Financial system
Chapter 2 - Society
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Welcome to the Financial system page
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Money is solidified surplus energy
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A common idea is that money makes the world go round. But money is only a third-order invention.
- First, there is the physical world supporting human existence by extracting energy from low entropy
- Second, we have human activities with the purpose of creating surplus value from low entropy resources
- Only in the third step does money appear as a method of conserving that added value.
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Core ideas
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Neo-classical view on money
Fiat money
A government decree or fiat makes fiat money legal tender. The term is usually reserved for legal-tender paper money or coins that have face values far exceeding their commodity values and are not redeemable in gold or silver. Throughout history, paper money and banknotes have traditionally acted as promises to pay the bearer a specified amount of precious metal, typically silver or gold. By the late 20th century, it had become impossible for the United States to maintain gold at a fixed rate, and in August 1971, U.S. Pres. Richard M. Nixon said he would "suspend temporarily the dollar's convertibility into gold or other reserve assets." The move spelt the end of the Bretton Woods system and the last vestiges of the gold standard. Within two years, most major currencies "floated," rising and falling in value against one another based on market demand. According to the quantity theory of inflation, excessive issuance of fiat money can lead to its depreciation.
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Trust
Since fiat money doesn't have intrinsic value and isn't linked to physical commodities, its value derives from people's confidence and trust in the government that issues it. Financial authorities strictly regulate and oversee it to maintain and encourage a stable, reliable money system that protects consumers and businesses. The lack of tangible backing allows governments more flexibility in managing and regulating currency.
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Money creation
Money creation refers to the process by which the money supply increases. It involves creating new money, which can occur in two primary ways: central bank money creation and commercial bank money creation.
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Money destruction
Money contraction refers to the process by which the money supply in an economy decreases. It occurs when money is removed from circulation or when the economy's ability to use money as a medium of exchange diminishes. Central banks can intentionally reduce the money supply through specific monetary policy tools. In a deflationary environment, falling prices discourage spending and borrowing. As debts are repaid or written off without being replaced by new loans, money is removed from the economy.
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The little money secret
Growth of the global money supply
Interests
As global economies grow, the demand for money to facilitate transactions, investments, and savings also increases. A growing population and higher productivity lead to greater economic output, requiring a larger money supply to support these activities. Economic growth often relies on credit. Commercial banks create money by issuing loans, which contributes to the expansion of the money supply.
Money is created with every loan a bank issues. That money is destroyed again when it is repaid.
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The interest is not destroyed and is profit for the bank.
This means that money is created on demand and once it is created the destruction mechanism is automatically set in motion. A destruction system that creates money at an exponential rate.
Loans by wealth
Of course, it is not forbidden for the wealthy to take out loans, whatever one does. Wealth is in stocks, bonds, or other financial products that one uses as collateral for loans. In this way, money is created by wealth, and wealth keeps the dividends and tax deductions that apply to loans.
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Exponential growth
Exponential growth occurs when a quantity grows at a rate directly proportional to its present size. Any quantity that grows at the same rate every year (or every month, day, hour, etc.) is experiencing exponential growth. Fixed interest rate bank deposits show exponential growth.
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Doubling time
Doubling time is the time required to double the starting value at a given steady growth rate per unit of time. The formula for this is very simple:
T2 = 70 / % growth per T (= unit of time)
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| 1Y | 2Y | 3Y | 4Y | 5Y | 6Y | 7Y | 8Y | 9Y | 10Y | ... | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| 1% | ... 70 Years | ||||||||||
| 2% | ... 35 Years | ||||||||||
| 3% | ... 23.5 Years | ||||||||||
| 4% | ... 17.5 Years | ||||||||||
| 5% | ... 14 Years | ||||||||||
| 6% | ... 11.5 Years | ||||||||||
| 7% | 10Y | ||||||||||
| 8% | 8.75Y | ||||||||||
| 9% | 7.75Y | ||||||||||
| 10% | 7Y | ||||||||||
| 11% | 6.3Y | ||||||||||
| 12% | 5.8Y | ||||||||||
| 13% | 5.3Y | ||||||||||
| 14% | 5Y | ||||||||||
| 15% | 4.6Y | ||||||||||
| 16% | 4.3Y | ||||||||||
| 17% | 4.1Y | ||||||||||
| 18% | 3.8Y | ||||||||||
| 19% | 3.6Y | ||||||||||
| 20% | 3.5Y |
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Ethical system from the past
Deuteronomy 15:1
At the end of every seven years you must cancel debts. This is the manner of remission: Every creditor shall cancel what he has loaned to his neighbor. He is not to collect anything from his neighbor or brother, because the LORD’s time of release has been proclaimed.…
When someone uses your lent talents at 10% per year, after 7 years, he has paid you back the money you lent in full and has the borrowed money as capital.
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Deep dive
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Money creation
Central banks
Central banks create money primarily by buying financial assets (e.g., government bonds) from the public or banks. They pay for these purchases by crediting the sellers' accounts at the central bank, effectively creating new money. This money circulates as currency (physical cash) or reserves (electronic money held by commercial banks at the central bank).
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Commercial banks
Banks create money by issuing loans. When a bank issues a loan, it credits the borrower's account with a deposit. This deposit functions as new money. While the bank holds only a fraction of the deposit as reserves (to meet withdrawal demands), the rest is loaned out or invested. Borrowers use the money, which eventually gets redeposited in the banking system, allowing the cycle of loan creation to continue. Factors like demand for loans, the willingness of banks to lend, and consumer behaviour affect how much money is created.
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All the money in the world
The global money supply continues to grow for several interconnected reasons. These reasons are driven by economic, policy, and demographic factors, reflecting the dynamics of modern economies and financial systems. As global economies grow, the demand for money to facilitate transactions, investments, and savings also increases. A growing population and higher productivity lead to greater economic output, requiring a larger money supply to support these activities.
Economic growth often relies on credit. Commercial banks create money by issuing loans, expanding the money supply.
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Central bank policies
Most central banks aim to maintain a moderate level of inflation (e.g., 2% annually). To achieve this, they often expand the money supply in line with or slightly above the economic growth rate, preventing deflation and supporting stable price levels.
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Government spendings
Governments finance large-scale projects (e.g., infrastructure, education, healthcare) by creating or borrowing money, which enters circulation and expands the money supply. They often spend more than they collect in taxes, covering the difference by borrowing or creating new money. Central banks may buy government debt, injecting money into the economy and increasing the money supply.
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Trade
As global trade and investment expand, money moves across borders, often requiring the creation of additional money to facilitate transactions and maintain liquidity.
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Wealth
Expanding economies generate higher levels of income and savings, which require larger financial systems and greater monetary support. As global wealth grows, more money is needed to support rising asset prices, such as real estate, stocks, and commodities. Central banks often accommodate this by increasing liquidity.
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Depreciation
Advancements in technology improve economic efficiency and output, which drives the need for a larger money supply to reflect higher transaction volumes and economic activity. As inflation occurs, the value of money decreases, requiring more nominal funds to perform the same functions. Over time, this contributes to a larger nominal money supply.
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Money supply
M1
M1 is the money supply that is composed of currency, demand deposits, other liquid deposits—which includes savings deposits. M1 includes the most liquid portions of the money supply because it contains currency and assets that either are or can be quickly converted to cash.
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M2
M2 is a more comprehensive calculation than M1 because it includes assets that are highly liquid but are not intended to be routinely used as cash. Consumers and businesses don't usually use time deposits when making purchases or paying bills, but in a pinch, they could convert them to cash in short order.
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M3
The M3 classification is the broadest measure of an economy's money supply. It emphasizes money as a store of value more so than as a medium of exchange, hence the inclusion of less-liquid assets in M3. Less liquid assets would include those that are not easily convertible to cash and therefore not ready to use if needed right away.
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Quantity theory
In the 19th century, quantity theory contributed to the ascendancy of free trade over protectionism. In the 19th and 20th centuries, it played a part in the analysis of business cycles and in the theory of foreign exchange rates.
In economic contexts, efficiency means that the monetary evaluation of the inputs used to produce some goal is minimal and that the costs associated with achieving that goal are minimal. If something is called inefficient, the goal could have been reached with less cost or could have been better achieved (in some monetarily measurable fashion) with the same expenses.
One implication of this theory is that the size of the money supply must be considered when shaping governmental policies to control prices and maintain full employment.
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Money destruction
In a deflationary environment, falling prices discourage spending and borrowing. As debts are repaid or written off without being replaced by new loans, money is removed from the economy.
Central banks can intentionally reduce the money supply through specific monetary policy tools. They may increase the reserve ratio, forcing commercial banks to hold more money as reserves and reducing their ability to issue loans. They may also reduce their balance sheets after quantitative easing (QE) periods by selling off assets or letting bonds mature without reinvestment.
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Loan repayment
When a borrower repays a loan, the principal amount is removed from the bank’s balance sheet, reducing the money supply. If a borrower defaults on a loan, the bank writes off the unpaid amount as a loss.
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