A Look at the Modern Credit System

credit system

submitted by jwithrow.credit system

Journal of a Wayward Philosopher
A Look at the Modern Credit System

June 22, 2015
Emerald Isle, NC

The S&P closed out Friday at $2,110. Gold closed at $1,202 per ounce. Oil checked out at $60 per barrel. The 10-year Treasury rate closed at 2.27%, and bitcoin is trading around $247 per BTC.

Dear Journal,

I am writing this entry from North Carolina’s glorious Crystal Coast. My family has been making a week-long trip to Emerald Isle every summer since the 1970’s. Back then the island consisted of a small convenience store, Clyde’s Shrimp Shack, and a few dinky cottages by the beach.

The Withrow clan still rents a couple beach-front cottages each summer but the cottages have magically transformed. In the early days, the luxury cottages had a spiral staircase leading up to a second floor with an extra bedroom. The average cottages offered a few bedrooms on the ground level with no spiral staircase. You now find three story luxury homes towering over the beach where the dinky cottages or empty lots once stood.

To most eyes this looks like progress. Maybe it is. However, my eyes only see evidence of the exponential credit expansion that has been taking place for more than forty years now. I feel slightly hypocritical as I enjoy a cold beverage from the the third story balcony watching the waves crash down upon the beach below. You see, I know how this all got here. I know how this went from a dinky little cottage to a three-story luxury home with a balcony overlooking the sea.

President Johnson pulled out a pen back in 1968 and signed a bill that removed gold backing from the U.S. dollar. Then President Nixon went on television in 1971 and proclaimed the international gold window to be closed. The dollar would no longer be linked to gold but don’t worry it was still valuable, he said. We can point to those two events and say that’s where this magical transformation began. Of course we would then need to go back further and determine how we got to those events in the first place but that’s a story for another day.

The credit system worked much differently prior to those two events. To originate a loan the banks needed to have a little bit of money in reserve and that money had to have a little bit of gold backing it. Since there could only be so much gold in the vault at any time, there could only be so much money in the bank’s reserve. This meant there could only be so many loans outstanding so lenders had to be very particular about the projects they financed. Which meant there were only rinky-dink cottages and empty lots lining the beach of North Carolina’s Crystal Coast.

The aforementioned events removed gold from the picture which altered the credit system entirely. Now, to originate a loan, the banks still need to have a little bit of money in reserve but this money is no longer backed by anything. This little nuance means that fiat money is the only restriction to how many loans can be issued. And how is fiat money created? Well, by loaning it into existence of course!

Wait… what? You need more money to do more loans and you get more money by loaning it into existence so the restriction to lending is solved by doing more lending?

Let’s use Bob as an example to illustrate how this works. Bob goes to the bank to finance a new car for $20,000. The bank approves the loan and sends $20,000 to the dealership then Bob speeds off the lot in his new car.

Where did the $20,000 come from?

No one actually asks this question, but if they did the bank would say they lend out deposits. But whose deposits were lent? Did the bank take $20,000 out of somebody’s checking account to send to the car dealer? Of course not!

Did the bank take $20,000 from its own checking account? Let’s look at the accounting to answer this: the bank records the $20,000 loan as an asset and it offsets this entry with a $20,000 credit to deposits on the liability side of the balance sheet. Both the assets and the liabilities figure on the bank’s balance sheet increased by $20,000 which means the bank did not take the funds from its own checking account. So then, where did the $20,000 come from?

The accounting clearly shows that the $20,000 did not exist prior to loan origination which means the money for Bob’s loan could only have come from one place… thin air. Further, we see that Bob’s loan actually increased the amount of deposits within the banking system which means the bank has more money than it did before thus it can issue more loans.

As you can see, the post-1971 credit system really warps the incentive structure – there’s virtually no limit to the amount of loans outstanding at any time so long as the money is flowing. This is why lending standards have decreased dramatically and it is why debt has piled up to the ceiling over the past forty years.

It is also how I am relaxing in a luxury house on the beach in Emerald Isle, NC. The banks had little interested in financing seasonal projects such as luxury beach houses on a mass scale prior to 1971 because such projects are just too risky. If the beach house generates the vast majority of its revenue over a three-month time period each year, what happens if it does poorly during those three months at some point in the future?

Lenders didn’t care to find out the answer to this question prior to 1971 because they needed to focus on less risky projects. Post 1971 lenders don’t care to even ask this question in the first place. They can do as many loans as they want so they are willing to finance anything that looks remotely good on paper. After all, more loans = more money = more loans.

This is why the credit expansion is exponential in nature; it self-perpetuates and builds upon itself.

There is one catch though: the system constantly needs more and more money to sustain itself. We saw how Bob’s loan added an extra $20,000 to the system that did not exist previously. $20,000 is just the principal balance on the loan, however. Bob is going to have to pay interest on top of it. So the loan created $20,000 in new money but it created a debt in excess of $20,000.

Now if Bob’s loan was just an isolated incident then this shouldn’t be much of a problem… Bob just needs to work a little harder to acquire more money.

But what happens when we extrapolate this phenomenon out across the entire financial system to the tune of millions of people and trillions of dollars? We see a system creating more debt than it has money to service that debt with thus more and more money must constantly be created to keep the system afloat. But the only way to create more money is to lend it into existence thus creating more debt as well.

Further, what happens when much of this debt is securitized and packaged into the pension plans and 401(k) plans that a very large percentage of the population plans to retire on? Can the system be sustained?

Something to think about…

More to come,







Joe Withrow
Wayward Philosopher

For more of Joe’s thoughts on the “Great Reset” and the emerging cultural shift please read “The Individual is Rising: 2nd edition” which will be available later this year. Please sign up for the notifications mailing list at http://www.theindividualisrising.com/.

2 thoughts on “A Look at the Modern Credit System”

  1. Last sentence made me remember about 50% of baby boomer currently are drawing from 401k.
    My mind is shutting down just thinking about it.

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