How does money work? Many people know that money is “printed” at the Central Bank so that we can use it in our economy. But how, exactly, does this process work? How did we go from using gold and silver to paper as our money?

“Paper” money was invented due to necessity. At the start of the industrial revolution, businesses were expanding at rates never seen before and they needed money to finance their expansion. At that time, people used gold and silver coins for money. So if it cost one million gold coins to build a new factory, then you had to actually find one million gold coins. But gold and silver are rare so there was not enough gold to satisfy the demand for money.

A man named John Law solved this problem by inventing what would later be known as the fractional reserve system. He invented a new type of money to replace the use of gold coins. It is important to note that his invention created the mechanism to finance the industrial revolution and, indeed, our modern technological world.

Law’s solution was to create “paper” money, a.k.a banknotes, and use it instead of gold coins. The banknotes would then be officially recognised as “real money”. The advantage was that paper money could be expanded infinitely (unlike gold) and was much cheaper to make. To get and keep initial public confidence (people questioned why they should stop using gold and start using paper), Law suggested that a fraction of gold always be kept on hand for the few people who wanted to redeem their notes for real actual gold. Through trial and error, it was found that gold reserves could safely “back up” up to ten times their value of paper money. That is, if a bank had Kshs 100 worth of gold, they could safely print up to Kshs 1,000 bank notes.

As stated above, at the start, banks had to have real gold reserves roughly equal to 10% of all the paper money that they printed. However, in the 1930s, the ability for people to convert their paper money into gold was dropped. This removed the need for central banks to have gold reserves in their possession and, indeed, virtually no central bank in the world today has gold reserves that can fully back up all their paper money. John Law’s method of money creation is still the dynamo that powers our present world.

However, there exists a grave problem. Let’s imagine that the Central Bank of Kenya wanted to print Kshs 100 today. They would print it and then would lend it to the government of Kenya or any one of the local banks. Naturally, the Central Bank incurred some costs while printing the money so it has to charge interest to whoever takes the newly printed Kshs 100. That is, if the interest rate is 10%, the Central Bank will expect to be paid back Kshs 110 for every Kshs 100 that it prints. Think about this. Who prints the Kshs 10 to pay back the initial amount? The answer is no one. This money is created out of thin air.

When presented with this scenario, there is often a tendency to think:”Ah, but the borrower can always make the extra Ksh 10 somewhere else, through hard work or a deal overseas.” However, although we frequently interchange the two sayings, earning money is not the same as making it. Earnings are simply a transfer of money from one ownership to another and neither increase nor decrease the total money in existence. Making money actually does increase the nation’s money supply but no-one can do that but the central bank itself.

The result of creating Kshs 100 but demanding Kshs 110 in return is that the collective borrowers of a nation are forever trying to repay an amount that they will never be able to repay: the mythical Kshs 10 that was never actually printed. This debt is, in fact, unrepayable and every time more money is printed, the nation’s overall indebtedness increases by the amount of interest due to the Central Bank.

Many economists know about this problem but pass it off as irrelevant. The idea is that if the economy keeps expanding, it fuels an increase in the total money supply in which case there is no problem with meeting interest payments on an increasing debt load. It is important to note that when John Law lived, the need to continuously expand to meet growing debt repayments was seen as a minor problem. Today, however, we are faced with the reality that our world cannot support infinite growth. In spite of this, we have to grow consistently forever or face total economic collapse due to the eternal debt inherent in our monetary system.

This “eternal debt” creates some interesting problems which I will cover in a later article.