Note: I wrote this article during the beginning of 2009 when central banks first mulled the idea of creating money to put into the economies they serve. The original publishing date has been lost due to the conversion of JournalXtra from a forum into a blog. I’m sure the Internet Archive will have a record of the original publishing date.

This isn’t intended to be a fully involved, complete delving into the complexities into the way money is given value and how that value is manipulated for economic benefit. I’ve kept it simple and basic to lay the ground work for the more complex intricacies to be garnered at a later date.

In recent months we’ve all heard about a measure that Central Banks may use to encourage economic growth after interest rates have hit zero. For those who haven’t heard, it’s called Quantitative Easing. You’re probably wondering what it is and how it works.

I could give you the short answer here but I’m not going to do that. First I’m going to explain the basics of how money is valued, and then you’ll understand what Quantitative Easing is and how it works to improve trade. For those who want instant satisfaction, the short answer is written in bold at the bottom of this article (be warned that it isn’t the nice measure that it’s being made out to be).

We’re going to miss out the origins of money as the transition from bartering one item or more for another item of equal value. We’re going to jump in at the deep end and start from the equating of precious metals with coins, paper notes, cheques (checks for our U.S friends) and digital money. From this point onwards, when I refer to money I mean any form of cash, dosh, wanga – or whatever you want to call it – and any other form of centrally issued product that is used to facilitate the purchase and hire of tangible and non-tangible goods and products from one entity (human, group, business…) by another.

Different parts of the world have different forms of officially issued and usable money with which to trade products: one place might use Dollars, another Stirling yet others still the Yen or Rupee… Each place that uses a particular official money type is known as a Currency Zone, for example the Euro Zone or the Dollar Zone. Some places permit the use of several currencies for day-to-day trade by their citizens although usually a single currency is used within any one zone.

Most currencies are regulated by their zone’s Central Bank which stores the precious metals (usually gold) that back that currency and give it tradable value. To keep this explanation simple, we’re going to assume that gold is the sole precious metal used to back money and stored by central banks.

The amount of money issued by a Central Bank to represent its currency is called its Money Stock, for example all the US Dollars issued by the US Federal Reserve also constitute the total money stock of the United State’s Federal Reserve; it doesn’t matter where those US Dollars are in the Universe, each Dollar, Quart, Cent represents part of the Federal Reserve’s gold store and is a part of the Fed’s money stock.

Neglecting artistic value, any two bars of gold with equal size and purity hence density (mass divided by volume) hold equal value so it follows that when two Central Banks have an equal number of gold bars and an equal amount of money to represent those gold bars then both currencies hold equal comparative value i.e one bar of pure gold that occupies 100cm³ of space has the same value as another bar of pure gold that occupies 100cm³ of space.

Premise 1:

• Central Bank A holds 100 gold bars,
• Central Bank B holds 100 gold bars.

The money we use is a representation of a fraction of our currency zone’s central bank’s gold stores. When we earn money, we effectively earn a stake in that gold. I’m not saying any one of us will ever be able to walk into a central bank and trade our money (notes and coins) for the value of gold they represent but what you can do is trade your time and skills for a greater stake or trade your stake (partly or wholly) with someone else for their goods. Money is a store of wealth – it represents a stake in its issuing central bank’s gold store.

Premise 2:

• A stake in a central bank’s metal store can be traded:
• that trade can be for money issued by another bank (currency exchange),
• that trade can be for someone else’s time and skills (employment),
• that trade can be for someone else’s belongings (a purchase).

Money issued by a central bank only has tradable value because it represents a denomination of the issuing central bank’s gold store. That denomination is determined by how much money is created to represent that store.

Premise 3:

• Central Bank A creates 100 Currency A coins to represent its 100 gold bars.
• Central Bank B creates 100 Currency B coins to represent its 100 gold bars.
• For both Bank A and Bank B, 1 coin represents 1 gold bar.
• Neither has a currency unit smaller or greater than 1 coin.

When money is traded within a central bank’s zone i.e traded only where that currency is used, then that central bank’s gold stores neither increase nor decrease in consequence of that trade. The result of internal trade is that the currency neither loses nor gains value.

When money is traded between different currency zones, i.e one currency is traded for goods somewhere another currency is used, then the gold stores of those central banks either increase or decrease dependent upon the direction of that trade.

Premise 4:

• Central Bank A’s currency is used in Zone A.
• Central Bank B’s currency is used in Zone B.
• When Currency A is traded for goods in Zone B then Central Bank B gains gold from Central Bank A.
• When Zone B takes gold from Central Bank A then Central Bank A loses gold from its stores to Central Bank B.
• Region A and Region B can trade with each other by moving gold between their Central Banks.

The more gold a central bank has to back its currency the more that currency is worth relative to other currencies with less gold backing them. The opposite is also true, central banks with a currency backed by less gold have lower valued currencies than those with currencies backed by more gold.

Premise 5:

• If Central Bank A has 100 coins against 100 gold bars then each coin is worth 1 gold bar (100 bars divided by 100 coins).
• If Central Bank B has 100 coins against 100 gold bars then each coin is worth 1 gold bar.
• Currency A is in parity with currency B only when 1 coin A and 1 coin B each represent 1 gold bar (1 Coin A is worth 1 coin B).

Before I show how currency values change I’d like to ask you a question: what will happen to Central Bank A’s currency when people in zone A trade coins with people in Central Bank B’s zone (Zone B)?

If you don’t know the answer don’t worry, you soon will and I suspect you’ll kick yourself for not voicing what you actually thought the answer to be because your unvoiced answer is probably correct. If you do know the answer then well done, smile and get someone to pat your back.

When people in Zone A use Central Bank A’s coins to buy goods from Zone B they are effectively instructing Bank A to send gold bars to the value of the spent coins over to Central Bank B. The effect of this trade is to lower the value of Central Bank A’s coins whilst increasing the value of Central Bank B’s coins. For example,

• 50 Zone A coins are spent in Zone B hence,
• Zone A now has 50 gold bars represented by 100 coins,
• Zone B now has 100 plus 50 gold bars represented by 100 coins.

• Central Bank A’s coins are now worth 0.50 gold bars each (50 gold bars divided by 100 coins),
• Central Bank B’s coins are now worth 1.50 gold bars each (150 gold bars divided by 100 coins),
• A single coin B is now worth 3 C coins.

The trade between Zone A and Zone B is a good thing for Zone A because it makes it an attractive place for people in Zone B to trade due to each coin from Zone B being now worth 3 coins from Zone A.

As Zone B trades more with Zone A, Zone A’s currency will increase in value as the number of gold bars flowing into Zone A’s central Bank increase. This reflects the balance of trade. When trade takes stores from a zone then that zone has a trade deficit with any zone that takes more from it than it returns to it. In our premises, Zone A has a trade deficit with Zone B whilst Zone B has a trade surplus with Zone A.

Premise 6:

Trade between currency zones can boost overall trade between those zones:

• A trade deficit decreases trade flow from a zone in deficit (that loses stores) toward a gaining zone (due to the surplus zone’s currency’s relatively increased value).
• A trade deficit increases trade flow to a zone in deficit (that loses its reserves) from a zone in surplus (due to the deficient zone’s currency’s relatively lowered value),

When a currency’s value is considered to be too high a central bank might increase the amount of currency that represents its gold stores. That process is termed Quantitative Easing.

Increasing the amount of currency in circulation serves to lower its value relative to other currencies by decreasing the currency unit’s stake in that central bank’s stores.

Increasing the amount of currency available in a zone has one direct effect and two possible consequences: it lowers the currency’s value relative to other currencies; this

1. increases trade to the devalued currency’s zone from zones with more highly valued currencies, and,
2. decreases trade from the devalued currency’s zone to zones with more equal or higher valued currencies.

Premise 7:

• Devaluing a currency increases the flow of gold from other zone’s central bank’s stores with more highly valued currencies.
• Devaluing a currency decreases the flow of metals from the devalued currency’s central bank’s stores to other regions with higher value currencies.

Central banks can increase the value of their currency by decreasing the amount of money that represents that currency. For example,

Central Bank A increases the value of its currency by removing 50 coins from circulation, and Central Bank B decreases the value of its currency by producing another 50 coins, therefore

• Coin A is now worth 1 gold bar (50 gold bars divided by (100 minus 50 coins),
• Coin B is now worth 1 gold bar (150 gold bars divided by (100 plus 50 coins),
• Consequently, Coin A again has the same value as Coin B (they are at parity)

Although we’ve used gold to represent a central banks stores, those stores might also be silver or copper etc.. but usually will be gold.

The process of trade between central banks used to involve precious metals being housed in different vaults within a complex at each central bank. Each vault represented a currency. At the end of each trade day, the balance of trade would be calculated and metals would be moved from one vault to another. Some vaults would gain, some would lose. The system in use now is a little different.

Quantitative Easing is another way of saying devaluation.

The explanation I’ve given above is basic compared to the more complex real world but the principles remain the same: the direction of trade (along with other events that increase a central bank’s metal stores) and the amount of money created by a central bank determine the value of the money issued by a central bank.

My opinion is that devaluation of a currency is similar to theft from a currency’s money holders (you and I). When currency is devalued it stores less of a stake in its issuing central bank’s metal stores.

Quantitative Easing could be likened to a central bank borrowing from its currency’s money holders because, in the long term, a devalued currency’s value could be increased by removal of the additional money created during the devaluation (increased trade from zones with more highly valued currency’s spurred by a devalued currency brings more metals to the devalued currency’s central bank’s stores. Destroying some currency increases the value of the remaining currency because the metals that back it are spread less thinly by it).

The downside to devaluation and quantitative easing is that the currency’s money holders at the time of devaluation lose some of their financial worth – money held as that currency is worth less, assets (homes, cars, other property, time, skills etc…) become worth less when traded outside that currency’s zone. Assets held outside of, and traded outside of, the devalued currency’s zone remain unaffected by the value of the devalued currency relative to their own zone’s currency; but being worth more of the devalued currency, assets outside of the devalued currency’s zone could be traded for the devalued currency (of which more would be obtained) in holding for that currency’s increased value at some future time (possibly through revaluation) (i.e a currency trade).

In the real world, a currency’s value is affected by other factors too. One of those factors is an increase in a central banks gold stores through gold mining which effects inflation; the current global average inflationary increase through gold mining is 2% i.e gold stores increase in quantity by 2% each year. If you want to know about other factors then I recommend you do a little research into currency, money, central banks, gold reserves and inflation. It isn’t difficult to research – I worked it out through introspection followed by research to validate and refute my reckoning. If you do do some research, then I bid you good look.

For those who just wanted the quick answer:

Quantitative Easing is another way of saying devaluation. The reason is explained above.

There’s a big, fundamental flaw with any banking system that allows banks to take money from savers then loan it out to borrowers.  It isn’t that savers can’t always get to their money when they need it.  It isn’t that borrowers don’t always pay it back.  It is, however, that banks loan out more money than they have been given by savers to look after and investors to gamble.

Were it as simple as banks loaning out more money than they have in knowledge that they need only keep so much in reserve for the fraction of their savers and investors whom withdraw their money on any given day then there wouldn’t be a problem.  What banks actually do is far more serious: they not only loan out more money than they physically have in reserve they also take money from people who borrow it from other banks. Why’s that an issue?  Here’s how it works:

Simple World has a population of 8 and enough gold to make $300.

• Bank A has $100,
• Bank B has $200,
• Bank A has 4 customers saving $25 each (A1,A2,A3,A4),
• Bank B has 4 customers saving $50 each (B1,B2,B3,B4),
• Bank A knows that its only competitor is Bank B, Bank B knows that it’s only competitor is Bank A.

Both bank A and bank B know that on any given day only a quarter of their capital is going to be withdrawn and the same amount is likely to be deposited by another saver.  So at anyone time, Bank A will hold approximately $75 and Bank B, $150.

Because each bank knows that only a quarter of its funds will be withdrawn at any given time they conclude that it is safe to loan out the remainder.  Further, because they know that when they loan money they will receive extra back, they gamble they can loan more money than they actually hold.  This is called Fractional Reserve Banking.

Both Bank A and Bank B assume they can safely loan 4 times more money than they hold.

Bank A will usually hold $75 so it will loan out up to $300,
Bank B will usually hold $150 so it will loan out up to $600,

When Bank A’s customer A1 uses his loan of $200 he spends $100 of it and deposits the other $100 in Bank B.

Bank B now has $300,
Bank B now assumes it will need $75 in reserve to cover withdrawals and can loan out up to $225×4 which is $900 to borrowers.

So the bank balance is:

Bank A had $100, reserved $25 for withdrawals and extended the capital it could loan by a factor of 4 to $300 of which $200 has been loaned out to customer A which leaves it with $25 reserve and $100 to loan (of which only 1 quarter of the $100 is backed by real capital)  Bank A is now worth $50, is owed $200 and owes $100.  In other words, if its customers all try to withdraw their savings then Bank A will not be able to pay out until customer A1 has repaid his loan of $200 which (because $100 of it has been put into Bank B) will contract Bank B’s balance.

Bank B had $200, reserved $50 for withdrawals and extended the capital it could loan by a factor of 4 to $600 of which none is loaned out.  However it took in an extra $100 so will now loan out up to $900 (i.e. 200/4×3x4).

Can you see what has happened?

From an initial amount of $300 the banks have created a potential $900 for loans with a reserve of $75 i.e $225 have been turned into $900 of debt for borrowers. But, since money has been moved about from Bank A to Bank B without proper tracking, Bank B thinks it has $300 working capital – Banks A and B between them have created money out of thin air.

Bank A has $25,
Bank B thinks it has $300, so
$300 has now become $325.  We have $25 extra to the real $300 that Simple World actually has.

The real world situation is much more complicated than my example shows but it is similar enough for the example to hold true.  Our current banking problems have been caused by improperly tracked real money being used to create a currency of debt.

To resolve this problem, wouldn’t it be better to enforce a new type of bank account, one that allows savers to decide how much of their money they’re willing to let banks loan out and invest, one that permits savers to invest their own money and control currency trades without incurring bank charges, an account that tracks loans but not savings.  I believe it’s possible to create such an account.  We need a bank account that allows savers to divide-up their deposits as they see fit that also separates credit from debt.  My solution is a bank account that is split into 5 deposit types,

• Withdrawal,
• Bank Investment,
• Personal Investment,
• Non-Withdrawal, and
• Loan,

Anything put into the Withdrawal deposit would be untouchable by banks; and savers would always have immediate and full access to their funds.  This would not need to be tracked as it would not contain any loaned monies.  This would not receive any interest.

Anything put into the Bank Investment deposit would form (and be equivalent to) the bank’s fractional reserve.  This would be the saver’s investment in the bank and as the bank would use this money for investments and loans, it should attract interest from the bank.  Funds here would need to be passed to the withdrawal account for the saver to use it.

Personal Investment deposits would be the money the saver wishes to invest in stocks and currencies.  This would not be touchable by a bank.  If the saver wants a safer bet then the Bank Investment deposit would be the better place for investment money.

The Loan Deposit would contain any money loaned to the account holder by the bank.  It would have to be tracked and would not be drawable as hard-currency, it should remain digital or as a physical IOU.  This would not be transferable to the Withdrawal deposit and as tracked money it would not be transferable to either investment accounts; it would however be transferable to other banks but only to a Non-Drawable deposit.

Non-Drawable deposits would hold funds transfered from Loan deposits and other Non-Drawable deposits.  Funds here would be usable to balance Loan deposits (funds created by fractional reserve banking practices would be used to settle each other), they’d be usable to buy goods and services from others they just wouldn’t be usable as hard currency.

The exception to Non-Drawable deposits from being converted to hard currency is this: when one account receives a payment from another account’s Loan Deposit it would be transfered to the one account’s Non-Drawable deposit; as the other account’s Loan Deposit is repaid, because the transfers are tracked, the one account’s Non-Drawable funds would be converted to drawable funds at an amount equal to the amount paid to the other’s Loan deposit (the actual amount could be specified as an exact payment else as a fractional payment based on the repayment amount spread across the number of active recipients from the other’s Loan deposit).

The intention is to keep credit and debt separated such that credit can be used to cancel debt but debt cannot be used to create credit.

The deposits would work like this,

Withdrawal, Bank Investment and Personal Investment deposits would be cross-transferable between each other, drawable and usable as hard-currency in the real world (as long as they’re transfered to Withdrawal accounts first);

Non-Drawable deposits would be transferable to both Non-Drawable deposits and Loan deposits of any bank;

Loan deposits would be only transferable to Non-Drawable deposits of any bank;

Loan deposits and Non-Drawable deposits would be tracked between banks to ensure they do not create money erroneously; and,

Loan repayments would lower a loan deposit’s balance and would generate the exchange of funds between the Non-Drawable deposit recipient of the repaid Loan deposit and the associated Drawable deposit.  Effectively, banks would be brokers between debtors and creditors aswellas being guarantors of loans.

It would be like having credit accounts and VISA accounts but keeping VISA as VISA not credit.  Debt would be less anonymous for everybody, people who do not use debt would not be hit by failing banks as hard as they currently are because their savings would be as safe as they choose them to be, creditors would always know whom holds their debt, and people would have greater choice over the amount of debt they choose to accept as payment.

The only two flaws I see are that people would need bank accounts before they can take a loan from a bank or accept a payment from a loan held by someone else; and people might be more bashful about taking on more debt than they can service (were it possible).  Are they flaws or benefits?  You decide.

If you really want to investigate fraction reserve banking and its implication for money creation then take a look at this very long Wikipedia article

Our governments have poured our tax money into bailing out businesses that have almost deliberately bankrupted themselves.  Like so many others, I think that bailing out banks and other badly managed businesses will make little long term difference – the recession will still happen, businesses will still go under, everyday people will still lose their jobs and continue to struggle to feed their families and hold onto their homes.  I feel the bailouts will only prolong this recession.

Granted, everybody who’s taken on some form of debt is partly blamable for our current recession.  But had the banks not taken advantage of our greed to line their own pockets, had they not taken for granted our ability to repay on demand, had they not over extended their loans excessively beyond the capital invested in them by savers and shareholders then we wouldn’t be suffering as much as we are increasingly going to suffer.

There is a fix.  A quick one.  A harsh one.  But one exists: we have to let them collapse; and nobody need lose their homes, their savings or their loans.

We’ve already, as taxpayers, put a lot of money into the banking system, or should I say into the bankers’ pockets, in hope that we can keep them afloat through this recession.  The sad thing is, recessions and depressions form part of the natural economic cycle – they happen, they always will happen.   They are inevitable because of the way free markets work.  This recession is no different to any other.  It will happen, it may only be staved-off, but it will happen.

The least costly solution to failing banks is to allow the badly managed ones to be taken over by stronger, better managed ones otherwise they must be allowed to fail.

We can protect the population and businesses from bank failures by defaulting failed banks’ assets and investments (all loans to home-buyers and businesses etc..) to tax-payers.  Tax payers could then pay-off savers.  A fund could be created by selling off the seized assets and by paying into it the returns from seized investments (loan and mortgage repayments along with interest earned from other investments).   Tax payers (first) then shareholders and other investors (second) could then be repaid from this fund with any left overs kept by the taxpayer as gratitude for taxpayers’ generosity.

By doing the above, savers keep their savings, homeowners keep their homes, borrowers keep their loans, and small businesses with loans wont fail because their loans wont be called-in; job losses will be limited to bank employees and peripheries; and shareholders and other investors will receive back some of their money (after all, all investment are understood to have  associated risks).

To be honest, I think shareholders need to remember that they gambled their own money, nobody else forced them to risk it so why should they expect every taxpayer to protect their gambled money.  Would shareholders bailout an investor in art who lost his most valuable asset in a fire?  Of course not; and neither should taxpayers be expected to owe anything to shareholders of failed businesses.  But by seizing failed banks then realizing their assets and investments at least all savers will be repaid their savings, borrowers will retain their loans and loan agreements, shareholders will be repaid some if not all of their investments and some (to most) of a bank’s liabilities will be serviced.

It could be argued that letting a bank go bust would affect the value of investments in other markets.  It might, but, provided investors know that their investments are at least partially protected in the event of a bank collapse then they will continue to invest; and investments in other areas might increase due to non-banking businesses not failing when banks fail.

As the markets are still collapsing despite bank bailouts, do we have anything to lose by letting banks fail?

Which do you prefer, your investment portfolio, your bankers’ portfolio, or your home (and relatives’ and friends’ homes) and mod-cons?  I know which I’d rather save.

That plan again:

• Let failing banks fall,
• Let strong, workable banks buyout failing banks,
• Let the assets and investments of failed banks default to taxpayers,
• Sell-off failed banks’ assets and pool the money into a common fund,
• Add to the pool repayments from failed banks’ borrowers,
• Pay savers from taxpayers’ funds (transfer their accounts to good banks to strengthen them),
• Repay taxpayers, shareholders and other investors using the pooled funds,
• Lastly, give any leftover money in the fund to taxpayers.

It’s workable and would be less costly or only as costly as the current taxpayer based bailouts; and fewer jobs and homes will be lost when banks crash.

Banks created this mess so why should we feel guilty about letting them fail?  Why should we sacrifice our own livelihoods and property so that bankers can benefit?  We shouldn’t and we don’t have to sacrifice ourselves for their benefit.

A fix exists – let them fail, seize them, pay the savers, realize the assets, receive loan repayments, repay shareholders, service the debts and keep the excess for taxpayers.