The government itself is perpetually in debt. Mainly because every year it fails to collect enough money in taxes to cover all it’s spending plans. To solve this problem it borrows money from private banks and other financial institutions. In the process it creates some fancy bits of paper with symbols, letters and numbers on them and calls them bonds, stocks or gilts. These bits of paper are really no more than elaborate I.O.U’s. It then sells them on the money markets, agreeing to buy them back at a higher price at some agreed time in the future. This represents a very good deal for the money men; not because the stocks and bonds are guaranteed by the government but because they’re backed by the tax paying people of Britain. In simple terms the UK national debt in 2008 consisted of nearly £700 billion of these gilt edged, government IOU’s, generating ‘interest’ payments of around £30 billion. When the massive sums of money the government has spent in ‘bailing out’ the banking system is added the total is well on its way to £1 trillion. A staggering amount of money, completely unrepayable and considering much of it was created from thin air by banks, totally unnecessary.
When bought by financial institutions such as insurance companies and pension funds they’re done so with money which has largely been borrowed into existence in the first place. A similar state of affairs to the one described by the Scottish economist H.D. Macleod when he said: "[if] a great London joint stock bank has perhaps £50,000,000 of deposits, it is almost universally believed that it has £50,000,000 of actual money to lend out... It is a complete and utter delusion. These deposits are not deposits in cash at all, they are nothing but an enormous superstructure of credit."
When banks buy stocks, bonds or gilts they do so using money they’ve ‘created from nothing’ through the fractional reserve banking system. The stocks become part of the banks assets and the newly created, debt money increases the money supply in the economy, invariably leading to inflation. As Benjamin Franklin indicated; instead of swapping government created i.o.u’s for bank created new money the government could have created the money themselves. In the process they could have saved the public a fortune in interest payments and had greater control over the inflationary consequences of creating more money than the growth in goods and services warrants.
The money the government borrows is usually spent into the economy on such things as wages for its employees, buying equipment for the NHS or stocking the subsidized bars and restaurants in the House of Commons. In this way it finds its way into the bank accounts of people and businesses. This debt money, which has been created out of thin air and is owed to somebody else enters the banking system and is registered as new deposits, which in turn then becomes part of the banks' assets giving it more collateral for lending via the fractional reserve system. The Federal Reserve in New York explains this in simple terms: "Because of the 'fractional' reserve system, banks, as a whole, can expand our money supply several times, by making loans and investments." "Commercial banks create checkbook money whenever they grant a loan, simply by adding new deposit dollars in accounts on their books in exchange for a borrower's IOU."
A bank’s liabilities are the amounts it might be called upon to provide to its customers at any one time. Its assets are the cash and any other resources available to it to meet those liabilities. If a bank has assets and liabilities of the same amount then it has enough cash to meet any demands that are made on it by its customers.
But the banks soon realised that cash demands in the form of cheques written and money withdrawn only ever amounted to around 10 per cent of total deposits. This meant that if the bank had deposits of, for example, £10,000 then the most cash the bank would need to meet any demands from its customers was actually only £1,000. The banks looked at this in a slightly different way and decided that if they had cash assets of £10,000 they could afford liabilities of £100,000. A fractional reserve ratio of 9 to 1, which meant that banks could loan up to 9 times the amount of their total deposits, money that didn’t previously exist. This is what’s called the fractional reserve system and is how banks are said to create money out of thin air. The ratios do vary and can sometimes be much higher but 9 to 1 is fairly standard.
When a bank makes a loan, no one else in the bank with an account is sent a letter telling them that the money in their account is temporarily unavailable, because it has been lent to someone else. No one’s account in the bank has been touched, reduced or affected in any way. At the stroke of a bank manager’s pen a debt has been created and brand new money, numbers on a computer screen, has entered the economy. This was neatly summarised by Graham Towers, the former Governor of the Central Bank of Canada when he said, "Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . .Each and every time a bank makes a loan, new bank credit is created -- new deposits -- brand new money."
At first sight it appears this merry-ground of loans into deposits could go on forever. That would be true if the banks didn’t have to honour each other’s cheques. They have to be careful not to create more money than they realistically can pay out when other banks demand it in settlement. Generally each bank can rely on cheques from other banks clearing through its books to offset its own obligations. But just in case they keep a safety margin, making sure they don’t create more loans than are being created, on average, by other banks. The end result is that the actual fractional reserve ratio within the entire banking system is always slightly less than the theoretical maximum.
The fractional reserve system is inherently inflationary. As the economist Ludwig Von Mises wrote: "If you increase the quantity of money, you bring about the lowering of the purchasing power of the monetary unit." Inflation is usually seen as prices rising but what is really happening is the money in your pocket is buying you less and less. Contrary to what many people think rising inflation is not generally caused by the government irresponsibly printing money. It is caused by banks expanding the money supply with loans. When new money is created, without a corresponding increase in goods and services, it dilutes the existing money’s value. The fact that this process is abused by governments was admitted in a quote by John Maynard Keynes in his 1920 book, ‘Economic Consequences of the Peace’. In it he said: “[by] a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but confiscate arbitrarily: and while the process impoverishes many, it actually enriches some. The process engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose.”
“Inflation is the one form of taxation that can be imposed without legislation” is a quote attributed to the economist Milton Friedman, but it perfectly explains why it's often called a hidden tax. However it’s not only governments that benefit, far from it. A review, produced by the St. Louis Federal Reserve Bank in November 1975, explained: "The decrease in purchasing power incurred by holders of money due to inflation imparts gains to the issuers of money.” Among those most affected are savers; people on fixed incomes and those with below inflation wage rises who are having purchasing power 'stolen' from every pound they’ve earned or saved.
Of course, not only are the banks able to create new money out of thin air, they’re also able to charge interest on it, a practice often referred to as usury. But there's something very important to note about this, which is that when they make the original loan they don't create the additional money to pay the interest. Belgian economist Bernard Lietaer, who was also a former central banker, looked at it like this: “Money is created when banks lend it into existence. When a bank provides you with a $100,000 mortgage, it creates only the principal, which you spend and which then circulates in the economy. The bank expects you to pay back $200,000 over the next 20 years, but it doesn't create the second $100,000 - the interest. Instead, the bank sends you out into the tough world to battle against everybody else to bring back the second $100,000."
G. Edward Griffin, the author of ‘The Creature From Jekyll Island’ has a different perspective. He says the reason this doesn’t become a major problem is that as the loan and interest is paid back the loan part is extinguished but the interest itself is retained by the bank as its profit, which then circulates back into the system in some way or another. He sums the situation up perfectly when he says: “… all interest is paid eventually by human effort. And the significance of that fact is … that the total of this human effort ultimately is for the benefit of those who create fiat money. It is a form of modern serfdom in which the great mass of society works as indentured servants to a ruling class of financial nobility.” Leo (Lev)Tolstoy put it in a slightly different way to Griffin but he was essentially saying the same thing: “Money is a new form of slavery, and distinguishable from the old simply by the fact that it is impersonal, that there is no human relation between master and slave.”
It seems that there's an element of truth in what both Lietaer and Griffin are saying. There would certainly be a problem for borrowers if they had to repay the loan, including the interest, all at once. This never actually happens though as repayments are made over a fixed period of time. Defenders of the current system claim that the interest is recycled by the banks in the form of operating expenses, interest to depositors and dividends to shareholders. Obviously, if 100% of the interest payments made was recycled there'd be no problem. A closer look, however, reveals that this is not the case. Anything less than 100% means that the present system operates in such a way as to guarantee that a certain number of borrowers will be unable to repay their debts and will default on their loans.