How Does Money Work? The Complete Guide to Monetary Systems

A key to mastering anything is understanding the foundation or base of that concept so that you can build on it. As investors, our route goal is often to turn money into more money. If that is the case, then isn’t it important to understand what money is, where it comes from, and how it works at the base level?

In school, we are not taught about money on a macro or even micro level. Many do not understand the basic concepts of money, let alone how money works. Stepping back and looking at our monetary system as a whole gives us the ability to look at investments with a wider lens than just focusing on a small part of the grand scheme.

Many look at investments by focusing only on the specific asset. This would be like watching a football game through a drinking straw. You might be able to get a clear picture of the ball, but you don’t really know what is going on around the ball to make it go up and down the field.

Looking at the asset and the market would be like watching the same football game through a paper towel cardboard tube. You would see some of the players close to the ball and understand why the ball is moving one way or the other. But if you remove the straw or tube and look through a full, unobstructed perspective, you will see the coaches calling plays, the weather that affects the play calls, the team of coordinators up in the box relaying information down to coaches and players, and many other important factors.

A full perspective in investing would look at the whole system — how money works and why all parties are incentivized to do what they are doing. Understanding this will allow you to answer some basic questions like “Why should I invest in real estate?” or help you see opportunities where others miss.

If we want to start at the root of an investment, it is vital to understand what money is, how it works, and what incentives are behind all parties involved in a transaction. To understand this, I believe we have to understand our monetary system. Our monetary system is a complex shell game mixed with smoke and mirrors that are hardly ever discussed, let alone taught. In this article, I will do my best to describe how the United States’ and many other countries’ monetary system works. I will then share specific examples of how this information can be utilized in real world investing with a focus on real estate.

Our Monetary System

Our current monetary system in the U.S. starts at the United States Treasury. The Treasury creates a bond to place for sale at bond auction. A treasury bond essentially is an IOU that states, “If you (buyer) gives me X dollars, I (treasury) will give you Y% interest on that money over Z years, plus the full X dollars in principal.”

If the U.S. treasury says, “We would like to sell $1 trillion in bonds,” who steps up and buys them? The world’s biggest banks do. Then those banks look for buyers of the bonds at a premium. Here is where the Federal Reserve comes in. The Federal Reserve will buy the bonds from the big banks and wire them a nice payday of electronic money. You may wonder where the Fed got all that money from. They created it out of thin air not by printing, but by simply doing an electronic credit to the big banks’ account at the Fed.

You may be scratching your head. So, let me break this down: Big Bank X bought a $2 trillion bond and sold it to the Federal Reserve for $2 trillion, plus a premium. The Fed then says, “Instead of me sending you a check, why don’t I just credit the savings account you have here at the Fed?” Big Bank X says, “Sure, go ahead.” With a couple of keyboard strokes, the Fed just created $2 trillion of electronic currency sitting in Big Bank X’s account.

Sound like nonsense? Here is a quote from our former chairman of the Fed, Ben Bernanke, describing the real world example back in 2012 during a lecture at George Washington University:

“Now, you might ask the question, well, the Fed is going out and buying 2 trillion dollars of securities — how did we pay for that? And the answer is that we paid for those securities by crediting the bank accounts of the people who sold them to us, and those accounts, at the banks, showed up as reserves that the banks would hold with the Fed. So the Fed is a bank for the banks. Banks can hold deposit accounts with the Fed, essentially, and those are called reserve accounts. And so as the purchases of securities occurred, the way we paid for them was basically by increasing the amount of reserves that banks had in their accounts with the Fed.”

You can see the full lecture here and this exact quote at 19:08 of the video.

So now magically Big Bank X has all this money in its account at the Fed. What will Big Bank X do with all this new money in its accounts? Well, Big Bank X just did pretty well in buying treasury bonds, so why not go buy some more? They go back to the bond auction, buy more bonds, and yet again, the Fed buys the bonds by crediting their account. This leaves the Treasury with a bunch of electronic money the bankers paid them. Big Bank X is nice and rich from the premiums. And the Fed is unaffected because all they did was enter a transaction on the computer to make it happen, and now they start collecting the Y% interest on the bonds they own.

If you still are scratching your head thinking, “No they can’t do that,” here is a quote right from Federal Reserve Bank of Boston, Putting It Simply (1984): “When you or I write a check there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money.”

But wait! Now the treasury has a whole bunch of money. What do they do with it? They spend it! They give it out to different parts of the government, and they spend it on roads, bridges, social programs, and the military.

The owners and employees of the construction companies, government organizations, and any other companies/individuals who makes money from these government expenditures then put their paychecks into their bank accounts for safe keeping.

The Fractional Reserve Banking System

Because we and many other countries use a fractional reserve banking system, banks can now lend a percentage of its total deposits. Although reserve ratios can change, in many cases banks are allowed to lend out 90% of all deposits and keep 10% on reserve for account holders to withdraw if they want their money. This means 90% of the money the workers in our example earned and put into their bank ends up getting lent out. But that money goes somewhere, right? Yes. I’ll give a specific example to explain where it goes.

For a specific but very basic example of fractional reserve banking and what it does to our currency supply, we’ll look at a school teacher. Let’s say a teacher makes $50,000 and has it direct deposited into her bank account. The bank then can and does lends out $45,000, or 90%, of her deposits. Let’s say that bank decides to lend $45,000 to a company to buy a work truck. The truck dealer who sold the truck then takes the $45,000 payment and deposits it into their bank account. The bank then lends out 90% of that, or $40,500, to someone who wants a boat. The buyer of the boat then hands $40,500 to the seller, and the boat seller deposits it into his/her account. And then boat sellers bank lends out 90%. This goes on and on until the $50,000 that the teacher deposited is expanded to $500,000 in bank loans.

When you hear that there isn’t any money being printed, they are not lying. The printers might not be running, but the currency is being stretched through our banking system. The reality is 92%-96% of all currency created is formed in this exact banking system.

This constant increase in currency in the economy is sure to have an effect. The more currency in the cycle, the higher prices climb to meet that supply of currency. Everyday people then work to pay for those items that now cost more. We all trade our life and our time here on Earth in exchange for money to buy those very things that keep increasing in cost.

When the Dollar is Worth Less, it Makes Paying Off Existing Debt Easier

What does this all mean? This means the U.S. Treasury is taking on trillions and trillions of debt — roughly $19.5 trillion when I wrote this article, but you can see the real time debt figure here. They are doing this by borrowing dollars into creation from the Fed, which increases the currency supply and inevitably causes inflation.

Why would the treasury want inflation? It makes the massive debt figure hurt less and easier to pay. Let me explain. Four years ago in our example, the treasury borrowed $2 trillion. That $2 trillion maybe had a purchasing power able to purchase 100 aircraft carriers for our military.

But 4 years later, since the magically created $2 trillion has worked its way through our banking system and has become $20 trillion in private debt, the currency supply has magnified, and because of that, the prices on everything have gone up to reflect the excess supply of currency. This increase in prices includes prices on aircraft carriers. So the government got to buy 100 aircraft carries for $2 trillion, but now maybe $2 trillion will only buy 90 aircraft carriers because their prices went up with everything else. This means their 100 aircraft carriers may now be worth $2.2 trillion dollars, but they still only owe the fixed $2 trillion they borrowed. When the dollar is worth less, it makes paying off existing debt easier.

Inflation eating away purchasing power is a tricky thought to grasp, so let’s look at another example. Joe buys a brand new house in 1970 for $22,000, which was the median new home price in the United States in 1970 (you can find the data in this chart). Joe finds a banker that gives him a 30-year fixed rate mortgage. Joe borrows the full $22,000. Over the next 30 years, Joe pays down his mortgage. As he pays down this mortgage, his house, like the price of everything else, slowly climbs due to inflation. But does Joe ever have to pay any more principal than the agreed upon $22,000? No. The debt is a bookmark in time, freezing the dollar’s purchasing power in 1970, even though everything else in the world continues to get more expensive.

Related: 7 Toxic Money Habits That Harm Your Financial Future

The government understands this. Their debt is easier to pay as the dollar’s purchasing power becomes diluted through inflation. On top of this, the increased inflation helps slide income levels up, pushing individuals into higher tax brackets, which makes it easier to collect more taxes to pay for all that interest on the debt.

If you don’t believe me take it straight from the Federal Reserve’s mouth:

“The decrease in purchasing power incurred by holders of money due to inflation imparts gains to the issuers of money” — St. Louis Federal Reserve Bank, Review, Nov. 1975, P.22

There is one piece of the puzzle that we haven’t covered. Do you remember way back in the beginning when the Fed did some computer entries to buy bonds that pay Y% interest? Well, that means the Treasury, who issued the bonds, owes the Fed Y% interest plus the principal. That has to come from somewhere. Ah, yes, the IRS will collect that money for the treasury through income taxes. Yep, our hard-earned money that is taxed goes to paying off debt rather than fixing our schools, roads, or anything else useful.

How This Relates to You

If you made it this far, you may be thinking, “How in the heck does this relate to me?” It greatly does, and understanding how our money works gives you the ability to see things differently. Not only will it show you how our monetary system is a scam, it will enlighten you to align yourself with the inevitable outcome of this madness.

Why not play the same game as our government? Remember our example of Joe buying his house back in 1970 with debt? Why couldn’t we do the same thing with all our investment properties? I have said several times in other articles, “The most powerful tools in real estate are debt and taxes.” Debt freezes the dollar’s purchasing power in time, and real estate is the most tax-friendly asset class there is.

I can only believe the amount of money falsely created and injected into our economy during the past years of quantitative easing making its way through the banking system will result in inflation. It may take a few years and a few events to happen because much of that money is roosting overseas at this point. But I believe when you increase the amount of currency in the system like our government has, we are bound to see the purchasing power of the dollar go down. This is why debt is powerful, bookmarking in time the purchasing power prior to seeing the inflationary results of our government’s actions. By doing this, you are simply aligning your interest with those in charge.

Ultimately, our monetary system has two paths: It can hyper-inflate, or America will have to make a full-blown overhaul to the monetary system. It is my personal belief that countries will lose faith in the dollar and begin trading in other currencies and dump their U.S. bonds. This will result in much of our quantitative easing money coming back from overseas, and we will go into hyperinflation.

In either scenario, I want to be holding tangible assets like real estate. If prices skyrocket from inflation, good for real estate investors. We will see massive appreciation, increases in rent, and we still only owe our original debt at the lower costs. If the dollars goes down in a blaze and we have a full-blown overhaul, I would like to own something people still need, so that way, whatever the next monetary system comes into play, my assets will be worth lots of the new currency.

Understanding the monetary system can also affect factors in day-to-day operations rather than only macro analysis. Recently, on the purchase of a multimillion dollar apartment complex, I negotiated a 5% increase in LTV if I deposited the 5% difference in a CD at their bank. Until I made this offer, I was stuck at a 75% LTV. Once I made this offer, we bumped to an 80% LTV.

Why would they do this? Because they were able to go lend 90% of my CD out to someone else and earn more interest on it. I was happy because I go to pull the CD money out in 12 months. But in 12 months, does the bank have to call in the loan they gave out on my CD deposit? Nope. Because I understood how the monetary system worked, I was able to borrow an additional $100k. Which, of course, is a good thing, as that debt will likely be diluted through inflation.

Or how about taking the economic concepts of the monetary system and focusing them on a specific demographic or psychographic groups? For example, if minimum wage goes up to $15 an hour, what do you think will happen? Many say, “Well, all the low-income earners will be replaced with robots.” Yes, maybe some, but what is shown in countless studies is more frequently prices of items that are a primary cost to the people of that specific demographic will rise. This is because the currency was forced into one demographic, and in a free market, the prices always adjust for excess currency. The ability to rent (demand) will go up with supply staying stagnant. If the minimum wage gets bumped to $15 an hour, do you think you can expect rental rates in C and D class property to go up? Absolutely. It’s not a discussion of if that’s morally right or wrong; it’s just a matter of fact when it comes to free market economics.

It is so important to understand how our monetary system works and understand why the government does things it does. Having that understanding will allow you the ability to look at investments through a full lens perspective. If you can understand, you can position your own investments in a way that align with the interests of those who call the shots, while also protecting yourself if things crash and burn from the madness.

This was a pretty in-depth discussion. Any questions? How do YOU use the monetary system to your advantage?

Let me know your thoughts with a comment!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.