As the fake money rolls off the proverbial government printing press, the banks multiply it to create more fake money.
The fraud sounds unbelievable, but its true.
In a fractional reserve banking system, banks don't keep your money in the bank. They use it to buy debt, such as by making loans, or buying government bonds. in the process, banks create more artificial money that doesn't exist in reality.
To create an intuition for the system (or scam, depending on how you look at it), let's imagine a brand new start-up country.
The Founder of a new startup country possess 2.85 ounces of gold, which is worth $35 an ounce at the time, or $100 total.
The founder doesn't want to carry it around, so the Founder puts the gold in a national vault, and prints 100 $1 bills as the new national currency, backed by gold, and exchangeable for gold at $35 / ounce.
Specifically what each dollar means is gold at $35 an ounce. People can use the currency, knowing that at any time it can be exchanged for gold, which is the trusted medium of exchange over thousands of years.
This allows him to walk around with paper money in his pocket, rather than physical gold, because everyone trusts that "a dollar is a dollar", and can always be exchanged for the gold in the vault.
The Founder doesn't need all the money, wants to keep it safe, and doesn't want to put it under his mattress, so he takes it to the bank.
The bank accepts the deposit, and the Founder tells them to guard it safely, for he will soon return for it.
As he leaves the bank, another customer walks in, and asks the bank for a $50 loan.
Because the Founder and the bank have agreed to a fractional reserve banking system, the bank only needs to retain a fraction of the Founders deposit in the vault, and it is free to lend the rest out.
Betting that the Founder won't need all of his money back soon, and desiring to maximize its profits, the bank offers the second citizen a loan of $95 (yes, it is really that egregious. banks often keep less than 10% reserves).
The second citizen is humbled by the generosity and low interest rates, so he accepts the $95 loan. Since he only needs $50, he deposits the other $45 back in the bank.
Now, there is $195 in circulation - the $100 the founder deposited, plus the $95 the bank lent out. What doesn't exist, is the money to pay the interest on the loan.
A third customer walks in and asks for a loan, and the bank does the same thing. It retains $2 of the $45 deposit, and lends the third customer $43.
The bank now has assets of $7 cash in the vault, and $138 in loans it expects to be paid back ($145 total), and liabilities of $145 in deposits it expects to eventually have to pay out to depositors, and it desperately hopes that no one needs more than $7 at any time.
However already, the banking system is sick, because there is $238 in circulation, only $7 in the bank, only $100 in gold (which is no longer worth $100), and no money to pay the debt on the loans.
When the three citizens realize what happened, they all rush to the bank and ask for their deposits back.
The bank, only possessing $7, no gold, and faced with demands for $145 in cash, pulls the Founder of the country aside and explains the situation.
Realizing The Game would be over if the citizens or surrounding communities found out, the Founder reluctantly agrees to leave his $100 dollars "in the bank", rushes back to headquarters, and prints $45 in additional currency. He furtively sneaks it in the back door of the bank, and the bank gives the $45 to the citizens. The citizens are satisfied, remark what a fine country and banking system they have, and leave the building.
The Founder and the bank sigh, relieved.
Inspired by the magic, and the faith of the Founder to leave his money in the game, the next day the relieved citizens bring their money back to the bank they now believe is safe and deposit it.
The bank, liking the leverage of the new game, accepts the $45 in deposits, puts $2 in the vault, and lends $43 out to a fourth customer.
Now, there is there $238 in circulation from before, plus the additional $45 printed by the government, plus new $43 loan.
The young nation is awash in money and everyone is very happy.
However the founder and the bank realize they have a problem. If everyone were to try to convert their $326 into gold, the problem would be instantly exposed and the game would be over. So after a secret meeting, the Founder announces to the citizens that to protect them against speculators and financial sharks, they are closing the gold window, going off the gold standard, and dollars will no longer be redeemable for gold.
The citizens are shocked, however afraid of the fake enemies created by the founder, burdened with debt, and possessing no alternative, they quietly go along with it.
Now unconstrained by the need to justify its expenses in gold, the government floats a $50 bond to pave the main road of the country. Unable to find anyone to lend to it, it prints the $52 and deposits it in the bank. The bank puts $2 in the vaults, and uses the other $50 to buy the government bond, and hands $50 back to the government.
The government, now flush with cash, uses $25 of the money to hire the citizens to build the road, and deposits the other $25 in the bank. The bank keeps $1 of it in the vault, and lends out the other $24 to the citizens, who use it to buy tools and materials to build the road.
It kind of sounds like a ponzi scheme, and perhaps it is.
Over the course of a few years as the game unfolds, there is suddenly $5,700 in circulation instead of $100. There is still only 2.85 ounces of gold. The theoretical price of gold is now $2,000 an ounce.
This simple allegory illustrates the way that inflation works. Inflation is not a function of the price of underlying goods changing over time. It is a function of the quantity of money changing over time, divided by the changing quantity of the underlying goods.
As long as the the supply of money increases faster than the rate of production, prices rise.
INFLATION = INFLATION OF THE MONETARY SUPPLY. INFLATION IS A SECRET TAX.
This core mechanism of fractional reserve banking is sometimes called the multiplier effect, and creates additional "money", further inflating the supply of currency in circulation, and thus the prices of the aspects of reality the money is chasing.
In the long run, everything is measured against and must align to reality.
Forward to 2.11 Loan Backed Securities and Derivative Financial Instruments
Back to 2.9 Financing Debt With Inflation
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