Let’s go back in history to see clearly what it means. Fiat money initially appeared as bank notes confirming that they correspond to the value of real material resources kept in the bank. This means that bank notes were a numerical equivalent of real material resources – gold. A stock of precious metals was accumulated in state coffers and to make the turnover (exchange) easier a more or less corresponding amount of fiat money was issued, which could always be swapped for the real precious metal in the bank at any moment.
It is with the appearance of fiat money that there appeared a unique possibility for financiers to scheme – money was always printed in greater volumes than there was gold, as bankers counted on the fact that all people will never come to the bank to swap fiat money for gold, that is why there was no full reservation. Nevertheless, when the bank offered fiat money at interest, people thought it fair because in fact it was the precious metal owned by the creditor that was loaned at interest.
In the modern financial system, money (the bulk of it) is not backed by precious metals or other material values on the part of banks. In accordance with laws of monetarism, money supply growth must correspond to gross domestic product growth to support money turnover, and economists compare the volume of current money with the volume of current GDP. Does it mean that money is backed with GDP? Of course, not! GDP does not belong to central banks, which control the issuance of national currency. GDP does not belong to the Federal Reserve System, which controls the issuance of key world currency, the U.S. dollar, either.
The Federal Reserve System is a private structure comprised of 12 private incorporated banks, each of which has the right to print money. There are no state reserves in this system and law does not require Federal Reserve decision be approved by president or any other state structures. Decisions are approved by core shareholders.
Which is the principle of modern credit institutions operation in such conditions? The same as in the times of ‘the gold standard.’ By issuing currency units that are not covered (by financiers) by material resources and demanding from their debtors that real material values be swapped for them, financial system representatives are in fact involved in unfounded and illegal exploitation of the society – this is what the common sense says.
Of course, people who know banking, can reasonably say that the Federal Reserve issues money with securities as collateral, mainly state bonds, which means that dollars are backed with state debt. But the Treasury does not swap bonds for real material values, it swaps them for the same currency units and noncash values at that (figures in the computer). Also, the United States passed a law at the end of 2003, which said any assets of the Federal Reserve System – the same dollars, for instance, - can be regarded as collateral for notes issued by the Reserve. But if you come to the Federal Reserve and demand a payment, you will simply get smaller change. (http://malchish.org/index.php?option=com_content&task=view&id=308&Itemid=31).
The Federal Reserve every day issues bank notes worth a total of 635 million dollars. The cost of one note is about 6 cents. Private banks, which make part of the Reserve, provide credit noncash money to other banks at a low interest. Cash money comes to commercial banks when correspondent noncash sums are written off their accounts. Commercial banks, in turn, give credits, with their own markup, to the business and households which create real material values filling the money supply with real value (GDP).
The suggestion that the credit money are formed from depositors’ money does not correspond to reality given that the bulk of U.S. population is in debt (U.S. consumer debt amounted to 124% of their disposable income as of the end of March 2009), while 80% of Russian population (by western measure) live below the poverty line.
In fact, it means that by lending money, the creditor gives the debtor part of GDP, or a numerical equivalent of what does not belong to him. The creditor has the right to print money, he owns the printing press and its produce – a piece of paper worth less than 6 cents per note.
But bankers demand that debtors collateralize a loan against a real material collateral. This means that while credit money sits in the bank, it is not covered by anything, but once the bank gives it as a credit, it becomes immediately covered by material values of the debtor. This means that credit money issued by the Federal Reserve is later backed by material values of debtors. Moreover, banking institutions demand from debtors not only interest for their work of printing and servicing money supply, but also the full sum of the debt, namely, money in fact backed (as a result of turnover) by real GDP. This would be logical if banks owned real material values themselves (like in the times of ‘the gold standard’).
To illustrate the situation, we can consider a notional example with an uninhabited island, which is not there on the map. Let’s say that some people landed on the uninhabited island after a shipwreck. There was a banker with a sack of paper money among them who offered credits to the inhabitants of the island on condition of repaying the full sum of the credit plus interest (purportedly with the aim of setting a civilized system of exchange with the help of money on the island). The people understood quickly that the banker wants to grab all natural resources of the island having only fiat money as well as to appropriate products of their labour. Of course, the people would get irritated, burn the money and would be happy with barter, like ordinary savages. If the banker were more prudent, he would have acted differently.
No matter how paradoxically it seems, but the modern financial system works as if it owned all natural resources, all practical achievements of the mankind and all human labour potential. In fact, it is the bankers who own all the aforementioned benefits and offer them (in the form of a credit) as a loan to the rest of the human society.
It happened that the financial system headed by the Federal Reserve turned the producing industry, households and the government into its debtor by issuing money supply which the system does not back. The current system does not cause popular anger only thanks to the customary and outdated stereotype of thinking. Everyone is used to treating money as securities backed with real material collateral on the part of bankers. In reality, it is the debtors (namely, products of their labour) that make the real backing of modern credit money.
People keep thinking that if money buys goods, it means money is covered by something (by GDP, if not gold). But they do not take into consideration the obvious fact that that the financial sector of the economy, responsible for money emission (printing), does not produce real values and GDP does not belong to it. By rejecting ‘the gold standard’ banking institutions have lost ethical and moral right to work under the old scheme, which now does not correspond to the very spirit of laws of the human society.
Here it is appropriate to recall the statement by U.S. President Jefferson, the author of the Declaration of Independence: "If the American people ever allow banks to control issuance of their currency, first by inflation, then deflation, the banks and corporations...will deprive the people of all property.... I sincerely believe that banking institutions are more dangerous to liberty than standing armies."
The current financial system has perverted the core principle of the economy, where demand must breed supply. In reality, demand is the result of an aggressively imposed supply. To put the situation in the right perspective and tune the economy so that supply is a natural result of demand is only possible if the very principle of cash flows forming and distribution is changed, meaning the system will attain stability and self-sustainability, if the monetary pyramid is turned from its top to its basis.
The new principle of the financial system operation is described in Financial Democracy at Work chapter. The basis of the modernization is the transfer of the insipient of money flows from the financial system to the civil society. Investment volumes in this case will depend not on the size of state debt, but on real demand of households, the rate of human potential development, technical progress and the volume of natural resources. It will not be the state debt which will guarantee the creation of money, but real households’ demand, which would grow simultaneously with the technical progress development.
A relatively quick modernization of the financial system is possible on the basis of existing innovative technologies – the electronic monetary system. Under this scheme, production growth will be backed with growth of demand, technical progress will get new incentives for development. Representatives of the financial system will be engaged in servicing the society, not its exploitation (like it happens now).
The social and political system will be insured against mass social unrest because citizens will get the basic and growing level of purchasing ability as a social guarantee. The human creative potential will be developed and implemented most actively because all necessary basic vital needs will be taken care of (The Maslow Pyramid of Needs). It is this factor which will give the necessary but absent incentive for economic development, helping the society enter a higher and more harmonious level of development.