Here is a graph of what the Federal Reserve in the United States terms the “Adjusted Monetary Base”.51 

St. Louis Adjusted Monetary Base

Here is the key take-away from the graph:

Under a fractional reserve banking system, recessions are a regular occurrence. Recessions are an inherent part of fractional reserve banking. Recessions are the norm, not the exception. No one should be surprised when the economy experiences excess variance, which is caused by bank credit money creation.

(Another take-away might be, given the astronomical amount of “money” created by central banks over the past decade, that the next bust in the economy will make 2008 look like a small bump).

You can see from the graph that it doesn’t matter if you are on the gold standard or not; it is the fractional reserve banking system itself that creates recessions.

51Federal Reserve Bank of St. Louis. Data from 1 January 1918 to 30 September 2018. Where are the data series on credit money creation by banks? What about details of credit money used to finance asset purchases? No such data. You can get data on how many vacuum cleaners were sold in each state, but nothing on the statics that really matter for evaluating excess economic variance.

When bank credit money is used to finance assets that subsequently decline in value, banks have effectively created purchasing power for which there are no future cashflows. The value that a bank ascribed to an asset, like real estate or stocks, is never going to be there; the value doesn’t exist. And, there is no cashflow coming from the asset to pay back the loan … which the created “money” was based on. Value impairment through the recursive destruction of credit money linked to asset financing is what causes most of the downward excess variance in the business cycle.

There is a reason why the love of money is the root of all evil. It is because it distorts our memory of value created, as well as our values. It causes us to be less human.

How do banks protect themselves against recessions?

Modern, fractional reserve banking is an inherently risky activity.

Here is why:

  1. The core philosophy of fractional reserve banking is based on dishonesty. The bank tells depositors that it is their money, sitting in their account, and they can have it back at any time. At the same time, the bank lends most of the money to borrowers or uses it themselves, including as an input to their own credit money creation. The fundamental premise of fractional reserve banking is built on a lie. This lie is then propagated by the banks’ enablers in society and enforced by the state.
  2. These banks create their own “money” today, which has current purchasing power and which they give to borrowers. The value of this money, however, is dependent on future cashflows. If these future cashflows do not materialise, recursive credit money destruction causes economic crises and means that the bank may not have enough reserves to cover the lie that they told depositors: that they could have their money back.

The risk structure of fractional reserve banking:

An inverted house of cards

Even a small change in “g”, the growth number used in the valuation formula for future cashflows, has a significant impact on the calculation of banks’ asset values. That is the reason why most banks don’t lend much again during/after a recession, regardless of the price of money set by the central bank. The money price (part of their cost of funds) is a component of asset value, but is much less important than the “g” estimate.

The value of “g” causes a wide variance in the estimated future value of a bank’s assets, the cards at the top of the inverted pyramid. As the amount held in reserve is small compared to the expected future value of the assets forecasted into the future, the effect is that systemic shocks in the economy can wipe out the PV money valuation of many banks. In the old days, there would (rightly) be a bank run. In 2008, after the collapse of Lehman Brothers, many large, global banks quietly admitted to their home governments that their reserves were gone, that they were insolvent.

Hence, the bail-out of banks by society, cleverly disguised by most governments through the use of euphemistic language to describe what they are doing. Not sure what quantitative easing is? Well, it is injecting newly printed money into the economy banking system. Has that prompted the helpful banks-as-simple-financial-intermediaries to lend again? No. What will cause them to lend again? Well, it will be their internal, profit-motive-driven estimate of the value of “g”. Their estimate of future expected cashflows to their assets (loans).

So, as a bank, how do you protect yourself against the risk of failure? The answers are set out below.

  1. Bank contributions pay the salaries of the regulators, in most countries.
  2. Scale is important: banks want to be as big and diversified as possible to handle shocks. Then, you can get yourself labelled “systemically important” or “too big to fail” by your enablers at the regulatory agencies.
  3. Banks contribute to politicians, who set the rules governing the banks.
  4. Banks, and their enablers, attack any other financial system that poses a threat to the fractional reserve system.

Some commercial bank insiders, perhaps more cynical or more versed in game theory, have a different approach to protecting against future recessions: do nothing. Recessions are a given. In good times, when a bank makes profits, it (and the bankers) receive the benefits. In a mild recession, banks suffer losses, but they are not enough to threaten to topple the house of cards. In a bad recession, everyone panics. Globally. Regardless of the political party in office. In these recessions, all commercial banks are saved by the government. The establishment unites around euphemistically labelled bank rescues, since the establishment needs, and benefits from, the banking system. That means that the government, whether it is obvious or not, takes a little bit from everyone in society to replenish the PV money at the bottom of the house of cards.

From a purely game theoretic approach in regard to payoffs, it is certainly the banks’ dominant strategy to do nothing, while still performing all of the relatively low-cost public relations exercises.


We now know that the power to create the money supply in an economy is granted to commercial banks. We know as well that bank credit money is tied to loans, which are just expected future cashflow streams. Essentially, a bank gives its borrower customer “money” today in return for the promise by the borrower of paying more money in the future. In its decision-making about loans (and money creation), a bank undertakes its operations driven by a profit motive.

This grant of money creation powers to banks raises some ethical issues, some of which are set out below.

  1. Society grants the exclusive right to commercial banks to create credit money in an economy.52 
  2. Banks create this credit money with the objective of maximising profits to their shareholders.
  3. This credit money is freely insured by the government, which provides a massive subsidiary to the banking sector.53 
  4. Bank regulation is determined by the political sector, including granting money creation rights, subsidies and restriction on use of funds for loans.
  5. Banks make significant transfers to the political sector.
  6. If banks make a profit, these profits are retained by the shareholders of the bank.
  7. If banks fail, the cost of failure, including recapitalisation, are borne mainly by society.

52This is FV money (dependent on future economic outcomes). PV money (which is not tied to any repayment) can only be created by the government.
53There is an explicit maximum amount per deposit account that is insured. Implicitly, all monies in a banking system are insured. For many governments, on an economic benefit basis, this is their largest single transfer of value after Defence, Social Security, Education, and Healthcare. Governments can usually satisfy this bank insurance obligation in a way that is seemingly costless (or even beneficial) to government, by printing money and causing inflation. Inflation reduces the liabilities of the government (hence, it is a benefit to the government). However, satisfying this insurance by printing money has a cost to society: it leads to those who have savings being worse off, as it essentially takes purchasing power from them.
54Insurance is the best descriptive term to use to give confidence to “depositors”, but it is not really insurance. When you insure your house in case of fire, the insurance company has a fund available to cover claims. With government “deposit” insurance, there is no such pot of money. If the government needs to bail out the financial sector (that is right: like what has happened for the past 10 years and what continues today), they print the money. They call it different names so nobody takes up arms, but it is newly created money. Who pays for all of this “insurance” that props up the banking sector? You do: the tax payer. Hard to believe that it isn’t really insurance? Don’t worry, it isn’t really a deposit, either. The correct way to understand the guarantees behind fractional reserve banking is that the deposit loan from you to the bank is backed by a government insurance policy promise to print more money so that the bank can give you back your deposit pay back the loan from you, (just with less value, meaning less purchasing power, caused by the newly created money process).

Since the deposits of a bank are insured by the government, it is a significant advantage to the banks. In addition to banks being granted the right to create credit money, which forms the vast majority of money in the economy and is used exclusively to the advantage of their shareholders, the government also provides an enormous subsidy to these banks in the form of free deposit insurance.54 Free deposit insurance does not only artificially increase bank profits, it also creates an extremely serious moral hazard issue, which contributes to the excess variance in the business cycle. Imagine for a moment that the banks themselves had to pay their own insurance premiums, either to the government or to a private sector insurance company. If ordinary businesses had free insurance on everything that they did, do you think that might impact their behaviour?

If you are getting all excited about:

… the possibilities to restrict banks from lending their credit money to finance asset purchases as a way to reduce excess variance in the business cycle, or

… getting banks to pay the costs of deposit insurance to reduce moral hazard, or

… banning banks from making political contributions, or

… putting warning labels on deposit accounts that tell people the truth about them really lending their savings to the bank and that the bank can do whatever it wants with the money, which is no longer theirs …


Don’t. Don’t get excited. The antiquated, dangerous fractional reserve system will be gone in 10 years. Of course, all of the above suggestions should be put into place, but you need to keep in mind that almost the entire establishment is enmeshed as enablers of this fractional reserve banking system.

Millions of people’s livelihoods depend on society not seeing behind the curtain, to see what banks really do. It will be a David versus a Goliath-on-steroids fight and, even if you succeeded with this reform, fractional reserve banking is still inherently dishonest and flawed.

More importantly, there is a new, better system that is emerging as an alternative. Technically, it is a digital system, compared to the analogue system that is traditional banking. It is an alternative that doesn’t have all of the moral perversity of the old fractional reserve system. One that restores the concept of memory of value created through productive effort in the economy. One that aligns with our most basic human values.

There is a new technology alternative that is like sunlight, a needed disinfectant to the sick system in which we now live.

What is the main role of central bankers in regulating the current system?

If you have seen the graph above of economic booms and busts occurring like clockwork over the past century, you might be tempted to burst out laughing at this question. You might conclude, on the evidence, that central bankers are ineffective. However, you might be being too kind to them, so let’s look at the details.

Let’s imagine that being a central banker was a real job, like being an engineer or a software developer or a medical doctor. The main objectives for a central banker are price stability and employment.

Well, here is a chart of the purchasing power of the US dollar since the inception of the Federal Reserve to the end of 2017.

Value of US Dollar Since Inception of the Federal Reserve

Explains why you don’t see too many “Five & Dime” stores in the US anymore. Great work, Fed. It looks like Zimbabwe, just over a longer timeframe.

OK, so the product has lost 95% of its value and you wanted it to be stable.55

55As hard as it is to believe, there are actually people in crypto right now working on creating “stablecoins” tied to the value of the US dollar.

Don’t worry about the central bankers getting depressed about underperformance, though. The crypto system that will soon arrive will have no need of their skills. It will be an excellent opportunity for elitist, out-of-touch economists finally to be able to practice what they preach to others and embark on job retraining.

Let’s turn to booms and busts. You recall the chart above. Well, there have been 18 officially recorded recessions over the past 100 years in the United States, of varying length. Let’s assume that there were no booms and that recession periods were the only bad periods for price stability. Let’s be generous and say that about once in every 10 years there is a system failure. So, what if the same thing happened in engineering? What if we built dams and every 10 years or so they burst? You think people might complain? What if you built smart phones and one in every 10 times you turned it on, it broke? You think people would keep buying your product? What if one in every 10 patients died on your watch? Do you think you would still be practicing?

So, why do we accept such failure from central bankers? Why do we just live with such excess variance in the business cycle, its destructive effects, and its repetition over time?

Where are all of the scholarly research papers on the effects of banks’ creating credit money? Where is the analysis of the impact of this credit money and its use for asset purchases? Where are the statistics on the recursive, backward destruction of this credit money when the (mainly arbitrary) asset valuations (which underpinned the credit money creation in the first place) decline below a trigger level, which causes the avalanche effect of credit money destruction? Where are the details on how the global inter-links of banks accepting other banks’ FV money transmits financial crises?

Is monetary policy really as ineffective as the evidence shows?

Speaking of failure, let’s have a look at central bankers’ preferred policy tool: monetary policy. People talk about monetary policy in reverent tones, as if some small conclave of government bureaucrats that sets the price of money (in supposedly free market, capitalist economies) has some magic crystal ball. People who have nothing better to do with their time actually track their votes at these useless conclaves. I mean, look at the track record: if these people were doctors, would you let them anywhere near you with a scalpel? Anyway, here is why monetary policy is weakly correlated with bank funding costs.56 

An illustration of sources and uses of funds for commercial banks, in regard to loans, is set out below.

Monetary policy is weakly correlated with a commercial bank’s actual funding costs; that is why it is so ineffective.

56This paper just deals with the main issue: why monetary policy is fundamentally flawed, since it only (indirectly) affects a minority aspect of banks’ funding costs. In addition to just being an unsound policy, monetary policy is also ineffective (even if it were not misguided). The policy implementation has a “lag effect” in which it takes months for rate changes to be transmitted through the banking system. Oh, and there are many central banks involved in the process. So, the formula is: committee of government economists + crystal ball looking out at least a year + maybe a half dozen important central banks = policy implementation. Which takes, say, 6 months to filter indirectly through to the economy. You have to be of diminished mental capacity if you think that this is effective. But, don’t worry about actually how ineffective the policy is. The entire approach is a joke. Which we probably should have known, like, 18 recessions ago.

Monetary policy mainly and indirectly affects only one of the four main sources of funds for a bank: borrowing from the central bank.57 This is a small minority of a bank’s cost of funds. The largest source of funds is a bank’s own internal, credit money creation. The cost of this money is not set by the central bank. As an example, as the good people at Lehman Brothers were packaging up toxic sub-prime mortgages and getting them rated AAA by S&P and Moody’s and preparing to sell them to unsuspecting buyers around the world, no one stopped and said, “Wait a minute, what is the Fed Funds rate?”  The expected revenue line was so high (and they were not going to hold them on their own books for very long, hopefully) that even if the central bank rate doubled it would have had very little effect on their cost of funds and, consequently, on their expected profits.

Here is a little brain teaser for you.

If commercial banks create the vast majority of credit money in an economy … and they do so “out of nothing” (almost, at least in terms of cost of funds), then … why does the central bank interest rate really matter? Why do we think that monetary policy is so important? Maybe we cannot see the forest for all of the dots around. Maybe the dot plot is the opiate of the financial masses, that keeps them from seeing fractional reserve banking for what it is.

The correct punch bowl analogy

Alan Greenspan remarked that the role of the central bank was to take the punch bowl away just when the party gets going. We all know how well that turned out. However, it was his intellectual point that was incorrect, because he doesn’t understand how banks actually operate (or isn’t telling the truth). It isn’t simply an issue of timing. It isn’t simply that the Federal Reserve can wait too long to raise interest rates, to pop an asset bubble (or, like 18 of them in the past century).

The correct point to understand about regulating banks is that:

They are not drinking your punch, man.

They have their own punch bowl. And, it is 10x the size of your punch bowl. And, the mix in their punch is a lot more intoxicating than your punch.

Yeah, of course, they come over and drink out of your punch bowl. And, out of the depositors’ punch bowl. But, that is not where the party is.

Your problem, Alan, is WYSIATI. What you see is all there is. The cognitive bias described by Daniel Kahneman and Amos Tversky. Perhaps central bankers in their nice offices, and the smug ivory tower economists who surround them, don’t spend much time thinking “well, there are still many things I don’t know”. You see the bankers drinking out of your punch bowl and you assume that is all they have to drink. Well, if banks only got money from the central bank and/or the central bank controlled this money supply through the reserve requirement/money multiplier, then taking the punch bowl away would, indeed, put a damper on the party. But, as explained above, this is a relatively small part of banks’ sources of funds, of the money supply, the money supply in the sense of both the gold and the IOU, since both have purchasing power. If you see banks mainly through the lens of the reserve requirement/money multiplier, you would be missing something; you would have fallen into this cognitive bias. (In addition to the fact that, just by empirical analysis, even taking your own punch bowl away obviously doesn’t work, so maybe it is time to revisit your mental model. Or, start telling the truth).

Likewise, if the banks only got money from depositors, if banks were only financial intermediaries, then taking the punch bowl away would be effective. But, again, this is a relatively small part of the money supply. If you see banks mainly through the lens of them as financial intermediaries, you would be missing something; you would have fallen into this cognitive bias.

So, who is right?

The proof can only be in the empirical results. These results are not in favour of the reserve requirement/money multiplier theory, nor the idea that banks only act as financial intermediaries. Nor do the results support the effectiveness of monetary policy in managing economic variances. Raising rates doesn’t end the party. Cutting rates doesn’t bring the party back to life.

If you see banks for what they really are, if you really understand money, then you know which punch bowl to take away.

However, even if you do understand the situation, there are a few fatal errors that arise due to the fractional reserve banking system, which are set out below.

  1. We are not talking about a physical punch bowl, of course. We are talking about raising central bank interest rates. This mainly just influences central bank money59, not a bank’s FV credit money (which is dependent on future expected cashflows as their main driver). As central bank money is a relatively minor source of funds for banks, changing the cost of this money will have a weak impact on a bank’s behaviour. Consequently, monetary policy is relatively ineffective.   
  2. Interest rates are a blunt instrument; they cannot be targeted to where the problem is, which is almost always the third use of funds: asset purchases. Interest rates are raised across the economy, affecting also the other two uses of funds: productive investment and time-shifting of consumption. This causes distortions in the economy and distorts price signals, without addressing the main issue of concern.
  3. Creation of credit money by banks is not directly controlled or regulated by the central bank; there is no regulation mechanism in place whatsoever, except perhaps moral suasion.
  4. The use of funds of this credit money is also not controlled or regulated. The two together (credit money creation + then using this money to fund asset purchases), have the greatest impact on excess variances in the business cycle.

57The inter-bank lending market also is impacted by the price of money decisions taken by a central bank, but the effect here is even weaker. The inter-bank market is where banks make loans to each other. The central bank rate is taken into (minor) consideration here but the main determinant is the riskiness of the bank to whom you are lending. So, the inter-bank market prices mainly on credit risk, not what the central bank funds rate is set at. For example, as the 2008 financial crisis unfolded, most central banks lowered their funding rates. Yet, as banks were (rightly) wary of each other’s riskiness, rates in the inter-bank market went the opposite way to central bank rates: they went up. Until the market froze, at which time banks were unwilling to lend to each other at any price. This means each bank was saying to itself: who knows that risks other banks are taking, what FV money creation they have been involved in? This is equivalent to old-fashioned bank runs, where some banks would not take other banks’ paper money, because of the credit risk (uh, yeah, how did you create that credit money? Lending to sub-prime borrowers? Lending against stock certificates? Why should I have that risk transferred to me?). In the United States, there was an era in which many banks issued their own money, the so-called Free Banking Era. Most economists will lie to you and tell you that this era is over. In fact, rather than their own bank notes, banks today print their own money in the form of deposit accounts. Which convey purchasing power. Which can be transferred to other banks. Which makes the FV money (tied to a loan) created by the originating bank … the problem of any linked bank as well. So, banks have two main risk transmission links: the inter-bank lending market and by accepting other bank’s deposit money transfers.
58Ignore, for the moment, the arrogance that a small group of government functionaries sees the future better than the knowledge that is diffused throughout society, that the centralised few are better than the decentralised community. And, that these supposed visionaries then do the right thing for the economy. You only need to look at the graphs of purchasing power and recessions to have this idea dispelled in your mind. Of course, rate changes do have an impact on financial markets, which are primarily PV money. However, the correlation between rate changes and bank lending volumes, as well as on deposit and borrowing rates, is very low.     
59Sure, changing the interest rate does have some impact throughout the economy, particularly at the margins. But, it is still a smaller part of the funding mix for banks. The central bank assumption that everyone is drinking from the same punch bowl is inconsistent with reality and it consequently assumes a greater efficacy for monetary policy than really exists.

So, in summary, you can take your own punch bowl away if you want. Banks won’t care very much. They are still going to keep partying, if the future they see seems bright. As you know, you cannot take their punch bowl away; the decision to drink or not has been granted to them, since they create most of the money in an economy. You cannot force them to stop drinking, just like you cannot force them later to start drinking again. The last decade has shown this to us clearly. What you do with your little punch bowl is weakly correlated with whether bankers want to party. Even worse than not being able to take the banks’ punch bowl away, you cannot control what they do when they are drunk on the punch. If bankers want to lend on the hope of ever-increasing asset prices (because the asset values are “tangible”), there is nothing regulators can do under the present system.

This is our modern fractional reserve banking system. It is not at all capitalist; it is more like a closed, medieval guild system and it will always exclude out-groups by its very nature. It is as destructive as it is dishonest. It is about as far away from the concept of value, and from our better human values, as you can get.

The Basel Fallacy

The Bank for International Settlements (BIS) was set up by the Bank of England and Nazi Germany’s Reichsbank in the 1930s, with the blessing of the Federal Reserve. The BIS is headquartered in Basel, Switzerland, although the bank’s offices are, by international treaty, outside of Swiss jurisdiction. The BIS is described as the central bank for the world’s largest central banks and holds regular, confidential meetings in Basel for its members.60 

To assist with creating confidence amongst banks, a committee under the supervision of the BIS has established rules for how much capital banks should hold, informally called the Basel Accords. Basel I was put in place in 1988 and suggested that banks hold 8% of their risk-weighted capital as reserves. I’m sure you are thinking: wow, 8% at the bottom of the inverted house of cards!!  That ought to give everyone a lot of confidence.

Then, after that didn’t have any observable effect whatsoever on financial crises, or their transmission amongst banks, or anything else, Basel II was put in place in 2004. Basel II was more complex: some of the finest minds in economics, many of whom are household names, helped devise a “Three Pillars” approach to managing fractional reserve banks. This was based on: (1) Minimum Capital Requirements, which moved away from a standardised reserves approach to something more customised, which could be created by each bank as they saw fit; (2) Supervisory Review, which give regulators “better tools” than previously available; and (3) Market Discipline, which contained a set of disclosure requirements so that banks could not hide toxic liabilities on their books. And … it worked really well. There has been no excess variance in the business cycle since 2004. Full employment. No near bank failures. No global systemic risk events. That is why the same familiar faces of economists, bankers and central bankers are all still around, have kept their jobs, and appear regularly at Davos to help run the world.

There is also a Basel III. I’ll spare you the details. It was supposed to be implemented in stages by 2015. However, it has been repeatedly deferred, now until 2019. Don’t look it up: it is designed to be complex and opaque for outsiders. If you do spend time researching it, at least three things will keep you up at night: fractional reserve requirement are insanely low; banks use their own internal risk models for many of the evaluations; and, much credit risk analysis is done by S&P and Moody’s (you might recall that their business model is that banks pay for the credit assessments from these two, which is unlikely to lead to any conflict of interest; they are also the ones who brought you thousands of AAA rated sub-prime mortgage vehicles). There are a lot of buzz words about macro-prudential regulation. Probably Basel III will be just as effective as the other accords.

The Basel Accords are not really enforced anywhere, except in the European Union. They are somewhat enshrined in law in the EU and overseen by the European Central Bank. The Basel Accords have, thankfully, prevented any problems in the fractional reserve banking systems of member states and, in particular, the banking systems of Portugal, Italy, Ireland, Greece and Spain have been doing really well over the past decade. The ECB, under the transparent leadership of the Italians and the French and despite printing more money than existed on Earth a few decades ago, most of which has been revealed to the European people in a completely forthright manner, is also doing super well.

The thing about the Basel Accords that is strange is that there is no mention anywhere in the thousands of pages of reports and recommendations of commercial banks creating money. The mystery again; why do you think that is?

The Basel Accords seek to regulate banks as if money were created only by the central bank and then there was a money multiplier effect based on the reserve ratio (you remember that crucial ratio, the one that Canada, Australia, Sweden, the UK, etc. don’t have) and/or as if banks were simply financial intermediaries, the Walt Disney version of what banks are all about. None of these accords consider the implications at all of bank credit money creation.

Here is the best way to understand the Basel Accords, in poetic form.61 

The regulatory system fails entirely
to regulate
the main source of funds,
self-created credit money,
for a bank.

The regulation also fails to control
a key use of funds,
into asset purchases,
which is the main cause
of excess variance
in the business cycle.

Other than these issues, there is nothing to worry about. 

Seriously, combined with what we know from the Gulf Investor Deception and banks’ ability to influence their own capital, the Basel Accords are a complete fallacy.

60If you are worried that I’m going to start to veer towards some weird conspiracy theories and are tempted to stop reading, don’t. The BIS sounds like something out of a Dan Brown novel, but I cannot help it; these are just the facts. For full disclosure, I have not read conspiracy books about the BIS, like The Tower of Basel, although a friend here in Switzerland told me that the book existed. Personally, I’m not so interested in such things; I’m just interested in economics and banking. I don’t think that the BIS or other central banks are involved in some vast conspiracy … mainly because they are just so completely ineffective in their day jobs that I cannot see them pulling it off.
61Originally written in German, the language of Basel. It doesn’t rhyme quite as well in English, but it hopefully makes the point.
Central banks and trust

Some have argued that it is central banks who engender trust in the banking system. The people who most often make this argument are central bankers. Let’s analyse their claim in respect of trust.

The establishment of the Federal Reserve System in the United States provides a good experiment to test whether the presence of a central bank had an impact on the stability of the commercial banking sector. The US central bank was established at the end of 1913. In a comparison of the two decades before and after this date (adjusting for the effects of the Great Depression), there was no significant change in the rate of bank failures. However, from 1933 onwards there were almost no bank failures. It was the first time in US history that bank failures came to an almost complete halt. What caused this? In 1933, the US created deposit insurance, in an entity separate from the central bank. Now, everyone’s bank deposits were insured by the government (at least that was the headline message, without getting into the details). Bank stability has little to do with central bankers or the central bank money rate. It has to do with insurance and confidence in a bank. Not confidence in central bankers’ ability to make wise economic decisions.   

Here is another way to look at trust in central banks’ management of a country’s money: how does the purchasing power of a currency compare to gold? Even better: if people actually trusted bankers (central bankers or commercial bankers), there would be no market for gold as a store of value. We would have discarded gold the way we stopped using shells. The difference between a nation state currency and gold is that central bankers cannot print gold.

Learning from the past: the banking system’s ability to protect society from future recessions

Economists go by several different labels. However, most share the same things in common, such as believing that banks are simply financial intermediaries, mainly excluding the banking function from their economic models, and never having worked in a bank. Almost none of these mainstream economists admit that commercial banks create the vast majority of money in an economy. All, however, have a strong view on the positive importance of monetary policy.

Almost all of them also take the same view in regard to the 2008 financial crisis: mal investment in asset lending, like against real estate values, had nothing to do with the near collapse of the banking sector. Banks are just helpful financial intermediaries. They don’t create money. No impact on banks when this “money” is destroyed by loan (their asset) shortfalls. Maybe in Fantasyland.

So, with economists like this in charge of central banks, writing textbooks, and teaching the brightest minds of the next generation of economists, we don’t have to worry about any repeat of past economic failures. Clearly, we have learned all of the lessons necessary in regard to the dangers of fractional reserve banking.

Monetary advice from the aliens

The aliens selling us the cure for cancer have a decision to make: what do they take in return? It depends on where they want to spend what they get in exchange. If they want to take it home, all of our “money” is worthless to them; money has no intrinsic value, except in that it gives you purchasing power. Back home, no one takes US dollars, gold or bitcoin. So, if they want to take something home, they just need to propose something that we have. Nothing in the world has a single price; all prices are just a ratio of two values. Let’s imagine that they fall in love with the statue La Pietà by Michelangelo. So, the price for the exchange is cancer drug : La Pietà. That is barter. Sometimes simple is best.

Now, however, suppose that they might want to buy a lot of stuff here on Earth, so they want to sell the cancer drug for money, which they can spend here. We give them three options: US dollars, gold or bitcoin.

They think about it and then give us the answers below.

US dollars OK, so this is your world’s reserve currency. It has a built-in mechanism where it loses a little bit of purchasing power every day, called inflation. It is better called a theft index. So, it innately encourages people to spend their money, rather than save it, which is bad for your civilisation, especially the poorest amongst you (although we see that you don’t seem to give bank accounts to poor people so they can save. And, why should your banks do that, anyway? It isn’t like they receive any benefits from society, so why should they give benefits?). The system is also fundamentally dishonest: you all pretend that you have money safely in the bank and yet it isn’t your money and it cannot both be in the bank and, at the same time, used by the bank. And, why does the world use it as a reserve currency and yet it is entirely tied to the performance of only one economy and under the control of their government (for a minority of money creation) and their banks (for a majority of the money creation)? The aliens conclude that US dollars are a poor store of value and that our banking system is financial cancer and intrinsically biased against out-groups, which they consider immoral. So, they don’t want this kind of money.   
Gold Next, they consider gold. OK, now we understand why you have an advanced civilisation and yet use pieces of metal as symbols of value. That is why you waste your time with the costs of mining: your traditional banking system and your money are so dangerous and dishonest that you are driven to seek this alternative. Gold has a slowly increasing supply and therefore is superior to US dollars, as a store of value, since dollars are created without limit. They ask around to see who accepts gold as payment. Well, almost no one does. So, they don’t want this kind of money either.
Bitcoin Next, they consider bitcoin. This is more like it: it is highly secure, based on mathematical formulas, so it cannot be copied and you don’t just need to trust human beings to do the right thing each time you use it. You can exchange it directly amongst people, like sending information, without going through a central switchboard. Transfers cost a small fraction of what it costs in dollars and they settle almost instantaneously, not in days or weeks. It has a fixed supply, so, by definition, is a superior store of value than dollars or gold. As with gold, that is why millions of you go to the expense of securing the crypto system: your banking and money system are so inferior in comparison. OK, they ask themselves, but why hasn’t this crypto system, which seems so much more in line with your human values of freedom and fairness, why has it not replaced the corrupt banking and money system run by elites that you have had in place since the Middle Ages? Why does bitcoin only mainly function outside of your real economy?

The aliens reflect on the money options for a nanosecond, then they take the statue and go home. Undoubtedly, they feel a little sorry for us, in the same way we might feel sorry for the ancient Romans who were slowly poisoning themselves with their everyday drinking water, without really stopping to consider what was hurting them.

Before they leave, the aliens leave us a copy of Aleksandr Solzhenitsyn’s The Gulag Archipelago. The message from this volume of books, they say, is that immoral control societies do not arise just from a small group of people. Everyone in a society contributes to the malaise, in their own small way, by telling or supporting lies.

The crypto system

OK, with that short review of the fractional reserve banking system, let’s summarise the crypto system as an alternative.

The crypto system is a profoundly natural, a very human invention. It is the most authentic form of money humanity has had since indications of value were part of our memory. It is characterised as set out below.

  • Based only on PV money (i.e. value that exists today, not tied to any required future value creation)
  • Allows value to be exchanged directly between two parties without any middleman, almost instantaneously and at extremely low cost.

A better description than the term crypto currencies is honest money. Money is about more than just exchanging value; it is also about our values. At its heart, crypto currencies are a representation of truth. Fiat, or paper, currencies, as well as fractional reserve banking, are intrinsically founded on a lie.

The table below summarises the difference between the fractional reserve banking system (including fintech banks and crypto banks) and the crypto system.


Traditional banking system

Crypto system

Value capture Bank shareholders, senior management Owned by all participants
Ability to create money Yes, unlimited No, fixed supply
Currencies as standard of value Poor, lots of currencies, all tied to nation states Poor, global (good), but lack of depth, lack of link to real economy
Currencies as store of value Poor, unlimited supply Good, fixed supply

Will be enhanced by depth

Payment system Expensive, slow settlement, rapid point of sale, inefficient Transaction time much slower than traditional, direct between users, low transaction fees, quick settlement
Ownership of deposited funds Owned by the bank Owned and controlled only by users
Profit driven by deposit-loan mis-match Yes No
Authority Nation state government, regulatory Global community, autonomous
Trust Single, centralised body: bank (including their servers, employees) Based on mathematical proofs; open, community verification
Organisational structure Highly centralised Distributed, based on the community
Links to the real economy High; strong links Almost non-existent
The opposition

Augustin Carstens, head of the Bank for International Settlements, the central bank for the world’s largest central banks, is a former politician, and former head of the central bank of Mexico. A vocal (and completely unbiased) critic of the crypto system, here is what he had to say recently.

“Cryptocurrencies are … a bubble, a Ponzi scheme and an environmental disaster.”

This is what you have to expect from the supporters of fractional reserve banking. It is an appropriate propaganda technique from the BIS: employ a “big lie” strategy to attack the enemy. The crypto system is a return to an earlier, more natural human system where money and value are clear to everyone, recorded forever in writing. Don’t think that they are ignorant; they know what crypto is. The crypto system is exactly the opposite of a Ponzi scheme, which is based on deception and secrecy; indeed, it is simply a fact that the fractional reserve banking system has Ponzi scheme characteristics. The 2008 financial crisis, the collapse of the inverted house of cards that is the fractional reserve banking system, was the impetus for the creation of the crypto system: to counter institutional fraud and protect people from being preyed upon.

There is another aspect of the “environmentalist” claim made by central bankers: they know why a global community of millions of people are willing to spend money for crypto transactions. They know that people spend this money because they don’t trust banks. They know that these people are the most awake, that they see that the emperor has no clothes, and that they don’t believe their corruption. They know that they are a grave danger to the banking system. That people are willing to spend money on supporting the bitcoin ecosystem sends a tangible message, backed by their own money: we don’t believe in the traditional banking system and we are going to create a better world, rather than just continuing to be taken advantage of.

Augustin Carstens’s reason for preferring the fractional reserve banking system is because …

“Central banks are trusted, and that trust is something they have built up over decades and for which there is no substitute right now.”

Further, “In my experience, it is always the poorest who suffer the most from inflation. It is therefore the duty of central bankers to ensure that purchasing power is maintained.”  In addition, crypto currencies, he says, are not “suitable as a store of value.”

So, why exactly are crypto currencies not money?

“They cannot assume the functions of money for the simple reason of how they are created.”  “It’s a fallacy to think money can be created from nothing.”

Carstens also adds,

“So, my message to young people would be: Stop trying to create money!”  It is fitting, final, inspiring words to the next generation, to those who want to make the world a better place. What he means is, “I can create money. My friends at the banks can create money. But, don’t you dare try to do it, young people. Know your place in life.” 

The choice today

Previous great generations had their own battles to fight, whether it was against totalitarian ideologies, against racism, or against sexism. The battle for our generation will be partly against a deceitful banking system. A system that, in the best case, holds us back from living life to the full or, in the worst case, excludes us because we are an out-group. A system that disadvantages the many to benefit the few. A system that preys on our ignorance in order to survive. A system that underpins much of the moral rottenness in other areas of life.

If you want to do some field research, to compare the two systems, go find the Filipino maid standing in line at some foreign exchange bureau. The one who sells herself into slavery to support a daughter back home. So, at least the daughter might have the hope of a better future. Tap the maid on the shoulder and ask how much our modern financial system is going to take from her earnings. 10%? 20%? 30%? What would she get her daughter if she had this extra money? More food? Better clothes? Music lessons? How many years, how much less time away from her daughter would this extra money bring her? And, what interest rate is she getting on her savings in her bank account? Does a bank even give her an account? Probably not.

You tell her that a new system is coming. In this new system, the money she worked hard for belongs to her, not to the bank. A system where sending money to someone will be quick and cheap, like sending information. You tell her that, in the 21st century, we will endure this old system no longer. You tell her that this evil is almost over.

Money is fundamental to life; it is how we keep track of much of our productive effort and how we care for others. It is not simply a question of one technology against another; it is a question of our values. Our choices in the next decade, whether we continue to lend our money to this old, dishonest banking system, will speak to the character of our generation.

Robert Sharratt

Robert is part-Canadian, part-British, somewhat autistic and lives in Geneva. He is going to link the crypto system to the real economy and create a better banking model, or die trying. His interests include mountain-climbing, chess, piano, programming and distrusting authority. In his early career, he was an M&A investment banker in London, then in private equity, and then moved to Switzerland to invest his own money. He holds an MSc degree in Finance from London Business School.




This article was first seen on the Daily Hodl and can be found here: