I’ve been reading about a set of interlocked issues that are going to dominate our lives and our conversations over the next decade.

One of these is money. If anyone has been wondering why the economy is a mess and when it might actually recover, perhaps the following information will be helpful in understanding what is going on.

In 1913 our current “federal reserve” system was formed. The “Fed” (as it is called) is not part of the government — it is “Fed” as in “FedEx.” It’s a consortium of private banks and extremely wealthy financiers. The Fed was formed in response to the problems that kept plaguing the banks of the late 1800’s, which functioned on a “fractional reserve” system. I’ll give a simple explanation of all that in a moment, but what I want to point out is that our entire economy is only a century old. Prior to 1900, money was an entirely different beast.

Here’s how fractional reserve banking works: if you deposit $100 in your bank, the bank is allowed to loan out $90 of that money — it is only required to keep a “fraction” of your money in “reserve,” typically about 10%. If you were the only customer, this would be a huge problem, because when you came to withdraw your money, the bank would only have $10 on hand. The rest of your money might not show up for six months — and might not come back at all if the debtors default on their loans. Of course, you aren’t the only customer, so when you take out your $100, the bank takes your $10, and nine other customers’ $10, and gives you your $100. If they only have ten customers, they are now in deep trouble, because they have absolutely no money left in the bank. The next customer who comes in and asks for even $10 will get nothing.

This is where the federal reserve comes in. They are the “lender of last resort,” and they make short term loans to any bank in this situation. So the question becomes, where does the federal reserve get its money?

The answer, as John Kenneth Galbraith once put it, is “repellently” simple. They create it. Out of absolutely nothing.

Technically, they loan the money out of nothing. When the borrowing bank gets a little excess cash, they pay back the loan, and the money that was created out of nothing vanishes back into nothing.

Almost.

The “almost” is the part that is breaking the economy. The “almost” is the interest that the bank is required to pay on the short-term loan that it took out. This interest rate is closely related to the “prime rate” you hear about in the news. The bank must pay back more than it borrowed. So where does this extra money come from?

In principle, it comes out of a growing economy — higher wages, more industry, increasing general wealth: more banking customers with more money making bigger deposits.

It’s pretty obvious that the whole system is in deep trouble when the economy isn’t growing. But that is not the worst of it.

Interest is based on the amount of money borrowed. Everyone who has kept a savings account or borrowed money knows how this works. If the bank is paying 5% on a savings account, then if you save $10, you earn fifty cents on your savings. If you save $1,000,000, you earn $50,000.

This kind of growth, where the increase is a percentage of the amount already there, is called “geometric” growth. It is equivalently called “exponential” growth. But there’s an even simpler way to understand it: it is doubling growth. For any given interest rate, your money will double in a fixed amount of time. For 1% growth, it takes about eighty years to double. For 5% growth, it takes about fifteen years. For 10% growth, it takes only eight years.

To keep up with a 1% prime rate, the economy must double every eighty years.
To keep up with a 5% prime rate, the economy must double every fifteen years.
To keep up with a 10% prime rate, the economy must double every eight years.

No matter what the prime rate (if it is above zero), the economy must keep doubling.

This is, of course, physically impossible in the long term. We can only sustain that kind of growth for very short periods, and only during especially prosperous times. So the problem here is not simply that the economy is not keeping up with the growth of the money supply, but that the economy cannot possibly, under any imaginable circumstances, keep up with the money supply. It’s flatly impossible. It has always been impossible.

So what happens when the economy doesn’t keep up with the increasing amount of money in circulation?

Inflation. Dollar devaluation.

In 1960, my father bought a single-family brick home in the suburbs for $16,000 — in 2006, I sold that same house for $150,000. In 1960, a new sedan straight off the showroom floor cost about $2500. In 2006, a new sedan cost about $25,000. In 1960, my family of four could get out of the grocery store with a month’s supply of food for about $100. In 2006, it was about $1000, perhaps a little less.

In 46 years, the dollar lost 90% of its value, which corresponds to a steady annual inflation rate of 5.1%. Over the last 46 years, the money supply has been steadily increasing at least 5.1% faster than the economy has been growing. Every year, each dollar represents 5% less in real goods.

Under the Federal Reserve system, inflation — dollar devaluation — is unavoidable, because no real economy can continue to double endlessly.

Inflation isn’t an insurmountable problem in itself. After all, pay could also increase at 5%. Who cares if you pay $100 for a McDonald’s Happy Meal if your annual salary as a bank teller is $250,000? (This compares to a $10 Happy Meal on a salary of $25,000). There are reasons that devaluing the dollar is dangerous, having to do with international treaties and trade, but those problems could be worked out.

However, pay does not keep up with inflation. I don’t recall the last time I heard of a 5% cost-of-living increase in anyone’s pay (other than Congresscritters, of course.) So the middle and lower classes — as well as seniors on fixed-income pensions and families on welfare — have been slowly suffocating under inflation.

There is one more hidden problem. The banks aren’t the only institution that can borrow from the Fed. The government borrows from it, too. Every time the government spends money that isn’t covered by a tax increase — “deficit spending” — it borrows the money from the Fed through a convoluted process involving Treasury Bonds. The multi-trillion bank bailout program that Bush crafted? It came from the Fed. The Obama Economic Recovery Bailout? It came from the Fed. The Iraq War funding? It came from the Fed. The funding for troop increases in Afghanistan? It comes from the Fed.

All those dollars are dumped into the economy out of absolutely nowhere. If they are not met by a corresponding growth in the economy, the money will decrease in value. If the government tries to “fix” this problem by spending even more money, it actually makes the problem worse — so much so that the economy can go into a spiral of what is called “hyperinflation.” Under hyperinflation, the value of the currency drops so fast that people are forced to push around wheelbarrows of cash to buy groceries. This phase doesn’t last long — the currency quickly becomes worthless and people stop using it entirely.

It’s important to not get too distracted by the government deficit spending, however. If the government immediately stopped borrowing from the Fed and somehow paid back all its debt this afternoon, it would not solve the underlying problem. All of the money in circulation demands that the money supply grow, because every dollar in circulation was — at some point — borrowed from the Fed at interest. Under the federal reserve system, money represents debt — not wealth. It is a liability, not an asset. Every dollar you hold in your hand represents an obligation for you or your children to pay back more than you have in your hand.

The problem isn’t the government. It isn’t really even the banks. The problem is money itself.

We’ve fundamentally mis-defined money. Money isn’t wealth, it’s debt. That’s why it can continue to increase exponentially, even when the economy is stagnant or shrinking.

This is why we are now facing a deep economic crisis. Economic growth has hit a plateau (at best). With a sensible money system, this would not be a problem. In the long run, any economy should reach steady-state. That’s what “sustainable” means. We should be settling into the long term.

Instead, we have a looming and completely unavoidable currency collapse ahead. Forget the Federal deficit — we can’t keep paying the interest on our own currency.

There are a great many ways out of this monetary crisis, but all of them (so far as I’ve seen) involve completely re-inventing the dollar. Both fractional reserve banking and the federal reserve system are questionable under any circumstances, but they are completely inappropriate in a flat or shrinking economy. We need to switch to a system of money where a) money represents wealth, not debt, and b) usury (interest) is either eliminated or very tightly controlled by law.

It seems unlikely to me that our corporate-owned government is going to manage this. All of its economic guidance comes from the people who benefit the most from fractional reserve banking. Corporations would be turned inside out by any sensible change in the monetary system, and the wealthiest people would necessarily lose much of their paper wealth. The government, which preferentially represents this wealth, will actively fight the changes that are needed to preserve the dollar.

So from everything I’ve read, we’ll face both inflation and joblessness in the near-term, followed by (at some point) a federal currency collapse. At that point, what tends to happen (historically) is the creation of local currencies. Since many of these will be based on traditional economic thinking and the “expertise” of local bankers, they’ll fall right into the same trap and will collapse very quickly. But a few communities will get the right idea — that money must represent wealth rather than debt — and those currencies will allow trade to resume.