By MoneyMorning.com.au
I got my start studying economics at UCLA. That started me on a career that’s lasted for more than 30 years, trading equities, bonds, commodities, currencies, derivatives, and real estate. It continues to be a great, rewarding career and it’s afforded me a wonderful lifestyle.
No one is born with a mastery of these fields. It takes careful study and years of experience before one gets a real grasp of economics, money, and the markets.
But you have a great head start.
We live in the Information Age. There are hundreds of financial and business news outlets. Discount brokerages have opened up everywhere, putting the power directly in the traders’ hands. The Internet offers a huge body of knowledge and opinion on investing, markets, and money.
All of this – and more – is available to each of us. But I’ve been wondering why there aren’t more successful investors or traders. Then, in an “Ah-ha!” moment the other day, I realized why: No one teaches you how to “fish” the markets!
You know the old saying… Feed a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime.
That’s just what I’m going to do. Starting today, and continuing on, I’m going to give vital insights on mastering the markets.
You’ll have the benefit of more than 30 years of experience and success in the palm of your hand. You will be the master of your own destiny.
Let’s Start With Money
It’s the root of all things (yeah, maybe that includes evil, but we’re not going there), so we have to understand it. Now, more than ever. You can’t understand where gold might go, or the dollar, or stocks, or the economy if you don’t understand money.
The history of money is fascinating, but we aren’t exactly studying history. We’re relating it to the present to predict the future – as best we can.
First there was commodity money, the exchange of goods or services for other goods or services.
Then came gold and silver – coveted precious metals that people imbued with value simply because they were rare and coveted.
People began exchanging commodities and goods and services for gold and silver because they knew other people would accept their gold and silver in exchange for their commodities, goods, and services.
Gold and Silver Coins as Currency
Gold and silver coins were measured and stamped and became the first widely accepted money.
Goldsmiths, in Europe and elsewhere, offered safe storage of depositors’ gold and silver and issued receipts for precious metals in their safekeeping. These receipts were evidence that the bearer had gold in safekeeping, and, since carrying around receipts was easier and safer than toting heavy metals, receipts became the new money.
Goldsmiths became bankers. The word banker itself comes to us, by turns, from the Old Italian word banca, bench. These benches were covered with green cloth, probably felt, and transactions were conducted there.
There, at the banca, these early bankers began to lend out depositors’ gold – without the depositors knowing. These loans would be in the form of actual gold or depositors’ receipts. The borrower would then pay a fee, interest, on the amount borrowed.
And just like that, as if by some alchemist’s magic, fractional banking – the foundation of our modern banking system – began. Fractional banking is what drives money and credit creation to this day.
What follows is critical to your understanding of money today. It will manifest itself throughout almost all of your endeavours to master the markets and make money.
It will come to you from everywhere, and you will start to see this strange phenomenon at work in the markets and in your life.
The Dangerous Cycle of Fractional Banking
Eventually, word got out that bankers were lending to borrowers by giving them gold, or receipts, for gold they hadn’t deposited and had no claim to.
But, the original depositors weren’t likely to want all their gold back at once, so as long as borrowers eventually turned in their borrowed receipts or replaced their receipts with gold, the original depositors accepted the fact that their gold was still there.
Besides, it didn’t take long for them to demand some of the interest being earned on lending against their gold.
To ensure that there would be plenty of gold in the vaults to cover depositors’ withdrawals, banks established reserves – an amount of gold that they would always keep on hand.
That’s how fractional banking turned into fractional reserve banking, which is exactly how all banks operate today.
Now, let’s move from the gold of the past to the greenbacks of today.
Let’s say I deposit $1 million (cash for now – we’ll get to credit, I promise) at my bank – a bank with a 10% reserve requirement. That means my bank has to put 10% of my money into its vault, in case I come looking to take out some of my money.
My bank has lots of other depositors, so if I wanted my $1 million back, there would be enough in the reserve vault from all the reserves held aside to withdraw me all of my money.
After the bank puts aside $100,000 for me, it has $900,000 of my money to lend out. If it lends out that $900,000 to someone, there’s a good chance that person will deposit their borrowed money back into the same bank until they need it.
If not, they would deposit it at another bank, or pay a debt, or make an investment. In any event, that money would eventually make its way to some bank as a deposit.
Now the bank has another deposit. It will have to set aside 10% of that $900,000, or $90,000, and it can lend out another $810,000. And so on and so on.
That’s the magic of fractional reserve banking. It multiplies money.
In the old days receipt money could be exchanged for gold – that’s the gold standard, by the way. Lenders lent gold and extended credit by issuing receipts.
But there would come times when depositors would want their gold and there wouldn’t be enough to pay them back because it had all been lent out, by means of fractional banking magic.
Needless to say, banks went out of business, panics ensued, and lots of people were ruined.
These same systems were set up over and over again, with almost always the same outcome.
But, eventually, a few things changed.
Eventually, people realized that banks might fail, that reserves could be exhausted. At that point, people’s receipt money became worthless. They demanded gold and silver.
So, what did the U.S. and other governments around the world do? They made “legal tender” laws that forced paper money, money they themselves would print, onto the people. It would be used without question “for all debts public and private.”
These days, no country backs its paper currency with gold or silver. Money is backed by nothing other than the “full faith and credit” of whatever government is printing that money.
The “full faith and credit” comes, in part, from the ability of the government to tax its citizens and raise money, to shore up the value of the currency. That’s called fiat money.
That’s today’s lesson – the history of currency as it relates to fractional reserve banking, and the dangers of panic. We still use the magical fractional reserve system and we’re still subject to all of the panic and ruin that magically comes when it all goes wrong.
But that’s just the tip of the money story iceberg.
Governments made legal tender laws to make it illegal not to use their paper money – backed by nothing but promises. But they also granted a bunch of private bankers the right to lend those governments as much money as they “needed.”
That’s just more magic, and you have to see through it to play the game the way the insiders do.
If you enjoyed this, you’re going to love next week’s lesson.
Shah Gilani
Contributing Editor, Money Morning
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