I'm trying to get my head around fractional reserve banking and had a couple of questions about this...
So as to avoid rewriting something that's already been quite well explained, I'll use the following as a starting point:
http://en.wikipedia.org/wiki/Fractional-reserve_banking
OK, so basically if we have a reserve requirement of 10% and the central bank "creates" $100 worth of central bank money, the commercial banks then use this to "create" a further $900 of money that various people in this economy now have at their disposal to conduct their day to day affairs (buying and selling goods and services from one another).
That $900 represents both the total amount of deposits and the total number of loans in the system... however the deposits will be earning an interest rate which is inferior to the that of the loans - so to keep things simple, imagine that deposits are earning 0% and loans are made at 2%. Also to keep things simple, imagine that the only thing that the loans were used for was to buy widgets.
In order to pay back all of their loans, the various people in the economy (let's call them the villagers) need to come up with $900 + interest, or $900 x 1.02 = $918... which you will note is more more money than they have at their disposal. If all the villagers pooled together all of the cash at their disposal then they'd only be able to scrounge together $900, so they'd still fall short of their loan repayments by $18. As such and failing the injection/creation of new money, a certain percentage of the villagers MUST necessarily default on their loans (regardless of how hard they've worked, saved or how many widgets they've all made).
So basically, my questions is one of money creation. From what I can tell, the only point at which new money can be injected into the system is the central bank. However we have the central bank at one end of the system , the commercial banks in the middle and the villagers at the other. Injecting cash into the system at the central banking end of the the system will only excacerbate the problem. The only kind of "money creation" which could alleviate this problem would be the kind of money creation that injected money into the system at the other end - i.e. money "created" by the villagers.
So my question is, how can the "villages" in this system create the money that they need to pay back the interest on the loans that they HAD to take out in order for there to be any money in the system at all? From what I can tell, this is a mathematical impossibility. The villagers have been hobbled right from the get go and there's nothing they can do about it???
The villagers can buy money from the bank in exchange for goods and services, thus the amount of money that can be paid back to the bank is theoretically limitless.
The fallacies of intellectual communism, a compilation - On the nature of power
Let's say Bob takes out a loan for $100, and pays Joe with the money, and then Joe deposits $100 in the bank. The bank can then loan out another $1000, which Bob borrowes and pays to Joe, and then Joe deposits $1000 in the bank, who can now lend out $10,000. . . .
Can this process be repeated forever, with the bank's generated money expanding without bound?
Harksaw:Let's say Bob takes out a loan for $100, and pays Joe with the money, and then Joe deposits $100 in the bank. The bank can then loan out another $1000, which Bob borrowes and pays to Joe, and then Joe deposits $1000 in the bank, who can now lend out $10,000. . . . Can this process be repeated forever, with the bank's generated money expanding without bound?
No, you're confusing two fundamentally different types of reserve ratios. The one which allows a bank to multiply $100 by 10 to create $1000 only applies to central banks. The commercial banks however are only allowed to loan out 90% of their money, so on $100 deposited they can only lend out $90. Once this money is once again deposited, $81 is lent out, and so on as the amount approaches $0. So central banks multiply by the ratio (in this case 10) while commercial banks divide by it. This is also why onbooks it appears as though commercial banks always have 10% mroe deposits than loans, creating the myth that they actually loan out their deposits.
In effect, if a central bank has $1000, with a reserve ratio of 10:1, the central bank can create and lend out $10,000. This 10,000 isthen re-deposited in a commercial bank which lends out $9,000, then $8,100, etc. In the end money initially owned by the central bank is multiplied by 100 times, giving us $100,000. That is if the cycle isn't interrupted (by hoarding). Of course, if the reserve ratio is larger, and in some countries such as the UK and Canada it is no longer present at all, then a lot more money can be created.
Technically I don't believe the banks have reserve requirements anymore, so there is no limit to how much they loan out so long as they manage to supply cash when demanded.
The problem is sometimes people demand all their cash at once, but that is just one of those 25-sigma events.
However, if the only way to reverse the perpetual default of debt by the villagers is to sell goods and services to the bank, won't this create a perpetual transfer of wealth to the banking system to avoid perpetual default? If the villagers are only selling products and services to the bank to counteract the excess interest due relative to the total money in circulation, they are still losing value to the banks to keep the system functioning, so the system still ends up with the banks owning everything and/or the system collapsing... is that accurate?
Kman: However, if the only way to reverse the perpetual default of debt by the villagers is to sell goods and services to the bank, won't this create a perpetual transfer of wealth to the banking system to avoid perpetual default? If the villagers are only selling products and services to the bank to counteract the excess interest due relative to the total money in circulation, they are still losing value to the banks to keep the system functioning, so the system still ends up with the banks owning everything and/or the system collapsing... is that accurate?
Yes that sounds right to me. This is why banking, together with inflation is usually equated to theft.
The biggest question is not how the system works, but whether this came about naturally, or whether it was a big scheme all along. I don't think we'll ever know, but I can tell you that the media's 300 year silence is not helping the widespread ignorance of what FRB is.
Kman: However, if the only way to reverse the perpetual default of debt by the villagers is to sell goods and services to the bank, won't this create a perpetual transfer of wealth to the banking system to avoid perpetual default?
However, if the only way to reverse the perpetual default of debt by the villagers is to sell goods and services to the bank, won't this create a perpetual transfer of wealth to the banking system to avoid perpetual default?
I suppose you ought to expect that if you never pay down the principal of your loan.
If the only source of money is a loan that is not accompanied by the creation of the interest needed to retire the loan, then a system of perpetual debt is created. There is not enough money to pay back the loan and the outstanding interest. This is the basis of fractional reserve banking. This is why it is inherently unstable - it creates perpetual insolvency (if all all callable loans were demanded, there would not be enough money in the system to pay them back). When fractional reserve banking is combined with an inelastic money supply, there will be panics as the money supply will not be able to be altered fast enough to cover the instability. This is why we have abandoned the gold standard. It is thought that gold is too inelastic. This is a mistake - it is not gold that is too inelastic, but that fractional reserve banking is too unstable.
In a true free-market, one would be able to use either a fractional- or full-reserve bank. The fractional-reserve banking customer would be responsible for his decision to use a cheaper, yet more volatile, business to store his money. Unfortunately, this option is unavailable because our democratic system allows citizens to steal from others when they make poor choices about future risk. As a result, the citizenry has used the government to subsidize and institutionalize fractional reserve banking, and they have institutionalized a monetary system that is 'flexible' enough that the risks that some take are spread over the dollar holding public at large. This spread of risk makes it cheaper to feed at the public trough than to engage in responsible behavior - when risk is removed from the decision-making process, the decisions become increasingly risky.
The moral course of action would have been to criminalize fractional reserve banking, instead of criminalizing gold - but the public was not aware that it was the instability of the fractional reserve system and not the inelasticity of the money supply that was causing the banking panics before the Federal Reserve Act.
Well put.
It seems as if the problem does not lie in the system itself, but in we the people who have authorized it through the outsourcing of personal consequences to a communal pot, creating a system where we cannot feel the pain of our poor decisions today (which initiates immediate positive behavior change to mitigate the pain), but instead we can make years of poor choices blithely ignorant of the eventual boiling point of a society that does not feel direct consequences...
The problem is that we the people wanted more than we could have in a balanced system, so we demanded an unstable system that could give us more now. The source of the problem is "we," not "they." Look how fervently we the people are demanding universal health care and increased minimum wage standards; we don't want to know the eventual consequences; we want the goods, and we want them now.
With that said, an education system bent on the indoctrination of we the people to depend on the mainstream media and government for our every need and pleasure certainly plays its part, but if we were a proactive people, there could be no hidden deceit. We are responsible, whether or not we acknowledge it. If we change us, the system will change too.
It is an interesting question whether the usurpation of wealth from the people to a centralized banking system is intentional and planned by an "elite," or whether it is simply a natural consequence of Darwinistic Capitalism and the selfish orientation of that economic system. I expect we can know the answer if we stop watching the mainstream news as if its journalistically balanced and start asking the right questions, scrutinizing every decision of the banking system and the government.
One thing I do know for sure, and it is not commonly acknowledged, is that those institutions are comprised of fallible people that could easily be acting in their own interests rather than in the public interest. Considering the system of power we currently have and the importance of money in the political system, I would say it is more likely than not that the majority of public "servants" are actually self servants. Money and power are more than enough motive to deceive.
With that said, when the government makes a big decision, or the mainstream media begins to focus on a particular movement or issue, consider, "What advantage is this decision or focus for the agents of that decision or focus?" There is usually a much more reasonable answer to that question than the one given.
But, like I said, the question still stands, and I don't whether it is premeditatively planned and executed or a simple matter of chance. You would think that the most experienced and best educated economists in the world would be able to see what we simple-minded amateurs can see plainly, but perhaps they are just too blinded by their own lust for power and wealth to ask the right questions. On the other hand, perhaps that same lust is what drives them to use their knowledge to carry out such an evil plan.
In conclusion: Good question.
rhys:If the only source of money is a loan that is not accompanied by the creation of the interest needed to retire the loan, then a system of perpetual debt is created. There is not enough money to pay back the loan and the outstanding interest. This is the basis of fractional reserve banking. This is why it is inherently unstable - it creates perpetual insolvency (if all all callable loans were demanded, there would not be enough money in the system to pay them back). When fractional reserve banking is combined with an inelastic money supply, there will be panics as the money supply will not be able to be altered fast enough to cover the instability. This is why we have abandoned the gold standard. It is thought that gold is too inelastic. This is a mistake - it is not gold that is too inelastic, but that fractional reserve banking is too unstable.In a true free-market, one would be able to use either a fractional- or full-reserve bank. The fractional-reserve banking customer would be responsible for his decision to use a cheaper, yet more volatile, business to store his money. Unfortunately, this option is unavailable because our democratic system allows citizens to steal from others when they make poor choices about future risk. As a result, the citizenry has used the government to subsidize and institutionalize fractional reserve banking, and they have institutionalized a monetary system that is 'flexible' enough that the risks that some take are spread over the dollar holding public at large. This spread of risk makes it cheaper to feed at the public trough than to engage in responsible behavior - when risk is removed from the decision-making process, the decisions become increasingly risky.The moral course of action would have been to criminalize fractional reserve banking, instead of criminalizing gold - but the public was not aware that it was the instability of the fractional reserve system and not the inelasticity of the money supply that was causing the banking panics before the Federal Reserve Act.
Surely the same problem exists with a full reserve banking system as well though? If the commercial banks loan money to the villagers and expects them to pay back the principal + interest, you are still left with the problem that there is not enough money in existence for the villagers to pay back the interest. Unless the villagers have some way of "creating" money, at very best, they are only able to pay back the principal.
I can see one potential (although darstedly) way around this with the current banking system. There are currently two kinds of central banks: private and public. The New Zealand central bank (the Reserve Bank of New Zealand) is an example of a public central bank, which doesn't really offer a solution to the problem, although I should say that I see it as the better of two evils. The Federal Reserve Bank is the US is an example of a private central bank... when the commercial banks pay back loans that they've taken out from the Fed (+ interest) the interest represents a profit to the shareholders of the Fed, which the Fed can then pay out as fat bonus cheques to it's employees or as fat dividend cheques to it's shareholders... money that those shareholders and employees can then spend in the economy thus injecting the missing money back into the economy (this profit will be exactly equal to the amount of money that was missing from the equation above). So although this makes the system more "sustainable" it still results in a net transfer of wealth from the villagers to the commercial banks and then from the commercial banks to the Fed (which as it turns out, I think is owned by a consortium of commercial banks so basically we have, on the balance of things, a transfer of wealth from the villagers to the bankers).
My main problem with all of this is that it's not credible - I can't believe that the system could exist in this form? Surely I'm not the first person to have noticed that such a system is fundamentally broken... So I can't believe that the system is actually like this. There must be something that I'm missing here...
Rhys, good post. I have a question for you though.
I understand perfectly well how a full reserve banking system would make a profit (by charging customers to safeguard money). I don't however see a solution to the problem of offering loans.
Loans are obviously a necessary part of investment, and the only incentive to provide a loan is the interest one can gain from it, what's more, is the interest is the only motivation for the debtor to repay his credit. Yet if this interest is not added to the overall money supply, then how does one pay off his loans? This creates the problem of insolvency, but how is this problem solved? I don't see how you could simply inject the extra interest required into the money supply, I mean, who would you give it to?
Basically the question is, how do you create a banking system which allows loans with interest (since without there would be none) without creating inevitable insolvency?
Edit: Jimmy, didn't see your post, and I think it fundamentally poses the same question.
The value of trade goods incl. money is not static.
Junker:The value of trade goods incl. money is not static.
That may be the case, but when you sign a contract for a loan at your bank you're asked to repay the loan (and the interest) in dollars (or whatever currency is stipulated in the loan contract). You can't walk in at the end of the loan contract and give him back, say, the principal in dollars and the rest in cakes and fish! And I believe the same is true of the loans that central banks make to commercial banks.
About the only thing that I found in the wikipedia article (that originally linked to in my original post) which might indicate a way out of this is that the central bank can sometimes buy "financial assets" from the commercial banks - which would be an alternative way of injecting cash into the system... and by alternative here I mean an alternative to a loan. However this depends what is meant by a "financial asset" since typically when banks refer to as assets they are referring to loans that they've made (or mortgage backed securities or whatever, which amounts to a complicated version of the same thing)... and loans can only be made on the basis of reserves, which can only be issued by the central bank - so I don't see how that solves the problem for the villagers either.
If gold and silver can still be used as reserves then one way out of the dilemma would be for our villagers to start a mining company - since they could then use new gold and silver that they dig up to pay back the interest on their loans. If stocks in companies could be used as reserves then the villagers could start companies like Google and use value that they "create" (such as the goodwill in these companies) to pay off the interest on their loans... any way you look at it though, the villagers need to find something other than cash that they can use to pay off the interest on loans they take out, and commercial banks must do the same thing for the interest that they will accumulate on central bank loans.
So to rephrase the question, what are the "financial assets" that central banks might purchase from commercial banks as a way of injecting extra central bank money into the system without creating any corresponding debt?
PS: This still implies a net transfer of wealth from the villagers to the bankers, but at least provides a ray of hope that defaulting on their loans is no longer an inevitability.
I'm in no shape or form an expert, and please excuse the english... But here my explanation goes:
Okay, so assume we have an economy where there are two people: mister Smith and mister Anderson. Say that mister Smith has $200 which he is willing to lend at an interest. Mister Anderson borrows $100 from mister Smith at a 10% interest. Smith now has $100, and Anderson has $100. So there's still only $200 in the economy.
( And iff this were Frac-Res-Banking with a reserve rate of 10%, Smith would have $190 (200 - 0.1 x 100) and Anderson $100, which means the total amount of money would have been $290 (since you don't need to give up 100%, but only 10% of the amount you're lending). This means the purchasing power of the money would have dropped, making goods more expensive (inflation). )
Now, in order to pay back these extra $10, what does mister Anderson have to do? Well, of course, he needs to make $10 somehow. And in this economy of two, the only way he can make money, is either by selling goods or labor to mister Smith. So he works a bit, and sells a few things, and for this Smith gives Anderson $10. Anderson now has $110 (Anderson didn't spend his borrowed money in this example) and Smith only $90. Now Anderson pays back $110 to Smith. Smith now has $200, and Anderson $0. Exactly the same as before.
But wait, doesn't this mean that Smith didn't make anything? He still only has $200 after all. Doesn't there need to be more that $200 in the bank account in order for Smith to have made a profit?
No. While Smith still only has $200, he has in fact gained goods and some labor from mister Anderson. So he has still made a profit, just not a monetary profit (instead he has made goods and labor).
So... What happens if Smith were to lend all of his $200 to Anderson? What if all the money in the economy simultaneously was being loaned at an interest? So, what happens when Anderson has paid back $200? He needs to make $20 somehow! He now realises that there is no more money to give to mister Smith... So in order to pay his debt, what does he have to do? Well of course, the only way for him to make $20, is by selling goods or labor to mister Smith. These goods and services would be the "collateral".
Now you might ask... What happens if Anderson has no goods or labor to sell to Smith? Well, if there was collateral, and Anderson somehow managed to destroy it or whatever, this means Smith suffers a loss. Anderson has "stolen" these $20, since he is unable to repay it either with money or collateral. If there was no collateral... Well, who in their right mind would lend money out without collateral? This means the risk of not getting money back is quite big. :)
The fact that Smith knows with decent accuracy if Anderson will be able to repay him or not, determines if he is going to lend his money out or not (and at what interest). If Smith knows for sure that Anderson would be unable to pay back his money (either in terms of money or collateral), he certainly wouldn't lend it out. And if he did, he would know for sure that he wouldn't actually be payed any interest, and thus he would be involving himself in "charity".
So even though the money supply isn't changing, people can still make profits (in terms of labor and goods). The fact that you don't know for sure if you're going to get all of your money back, is what gives rise to the risk-part of the interest rate.The only real, decent reason to be able to create extra money would be to compensate Smith for his loss if he didn't get the money or collateral back from the person he lent to. As in, the ability to reprint the "stolen money" which Anderson took from the economy in the last example.
Hope that makes sense!
Aha... yes that makes a lot of sense - thanks Eli. I'm sorry I already posted a reply to a previous post before reading your post.
In any case, as I mentioned in my other post, the commercial banks are in more or less the same position vis a vis the central bank and your explanation implies that these commercial banks are going to have to do some work for the central bank in order to be able to pay off the interest on loans that they've taken out from the central bank. This fits quite well with what I'd already posted which is that I noticed the central banks sometimes "buy" financial assets from commercial banks, which would be an alternative way of injecting cash into the system.
However, if you read my previous post, I still have some doubts about the nature of these financial assets (what sort of financial assets the central banks will buy for example)... If you know the answer to this, I'd be extremely interested to hear it!
Thanks once again.
Fred Furash:I understand perfectly well how a full reserve banking system would make a profit (by charging customers to safeguard money). I don't however see a solution to the problem of offering loans.Loans are obviously a necessary part of investment, and the only incentive to provide a loan is the interest one can gain from it, what's more, is the interest is the only motivation for the debtor to repay his credit. Yet if this interest is not added to the overall money supply, then how does one pay off his loans? This creates the problem of insolvency, but how is this problem solved? I don't see how you could simply inject the extra interest required into the money supply, I mean, who would you give it to?Basically the question is, how do you create a banking system which allows loans with interest (since without there would be none) without creating inevitable insolvency?
This is complicated, but an example may help:
Assume that there exists one axe. Bob has the axe. He loans the axe to John in exchange for two axes a year from now. Assume axes are money, and Bob and John are the only two actors. The question is, from where does the extra axe come? The answer is, either Bob or John may produce the additional axe. If John produces it, then all is even a year from now; if Bob produces it, John will have to borrow it at a greater cost than the original loan to repay Bob. So, John may repay Bob with either profit or credit.
To ask from whence does the interest come, is to assume the supply of money is credit; that is, this question only makes sense if one assumes that borrowers cannot create the interest themselves - which is essentially true when money is debt. When money is debt, interest can only come in the form of increased debt - like when John repays the interest to Bob by with credit in the form of an axe borrowed from Bob. In that specific example, Bob would represent of the role of a central bank - slowly bleeding John dry.
Think about it - if John cannot make an axe, yet he borrows an axe before he repays an axe, than at one point in the transaction, John is borrowing an axe before he has paid the interest on the previous loan. This corresponds to a debt of two axes - one axe owed within 24 hours with its corresponding interest of 1/365th of an axe in addition to the axe owed a year from today! Which is just to say, that John will fall deeper and deeper in debt each year. His only saving grace is his ability to increase his productivity at a rate greater than or equal to the rate of his increasing debt of 1/365th of an axe per year in perpetuity - exactly the problem the US citizens face today with the parasitic Fed and its fiat inflation!
On the other hand, with free-market money, profit will be exchangable for money prior to the creation of the money by the creditor. In that specific example, John uses his productivity to save enough time and resources to make the axe he owes, and when his debt is paid it is not paid with credit, but with the profit of his enterprise.
Think about it - If John can create the axe on his own, than he will be able to use the profit of his wise borrowing to create an additional axe prior to the due date of the loan - thereby averting additional debt.
Gold is free-market money that the debtor may produce before the interest comes due, fiat currency is debt-money that the debtor must borrow before the interest comes due.
This is why fractional reserve banking requires elastic money - in a fractional reserve system, one must borrow before the interest is due. Without credit heaped upon credit, fractional reserve banking fails. But gold does not allow credit heaped upon credit. Gold must be earned - dug from the ground. Fiat currency is not earned, so it can be used as a system of practically never-ending credit and debt - two sides of the same coin. Gold can't create a system of never-ending credit and debt because it is realized too soon, that the supply of gold is more limited than the credit extended, and recession causes liquidation of mal-investment.
Credit is a leash. On a long leash, dogs may run around the corner and do things that cause havok in civil society. On a short leash, corrections come instantly and constantly. People want the long leash, but not because it is helpful. They want it so they can ignore the punishing effects of living in civil society. Our monetary system is a fantasy built on barbarism and unreality. It is a 1980's gay lifestyle that is ignorant of the HIV running through the society. Watch the slow decline of the ignorant. There is no savior, but for a return to compliance with reality. I hate to seem apocalyptic, but economics is unavoidable. If we would quickly take the brutal hit, we could be king again in a year or two, but alas, I am afraid socialism (compromise) will drag us down to the same level as the rest of the world...
jimmy:In order to pay back all of their loans, the various people in the economy (let's call them the villagers) need to come up with $900 + interest, or $900 x 1.02 = $918... which you will note is more more money than they have at their disposal. If all the villagers pooled together all of the cash at their disposal then they'd only be able to scrounge together $900, so they'd still fall short of their loan repayments by $18. As such and failing the injection/creation of new money, a certain percentage of the villagers MUST necessarily default on their loans (regardless of how hard they've worked, saved or how many widgets they've all made).
In order to pay back all of their loans, the various people in the economy (let's call them the villagers) need to come up with $900 + interest, or $900 x 1.02 = $918... which you will note is more more money than they have at their disposal.
If all the villagers pooled together all of the cash at their disposal then they'd only be able to scrounge together $900, so they'd still fall short of their loan repayments by $18.
As such and failing the injection/creation of new money, a certain percentage of the villagers MUST necessarily default on their loans (regardless of how hard they've worked, saved or how many widgets they've all made).
Very good. That's how it works.
So basically, my questions is one of money creation. From what I can tell, the only point at which new money can be injected into the system is the central bank. However we have the central bank at one end of the system , the commercial banks in the middle and the villagers at the other. Injecting cash into the system at the central banking end of the the system will only excacerbate the problem. The only kind of "money creation" which could alleviate this problem would be the kind of money creation that injected money into the system at the other end - i.e. money "created" by the villagers. So my question is, how can the "villages" in this system create the money that they need to pay back the interest on the loans that they HAD to take out in order for there to be any money in the system at all? From what I can tell, this is a mathematical impossibility. The villagers have been hobbled right from the get go and there's nothing they can do about it???
There are three ways the money supply can be altered.
Go to your countrys central bank web page and download the money aggregate figures.
You will find that notes and coins M0? make up a small fraction of the broad money supply. The rest has been created by debt or OMOs at some point.
The villager doesn't create money. They add value to it by working off their debts.
Most are trapped in the system. The best they can do is to save for what they buy - staying free from debt.
If they get far enough in the black, they can add value to the economy (start a business) free from debt.
Owning a bank makes them masters of the system.
Pretty much.
The way things are set up, borrowing weakens the money supply by diluting it, causing inflation. Lenders get to keep the interest on something that's largely created out of thin air.
How is interest justified? by inflation - the very thing caused mainly by borrowing.
Conversley:
No borrowing. No interest. Almost no inflation. Stability. Slow growth is the only downside.
goodAsGold:There are three ways the money supply can be altered.by the issue of notes and coins by obtaining debt ( also known as credit) in some formby the central bank performing open market opperations (OMOs) - exchanging government bonds for money and vice versa within the banking system. Go to your countrys central bank web page and download the money aggregate figures.You will find that notes and coins M0? make up a small fraction of the broad money supply. The rest has been created by debt or OMOs at some point.
OK thanks. My country is a bit vague but for accademic purposes any old country will do. I was just listening to http://mises.org/multimedia/mp3/MU2007/49-Garrison.mp3 and the speaker (Garrison?) mentions that M0 in the US has gone from around 27% back in 1980 to almost 50% today, as a result of phasing out "Regulation Q"... all of which is quite interesting listenning.
In any event, as notes, coins and the issuing of debt/credit are merely fuel for the fire, the answer to my question seems to lie in these Open Market Operations, which are described in Wikipedia at http://en.wikipedia.org/wiki/Open_market_operations. That web page mentions three examples: government securities (debt - that won't help us), foreign exchange (yet more debt - this might help at a national level but if we expand the economic system to include the world at large then that still doesn't help us) and finally gold. So of the three, gold is basically the only thing that commercial banks and governments can give central banks in order to pay off the interest on loans (or to pay the yeild on bonds).
It's hinted at http://en.wikipedia.org/wiki/Financial_instrument that financial assets might take the form of securities as well, which could potentially mean stocks and options in the companies that or villagers have created (and subsequently sold to commercial banks to pay off the interest on their loans). I'm not sure whether central banks will purchase securities or not - I suspect the answer to that is no...
So from what I can tell, the long and short of it is that:
jimmy: I'm trying to get my head around fractional reserve banking and had a couple of questions about this.......................
I'm trying to get my head around fractional reserve banking and had a couple of questions about this.......................
Jimmy,
Back in the mid-80's having been of question on the Fed for about 10 years I ran across some Federal Reserve Bank publications entitled, "I Bet You Thought" published by the NY Fed and "Modern Money Mechanics" published by the Chicago Fed. Now both these documents are no longer in print, many informed minds believe because of it's content and admissions and that may be true, but thanks to the internet and some heavenly souls you too can read them. But first, I'd like to wet your appetite hopefully on what you'll find inside.
"What they [banks] do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by [the amount of the "loan"]." That is from page 6 of Modern Money Mechanics and some speculate this sentence alone is why they stop printing. I'll let others judge that but in others words, when the bank makes a loan, they create book entry money on both sides of the ledger. The one thing I always found insidous about the fiat money creation is that in order for money to enter our economy (the only way) it must be borrowed in. OK, we are day one of our brand new economy and we have $0 balance in our new economic universe. I decide I'll get the ball rolling and I walk in and place my security up on the table and in exchange I get a $100 dollar loan at say 3% interest over a 1 year period. Now I walk out with the $100 which is the sum total of everything in our new economy but where will the 3% in interest that I have to pay come from? IMO, if Social Security is a ponzi scheme, what is this? This is also another reason the system is forced and monopolistic as it would fail on his very face if free markets were allowed to reign.
Both publications are chocked full of eye catching pieces of info and it's surprising what they do say although they don't openly admit some grand conspiratorial scheme if one is looking for that. They also do a bit of soft selling IMO to try and divert the uneducated reader from asking to much. Hope you find them useful concerning your questions.
Modern Money Mechanics
http://landru.i-link-2.net/monques/mmm2.html
I Bet You Thought (Catchy title is it not?)
http://www.reallyneatstuffalaska.com/I_Bet_You_Thought
Best of luck!
Sorry folks. Just saw where you guys covered the "where does the interest to pay the loan come from" question. Sorry for the echo!
Nice job BTW.
wkmac:I Bet You Thought (Catchy title is it not?) http://www.reallyneatstuffalaska.com/I_Bet_You_Thought Best of luck!
Fantastic - thanks. That article gives quite a lot more detail on how the Fed works and how the Open Market Operations work. I still find it quite amazing that the government handed over a monopoly on money creation to a bunch of bankers who receive 6% dividends on profits derived from something they've literally pulled out of thin air... but apparently the American public are quite happy with this situation. As a non-US citizen I suppose I'm not really in a position to offer them advice on how they manage their affairs and can only wish them the best of luck.
Jimmy
jimmy: As a non-US citizen I suppose I'm not really in a position to offer them advice on how they manage their affairs and can only wish them the best of luck. Jimmy
As a non-US citizen I suppose I'm not really in a position to offer them advice on how they manage their affairs and can only wish them the best of luck.
Hey Jimmy,
Offer away on the advice because the folks who run this whole show act like non-americans anyway and we follow them like dumb lemmings!
I'll willing to risk you've got a better idea anyway!
Fred Furash:Basically the question is, how do you create a banking system which allows loans with interest (since without there would be none) without creating inevitable insolvency?
I think I have an answer to this. You lend without interest. If there's no growth in the money supply then the creation of wealth from investment will result in deflation, and loaned money will have increased in value upon return. So to turn a profit all the bank would have to do is keep operating costs lower than their real profit from the deflation. I see some potential problems with this. Unless a significant amount of the total money suppy is invested (and producing wealth) it may be impossible for banks to keep overhead low enough to operate profitably (anyone, feel free to correct me on this - I have no banking experience). Secondly, anyone saving, but not investing (they're hiding it under the mattress I gues) is benefitting as a kind of - at least as I see it - free rider, although it would seem to me that the most benefit for all would come from all available savings being invested. At least if they could be in a manner where one could expect their money back.
Also, it seems to me that interest is possible - without the insolvency, as long as it is no higher than the rate of monetary expansion. So I suppose the banks would be keeping an eye on those pesky gold miners.
Forgive me if I butchered any terminology etc. I'll be happy to clarify if desired.
Hedgepig: think I have an answer to this. You lend without interest. If there's no growth in the money supply then the creation of wealth from investment will result in deflation, and loaned money will have increased in value upon return.
think I have an answer to this. You lend without interest. If there's no growth in the money supply then the creation of wealth from investment will result in deflation, and loaned money will have increased in value upon return.
Hm, it's an interesting idea but I have a couple of reservations about such a system. The first problem I can see with such a system is that you effectively get paid to horde your cash, which could certainly have some consequences on the velocity of money in the system. If velocity goes down then this effectively reduces the amount of money available to conduct transactions and you have fewer dollars chasing the same amount of products (either prices go down or production goes down and prices remain stable)... I think such a system will be rather like stocks in a company - with a static number of stocks, as the value of the company increases (or the economy as a whole in the case of your monetary system) those that got a stake early will end up mega rich. In the case of a company, this makes sense since they are typically the ones that took the most risk and thus contributed the most to the company's eventual success. In the case of this theoretical economy I think they're just piggybacking on a fault in the system - the same fault as that of inflation in our current system - which is that money is not holding its value... instead, in your monetary system, it's gaining in value relative to all other products, and not necessarily because the holder of that money is producing more or less - just as inflation taxes people who hold money indiscriminately, such a system would reward such people indiscriminately.
The second problem I have is that such a system effectively takes different interest rates out of the equation totally. All the "banks" in this case would be obliged to lend money at the same rate (i.e. 0%) and thus to make the same loss/return proportional to their loans. In our current market, interest rates that banks charge would typically incorporate:
The system you were proposing of zero interest rates eliminates the possibility that banks charge different rates depending on the risk that the customer in front of them represents. They effectively have two choices: loan at the compulsory 0% interest rate or don't loan at all. This means that lots of customers who would have found capital for their new ventures (e.g. Google), although having a profile and proposal that represented a relatively high risk, would not find capital in such a system... they would not be offered the possibility of paying higher interest rates - they simply would not be offered money at all. This is to take quite a useful element out of our current lending mechanisms (an element which would exists in the gold standard as well).
I'm not dead set against the system you're proposing - I'm providing the above arguments as much to play devil's advocate as much as anything... but I do think that you'd need to at least consider the possible effects of the decreased velocity of money and the inability of banks to effectively price the risk component in the loans they make (this being particularly pertinent now, at a time when many banks are going belly up over sub-prime lending in the US).
wkmac:Offer away on the advice because the folks who run this whole show act like non-americans anyway and we follow them like dumb lemmings! I'll willing to risk you've got a better idea anyway!
Well, in principal, I can see the benefit of an elastic money supply. However, from what I've been able to understand so far, the basic problem is that currently new money currently gets injected into the wrong end of the system. A simple solution to this problem would be to inject all new money into the other end of the system... so you'd still keep track of inflation and try to target a figure which is approximately 0% inflation (which ensures enough new money to cope with any growth in the economy) but if you ever do need to inject new money into the system you don't inject it in the form of a loan at the banking end of the system. Instead you'd inject it in the form of savings at the other end.
For example, if the guys controlling the money (let's say some kind of public central bank, run out of tax payer's money) witnessed deflation of 0.2% they might say, "OK - we need some extra cash". They'd then inject the new money into the system simply by modifying the account balances of anyone who had savings in the economy, in a manor which was proportional to the savings they had. So it would be kind of like a "central bank interest" that would accumulate on people's savings (but not be charged on loans). If you needed to contract the money supply then you could do so by charging a similar "central bank interest", this time on loans but not on savings.
I'm not sure if such a system would work or not - it's just something I made up as I was writing this post - I'd be interested to hear any [constructive] criticism though.
jimmy:Well, in principal, I can see the benefit of an elastic money supply.
libertarian:I don't see *any* benefit of an elastic money supply.
So you favour a system of deflation in the wake of economic growth and inflation in the wake of recession?
Surely the principal function of money, and it's most important function, is that it should hold it's value between the time that you accept it as payment for goods/services you provide and the time that you spend it on whatever it was you actually wanted for yourself. If money supply is inelastic then it's pretty much impossible to achieve this since the quantity of goods and services in any economy constantly changes - so only monetary systems that use an elastic money supply will be able to maintain anything close to 0% inflation... even the gold standard has some elasticity built into it's design in that you can dig new gold out of the ground (which is useful in times when the economy is expanding at around the same rate as the supply of gold - as it turns out I think that's probably the most common case but I doubt that it's always the case).
Do you disagree with any of the above for any particular reason or are you just being contrary for the sake of it?
jimmy:So you favour a system of deflation in the wake of economic growth and inflation in the wake of recession?
Woah, I'm not even sure where to begin here. You're got rather a dogmatic style of writing, but I think I get where you're coming from and I'll try my best.
libertarian:Businesses cycles are caused by the FED, therefore economic growth and recession should not happen in a free market.
OK - so you've started with a completely unfounded statement and then used this leap to a completely unrelated and rather backward conclusion. None the less, the idea that growth and recessions don't happen in a free market is pretty much ridiculous. The Easter Islands, for example, experienced what is more often termed a collapse (not just a recession) after they chopped down all their trees... And one could hardly argue that the discovery of combustion and the industrial revolution didn't contribute to relative economic growth.
libertarian: People are forced to use government-created money because they have to use that money to pay taxes
Indeed.
libertarian: Credit expansion subsidizes unproductive business methods at the expense of the poor
Erm... I'm not too sure about that one. I think the people paying for credit expansion are anyone with savings (not necessarily or specifically poor people). And the subsidies generally get injected into the system at the banking end of the system. Admittedly one result of these subsidies will be lower interest rates (easier access to credit) than you'd probably find under a gold standard, but the people benefiting from the system are primarily the central and commercial banks.
libertarian: Setting a stable price index, even if it is effective in maintaing all prices stable, is worser than deflation.
??? There's no logic here to refute, so I'm really not sure what to say. Once again, your writing style is rather dogmatic.
libertarian:It is always possible to invest in an inelastic alternative currency, such as gold, silver, housing, gasoline, etc.
As I said above, even the gold standard has a degree of elasticity built into it. The question is, is this sufficient to maintain stable prices. By in large I think history proved that it was - so I fully agree that the gold standard would be a preferable monetary system to the fiat money system. However it's rather fanciful to think that the gold standard doesn't have it's own flaws/weaknesses. For a start, if the banks buy the gold mines then you find youself in exactly the same situation as we are currently (i.e. a net transfer of wealth to the bankers).
In any event, I think there's way too much ground to cover between your relatively inflexible position and my own - so there's probably not too much point in us continuing this discussion.
jimmy: libertarian:It is always possible to invest in an inelastic alternative currency, such as gold, silver, housing, gasoline, etc.As I said above, even the gold standard has a degree of elasticity built into it. The question is, is this sufficient to maintain stable prices. By in large I think history proved that it was - so I fully agree that the gold standard would be a preferable monetary system to the fiat money system. However it's rather fanciful to think that the gold standard doesn't have it's own flaws/weaknesses. For a start, if the banks buy the gold mines then you find youself in exactly the same situation as we are currently (i.e. a net transfer of wealth to the bankers).
libertarian:Unstable prices is not a problem in the market. You would still have the same purchasing power if prices suddenly went high by inflation or prices are low by deflation.
OK, I see what you're saying. Essentially you're saying price stability isn't the holy grail. However imagine an economy that starts out with 100 gold coins and 100 apples. On day one, if you buy an apple it costs you 1 gold coin - and if you sell an apple you earn a gold coin. Now imagine apple production soars due to better growing techniques... We now have 200 apples produced each day. Two apples now cost 1 gold coin and you have to sell a couple of apples to earn a gold coin. That's all very well and it turns out people in the economy are always improving their growing techniques, making adjustments here and there and managing to make ever more apples with the same number of hours in every day and on the same land. People start to think "if I save the gold coin I earn today, I'll be able to buy twice as many apples for it tomorrow"... and so they stop spending their gold and start buying less apples. Of course, with less gold in supply and less people buying apples this causes the price of apples to go down even further.
One result of such a system is a decrease in the velocity of money, which contributes to a decrease in the quantity of money available - which I admit I'd only suspected might be a problem (and which lead me to think that an elastic money supply could have some benefits - providing they targetted 0% inflation, which they certainly don't and couldn't in our current fiat money system).
libertarian: Why are you against the banks investing gold?
On second thoughts, I think I made this statement a little too quickly. The first post on the second page of posts for this thread explains why this wouldn't be a problem.
In any event, can you see any problem with the monetary system I proposed which targetted 0% inflation and didn't require vast amounts of effort to dig otherwise useless metal out of the ground?
jimmy:In any event, can you see any problem with the monetary system I proposed which targetted 0% inflation and didn't require vast amounts of effort to dig otherwise useless metal out of the ground?
libertarian:The "Consumer Price Index" only measures consumer goods
Yes but my post made no mention of the CPI. I never suggested using the CPI (I'm well aware of the many ways in which this statistic is fanciful).
libertarian: The Federal Reserve inflates money to stablize the "Consumer Price Index" (CPI)
They may well do, but my post made no mention of the FED either.
I think perhaps you've rather misunderstood the system I was suggesting. You seem to be under the impression that I'm suggesting a system which closely resembles our current system, which is not the case for various reasons:
Your main objection to our current fiat money system is that the FED effectively confiscates people's savings via monetary inflation and I'm in whole hearted agreement with this (I've be trading precious metals for the past couple of years to avoid loosing the value of my USD savings - a lesson which I learnt the hard way by holding USD savings between 2001 and 2006 which went from 0.85c on the euro to 1.33c on the euro - my solution was not to buy Euros which suffer much the same problem as dollars, but to buy precious metals that hold their value). What I was proposing was an alternative system which would offer a solution to the problem of central bank created inflation.
Gold is an alternative system (your writing makes me think you're convinced it's the only possible alternative system and that no other could possibly take it's place - which seems rather more like blind devotion than reason, although not without some foundation in reality). By in large, I think gold is a far superior system to our current fiat money system since it has built in protection against inflation. If we could pay taxes in gold then I'd go get an eGold account tomorrow. However it does require a massive amount of effort to maintain (you only have to visit the "Big Hole" in South Africa to get an indea of how much) - gold mining consumes substantial physical resources and has a not inconsiderable impact on the environmental (Jarred Diamond's Collapse makes for interesting reading in this regard). So if it were possible to create a less onerous system that was as effective then that would be a good thing right?
Essentially zero price inflation contributed largely to the beginning of the Great Depression. Although consumer prices stayed pretty much the same throughout the '20s, the money supply increased greatly.
If it was not possible to lend money against deposits, prices would have gradually fallen during the '20s as the money supply stayed constant - the liquidity that funded the stock market bubble would also have never came into existence.
While the causes of the Great Depression are a bit more complex than this (price & wage supports, along with New Deal like programs that started under Hoover contributed quite a bit), it is false to think that 'stable prices' cannot lead to booms and busts fueled by credit expansion.
However, I agree that if there was some way to keep the money supply the same (not prices, prices fall naturally over time in a system where the money supply is fixed or pegged 100% to gold, with the exception of times of great gold discovery), that such a system would be just as good as a gold backed money system. However, such a system, once put into place, is much easier to manipulate by the powers that be, and doesn't make much sense to most people. At least gold has a tangible value that can easily convince you that banks that lend out against your gold deposits, which are supposed to be available at any time, are stealing from you.
Fair enough. That's the kind of answer I can relate to. Sounds solid.
PS: Do you have any recommend reading regarding the above (in particular related to the Great Depression)? I'm guessing Hayek had a few words to say about this...
jimmy: Well, in principal, I can see the benefit of an elastic money supply. However, from what I've been able to understand so far, the basic problem is that currently new money currently gets injected into the wrong end of the system. A simple solution to this problem would be to inject all new money into the other end of the system... so you'd still keep track of inflation and try to target a figure which is approximately 0% inflation (which ensures enough new money to cope with any growth in the economy) but if you ever do need to inject new money into the system you don't inject it in the form of a loan at the banking end of the system. Instead you'd inject it in the form of savings at the other end. For example, if the guys controlling the money (let's say some kind of public central bank, run out of tax payer's money) witnessed deflation of 0.2% they might say, "OK - we need some extra cash". They'd then inject the new money into the system simply by modifying the account balances of anyone who had savings in the economy, in a manor which was proportional to the savings they had. So it would be kind of like a "central bank interest" that would accumulate on people's savings (but not be charged on loans). If you needed to contract the money supply then you could do so by charging a similar "central bank interest", this time on loans but not on savings. I'm not sure if such a system would work or not - it's just something I made up as I was writing this post - I'd be interested to hear any [constructive] criticism though. Jimmy
Here's another aspect of the expansion/inflation problem I see with our monetary system, specifically Fractional Reserve Banking henceforth FRB, in the way money is created. Obviously the question, "then where does the money for interest come from?" seems the most looming of questions but I have another. It was proposed to me when I asked the question of what about inflation in respect to the money creation, specifically book entry money rather than real, physical Fed. notes of the mechanism to check rampant inflation. I was told by folks at the Atlanta Federal Reserve during a visit (interesting trip if you ever get the chance to any Fed. Bank) that interest rates were the check to inflation. Now for some time that satisfied me but in time it just never seem to total work the more I learned.
Along these lines in the early 1980's I became interested in our federal tax system as much out of curosity but also self-preservation. The IRS and I not being drinking buddies at the time and continuing into the mid-90's but as I studied not just tax law but through Freedom of Information Act filings of internal IRS workings I came to a personal conviction that the income tax as we know it is also and moreso the actual check on inflation but in an odd kinda way. This I would venture to say or what I'm about to say is not a widely held POV to my knowledge and being that the IRS and I have lived in happy harmony for the last 12 plus years, some aspects of this worked for me so at least from my end I was happy knocking down a few cold ones with the IRS. Most of the documentation I had to convey this point is now gone or buried somewhere in storage boxes and I know the suggestion almost seems conspiratorial in light of common thinking but I still believe there is an inflationary checking relationship between FRB and tax policy. The harvesting of money through debt payments and then the extracting of interest just doesn't work for me at all. Especially when you consider a debt payment (say a monthly mortgage) becomes a asset on the bank books and therefore a new influx on reserves to which more money can be created and loaned out. On that scenario, where is the inflationary check? I'm not the sharpest knife in the drawer so if there are any sharper I'm all ears.
The only other central mechanism taking money out of the circulation is taxation and now that statement alone doesn't make it the key to the kingdom. In the 1980's during his first tenure in Congress, Ron Paul commented about our income tax system and specifically where tax dollars under the income tax went to once collected. At the time Ron made what I thought was an incredible if not unbelievable statement that "Congress has no idea where the money collected by the IRS for income taxes goes too!" Now at first I thought it was a slam to the dummies he worked with in Washington concerning wasteful spending until I got via FOIA all of Chapter 21 or 23 of the Internal Revenue Manual. (Sorry, it's been years until this conversation and I've been playing a good little boy for the master) The IRM is a internal operations manual for the IRS and you can get them fairly easily or at least in the late 80's you could. Chapter 21 or 23 covers the accouting practices within the agency when tax returns are processed and it was rather eye poping to me. To my shock it seemed to validate what Ron was saying. None of the money goes to Washington and the general fund as we think. There was even a section within Chapter 21/23 (sorry been to long to remember actual citing) where tax recepts collected were paid directly to the Agency for International Development (AID for short). If you just said "What the F----!" join the club, so did I when I read it. What is AID you ask?
AID is know known as USAID and I think it was a reorganization via Congress in 2000' or 2001' that did this, I don't consider that important fact to this so therefore no link to source. Lookup USAID for yourself. Anyway USAID is an independent gov't agency who's currency arm is the Export/Import Bank. What is that? A 1934' Corporation established by FDR http://www.presidency.ucsb.edu/ws/?pid=14772 whose function it was to promote the export of American goods and services through loans to foreign entities to purchase such. My view at this time was FDR saw this as a means of advancing the economy to help pull the country out of depression. Now those here with vast views different to that statement on the FDR Mussolini economic model (hope that makes you feel better) just sit tight. The point is not that at this time, FDR ain't my friend either LOL! In 1961, Kennedy reorganized the Foreign Policy Act (Public Law, 87-195.75, codified in 22 USC sec. 2151) set in place in 1945' and the Marshall Plan in which time AID or now USAID was created.
Here's my skinny on all of this and obviously I've just barely skimmed the surface. 1913' Federal Reserve created along with the 16th amendment income tax. Tax rate was low and limited as the money supply was also. Economy expanded or I should say money supply but in time it became evident this model like a ponzi scheme needs new blood to further it's game. Keeping the game confined within national borders meant at some point a saturation point is met and meltdown because you've monetized everything. Remember, how is money pulled into being? Via the loan process and security is needed to do this and thus you monetize goods and property. Also gold and silver backing caused a crisis point of where the meltdown would accur so what's the fix? Remove it from the picture!
Taking this economic model global allowed for 1 basic truism of economics (that's IMO folks so take it for what's it's worth, maybe zero grant you) to be fulfilled. If you have to continue to expand the money supply to meet the interest payments (debt service)for which no money initally was created, over time inflationary pressure builds and you either have to contract to let everything settle at which point the masses will realize the game (gold and silver almost did this)or you expand into other markets which lets the overflow wash out and from which you are able to print more money for the current masses to meet debt payments with while monetizing across the globe.
At this point, I perceive the IRS and income tax as a federal collection plan designed to redistribute excess inflationary dollars within our own economy and thus transfer those dollars globally to monetize global assets to keep the whole thing going. We are the Fed. note factory and the globe our customer although the globe if you will. IMO we're also into empire but that's a whole other issue in itself. Now obviously, it would take lots of research and vastly more documentation than was given here to prove this seemingly crazy theory and I'm cool with those who consider it X-Filish and maybe it is. I'll concede that potential. However, I present it as a means to provoke further thought of the relationship of a managed monetary policy that we completely and wholely accept when it comes to money creation and economic expansion but never, ever consider that taxation is also a part of that larger economic planning process. The 2 really go hand in hand and are not whole seperate entites in and of themselves but in fact left/right arms of the same body. JMO and thanks for listening or even rolling your eyes if you did that!
wkmac:The harvesting of money through debt payments and then the extracting of interest just doesn't work for me at all. Especially when you consider a debt payment (say a monthly mortgage) becomes a asset on the bank books and therefore a new influx on reserves to which more money can be created and loaned out. On that scenario, where is the inflationary check? I'm not the sharpest knife in the drawer so if there are any sharper I'm all ears.
To start with, I think I basically agree with you - I'm simply going to go about explaining why in a round about way...
So, I'd have difficulty believing payments that you make to commercial banks would be an inflationary check since, as you say, these payments are simply used as reserves to make more loans. However I think there are two points in the system at which higher interest rates could have some effect on inflation - exactly what the magnitude of that effect is I'm not sure but here goes... Firstly the fact that there are higher interest rates means that people will be less inclined to borrow - as such less loans will be made and, as you know, in our current money system loans are the way money is created... so less loans = less money. Second, higher interest rates result in a higher net flow of wealth from commercial banks back to the reserve bank. Now in the US, the FED has a static dividend that it pays out to it's shareholders of 6%... so if more money is flowing into the FED from the commercial banks then the FED is paying bigger nominal dividends to it's shareholders (primarily these guys ARE the commercial banks from what I can tell) which is money that flows back into the system, but none the less only 6% of the money that flows in leaks back out... so all in all I think higher interest rates will slow inflation (as compared with lower interest rates that is, in which case loans are made willy nilly and money basically falls out of the sky).
Having said that, I don't think most of the money that get's created actually passes between the commercial banks and the central banks any more. From memory, around 90% of the Open Market Operations conducted by the FED concern either the purchase or sale of government bonds. So I suspect government expenditure plays a HUGE role in inflation. Most of the money that gets taken out of the system, it would seem, gets removed by way of the government buying back bonds (and vice versa)... and it's not always the FED that is buying government bonds when money is being injected into the system - of late it's often been the Chinese.
None the less, if you were to lump all the central banks in the world together though (the Chinese included), and consider them as the source of all new money creation, I think you'd end up with a picture of the world that more or less revolved around the central banks injecting money into the system as a response to the massive overexpenditure (and the resulting debt) of one or more governments who then "create" bonds which they sell to the central banks and voila - a whole crapload of cash rains down on the economy... all of which, as you noted, can only be financed by taxation.
If the above is true then this would imply that governments can:
a) Tax arbitrarily - someone has to pay back that debt and it's taxpayers as usual. Even though you might not know it becuase Bush is pretending to give out tax cuts, behind your back he's taxing at one of the highest rates in US history, he simply hasn't given you the bill yet.
b) Governments can also create money and inflation, despite the fact that they are not officially the central bank... This is simply a consequence of the fact that they're the biggest borrowers in existence and no one ever turns them down when they ask for a loan. Banks know that they're promise to pay is backed by the forced labour of your children and their children after them... children who have the honour of working to pay back debts that were contracted before they were even conceived (which has certain moral implications I won't go into here).
So essentially all of this is pretty much in agreement with what you were saying, that taxation is one of the primary mechanisms of dealing with inflation... but the only time it actually serves to counter inflation is when the government turns a surplus (e.g. New Zealand or Australia at the moment) and when they don't spend their windfall (not the case in Australia and New Zealand - which explains their continuing high inflation), but instead use it pay off their debts.