If people are living a hand to mouth existence, we call that survival.  Fortunately, humanity has evolved to the point where people, when aided by tools and energy, can produce more than they need to consume in order to just survive.  When people produce more than what they can consume they naturally look to trade the excess production with others.  The natural goal of this is diversification of consumption.  Diversifying consumption makes for a fuller, longer, richer life.

An economy is a system whereby people work to produce the things that they need and then trade their excess production for the things they need but which they cannot produce easily or cheaply themselves.  If people were all working flat out and still living hand to mouth with no excess production to trade, there would be no economy. 

In today’s global economy humans have become adept at making automated tools.  Also, energy to run them is still available and cheap enough.  The result is that production is generally not a problem.  So what ends up happening is specialization.  Some countries don’t make everything they need to survive but they are really good at making some specialized things and so they greatly overproduce in that category.  Germany makes far more cars than it can consume itself and Spain produces more oranges than it can consume itself and so both of those countries export what they manufacture in surplus.

In order to trade, economies use money.  It would work to instead have a strict exchange of commodities but it would have to work sort of like a cold war prisoner exchange.  Both parties would have to bring their goods to the border at the same time and then do the exchange of goods for goods.  That is not always practical.  Spain only produces oranges during growing season but it might need to buy German cars during the winter when oranges are not growing.  This drives the need for some universally fungible intermediate trading mechanism which we call money.

Nobody actually trades goods like cars with the hopes of getting paper currency in return.  The accumulation of paper is not the goal.  The goal is trade of commodities for commodities.  By accepting the paper (or electronic) currency, the producer nation is actually loaning its goods to the consumer nation.  The currency is the marker for the loan.  The producer hopes that the consumer nation will at some point produce something that it wants so that it can trade that IOU back for goods or services.  Over time this can produce significant problems if exporters get too greedy and produce too much in search of profits while importers/consumers also get too greedy by wanting things today even though they have not produced enough stuff to trade for them yet.  It can become a vicious cycle.

Take Germany and France for example.  They are the big producers in the European Union and other countries could not keep up with them in production.  This was becoming an impediment to the growth of Germany and France so they created the EU and the Euro in order to make it easy for the smaller, less productive nations to obtain credit in order to buy French and German exports.  Once the EU and the Euro were in place, greedy German and French businesses borrowed a whole lot of money to create a whole lot of excess production which they planned to sell to other Euro nations on credit. 

After a few years of this it became obvious that the so called PIIGS (Portugal, Ireland, Italy, Greece, Spain) could not repay their debts.  Germany and France had a bunch of paper IOUs for goods that they could not cash in because PIIGS were not producing any excess capacity.  They were consuming all they could produce and then also consuming imports from Germany and France and no magic was likely to happen which would increase productivity of PIIGS that would change things.

Of course France and Germany act like they are the injured parties but the truth of the matter is that they have been trading with those other countries for many, many decades and they knew the other countries could never produce enough goods to export to offset the goods that they were importing.  But Germany and France were like US banks.  They sold stuff to deadbeats knowing repayment was impossible because it looked good for business in the short term.  It’s called a vendor finance scam.  Vendor finance is when the seller loans the buyer the money for the sale and then records it as a sale on his books even though he has in reality received no money.  All he has done is give the stuff away and hope beyond any mathematical possibility that the "buyer" (debtor, really) would somehow be able to repay the loan in the future.

A similar relationship currently exists between China and the USA.  China produces low cost low margin goods by the ton and ships them to the US.  We have chased much of our manufacturing offshore and thus we do not have the capacity to create finished goods to trade back to them at prices they can afford to pay.  So instead we have been giving them our IOUs called dollars and China has currently got about 3 trillion of these IOUs in their possession.  This is far more than we can afford to repay and so at some point we will default on the loan just as the PIIGS are defaulting right now on France and Germany.  The fault is on both sides.  If either side had behaved honestly then the imbalance could not have occurred.  China does not have the internal wealth to buy the stuff it makes because the Chinese government has kept the exchange rate so low for so many years.  China must export to the US and others or there will be no jobs which will mean widespread starvation which always leads to civil unrest.  Chinese leaders do not want to be dragged through the streets and hanged by angry starving people so they continue to play the vendor finance game with the USA.

Shifting gears, the exchange rate for goods and services is a direct function of the money supply.  Another way of looking at it is that all the money in existence must be matched up to all of the goods in existence to determine the value of the money.  An example works best to explain this.  Imagine a universe with two people in it.  One of them has a dollar and the other has an apple.  That’s it – there is nothing else in the whole universe.  Under these conditions, the apple is worth exactly $1.  Why?  Well, let’s say the owner of the apple wants to charge $2.  There is only $1 in existence so he can want for the rest of his life but he will never make the sale because there simply is not enough money in existence to pay his price.  An important side lesson which is made obvious by this example is that buyers set the price, not sellers.  Sellers can set the asking price but if nobody is willing or able to pay it then the seller must lower the price until it reaches a level where buyers show up.  Take a look at Florida housing if you still question this concept…

The flip side of the price example is the case where the buyer is only willing to spend 50 cents.  I guess he could rip that dollar in half and trade it for the apple but then he would be left with half a dollar and nothing in the universe to spend it on.  What good is holding money when you have already bought everything in the universe?  For that reason, the dollar cost of goods is always based on a relationship between the amount of money in the economy vs. the amount of stuff for sale.  It doesn’t matter if the one item for sale in the universe is a car or an apple as long as only one or the other of them exists in the universe at any instance in time – if there is only $1 of money in the system then the price for either the car or the apple is $1.  Now if you add a second apple to the economy then the price per apple has to be 50 cents by the same logic.  If you have a car and an apple for sale then charge whatever you want for each of those items as long as it adds up to $1.  Conversely, if you have 1 apple in the universe but instead of only $1 you have $2 in the economic universe then the price for the apple is $2.

So the basic rules are that when the money supply increases (inflates) relative to the amount and type and quality of stuff for sale then it causes a corresponding rise in prices.  Intelligent economists will tell you that inflation is not the rise in prices but rather the rise in the money supply.  Milton Friedman (an intelligent economist) put it this way, "Inflation is always and everywhere a monetary phenomenon".  Rising prices are a symptom of inflation as opposed to being inflation in and of itself.  Conversely, if the money supply decreases relative to the amount and type and quality of stuff for sale then it is called deflation.  The typical sign of deflation is falling prices.

Where things get interesting is when credit appears.  Credit is not money but it spends as if it were money.  You can pay for things the same way with paper or plastic.  Credit is a promise to pay money at some later date.  There are many ways to create credit but our monetary system uses something called fractional reserve banking which is a policy controlled by the Federal Reserve bank – a privately owned, privately controlled bank which controls our money and credit supply.  With some exceptions, the Federal Reserve is about as “federal” as “Federal Express”.   It’s mainly just a name made up by people with a flair for marketing to give the idea of government control.  If you ever get the feeling that private banks run our country it’s because they in fact control the money supply.  He who has the gold makes the rule.  If you ever mistakenly believe that the Federal Reserve is under the control of the government then ask yourself why it has never allowed anyone to perform a public audit.  The Federal Reserve routinely testifies before congress (just like CEOs of other banks do) and when asked if it will submit to an audit the response is "Sorry, that will politicize the control of our nation's money supply".  If congress is ever allowed to audit the private Federal Reserve bank it will be under authority of some statute which allows auditing of any private entity whose dealings have the potential to negatively impact the US and global economy.  In other words, the Fed's own response to "to big to fail" will be turned on itself.

There is not enough room on this page to discuss the intricacies of fractional reserve banking but there is a good write up about it in Wiki.  One key thing to know is that anytime credit is offered by a bank and subsequently accepted by a consumer, the overall money supply is increased by the amount of the corresponding debt.  The other thing to know is that fractional reserve banking allows credit to be extended in amounts many times larger than the money which is printed up (physically or via electronic accounts) by the Federal Reserve (which is called the monetary base).

From what I explained earlier, an increase in the money supply relative to goods for sale was called inflation.  Having discussed credit and fractional reserve lending, that description now needs to be modified: inflation is an increase either the monetary base or the debt taken on under the fractional reserve lending system relative to the amount of stuff for sale.  Because of this, and bear with the redundancy here because it is so important to internalize, every time someone takes out a loan it increases the money supply (through credit based inflation) which means that prices in the economy go up.  This is why housing prices skyrocketed during the credit bubble.  Conversely, when debt is repudiated or paid off, the money supply shrinks causing deflation.

In a fractional reserve system, the first people to use credit can buy stuff at low prices with the borrowed money but as everyone gets into the act the prices go higher and higher until the last guys in are borrowing $600k to buy shoe box homes in a slum.  At some point nobody is willing to take out a loan that large on something so small and valueless (even at nearly 0% APR) and the whole thing begins a deflationary spiral which is exactly what we see happening in California, Nevada, Florida and all parts in between to a lesser degree.  People see housing prices going down and so they wait to see if they will go down more.  As they go down people who got in early try to escape with the profits they still have.  At the same time foreclosures and short sales flood the market with low priced homes.  New debt is avoided and existing debt is repudiated or paid down causing the deflation.

The problems with this boom-bust system are that lots of homeowners are left making large mortgage payments on a house that is now worth less than they owe on it.  This makes no economic sense and so people exercise their legal right to default on the loans (America has no debtor’s jail…).  The problem here is that the banks then end up taking massive losses on these greedy loans they made and so the Federal Reserve has to go into overdrive printing new money from thin air so that the debt deflation doesn’t collapse our entire banking system. 

At the end of the day, the proper model for what fiat currency and fractional reserve banking produce is called a Debt Ponzi scheme, named after financial scammer Charles Ponzi.  Basically, a debt Ponzi appears to be a working system, sometimes for quite a while.  But it is in fact mathematically unsustainable from day one.  Each time someone tries to exit the system with his supposed profits, someone else must come into the system with enough new money (or in the case of a Debt Ponzi, with enough new credit and debt) in order to not only pay off those leaving the system but also to make up for internal losses spirited out the back door by the banksters who demand an interest payment on the credit they conjure up from thin air.  At some point it is no longer possible to keep inflating the Ponzi and it begins to deflate - the Ponzi scheme begins to collapse.  The recent Madoff Ponzi was a textbook case of this.  People thought they had value in the system when in fact it was all just lies.  In short, any banking system built on fiat currency and fractional reserve banking is a pack of lies that will eventually collapse under its own corrupt weight and, sadly, the entire world currently labors under such a system.

It is not certain by any measure that the Fed is even capable of printing the amounts of money needed to offset banking losses.  It is widely understood that our banking system would have collapsed had the government not decided in early 2009 to impose a policy of “regulatory forbearance” on the banks which is weasel-talk for “just don’t admit you are bankrupt”.  It’s sort of a don’t ask don’t tell for the banking system.  Of course China and our other creditors are hopping mad about us printing up all that money but they are not angels either so it’s devil vs. devil in a game of “who is the biggest con man”.  So far I think the US is in the lead.  We’ve always had the best money scammers on the planet in this country.
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