A Primer on Money and Debt

By Greg Cooper

This article is philosophy and general advice about what money and debt are and how to use them. It is not advice on how to make money. If you want that, read 'Rich Dad, Poor Dad'.

Goods and services are essential to everyone’s life, and money is the quantified, exchangable entitlement to goods and services. So it is interesting to understand what money essentially is and where it comes from.

Money is defined as a commodity or asset, such as gold, an officially issued currency, coin, or paper note, that can be legally exchanged for something equivalent, such as goods or services. [www.dictionary.com. Investopedia.com. Investopedia Inc. http://dictionary.reference.com/browse/money (accessed: November 07, 2009).]

As an entitlement to goods and services, money is kept track of in many ways, including by the amount of your bank balance, by the coins and bills in your wallet and by the figures on your mortgage document.

People get this entitlement, money, from other people, usually by giving up something of value, such as some of their property or their labor. And those other people have normally gotten it from ‘other’ other people or businesses.

But who were the first ‘other’ people, who the money originally come from? After all, there is certainly more money in our economy now than there was 100 or even 10 years ago, so it most be constantly coming from somewhere as time is going by.

Note that the money I refer to in this paper is fiat money, which is money that has no intrinsic value, but rather has its value assigned by government. This distinguishes it from gold or silver coins, which by contrast do have intrinsic value.

Such fiat money is created when any loan is obtained from a central or chartered bank. The documentation required to create money consists of:

1) the paper held by the lending bank, entitling the bank to receive the money back in the future, usually with interest, and

2) the money (also paper) held by the borrower, which besides entitling the borrower to the usual goods and services, requires the lending bank, at the borrower’s option, to pay the borrower that amount of money.[sic]

Money begins its existence when a government obtains, from its central bank, such a loan, of the new money.

The government can get this loan because it can give the central bank security in the form of a promise of future repayments with interest and/or forfeiture of its assets or its political power.

In order to be confident it can make the future repayments, the government uses its access to future cash flow from taxation, and in order to provide the assets to secure the loan, the government uses its rights to the land and resources of its country.

As a last resort, a government may even offer its own political power as security for a loan. In other words, if the government can not meet the repayment obligations of the loan, it may give control of the country to the central bank or other lender.

If the central bank is satisfied that the government will make the future repayments (or forfeit its land, resources or power) the central bank creates the original money and lends it to the government. The government then uses it for innumerable projects, so it trickles through the economy.

This process of the central bank creating money and loaning it to governments has been casually referred to as ‘printing money’ or ‘creating money out of nothing’. Although on the surface, the process has this unreal aspect to it, the requirements of future repayments or forfeiture of assets show that the money does not come out of nothing, but rather out of a firm guarantee of future tangible benefits to be repaid from the government to the lender.

Through the money-creation process, the central bank accumulates assets and debts – its main assets being the loans receivable from the money it lent to its government, and its debts being the responsibility to pay to anyone who has any of the money, the face value of that money [sic].

The total amount of money grows in this way, along with the assets and liabilities of the central bank. The size of most governments grows too, but since most governments spend most of the money, the government’s liabilities grow much faster than its assets, producing deficits and high interest expenses.

When an ordinary private business borrows money, it normally tries to spend the money on something that produces more money, so that its assets can accumulate faster than its liabilities. But in the case of many governments, because of political pressure, they spend (or give away) too much of the money they get from loans and are often left in a deficit position – a situation where their liabilities exceed their assets.

In a private business, this would lead to excessive interest expense and possibly bankruptcy, just like if you kept charging things to your credit card without paying it off each month. But with many governments, they just keep borrowing and taxing more, to get more money to pay the ever-increasing interest. Many people believe this is not sustainable and will lead to financial collapse, as people start to see that their money is too ‘diluted’ and not ‘backed’ by any real guarantee to goods or services in the future.

Like central banks, regular banks have a similar way of creating money, accomplished through their well known activities of accepting deposits and giving loans. The process is called ‘fractional reserve banking’. It happens when banks accept deposits, then loan out most of that deposit to someone else, who uses the money to buy some property. The person who sells the property then takes the money and puts it back into a bank, and the bank again lends most of it out to someone else, and the cycle repeats over and over again.

The result is that the ‘same’ money is getting deposited and re-loaned by the banks. Economists can predict and you can read it in Wikipedia, about how the total amount of money increases through this process of ‘fractional reserve banking’. This is how regular banks create more money ‘out of nothing’.

Note that, as the total amount of money increases during each of the above consecutive loan transactions, a new and different repayment schedule with new and different security is pledged by the borrower. Therefore, when the loan is done with proper security, the new money created in fractional reserve banking is ‘backed’ by some new goods or services, so I would not say that money is created ‘out of nothing’.

But in the cases where new money is created with new loans and there is not realistic backing for the new money, that is, where sufficient security is not pledged, there is a danger of possible collapse of the value of that new money, as it is not based on its full value. In this case, the new money could be said to have been created ‘out of nothing’.

The important concept here is that with this process, the regular banks, like the central bank, have a way of creating money. Wherever the lend/borrow transaction occurs, the fundamentals are the same. As with central bank loans, regular bank loans require that the borrower (usually an individual or business) guarantee the loan with a promise of future repayments and/or real property forfeiture. If it is done properly, it works well, but because of political pressure (in the case of government borrowing) or because of over aggressive lenders and needy borrowers, things do go wrong.

Simply stated, things go wrong in two ways:

1. Loans are made in which the borrower is not comfortable with the repayments or with the asset forfeiture which may be required by the loan, or,

2. Borrowers cannot repay loans, are willing to forfeit assets, but the assets were not valued properly and so cannot be sold to realize the loan value.

So to avoid problems, it is essential that:

1. Borrowers, including people, governments and businesses, are comfortable with the repayment schedule of their loans or they can give up the property that they pledged as security for the loan without undue hardship, and,

2. Assets pledged as security for any loan be realistically valued, so that they can be sold if necessary to realize the value of the loan.

No matter how poor an individual, business or country, as long as they have something of value to offer as security, such as their future labor, their assets or political power, there will usually be a lender who will lend them what they want, to achieve their needs for goods and services in the short term. Lenders are happy to do this because they can’t lose – either they will get repaid with interest, or, they will get the lender’s property and the lender may be obligated to them indefinitely.

In the case of governments borrowing from the central bank, there is incredible political pressure for governments to borrow more than they can comfortably repay, in order to satisfy the short-term appetites of the electorate for goods and services. This results in ever-increasing national deficits, skyrocketing interest payments and in advanced cases, control of the country falling into the hands of the lender or central bank.

Unscrupulous lenders can’t exist without overly needy borrowers. Those people who are financially healthy have much more control over their own affairs than they do over the affairs of lenders. So rather than criticize the government, I encourage people to keep their own house in order so as to not fall into the excessive debt trap.

The number one rule is minimize 'uncomfortable' debt. It is generally thought to be acceptable to accrue debt for higher education and to buy precious metals and real estate. This is because, based on past experience, these expenses are usually of more value in the future than what you spend on them in the present.

When you do need to be in debt, have a clear repayment plan that you can afford. When you choose to be in debt for investments, have a comfortable debt-servicing plan, like using cash flow from a business or rentals, and an escape plan if the investment goes bad. Live below your means. Always use some of what you earn to pay down your debt, to increase your comfortable investment or to increase your savings.

Because money entitles you to almost any goods and services, debt is a measure of your lack of basic material needs, so uncomfortable debt should be avoided. I say avoid uncomfortable debt, like high interest credit card debt that you can't pay off, because comfortable debt is usually essential for making a lot of money. (Read Rich Dad, Poor Dad)

Furthermore uncomfortable debt is inversely proportional to freedom. When you have uncomfortable debt, you will find that your choices in many of life’s activities are diminished. Uncomfortable debt will make you compromise – you will be doing what you have to do, rather than what you really believe in.

So don’t get entrapped by the short-term fun of spending money from an uncomfortable loan. Save and wisely invest what you can and know that savings and other reliable investments, though they may not grow immediately, are the bedrock of your stability for goods and services needed for the future.

END