If you want to understand money and how it and central banking contribute to the business (boom n bust) cycle you gotta read this guys articles.
http://www.lewrockwell.com/north/north784.html
By Gary North
MY FUNDAMENTAL POINT
In Part 1, I made the point that the Austrian School's theory of money is an extension of its overall theory of economic exchange. This distinguishes the Austrian School's view from all rival views of money.
The rival views insist that the free market is insufficient to provide a reliable monetary system. Either the national government or the nation's central bank must intervene in the free market in order to provide stability and reliability to the money system and therefore to the economy.
The logical extension of this outlook is that there is a great need for a world government and a world central bank, which together provide such stability internationally. Most economists and politicians refuse to say this in public, but this is a matter of prudence, not logic.
In contrast, the Austrians say that the free market can provide such a system of world money. We have already seen this system in operation. It was called the gold standard. It operated for most of the nineteenth century. It needed no world government and no world central bank to make it work. It did not need trained economists to make it work. You can imagine how popular Austrian School economics is with economists – about as popular as the gold standard.
The non-Austrians insist that money needs government coercion in order to be money. Money may have started without coercion, but this condition cannot last for long, nor did it. The defenders of this position rarely come out and explain why, in terms of their theory of markets, money is different from other goods and services. If private property and the right of exchange produce efficient markets for other scarce resources, why not for money? They do not say, exactly. They just insist that this is the case.
Then, not surprisingly, we find that in exception after exception, they insist that other aspects of the economy also cannot function without state coercion. In niche after niche, in sector after sector, we are told that market-clearing bids cannot arise. But the biggest sector of all is money.
WHAT IS MONEY?
Mises defined money in 1912. Money is the most marketable commodity. This identifies the central benefit of money: a means of exchange.
Contrary to the standard textbook accounts, money is not a measure of value. There is no measure of value. Value is subjective. You could as easily measure your love for your children.
Also contrary to these accounts, money is not a store of value, although it is a valuable thing to store. There is no store of value. There is at best continuity of price.
Money is a unit of account. It makes possible modern double-entry bookkeeping. Mises said that this was one of the greatest inventions of the modern world.
Mises argued that money arose out of voluntary exchange. A commodity that had been sought and bought for attributes other than its use as a means of exchange became a commonly accepted means of exchange. This created new demand for it. The government did not create money. Individual decision-makers did.
Civil government soon insisted on sovereignty over money. It stamped coins. This authenticated the coins. But, when governments found that they could steal from the public by debasing the gold or silver coins with cheaper (base) metals, the newer unauthentic coins de-legitimized the inflating governments. Authenticity became unauthenticity.
Fiat money is a form of counterfeiting. In a world of fiat national moneys that are in competition with each other, national governments have become members in a kind of competitive cartel of counterfeiters. "My counterfeit money is better than yours!" they insist.
Gresham's law states that bad money drives out good money. This law holds true only when governments set price controls – fixed rates of exchange – between different forms of money. The artificially overvalued money drives the artificially undervalued money out of circulation. We do not see gold and silver coins in use as money today because governments have artificially overvalued their own national currencies.
FIVE DECIDING ISSUES
There are five fundamental issues in every social order and every institution: (1) sovereignty, (2) authority, (3) law, (4) sanctions, and (5) continuity. Put in easily memorized form, they are:
1. Who's in charge here?
2. To whom do I report?
3. What are the rules?
4. What do I get if I obey? (disobey?)
5. Does this outfit have a future?
With respect to money, the Austrian theory of money answers these questions as follows:
1. The free market
2. The individual who has money
3. The right of exchange/contract
4. Profit and loss
5. Long use encourages future use
With respect to money, the other schools of opinion differ from each other, but not on these issues:
1. The state
2. The fractional reserve banking system
3. Never allow price deflation
4. Big bank bailouts
5. People will adjust to price inflation
The universal outlook of the non-Austrian schools of thought is that a steady price deflation is always bad, but a little price inflation is not so bad, and it is surely better than price deflation, recession, or depression. In all theories of money except Austrianism, the state is seen as the necessary agent of planning. Even in schools of thought that proclaim the inefficiency of central planning, the members hold to the necessity of scientific central planning of money. All of them call for the economists employed by the state-created central bank to adjust the money supply in order to achieve specific outcomes.
Deep within every non-Austrian free market economist, there is a central planner screaming to get out.
FRACTIONAL RESERVE BANKING
Under fractional reserve banking, banks are allowed to lend out money that has been promised to depositors. The depositors think of their deposits as money. So do borrowers. Borrowers spend this money. Then, one dark day, depositors also try to spend this money. A bank run begins.
Let us review how the system works. A bank accepts a deposit of $100. It sends $10 to the regional Federal Reserve Bank as its mandated legal reserve. It lends out $90. The borrower spends this money. His bank takes $9 and sends it to the FED. Then it lends out $81. On and on it goes, until the original $100 deposit turns into $900.
Inflationary? You bet!
The fractional reserve process allows the banking system to expand the money supply. This creates an economic boom by lowering commercial interest rates. To lend this new money, banks must find borrowers. To lure them in, the banks have to offer lower interest rates than what prevailed before the fiat money was created.
Entrepreneurs who borrow the money begin new projects. But then they find that they are running short of capital. The increase in fiat money did not represent an increase in thrift: future-orientation of consumers, i.e., a willingness to defer consumption. Businessmen must now compete for more money to finish projects. Interest rates rise. More companies then shut down incomplete projects. The recession begins.
Fractional reserve banking rests on an impossibility: that all depositors can withdraw currency at the same time, even though the money has been loaned out. The bank's contract allows depositors to withdraw currency on demand. This contract is inherently fraudulent. It cannot be fulfilled in a banking crisis. There are two legal claims on the same money: depositor and borrower.
If the bank's contract with depositors had specified that the money would not available until the subsequent loan was repaid by the borrower, there would be no problem. The problem arises from the simultaneity of economic value across time. Future value is always discounted by time. This is the phenomenon known as the time value of money. Mises called it time preference.
The heart of the contract's problem is that current money is always worth more than future money. The value of future money is discounted by three factors:
1. The discount of all future value
2. The risk of non-payment
3. The inflation premium (depreciated money)
Fractional reserve banking rests on an impossibility: "The discount applied to future money will not change." When a banking crisis occurs because of this, the size of the discrepancy between the present value of money and its future value, there are bank runs. The discount applied to future money increases due to a rising risk of default. "A bird in hand is worth two under the bush." Depositors want their now even more valuable present money rather than a legal claim on now less valuable future money. The banks do not have the currency to pay off the depositors.
The bank then calls in whatever loans that it can. The debtors cannot repay. They go bankrupt. Then banks that lent them the money go bankrupt.
A depression takes place because pricing of capital goods was made on a false assumption: the depositors would never all demand their money at the same time.
The assumption is false because the initial premise was false: "The present value of future money will not depreciate so much as to cause a run on the banks."
But couldn't bans raise the interest paid to depositors? Of course. They could get out their iPhones and speed dial 1-800-FREE-LUNCH 1-800-FREE-LUNCH .
Maybe depositors get fired because their employers could not meet the demand for repayment to the banks. The depositors then demand immediate money. Banks cannot deliver. The collapse of overextended banks exacerbates the depression.
The inverted pyramid of debt collapses. What goes up (boom) must come down (bust). But not for long. The central bank then steps in and creates new money to forestall this collapse. Another round of counterfeiting begins.
meltdown is not the same as MELTDOWN ! In my world a -5% is a meltdown 