Money Destroyer

(Cross posted from bartoncii)

In 1970 I decided to fill in a gap in my education. I took some classes at the University of Tennessee on subjects I had not studied as an undergraduate. In particular I took freshmen courses on Economic and Geology. These classes made useful additions to my general stock of knowledge and I still look at the world differently because I studied them.

One of the most interesting things I learned, was the way banks create money. If I take $1000 and put it in my savings account, it will earn interest. But in order to pay my interest, the bank will have to do something with my money. The bank has to put my money to work, by loaning it out. Banks make money by loaning money at a higher ate than they pay their customers. Now the interesting thing about a bank loan is that the bank does not take money out of my account to loan it to a customer. The bank still carries my acount as an obligation, so in theory my money is still there, but the customer gets the loan. So he has money too. Banks, I learned in Freshman economics, create money by making loans.

Now this is really neat stuff, but there can be problems. If banks create too much money you can get inflation. In flation is a situation in which too much money is chasing too few goods. As a consequence the price of the goods goes up. In order to control inflation the Federal Government created a central banking system, the Federal reserve system. The Federal Reserve system can control the amount of money banks can loan, and thus it controls the creation of money in the economy.

Now Americans enjoy a good standard of living. We like nice cars, big houses, and the latest electronic gadgets. These things are expensive to make. A long time ago some retailers, discovered that it was cheaper to buy gadgets abroad where they are made by low wage foreign workers, and sell them to American customers, rather than buying them from American manufacturers. There were other things that Americans wanted too, like Gasoline. Most oil is no longer produced in the United States, so if Americans wanted gas, they had to buy the oil from foreigners. We did not actually make the money that we used to pay for the oil, we sort of put it on the credit card. In fact that has been the story of the American economy for some time. We as a country don't make many things any more, instead we buy things that are made in other countries. But how do we pay for the things we buy? The answer is we don't, we put everything on the credit card. Foreigners loan us money to keep the American Economy afloat.

If you stopped making money and financed your life with credit card debt, sooner or later you would go broke. Eventually you would go bankrupt. What happens to the money you owe when you go bankrupt? Now this is an interesting subject, one which my professor did not talk about in freshman economics. The money gets destroyed. Remember that banks create money when they make loans? When loans cannot be repayed, they get written off as bad debt. The money represented by the loan is thus destroyed.

Now when foreigners lend americans money, they expect to get repaid with interest. If you look at the American economy as a whole, you would have to say, that eventually the foreigners will not get repaid, because the American economy has for the last generation steadily borrowed more and more money from obliging foreigners than we were able to repay. Because so much money is being loaned to the United States now, foreighners are looking for investment opportunities in the United States. Mortgage backed securities was one way to soak up the money foreigners were loaning us. Of course, there are only so many high quality housing loans generated in the United States every year. But the loans kept coming, and we needed the money to keep the American Economy afloat, so the money industry started generating low quality loans to back mortgage securities. These loans went to buyers who did not have money. If a would be buyer did not have the income to pay interest, no problem. The loan featured a low teaser interest rate for the first few years, and then the interest rate ballooned to a rate the borrower could not pay. The borrower does not have money for a down payment? No problem, loan the down payment money. Of course the borrower cannot pay that either. The important point is that the foreigners got a place to put their money, and the foreign loans that kept the American economy going kept coming.

Alan Greenspan, who created the system was hailed by everyone as a great and wise man, because inflation was under control, and the country appeared to be flourishing. Politicians did not worry as long as the voters got their new houses, their new cars, and the credit cards worked. But one day a home purchaser got an interest bill from his bank, that he could not pay. He moved out, and the Bank repossed the house. The next door neighbor got a high interest bill too, and moved out. Soon half of the houses on the block were empty. The back had long since sold the loans to Fannie Mae and Freddy Mac, who had packaged them and sold them to foreigners. Pretty soon everyone in the home loan industry was over his or her in debt, and it looked lioke the foreigners were going to get stiffed, and the economy was going to collapse. President Bush's advisors thought a bailout would work, but a loan to a man who lives by running up credit card debt, is not going to solve the problem. The problem is that the contry is bankrupt, and the solution to for the bankrupt is to write off the debt and start over. Our creditors are just going to loose a great deal of money, we will suffer a great many privations and hardships, but eventually life will go on.