The Myths Of Paper Money

By Benjamin Gisin

There are two popular myths about paper money. The first is that government prints so much paper money that it causes inflation. Secondly is that there is nothing backing the paper money. These myths are so prevalent they have taken on a mantra of reality. These myths are often associated with interests wanting to sell gold.

These myths are usually put forward as the cause of inflation and economic ills. They draw attention away from how the monetary system works, resulting in the wrong medicine recommendation for our economic woes. The monetary system is a process of indebtedness that curtails the economy by saturating it with debt and then being unable to find enough qualified borrowers to keep the economy going with more debt.

Paper money is a complex process that is a small piece of the larger money process of indebtedness. The purpose of paper money is to provide bank checking and savings account holders the option to convert what is in their bank account to paper money. Paper money has nothing to do with government printing to finance its operations or cause inflation.

The following explanation of the paper money process will provide some insight:

�         The Bureau of Engraving and Printing, which is a division of the United States Treasury, prints all denominations of paper money upon order from the Federal Reserve Bank (Fed). The Fed is a private banking corporation created by law with responsibilities to report its operations to the government. The Fed pays the Bureau of Engraving and Printing for the cost of printing the paper money.

�         The Fed puts the printed money in its vaults and awaits orders from banks who need paper money to cash checks or for ATM machines. Paper money is a debt of the Fed.

�         The Fed must create the reserves that banks use to buy the paper money from the Fed. This is done by the Fed buying, on the open market, U.S. Treasury and other debt securities. When the Fed buys securities, it credits the reserve account of the bank where the securities dealer has his account. It is this debt the Fed has to banks that banks use to purchase the paper money from the Fed at face value.

�         The Fed collateralizes the cash it ships to banks with the same basket of securities it purchased to create the reserves.

�         What the Fed owes banks in terms of reserves, is transferred to what the Fed owes in the form of cash at the bank.

�         When a customer cashes a check or makes an ATM withdrawal, the bank lowers what it owes the customer�s checking/savings account in exchange for the paper money which is an obligation of the Fed.

For the person unfamiliar with banking process, these six points of explanation can be confusing. The bottom line is that paper money is issued by banks (not government). The issuance of paper money is offset by the simultaneous extinguishing of checking/savings account money. The more paper money in circulation, the less money is in circulation via checks and debit cards.

So the use of one form of money (paper money) extinguishes another form of money (checking and savings deposits). Primarily, it is the banks� creation of checking and savings account money, and further secondary lending of that money, that causes inflation and increases the amount and speed of money in circulation.

As of 3/31/09 (source: FDIC) the U.S. banking system was obligated for $8,954 billion in customer deposits. As of 4/2/09 (source: Federal Reserve) there was $865 billion of paper money in circulation. When you deposit paper money in a bank, your bank account goes up by the same amount as the paper money that is now out of circulation and vice versa.

All paper money issued by the Federal Reserve is collateralized (backed) by some type of security. In recent months, the Fed purchased securities representing bonds collateralized by residential homes. Some of these bonds now collateralize some of the paper money in circulation (source: Federal Reserve).

The printing, issuance, and collateralization of paper money have little to do with financial and economic meltdown. The nation�s economic woes are the result of a financial system based entirely on complex processes of indebtedness. The money products of these processes (bank accounts and paper money) make an inferior means of exchange by virtue of saturating the economy with debt, barriers to access in that someone must qualify for credit and their use as savings, rather than circulating media.

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Benjamin Gisin is a veteran banker and former senior agricultural approval officer for one of the nation�s largest agricultural banks. Since 1998, he consults businesses and agricultural producers facing credit challenges. He writes and lectures extensively on the evolution of money, economics and food security.