1. How Money Really Works
This is our first example of how money really works. We're going to build a small financial system to show how a community creates and uses money, and how things like banks and debt really work too.
We'll keep it very simple. We're going to start with a very small community, a community of just 5 people, who have skills they want to trade in a local economy. We can build up a small financial system to show how they will interact with each other using money and doing so will capture the way we interact with each other in much larger societies, indeed the world as a whole, today.
A Basic Financial System
- Table 1 -
The above table shows each community member's finances at the beginning. The fact that the table is filled with zeros means there's no money in this community yet. But that's not a problem, because Mark, Jo, Cassie, Lauren and Sean all read the moneytruth.org website and they know very well how to get the system going and make everything work.
The reason we have money, of course, is to be able to offer people something in return for doing things for us - to pay them to build things, grow things, repair things, move things around etc. For this first example, let's imagine that Sean needs some emergency repairs carried out on his roof. Although no money exists right now, Sean knows that he can hire and pay Mark - a skilled roofer - to do the job. And he can hire him and pay him right now, right when the work needs to be done, even though it looks like he doesn't have the money to pay him.
All Sean needs to do is accept that he has a reciprocal debt for the value of the repairs carried out on his home and that debt will itself create the money that pays Mark and then goes on to circulate in their economy.
- Table 2 -
What you're seeing above is the actual creation of money. Sean's debt really did create 1000 currency units on the system. And although this may seem a simple process, this really is where money comes from.
Sean now has a legally binding debt on the system and Mark, having provided the materials and labor to repair Sean's roof, quite rightly is the owner of (he is the 'bearer' of) the corresponding legal credits/claims - money. You can see clearly here that money is relational, it is based in debt and has two sides: a legal debt and a legal claim. Mark's money can be spent with anyone else on the system and he isn't tied into an ongoing relationship with Sean.
Notice how this system solved a very important economic problem and avoided two other very important problems also:
Sean didn't have leave his roof in a state of disrepair while he labored elsewhere for a wage, 'saving up' the money to pay Mark.
He also didn't have to seek out someone who could lend him their money, thus he didn't have to enter a lender-borrow relationship or pay interest.
This system, then, cleverly solves many problems that might exist around money and debt. And it achieved it 'endogenously', without having to introduce any type of money from the outside, or any third-parties like lenders (thus traditional lender-borrower relations or interest) either. In other words, many historical problems associated with money, debt and the conflict between rich and poor have been removed.
Let's continue. Lauren would like to employ Jo, a skilled builder, to extend her property. Lauren's property is also the location of her daycare business, so extending it allows her to expand her business and her ability to serve the community. Just as above, Lauren enters into a legally binding 'promise to reciprocate' in order to create the money that allows the work to be done; she takes on a debt, 2000 units this time, and Jo works to earn the title to those claims.
- Table 3 -
Again we can see the two-sided, relational nature of money - Jo has labored and is now 2000 better off. Lauren has an extended property, but she is now 2000 in debt.
We can also see that Mark and Jo, having already earned money, can spend the money they have without creating new money. This reaffirms the fact that we only need to create money in response to the need for debt. So long as Mark or Jo wish to spend no more than they already have, they will not need to create more money. Indeed, the economy as a whole won't need to create any more money until someone needs to spend more money than they have. The money that already exists in the economy will continue to circulate until it has been settled again i.e. until the debt which created it has been paid down again.
So let's now see how the money we've created is eventually settled (that is, 'uncreated' or 'paid out of existence') again. The following table shows a transaction between Mark to Lauren. Mark (the roof repairer) has a young child who he would like to enroll in daycare with Lauren. The charge, for the remainder of the year, will be 1000.
- Table 4 -
You can see that Mark's account is debited and Lauren's account is credited by 1000. Mark goes from +1000 to 0 and Lauren's account shows that, whilst she has a debt of 2000, she also now has credits of 1000 too. There are still 3000 units of currency in existence (the total of either column), but Lauren now has credits which she can use to pay off her debts. And in doing so, the money she created in the previous round will be paid out of existence again.
- Table 5 -
By transferring 1000 currency units from her credit column to her debt column, Lauren paid off part of her debt. In doing so, she actually removed that 1000 units of currency from the system, leaving only 2000 currency units remaining.
From here, it's very easy to imagine almost any transaction we like between members of the community. We can imagine anyone going into debt and creating more money, we can imagine anyone paying money to anyone else, or even to everyone else, and we can imagine anyone paying off debts to eliminate money that their own debts created. We can even imagine everyone paying off all their debts at the same time, returning us to where we began at the beginning, with nothing but zeros in our system - no money and no debts at all.
So, we've seen money being created, we've seen it being transferred, and we've seen it being eliminated again. This is the 'lifecycle' of money. And although there's much more we can talk about, we've already seen the most important things that we can know about a monetary economy:
We've seen that money comes into existence, as we need it, when we go into debt. And that's because money is debt.
We've seen that debt is facilitated, not by "borrowing" anyone else's money, but by creating new money, endogenously, within the system.
We've seen that money is not returned to a previous owner when it is paid back, but is in fact paid out of existence again.
The lifecycle of money, the idea that money can easily be created, transferred through exchange and then destroyed again when it has served its purpose, can be confusing for those used to thinking about money in a different way, for example, if they think of money as physical objects like banknotes or coins (which obviously don't just disappear when you give them back). But remember we haven't introduced any physical money into our system at all yet. Everything we did we did with accounts entries, simple numbers written down on a table, and you'll see later that even when we do introduce physical money, it doesn't change what is happening underneath.
So money, banking and debt work very differently to the way we commonly believe. Our financial systems are really something we call credit systems, because they create, circulate and destroy money in facilitating the economy's debts. And you've seen that they are really very remarkable things, that they solve many of the greatest problems associated with money, debt and trade and they do so in a very clever way.
We'll go on to add more to this model in upcoming sections, including adding a government and a plurality of banks in Sections 8 and 9.