Money is one of the most important things in the life of a human being. The amount of money one owns determines the survival value of this person. Money buys a way out of poverty, diseases and homelessness. Money brings status and friends. In general we like to accumulate as much as possible of it, as it brings an increasing amount of self determination. Money, though, is more than a piece of paper. It is linked to the world of production. With the growing amounts of paper money, we have lost more and more sight of what it actually is.

In the early days the ‘Western world’ was scattered with self sufficient communities owned by landlords. The landlords employed enslaved workers that were granted food, shelter and protection in exchange for their work. Mostly agricultural products were being cultivated. In this world, trading was either fairly non-existent (within communities) or rather uncomplicated (between communities). Most goods traded were perishables, which require consumption in the short term.

As the world opened up, and enslaved employment gradually disappeared, more and more people were able to start their own enterprises. This economic individualism encouraged competition, leading to specialisation and more (and different) products available for consumption. It also reduced the share of perishable goods in total production. With the increase in diversity of goods available and variability in demand for them trade would have been complicated without using some kind of intermediary.

Throughout history man has used several kinds of commodities as a means of exchange. For a commodity to be used as an intermediary, it is important that the public is confident about the stability of its future value. For fluctuations lead to changes in purchasing power, and like this influence the rewards of labour. Until recently gold was the commodity to be used as a means of exchange.

The introduction of a commodity has brought an additional advantage. It has enabled economic agents to postpone spending purchasing power for some time. By saving gold present income could be used to cover for unforeseen future events. At first, gold was put in an old sock and hidden under the bed. Some entrepreneurs sensed a new business opportunity and offered to store the money for a fee in their safe vaults.

In the vault the gold would not be of any use for a while. In the meantime there were others who were facing periods of gold shortages. The entrepreneurs were glad to provide these debtors with the gold at a slightly higher fee than they were paying to their creditors. The margin between the two represents the compensation for taking risks and for administrative costs. This is how banking started.

When the banks accepted the bags of gold they issued receipts, or IOUs (I owe you), to the savers stating the amount of gold stored. Today we call these IOUs money, which have standardised coupon values. As time passed and confidence grew, people eventually started paying each other with the IOUs. A substantial part of the gold was therefore not reclaimed by the savers. The bankers saw a new business opportunity. Instead of lending the gold in their vaults 1 on 1, i.e. lending the IOUs on the amount of gold that was physically present, they started lending out more IOUs than were covered. By doing so, money became detached from the underlying purchasing power.

Over lending seems a win-win situation. But it is not. In the days before money (IOUs) was actually traded, the price of gold was subject to fluctuations. Every time new gold was dug out of mines and brought to the market, the value of the existing stock of gold declined. As is the case with money the value of gold is based on trust. If nobody wants to have gold, it can be priced as cheap as a piece of paper used to write an IOU you on. In the end, therefore, it does not matter if we use gold or money as a currency. What does matter is that we should not change its value respective to the purchasing power.

It is here where things go off. The system of fractional reserve lending creates purchasing power that is not stored in saving accounts. Suppose banks are to hold a 20% of their savings as a reserve for those who want their savings to be returned. If someone were to deposit 1000 units of money, it implies that eventually 5000 units can be lent to borrowers. For: 20% times 5000 unit equals 1000 units. The first borrower will get (100-20) % x 1000 = 800. The borrower will use this money to buy products. The seller of this product will store the 800 units at a bank account. From this account 80% can be used to finance another loan of 640. This process goes on until the value of loans has been multiplied till 5000 units.

Suppose we would go to the bank and ask our 1000 units back. First of all, the bank needs some time to recollect the loans from the borrowers. Secondly, after collecting the first 1000 units the bank and the saver would have ended their agreement. What about the other 4000 units? Before we get our initial 1000 units back all the positions (described above) need to be reversed. We need to have returned each of the 20% stored as a reserve. This implies that all lent out capital needs to be returned.

What has this non-existent money been spent on? Let us assume there are two people on the planet: you and me. Every week I sell one text like the one you are reading. You produce two loaves of bread every week, of which you will sell one. So we trade. We have decided to use IOUs to be used as means of exchange (in our situation this would not be needed). As we trade text for bread, we trade products of similar value. Your IOU and mine both have a value of one unit. One week I come to you and I tell you that I want two loaves of bread from now on. You will ask me what you will get in return.

In a world without money, I would need to produce two texts (assuming you actually want to have two). Now, in our simple world with money, I tell you that I am giving you two IOUs. You would refuse to accept my second IOU. Where did the additional IOU come from? You would consider me to be a cheater and loose appetite for trading with me. In a world with more market participants, you do not know where the IOU originates from. You therefore do not know if the claim can really be exchanged for products.

The increase in demand for bread gives you two options. One: your bread seems to be wanted and you increase the price of the bread. Two: you expand capacity and produce an additional loaf a week. In the first case the rise of the price of bread leaves me with less purchasing power. One text will not even yield one loaf of bread. In the second case you misinterpret the demand. You observe there is an additional IOU available in exchange for the additional loaf of bread. This IOU, though, has no underlying value and is in itself worthless. You will only find out after increasing production, after selling the bread and after claiming the underlying of the IOU.

When people sense that the monetary system has become untrustworthy, they will immediately want to reclaim their belongings… in vain. The borrowers are asked to repay loans, but are unable because they spent it on (intermediate) goods. People will stop trading goods in exchange for this particular currency. Goods in production will not be bought. The value of money (inflation rises) drops. The interest rate rises to the points where it equals supply and demand again. New investments are put off and unemployment rises.

As people value stability of their money, they instituted (through governments) central banks that guard the value of money. In order to do so they control the fractional reserve rate, stage open market operations (buying or selling debt in order to steer the interest rates) and they set several short term interest rates (setting the rate implicitly requires them to control the amount of money available to the public). Does a central bank have better understanding of markets than individuals have? How can we influence it (we cannot)? Who guarantees that it will never be corrupted?

Money has become detached from what it actually is. The value of our money has been diluted by issuance of money that does not have any underlying purchasing power. The system of fractional reserve lending makes that money is unjustifiably abundant, and will eventually lead to a revaluation of the money we hold in our wallets. At same time dislocation of inputs (labour, capital and raw materials) will have to be corrected. This is the price to be paid for creating purchasing power that does not exist.