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Thursday, March 20, 2014

Economic Collapse...What Does That Mean Anyways?



How Money Is Created:

To fully appreciate the economic situation we are in, we first have to understand how money is created.
First, the Bank of Canada prints our money, or more accurately, whites a line in a ledger book.  Unlike the Federal Reserve in the US, The Bank of Canada is a crown corporation, essentially, the government’s very own money printing press.  When the government needs more money put into circulation to pay for public services and such, the Bank of Canada, under the direction of the finance minister prints it, or creates it numerically.  Surprisingly, only about 5% of money is created this way. 



The reality is that most money, about 95% of it, is loaned into existence through a process called fractional reserve banking.  The idea behind it could be considered fraudulent, but it is actually quite easy to understand.  Banks have two primary activities, other than charging you outrageous user fees, taking in deposits from people and companies, and loaning that money out to other people and companies.  Now, one would think that the user fees and interest on loans that the bank collects would be the source of its lending funds, but that is not so.  This is where fractional reserve comes into play.  In the fractional reserve system, banks are required to keep on hand only a small amount of the deposits they hold and are allowed to lend out the rest, thus the term fractional reserve.  The theory behind this is that its depositors will not want to remove all their money at once.  So just how little money are the banks required to keep on hand?  Well, usually that number is somewhere between 8 and 10 percent…surprisingly low, but workable in theory as the other 90 to 92 percent is constantly coming back to them with interest as debtors repay loans.  This is actually no longer the case in Canada, but I’ll get to that a bit later.

So where is the problem with this you might ask?  Well, bankers figured out pretty quickly how to literally create new money using this system…here’s how it works.

To simplify things, let’s imagine a small town somewhere in Canada with one bank.  A newcomer to the town goes to the bank, opens an account and deposits $1000.00.  So, with the fractional banking system in play, the bank goes out and finds someone who needs to borrow money and grants them a loan of $900.00, which keeps the reserve of $100.00 for withdrawals.  The borrower is building a home and purchases supplies from the local lumber yard with his borrowed $900.00.  All good right?  Well what do you think the lumber yard does…that’s right…straight to the bank and deposits it.  The bank now has $900.00, of which it can loan out $810.00.  This goes on and on and on average, the bank can loan, receive and reloan this original $1000.00 12.5 times…creating new fictional money each time.

Let’s take a look at the hard numbers.

The bank only ever received $1000.00 of actual money…everyone in play in this scenario used portions of that original deposit.

Original deposit:1000
Loan out:900
Balance:100
Deposit from lumber yard:900
Balance:1000
Loaned out:810
Balance:190

So, from this very short example, we see that from the original 1000.00 deposit, the bank loaned out $1710.00.  So where did that extra $710.00 come from?  Thin air!  Bad right?  Well it gets worse…a lot worse.

So how much real money is in circulation here?  $1000.00 right? So how it that guy building his house supposed to repay the bank with interest?  The bank must create more money…again, out of thin air using the fractional reserve system, or else the borrower must, by mathematics, default on the loan, meaning that the bank no longer has the original cash to cover withdrawals by the original depositor.
So where is the problem?  More money means more people have money to spend and everyone is happy right?  Wrong…remember, there is no real money other than the original $1000.00…everything else is just numbers on a balance sheet…it DOES NOT EXIST!

The kicker here, which makes it even worse, is that in 1981, then Prime Minister Brian Mulroney reduced the fractional reserve rule to zero…that’s right, banks no longer have to keep ANY of your deposits on hand by law, and are free to determine how much they keep on hand to cover withdrawals.

How Inflation Ties In

So isn’t the creation of new money inflationary?  Of course, and it is directly related to the supply and demand laws.  When an item such as gold is rare, its value remains high.  But suppose a new source of gold is found and there is suddenly a lot more of it around…the value goes down.  The same holds true for money, and it doesn’t matter if it’s printed by the Bank of Canada or created through loans made by chartered banks…both are inflationary.  Now, keep in mind that not all inflation is bad, as a matter of fact, it is quite necessary for an expanded economy to function.  Now, if the Bank of Canada, which is essentially the government, were to have control of money creation, there might be a better outlook, but remember, 95% of all money is created by chartered banks in the form of loans.  When a bank issues a loan, they create a debt that must be repaid with interest.  So, if the money supply was finite, interest could never be paid, so the banks issue more loans to create more money in the form of debt…with interest, and so on and so on.  The problem is that every time the banks issue loans, they must continue to do so at a greater rate to keep enough money in the system to enable debtors to repay with interest.  One would think that this creates a snowball effect that can never be stopped, and you would be bang on.  Mathematically, the banks cannot create money fast enough to keep up with the debts they have on books, and someone must default…these defaults, which come in waves, are what we call recessions.  Most of us define inflation as the increase in the price of goods and services, when actually, the reverse is true.  Inflation is your dollar being worth less as a result of a surplus of it.  This surplus is a natural result of the bank lending scheme that it needs to continue on an ongoing basis just to keep itself running.  As the banks lend more money into existence, inflation rises with it.  The problem is this…the more the banks lend, the more they have to lend to create money so that debtors can repay.  This goes on and on and becomes exponential, bringing the inflation rate with it. 

Although the banks system could theoretically go on forever, you cannot.  In order to fight inflation, you have to work harder and longer to keep up.  Humans have a breaking point and there is only so much time in a day, meaning that debtors have a ceiling of what they can do to repay debt…a fact that breaks the theory of an infinitely plausible scheme for the fractional banking system…it requires constant growth, which by the laws of nature, is not possible, and debts get defaulted on.  We have seen this play out in history over and over again with countless recessions, and let’s not forget the great depression of the 1930’s.

How The US and Canadian Dollar Are Related in Respect to a Collapse

There is no shortage of proponents of the US dollar collapsing, it seems more of a question of when.  But just what does that mean for our Canadian economy?  Will it suffer the same fate and if so why?  We have all heard how closely the two economies are related but just where is that relationship made?  The answer is in trade.  International trade is when goods or services created by the workers of one country are sold to the consumers of another.  In our case, the goods and services we sell to US consumers represents about 20% of goods and services sold by Canadian workers, which represents just over 347 billion dollars…at that number, it really doesn’t matter which currency you count in…it’s a lot of moulah!

In the case of an economic collapse in the US, Americans would simply not be able to afford Canadian goods if our dollar remained stable.  Therefore, it stands to reason that the Bank of Canada could deflate the loonie by injecting significant amounts of freshly printed cash, causing inflation here and create an equal footing with the US which represents almost 75% of its international trade.  In addition, the Bank of Canada currently holds more than half its reserves in US dollars.  

Canada also happens to be the number one supplier to the US of a very important and valuable resource…oil.  Millions of barrels of oil are bought and sold internationally every day in order to keep up with the world’s energy demands, mostly in transportation.  When buying or selling goods such as oil on the international market, a currency must be determined to be used between all the parties involved.  For oil, that currency is the US dollar.  Imagine how many US dollars are in circulation around the globe for the sole purpose of buying oil.  Should the international community decide to use another currency to buy and sell oil with, all that US money would be dumped into the economy, causing instant hyperinflation.  Not going to happen  you say…well, Iraq tried to switch to the euro in 2000 and Saadam Hussein got his neck stretched for his efforts.  Sure, a tiny country such as Iraq, already weakened by war and economic sanctions was easy to do this to, but what if say, Russia decided to do this?

The effect of bank runs

In any case, if this were to happen, Canada would find itself with over 50% of its cash reserve being devalued beyond use.   Why is this important?  Well, because the chartered banks do not need to keep any real cash on hand for withdrawals, although they do keep  some, it stands to reason that a high number of people drawing money they have deposited in those banks could cause the banks to simply and realistically run out of cash.  Normally, when this happens, the Bank of Canada steps in and lends them money from its reserve to keep them in operation.  With a reserve half the size of what it should be, they would have no choice but to print more money…lots of it and fast, creating a hyperinflation situation.

Hyper inflation is seen as a rise in prices, even if it is actually the currency not being able to buy the same goods or services.  Along with price increases comes consumer stinginess if you will.  With prices rising, consumers are less able to buy goods, therefore causing businesses to lay off people it no longer has the income to pay.  The more people become unemployed, the less they have to spend, and so on and so on…yet another snowball effect.

So What Happens Next?

Once a fiat currency goes hyperinflative, there are several things that begin to cascade out of control.  As unemployment rise, default on loans also skyrocket.  Remember, this is a mathematical certainty the way the system is set up.  There are two types of debts that are defaulted on…secured, meaning there is something physical that can be reclaimed by the bank such as a house, or a car, or a boat.  There are also unsecured debts such as credit cards that were used for items that cannot be reclaimed, or simply have little value such as diners at fancy restaurants, vacations to the Caribbean, or a bunch of music cds or video games, maybe even the cloths on your back.   Although the banks technically recover some of the loans through repossession on secured debt, they are left with physical property that must be sold to turn into cash to cover withdrawals.  However, with a high unemployment rate, no one is buying.

As an example from recent history, during the great depression, Canada’s unemployment rate hit about 30% nationally, with some regions reaching as high as 60%.  With no income and banks repossessing homes, the natural result is hunger and homelessness.  

What Can We Expect From an Economic Crash?  

If you happen to be listening on Blogtalk or through Prepper Broadcasting, you are seeing some pretty desperate images that go along with this podast.  Despite all of this, the often envisioned situation in the prepper community is more of a MAD MAX type of scenario, which in my opinion is pretty farfetched…nearing the mark of impossible.  However, like the depression era, I would not be surprised to see uncountable people living in the streets, or at best, multiple families living under one roof just to make a go of it, and still eating mainly at soup kitchens and through whatever charitable organizations that would be still able to help.

As often happens in these situations, the common man, having no value in paper money, resorts to a barter system of trade.  As no one could possible store up enough of any one essential item that could be used for barter, the only sensible solution is to be able to produce something or provide a service through skills that are necessary for life, such as food or tool making, just to name a couple.  Of course, if you are able to produce at least enough food to support your family, you are on the right track and owning your own home free of debt would be even better.

Conclusion

As we have learned, a collapse of fiat money is an eventual certainty, it’s always just a matter of time.  Sure, economists will always point to fiats that have not collapsed, but the only answer to that which could make any sense at all is ”yet”.  There are even more issues at play in the economy today that I just couldn’t get to for time reasons, but suffice it to say, we have turned a corner economically, and there is no turning back at this point.  Simply put, an economic collapse is not a question of when, but how soon.

On the bright side, there are always better times after a collapse.  Usually, a new currency is introduced and exchanged for the old one, but by looking at collapses in the past such as in Germany, Argentina, and Zimbabwe, just to name a few, new currency is usually exchanged at a rate of 1000 to 1…sometimes much much more.  The biggest downside to this is that the new currency, is also a fiat, and will eventually suffer the same consequences.  In fact, many countries that do this, end up doing so many times in a few short years, before one new currency takes hold and restarts the long cycle.

10 comments:

  1. This is one of the best explanations regarding banking and potential for collapse that I have ever read. I will definitely be linking back to this wonderful post ! Thank you.

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  2. Glad you found it helpful and link backs are always appreciated!

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  3. I posted the link on my blog and Facebook, but few folks on Facebook read anything of substance, so I'm not sure how many folks it will help.

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  4. Any thoughts on what we should do to protect our investments? Convert some portion into gold and silver? And I mean gold and silver that is physically in your home vault, not paper gold would be one thought that comes to mind. Buy land locally.

    What about electronic investments. A person could invest in asset based companies or resource based companies I suppose. But in the event of a collapse and conversion to a new currency, would these investments survive the conversion?

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  5. I wouldn't go spending all my cash on shiny metals if you don't have enough left over for guns ammo and food

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  6. In these times it would seem the best investments would be food guns ammo and anything else that serves a real life purpose. I wouldn't bother buying up shiny metals unless you have more than enough cash for the more useful supplies

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  7. Thanks for the brilliantly easy-to-grasp explanation!

    As for things to invest in, don't forget seeds and livestock! Even a small suburban yard can support chickens, a fish pond and veggie gardens using good permaculture design ;)

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