- first the central bank ‘prints’ or more accurately ‘conjures’ money out of thin air by putting digits on a computer screen,
- then they place those digits on a borrowers account, normally a commercial bank, as a loan;
- then the commercial bank, generally, and conservatively, lends that money and the money of other depositors using a formula of ten dollars/euros or pesos for each one dollar or peso the lender bank has on deposit.
Every time those ‘monetary units’ are used to pay someone else the same quantity of new money is created. Therefore the more that money moves the more that is created. That is currency velocity.
- Create too much of it in relation to the amount of stuff, things, services, economic activity that is created, an economy then gets price inflation. Too much price inflation means each monetary unit/dollar/peso/euro will buy less stuff.
- Incidentally, only the ‘stuff’ and ‘services’ that are produced creates what is called ‘wealth’. It isn’t the creation of money/monetary units by moving money around that creates wealth.
- Another reality is that by the creation of credit people can buy stuff and services without having money or savings. That means that nothing is paid for when it is produced or ‘bought’ and or used. Done excessively, it can’t be paid for by working, saving or investing.
Borrowing from the future frequently ends in the ‘insolvency’ of governments or ‘bankruptcy’ of businesses and individuals. For examples think of Greece and any number of our friends who have lots of stuff that is all financed by borrowed money. In other words, they don’t have any assets or wealth which they own.
In even more simplistic and, I might add, more humourous terms, the little story below demonstrates what economists call ‘money velocity’ and…
how a bailout package (think Greece) works!
It is a slow day in a little Greek Village. The rain is beating down and the streets are deserted.
Times are tough, everybody is in debt, and everybody lives on credit.
On this particular day a rich German tourist is driving through the village, stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night.
The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher.
The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer.
The pig farmer takes the €100 note and heads off to pay his bill at the supplier of feed and fuel.
The guy at the Farmers’ Co-op takes the €100 note and runs to pay his drinks bill at the taverna.
The publican slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him “services” on credit.
The hooker then rushes to the hotel and pays off her room bill to the hotel owner with the €100 note.
The hotel proprietor then places the €100 note back on the counter so the rich traveller will not suspect anything.
At that moment the traveller comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, takes the money, and leaves town.