Money, on the face of it, seems pretty simple, but it's kind of like the sausage factory. Our modern monetary systems around most of the free world, as I understand it, are fractional reserve banking systems. This means our monetary system is debt-based, which has some apparently startling implications to some (from Wikipedia, emphasis mine):
Robert H. Hemphill, credit manager of the Federal Reserve in Atlanta stated: “If all the bank loans were paid, no one would have a bank deposit and there would not be a dollar of coin or currency in circulation. This is a staggering thought. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. When one gets a complete grasp of the picture the tragic absurdity of our hopeless position is almost incredible, but there it is. It (the banking problem) is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.”
I'd like to be at the hypothetical table when Cramer and this guy got together for a few beers after the Bear Stearns conference call. What does synthetic money in the above quote mean? Well, if you thought your government created all the money, you'd be wrong. They actually only create a fraction of it such as in the form of coinage and paper money, among other things. Private banks create much of it via loans. The central banks have the delicate task of controlling how much money is created (or destroyed) via open market operations. If you think about it, unless you're Tony Soprano, nearly all of the money you handle is non-physical, and nearly all this money is created by regulated private banks.
Seigniorage. Creating money out of thin air is, as you can imagine, quite profitable and is called seigniorage when a monarchy, bank or government does it. If you do it yourself, say by color xeroxing $20 bills on a color copier, it's called counterfeiting, and you'd be in big trouble, bub. If you deposit money in a bank (most likely by check or electronic payment), a fraction of that money is kept on-hand by the bank, and the rest is loaned out to say, finance a sub-prime mortgage. In theory, money now exists in your account and as a loan. That loan money is used to pay builders who deposit the profits and the process continues ad-infinitum. Of course, it's more complicated than that with the Federal Reserve (which is actually quasi-private) involved as well as banking regulations, but you get the idea. Conspiracy theories about all this abound ever since the Federal Reserve Act of 1913 basically created the current system.
Seigniorage and Inflation. If the money supply inflates, seigniorage obviously does too. A cynical view would say that those who create money can kick back and relax during inflation, while the rest of us have to work hard to keep ahead of it or stay even. Somewhere I read that a dollar today is worth about $.04 in 1913 dollars. Hiding money under a mattress just doesn't pay. In 1971, we adopted Chartalism, as the rest of the world did or had previously done.
Currency. Money is emotional and political, of course, and there are people who want to abolish the current system, making the State the only authority to create money (seigniorage reform) and profit from it. There are those at the other end of the spectrum who want to give nearly anyone the authority to be a bank (free banking). No matter who within an economy profits from seigniorage, the nation or entity that controls the currency, controls the profits from it. If yours happens to be a reserve currency, you control the seigniorage profits from creating the reserve currency, among other benefits. There are people who don't like that (not one bit), and I never really understood why the Euro was created until I discovered this. To the extent the Euro replaces the Dollar as a reserve currency, subsidies will flow to Europe rather than the US, and US banks I would think would see less profits. It's pure speculation, but to the extent the subprime mess increases that trend, it will have a greater impact. (Update: a WSJ list of fallout).
In a future post, I'll try to decipher what all this means for CASTrader.
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