#4: Most of the Money in the U.S. Economy is Fake.

Why most of the money in the U.S. economy is fake.

Did you know that most of the money in the United States economy is fake? I didn't. More shockingly, there are multiple sources of fake money. Fractional reserve banking is just one. Quantitive easing is another. Could hoarding cash under my mattress be safer than putting it in my bank?

Why was learning about the U.S. banking system?

As part of my effort to debunk (or support, yikes!) the assertion of James Dale Davidson that the U.S. economy is on the brink of collapse, I’ve been educating myself about U.S. monetary policy. What I learned about fractional reserve accounting and open market operations undertaken by the Federal Reserve was eye-opening. Add in recent stock market trends, and I’m starting to understand Davidson’s position (yikes, again!)

Why do fractional reserve banking and quantitative easing create fake money?

To pull the U.S. out of The Great Recession, The Federal Reserve began printing money. The Fed would say it started a program of Quantitative Easing, but Quantitative Easing simply means artificially increasing the supply of money in circulation through a process called Open Market Operations. Basically, the Fed prints new money and with that new money buys securities from private banks.

For example, if The Fed wanted to put an additional $626 billion dollars in circulation, it would buy $616 billion worth of U.S. Treasury, Government Agency, and Mortgage-backed securities from security-holders. It did this between May 28, 2008 and May 27, 2009, increasing the total value of its securities portfolio from $491 billion to $1.1 trillion. The idea is that banks, flush with new cash, would lend this money to struggling consumers like me and voila!—I’m better off. Theoretically, at least.

The Fed didn’t stop at $491 billion. By May 26, 2010, the value of The Fed’s securities portfolio had roughly doubled, to $2.1 trillion. By May 25, 2011 it was up to $2.6 trillion. Between 2011 and 2012, the value of the portfolio grew “only” $33 billion, but from mid-2012 to mid-2013, another $702 billion of securities were purchased, and another $841 billion between mid-2013 and mid-2014.

As of July 30, 2014, the value of the securities portfolio at The Fed was $4.1 trillion. As of October 26, 2012 the value was $4.2 trillion. Between May 28, 2008 and July 30, 2014, the Fed introduced $3.7 trillion dollars into the economy through open market operations.

If that’s not interesting enough on its own, enter fractional reserving—a slick provision that turns that fake money into more fake money—10 times more fake money, to be exact. Instead of requiring  banks to keep my entire deposit on hand—in case I decide one day I want to withdraw all of it—the law allows banks to lend 90% (a “fraction”) of my checking account balance out to other customers. And this process doesn’t stop with me. In fact, this process can continue indefinitely, and thanks to mathematics, there is a tidy formula that says my $1 can grow to be $10.

To see how this can happen, consider this example: When I deposit $1 into my checking account, I have $1 to spend. The bank keeps $0.10 on hand, and loans $0.90 to my hero, Beyoncé who deposits it into her checking account. She now has $0.90 to spend. Her bank keeps $0.09 on hand, and loans $0.81 to her boyfriend Jay-Z who deposits it into his checking account. Jay-Z’s bank keeps $0.08 on hand, and loans $0.73 to his gal pal Rhianna who...

We’re only 3 singers deep into what must be a vast R&B network of friends, and already my initial deposit of $1 was turned into $1 in my pocket plus $0.90 in Beyoncé’s plus $0.81 in Jay-Z’s plus $0.73 in Rhianna’s thanks to fractional reserving.  In total the four of us now have $3.44 to spend, but only $1 of it is real. Sounds like song lyrics, doesn’t it?

To complete the trifecta of interesting data points, I’d like to submit recent trends in the S&P 500 P/E ratio. P/E ratio is the ratio of the share price to the company’s earnings per share. The S&P 500 is an equity index comprised of 500 large companies, so looking at the P/E ratio of the Index is a proxy for the average P/E ratio of the 500 companies.

There is no ideal P/E ratio, just historical values and opinion. Historically, the P/E ratio has been around 16. (It’s not 1.0 because investors expect and price for growth.) As of September 2016, the Index’s P/E ratio was  25.13, after a steady uphill climb from it’s recent low of 13.01 on 9/30/2011. Standard and Poor’s projects the P/E ratio to be at 18.51 by the end of 2017.

What else did I accidentally learn along the way?

An advanced degree in applied statistics is a great degree to have for an amateur economist.

What were my sources?

Khan Academy series on The Monetary System: https://www.khanacademy.org/economics-finance-domain/macroeconomics/monetary-system-topic

Federal Reserve balance sheet from June 2009: https://www.federalreserve.gov/monetarypolicy/files/monthlyclbsreport200906.pdf