Dear friends, let's start learning about what is really wrong about
American economy.
I will post 5 articles, 20 pages each, during the next several days.
It will take just a few hours to read the whole thing, but the reader
will get a good understanding of how our economy really functions.
Copy and save these articles.
____________________________

PROLOGUE

Why economic recessions happen? What are the causes of instability
of our economy? Why our economy is losing close to one million jobs
every year? Is another Great Depression possible? This book answers
those questions.
Chapter One explains the main cause of instability of economy and
what needs to be done to have stable economy.
Chapter Two explains a few concepts of political economics - those
economic problems that politicians promise to fix but never do.
Chapter Three explains the concept of financial terrorism.
I've structured this book as a set of short articles. Every article
explains one idea or economic concept. I hope that this book will give
you a good understanding of "Bush economy".



CHAPTER ONE

INSTABILITY OF ECONOMY


This chapter explains the main cause of economic instability.
First, we have to learn how the banking system functions. Simple,
easy to understand examples illustrate how money functions in the
economy. We will learn how new money is created, how money is
destroyed, and how accumulation and liquidation of debt affect our
economy.
In the process we will discuss gold money, paper money and electronic
money.

1

GOLD COINS

Basic concepts of money are the same for all money systems. Money in
the form of gold coins was the simplest form of a money system. We
will learn basic concepts of money studying a money system based on
gold coins. After that it will be much easier to understand a modern
money system.
In a primitive economy one good is exchanged directly for another. A
pair of shoes might be exchanged for a couple of chickens. Such a
system is called barter, and it's not very convenient.
Money economy is an economy where goods are exchanged first for
money, and then for other goods. Money serves as a common unit of
exchange. Money is a medium of exchange.
For thousands of years precious metals were used as money. A merchant
would exchange his goods for gold coins because it was more convenient
to carry around gold instead of other goods. Value of gold coins was
determined by the value of gold content in the coins. Gold coins were
actually a commodity used as a common unit of exchange.


MONETARY SHARES OF WEALTH

To learn how money functions in our economy, throughout this chapter
we will use a very simplified example of a small country.
Suppose, there is a small country with 1,000 households, and their
money system is based on gold coins. Suppose also that each household
owns on average 100 gold coins. The total amount of money in the
country is 100,000 gold coins.
2

It means that total wealth of the country can be bought for 100,000
gold coins. Land, homes, furniture - total price of all assets in that
country is 100,000 gold coins.
Suppose now, one person owns 1,000 gold coins, which is one percent
of the total amount of gold coins. It means that he can buy one
percent of total wealth of the country.
If someone owns 50% of the total amount of gold coins, he can buy 50%
of all assets in that country. It's obvious that each gold coin is a
share of wealth of that country.
Is money wealth?
Platinum, gold and silver coins have intrinsic value determined by
content of precious metals in coins. These coins are not only shares
of wealth, but they are wealth by itself.
Modern money - paper or electronic - is not wealth by itself, but
every unit of money is a monetary share of wealth.


GOLD STANDARD

Some people believe that modern money has no real value because it is
not backed by gold. Let's examine the concept of gold standard.
Gold standard means that paper money is backed by gold and is
exchangeable for gold at a certain exchange rate. For example, $10
paper bill represents one gram of gold, and $10 bill is readily
exchangeable in a bank for a gold coin, which weights one gram. $100
paper bill is exchangeable for a gold coin, which weights 10 grams,
and so on. In effect, such a system creates a fixed price for gold,
because price of gold will always be $10 per one gram of gold.
Fixed price for gold means that supply and demand will not change

3

price of gold no matter how much gold is on the market. The price will
always be $10 per one gram of gold.
Gold enthusiasts say that the banking system should print only as
much paper money as there are real gold coins. If creation of new
money depends on ownership of gold by the banking system, then the
banking system will buy gold as commodity, mint gold coins, and print
paper money that is backed by gold. It sounds nice, really.
Suppose now, Russia, which is a major producer of gold, flooded the
world market with gold. In every country on earth the price of gold
will go down, except in the U.S. In the U.S. gold will sell for the
fixed price of $10 per one gram gold coin.
This would be very beneficial for gold-producing countries like
Russia. Russia would export tons of the yellow metal to the U.S. and
exchange it for billions of dollars. With billions of dollars Russia
would be able to buy controlling stakes in major companies of the
U.S., including defense contractors.
Gold standard is a pipe dream of gold enthusiasts. As a matter of
economic policy it's a tool to sell United States to some
gold-producing countries, in exchange for the yellow metal called
gold.


GOLDEN INFLATION

Gold cannot even prevent inflation in our little country.
Suppose, one person owns 100 gold coins. His brother-in-law borrowed
those gold coins from him in order to buy a house, and they agreed
that brother-in-law would return 100 gold coins 20 years later.
Suppose now, during those 20 years gold miners produced a lot of
gold, and many more gold coins have been minted. Quantity of gold
coins in circulation increased twice. Average family now owns two

4

times more gold coins than 20 years before. Now average house costs
200 gold coins, and 100 coins can buy only a half of an average house.
Surprise, surprise! Golden inflation! Because every gold coin is a
share of wealth, increase in the number of shares reduced amount of
wealth every share can buy.
This example illustrates that inflation is caused by increase in
quantity of money in circulation, if amount of goods for sale does not
increase. That is true regardless of what kind of money is used - gold
coins, paper money or just electronic bits on hard disks of the
banking system's computers.
This concept is somewhat similar to the concept of shareholders'
wealth in a corporation. A share of stock is a claim on assets of a
corporation. Similarly, every unit of money is a claim on wealth of a
country. Increase in quantity of money, other variables being equal,
will reduce amount of wealth one unit of money can buy.


FORMULA OF PRICE

Suppose now, quantity of money in circulation stayed the same for 20
years, but a number of houses increased twice. In this case the same
amount of money will buy twice more, or the same house will be sold
for twice less. Call it golden deflation.
As we see, both inflation and deflation are possible in the money
system based on gold. There are two factors at work here. Higher
quantity of money circulating in the economy is pushing prices higher.
Higher supply of goods is pushing prices lower.
General relationship between quantity of money, supply of goods, and
resulting prices can be expressed by the following equation.

5

P = M : G, where P stands for general level of Prices, M stands for
quantity of Money in circulation, and G stands for the amount of Goods
offered for sale.
Equation P = M : G states that general level of prices is directly
proportional to the quantity of money in circulation, and is adversely
proportional to the amount of goods offered for sale.
In other words, prices are determined by supply and demand. Demand is
amount of money chasing goods. Supply is amount of goods chasing
money. Using terms of supply and demand, we can say that Price is
directly proportional to Demand, and is inversely proportional to
Supply. Demand is pushing prices up, and Supply is pushing prices
down.
In this book we will be concerned with general level of prices,
quantity of money in circulation and amount of goods for sale in the
whole economy. That is why we will use terms "quantity of money" and
"amount of goods", rather than supply and demand.
Equation P = M : G is very simple, but extremely important. Using
this equation we can explain a few fascinating things, which otherwise
would be impossible to explain.


MONETARY INTEREST

We are starting a fascinating subject - interest. The power of
compound interest is said to be one of the wonders of the world.
Insurance companies make big profits selling financial products like
annuities, because most people have not been taught in the public
schools how to do simple calculations

6

The higher interest, the faster debt accumulates to become a mountain
of debt. The bigger mountain of debt the more difficult for the
economy to grow. That is why we need to understand concept of
interest.
Interest is the price borrowers pay for use of money. Suppose, a
person borrowed $100 for one year at 5% interest. He has to pay back
$105 one year later. The amount he borrowed - $100 - is called
principal, and the amount to be paid in excess of principal - $5 - is
called interest.
Simple interest means that interest is calculated only on a
principal. If a person borrowed $100 at 5% interest per year, to be
repaid as a single payment in 5 years, he has to pay back $100 + ($5
by 5 years)=$125. Interest equals $5 per year, and $25 total interest
will be paid for use of $100 for 5 years.
Compound interest means that interest is paid on principal and
accumulated interest.
Suppose, a person deposited $100 to his bank account, which pays
interest 5% per year. At the end of the first year deposit increased
by 5% and equals ($100 multiply by 1.05) $105. At the end of the
second year deposit equals ($105 by 1.05) $110.25. At the end of the
third year deposit equals ($110.25 by 1.05) $115.76. At the end of the
forth year deposit equals ($115.76 by 1.05) $121.55. At the end of the
fifth year deposit equals ($121.55 by 1.05) $127.63.
With 5% simple interest, $25 is paid as price for borrowing $100 for
5 years. With 5% compound interest, $27.63 is paid.
A borrower usually pays a portion of his debt every month. His
payment includes two parts. One part of the payment goes to reduce
principal amount of debt, and another part of the payment goes to pay
interest for the unpaid amount of principal.
For example, a person borrowed $100 for 4 months at 1% per month. He
has to pay $25 per month for 4 months to repay $100

7

principal amount of debt. Plus, he has to pay 1% per month on the
amount of principal he was still using.
At the end of the first month he pays $1 interest for using $100 for
one month, and he pays $25 to reduce principal. At this point, $75
remains to be repaid. At the end of the second month, he pays 75 cents
interest for using $75 dollars, and he pays $25 to reduce principal.
Now $50 remains to be paid. At the end of the third month he pays 50
cents for using $50, and he pays $25 to reduce principal. Now $25
remains to be repaid. At the end of the forth month he pays 25 cents
for using $25, and he pays the final installment of $25. Debt is paid
off.
As our main concern is how debt payments impact economy, we will
assume in our calculations that debt is paid at the end of the lending
period in a single payment, to make calculations simple. The example
above is simpler if we assume that the borrower returns $100 principal
and $4 interest after 4 months in a single payment.


NOMINAL INTEREST RATE


Why interest is paid, and what determines amount of interest to be
paid? Suppose, 100 gold coins can buy a house today, but 200 gold
coins will be needed to buy the same house 20 years later.
In this case money is expected to lose 50% of the purchasing power
because of expected 100% inflation. The moneylender has to charge 100%
interest in order to compensate for expected 100% inflation during
next 20 years.
Our moneylender does not make any profit in this case, because after
20 years 200 gold coins are needed to buy the same house. Purchasing
power of his money did not increase. It means our moneylender did not
make any profit.

8

To increase purchasing power of his money, our moneylender has to
charge even higher interest. The difference between the amount
borrowed and the amount paid back is called nominal interest. The
higher expected inflation of prices, the higher nominal interest
moneylenders charge.
The moneylender has to charge nominal interest rate high enough to
compensate for inflation and to make profit. It means that nominal
interest rate must be higher than expected rate of inflation.
As we see, there are two reasons to charge interest. First, to
compensate for expected inflation. Second, to make profit. Profit of
our moneylender is real interest. Real interest equals to the increase
in purchasing power of the amount of money loaned.
There is also credit risk, associated with loans. Some borrowers are
trustworthier than others. The higher credit risk, the higher risk
premium the borrower pays in the form of higher interest.
Different credit risks, associated with different borrowers, are not
our subject of discussion. For the sake of simplicity, we will not
take credit risks to the account in our calculations.
Nominal interest rate consists of two parts. One part is expected
inflation rate, and the second part is expected real interest rate.
Let's write it.

(Inflation rate) + (real interest rate) = nominal interest

This equation just states that nominal interest consists of two
parts. It does not mean that the sum of inflation rate and real
interest rate equals exactly nominal interest rate. The next article
explains why.

9

REAL INTEREST RATE


Suppose, someone borrowed 100 gold coins, paid back 200 coins at the
end of the lending period, and inflation was 50% during the lending
period. How much real interest our moneylender earned?
The borrower paid back 100 coins he originally borrowed, which is
called principal. Any amount above that is nominal interest. The
borrower paid (200 - 100) = 100 gold coins as nominal interest. This
nominal interest equals 100% of the amount borrowed. Inflation during
lending period was 50%. If we use equation above to calculate real
interest, we arrive at the following:

(Nominal interest rate) - (inflation rate) = real interest rate

According to this equation, real interest of our moneylender equals
(100% - 50%)=50%. It looks like real interest equals 50%.
If real interest equals 50%, increase in purchasing power should also
equal 50%. Let's check it out.
At the beginning of the lending period 100 gold coins have been
loaned. At that time 100 gold coins could buy a house.
At the end of the lending period the borrower paid back 200 gold
coins, but now the same house has a price of 150 gold coins, because
there was 50% inflation.
Let's calculate how many houses 200 gold coins can buy now.
200:150=1.33. 200 coins can buy one house and a third.
It means that purchasing power of the amount loaned increased by only
33%. Real interest earned by the moneylender equals in this case 33%.
Simply put, the often repeated statement that real interest rate
equals nominal interest rate minus inflation rate is not true.
Real interest rate is the rate earned above inflation, but we cannot

10

calculate it by subtracting inflation rate from nominal rate.
Let's use some simple visual tools to demonstrate the correct way to
calculate real interest. We will use lines of different length to
visualize different sums of money.
!-----------------! 100 gold coins were borrowed.
First, add expected inflation rate to the amount loaned. We add 50%
to 100 coins. The result is 150 coins. Purchasing power of 150 coins
is the same as 100 coins, just adjusted by the inflation rate of 50%.
!-----------------! 100 gold coins were borrowed.
!---------------------------! 150 gold coins are inflation-adjusted
100 coins.
Any amount of money above 150 coins is real interest. The borrower
paid back 200 gold coins.
Second, calculate real interest, which equals total amount paid back
by the borrower minus inflation-adjusted amount of money loaned. Real
interest equals (200-150)=50 gold coins. 50 coins increased purchasing
power of the amount of money loaned, which was 100 coins before
inflation, but became 150 coins after inflation. Real interest equals
50 gold coins. This is amount of money, not a percentage rate.

!-----------------! 100 gold coins were borrowed.
!--------------------------! 150 gold coins are inflation-adjusted 100
coins.
!------------------------------------! 200 gold coins were paid back.
!--------------------------!__50__! 50 gold coins represent real
interest.

Third, calculate percentage rate of increase in purchasing power of
the inflation-adjusted amount loaned. 50:150=. 33=33%.
The moneylender earned 33% real interest on his loan of 100 coins.
With understanding the logic of the matter, we can use a more simple
way to calculate real interest.
11


!-----------------------------------! 200 gold coins were paid back.
!--------------------------! 150 gold coins is the inflation-adjusted
amount of the loan.
Let's calculate purchasing power of 200 coins in relation to the
inflation-adjusted amount loaned. 200:150=1.33 200 coins can buy now
1.33 of a house, which equals 133% of the house, 33% higher than
inflation-adjusted amount of the loan can buy.
Purchasing power of 100 coins, with 100% nominal interest and 50%
inflation, increased by 33%. Had we deducted inflation rate from
nominal interest rate, we would have arrived at an erroneous result of
(100% - 50%)=50% real interest.
As we see, the easiest way to calculate real interest is to divide
the total amount of money paid back by the inflation-adjusted amount
borrowed. Let's write it down.
R.I.=T.A.: I.A.A.B.
The result has to be converted into percentage. If the result is
1.25, it means that the original purchasing power increased by
(1.25-1)=. 25=25%. If the result is 2.25, it means that the original
purchasing power increased by (2.25-1)=1.25=125%.
If the result is 1, it means that real interest is zero, because
original purchasing power did not increase.
We should note, however, that at the time a loan is made, no one
knows exactly what will be either inflation rate or real interest
rate. Both rates are really just educated guesses.
Only when the loan is paid back, our moneylender will know what was
inflation during the time period. Only then it is possible to
calculate real interest rate, which equals to the increase in
purchasing power of the amount of money loaned, taking actual
inflation rate to the account.
Suppose now, our moneylender loaned 100 gold coins, was paid back 200
gold coins, but inflation during the lending period was 100% instead
of expected 50%. The house now costs 200 gold coins.

12

Purchasing power of 200 coins equals (200:200)=1. It means that our
poor moneylender only preserved original purchasing power of his
money, but made no profit.
Had the inflation rate been higher than nominal rate, say, 125%, than
the inflation-adjusted price of the house equals (100 by 2.25)=225
gold coins, and purchasing power of 200 coins would have been
(200:225)=0.89=89%. It means, our poor moneylender lost (100% -
89%)=11% of purchasing power on his loan.
Does it really happen with moneylenders? It happens all the time with
moneylenders - when public acts as a moneylender, as we will see in
the next article.

INTEREST RATE ILLUSIONS

Interest rate illusions like the one described above are some of the
tricks of the trade. Financial companies sell a variety of financial
products structured to defraud investors.
Annuities, for example, are sold to people as income investments.
They tell you to pay regularly a certain amount of money for a certain
period of time, and later they will pay you a certain amount of money.
They tell you it's a good investment.
Guess what? You act as a moneylender to the insurance company. When
you pay them, you in fact are making a loan to them. Later they will
repay the loan plus interest.
Fast-talking salespeople will tell you that on every $100 you will
get back $200, and that is 100% interest on your money. That's right,
but 100% nominal interest is not real interest, which, by definition,
is increase in purchasing power of the amount of money loaned.

13

What fast-talking salespeople don't tell you is that inflation will
eat into purchasing power of your money. If inflation is 3% per year,
your money is losing 3% of purchasing power every year. Amount of
money that they will pay you will have lost a lot of purchasing power
by the time they will repay your loan with inflated dollars.
How much money you will need in 30 years to buy the same amount of
goods as $100 can buy today, if inflation is 3% per year? On a regular
calculator you multiply 1.03 by $100, and hit ( = ) sign 30 times. The
result will be $243. It means that in 30 years you will need $243 to
buy the same amount of goods as $100 can buy today.
Let's calculate real interest, as we did in the previous article.
They will pay you $200, but inflation-adjusted $100 will become $243.
Purchasing power of $200 will equal ($200:$243)=0.82=82% of the
purchasing power of $100 before inflation.
Your money will lose (100%-82%)=18% of purchasing power. Not only
you did not gain anything, but, in fact, you lost 18% of purchasing
power, even though you collected 100% nominal interest. But that is
not all. You will pay income taxes on earned interest, making your
loss even bigger.


GOLDEN OPPORTUNITY

Let's continue to study how our banking system evolved, and how money
functions in our economy.
There were people who owned gold coins, and there were people who
would like to borrow gold coins. Moneylenders started to serve as
middlemen between them.
14

It was truly a golden opportunity. Our moneylender could pay 5%
interest per year for the deposited gold, but with that gold he could
make loans at 10% per year, earning 5% nominal interest.
Suppose now, there is a total of 100,000 gold coins in the country,
and they are all deposited at our moneylender. When people sell assets
like a farm or a house, they deposit gold to our moneylender in order
to earn interest.
Now let's calculate total interest earned by our moneylender. There
are a total of 100,000 gold coins. Borrowers pay 10% per year. Total
interest equals 10,000 gold coins per year, every year.
But where 10,000 gold coins will come from every year? There are
only 100,000 gold coins in the country, all deposited at our
moneylender.
If someone borrowed gold from our money lender to buy a house, he
paid with borrowed gold, but the seller of the house promptly
deposited that gold back to our money lender in order to earn
interest. Total amount of gold coins did not change. Gold just changed
hands when it was exchanged for a house.
If borrowers pay 10% per year on 100,000 gold coins, in 10 years
borrowers have to pay back 200,000 gold coins. But where 200,000 gold
coins will come from if there is a total of only 100,000 gold coins?
This example illustrates that it was impossible to pay debt in gold
coins - unless, of course, more gold coins were minted and introduced
into economy.
There was a big need for gold, if only to pay interest. Gold miners
exchanged gold for other goods. New gold coins were minted and
introduced into economy.
If not for new gold, it would be impossible to pay debt in gold
coins. But what if gold miners did not produce that much gold?

15
ROOTS OF INSTABILITY

This article is extremely important to understand the roots of
instability of our economy. We are still studying gold coins, but
basic concepts are exactly the same for all kinds of money, is that
gold coins, paper money or just electronic bits on your credit card.
In this article we will discuss how borrowers accumulate and repay
their debt. For the sake of simplicity we assume that borrowers pay
their debt as a single payment at the end of the lending period.
Suppose, our moneylender has a total of 300 gold coins to lend at 10%
interest. Person A borrowed 100 gold coins for one year, and he has to
pay back 110 gold coins one year later. Person B borrowed 100 coins
for 2 years, and he has to pay back 120 coins two years later. Person
C borrowed 100 coins for three years, and he has to pay back 130 coins
three years later.
300 gold coins are circulating in the country, but the three
borrowers have to pay back total

(110+120+130) = 360 gold coins.

Total amount of debt is bigger than amount of money in circulation.
Can the three borrowers earn and pay back 360 gold coins if there are
only 300 gold coins circulating in the country?
Total debt outstanding equals (360:300)=1.2=120%
of the amount of gold coins in circulation. Let's see how the three
borrowers will pay off their debt.
In one year person A earned and paid back 110 gold coins, and he is
out of the game. Now (300-110)=190 gold coins are circulating in the
economy. Persons B and C still have to pay (120+130)=250 gold coins.
Can they earn 250 gold coins if there are only 190 gold coins
circulating in the country?
16

Our moneylender now has 110 gold coins to lend, and he made a new
loan to person D, who borrowed 110 coins for 3 years. Person D is
supposed to pay back 110 coins plus 30% interest. His debt equals (110
multiply by 1.3) = 143 coins.
Now again (190+110)=300 gold coins are circulating in the country.
Persons B, C and D have to pay back

120+130+143=393 gold coins.
(393:300)=1.31=131%.

Total debt increased to 131% of the amount of gold coins in
circulation.
Two years later person B paid back 120 gold coins, and he is out of
the game. Now (300-120)=180 gold coins are circulating in the country
economy. Persons C and D still have to pay 130+143=273 gold coins.
Now our moneylender has 120 gold coins to lend, and he made a new
loan to person E, who borrowed 120 gold coins for 3 years. Person E
has to pay back 120 coins plus 30% interest. His debt equals (120
multiply by 1.3) = 156 gold coins.
Now again (180+120)=300 gold coins are circulating in the economy.
Persons C, D and E have to pay back

130+143+156=429 gold coins.
429 : 300=1.43=143%.

Total debt increased to 143% of the amount of gold coins in
circulation.
Person C earned and paid back 130 gold coins, and he is out of the
game. Now there is (300-130)=170 gold coins in circulation. Persons D
and E still have to pay (143+156)=299 coins.

17

As we see, persons A, B and C have paid their debt. But they were
able to pay off their debt only because our moneylender was making new
loans, only because persons D and E borrowed money. Had persons D and
E not borrowed money from our moneylender, persons A, B and C would
not be able to pay 360 gold coins.
As we continue to play this game, two things will happen.
First, our moneylender will earn more and more interest. Second,
total amount of debt will grow bigger and bigger. It means that our
moneylender will own a bigger and bigger part of our little country.
If our moneylender stops making new loans, the game is over.
Borrowers will not be able to pay their debt. More and more people
will find themselves in bankruptcy.
This example illustrates the most fundamental principle of our
banking system. It's impossible to pay accumulated debt unless the
banking system continuously makes new loans.
This fundamental principle is very important to remember as we
continue our study of the banking system.


GOLD CERTIFICATES

When someone deposited, say, 100 gold coins, our moneylender would
write a certificate of deposit. The certificate stated that the owner
of the certificate has 100 gold coins on deposit at our moneylender.
Certificates of deposit were backed by gold at 100%, and they were as
good as gold. People started to use certificates of deposit to make
payments. Those gold certificates became the very first "paper money".

18

Now let's answer the following question. What was that gold
certificate? Certificate of deposit was evidence of debt. Our
moneylender owed 100 gold coins to the depositor.
As evidence of debt, it represented a claim on assets of our
moneylender. At any time owner of a gold certificate could demand 100
real gold coins in exchange for the gold certificate.
Let's remember these characteristics of gold certificates.
1. Gold certificates were the first "paper money".
2. Gold certificates represented debt of the moneylender.
3. Gold certificates represented a claim on assets of the moneylender.
4. As a medium of exchange they represented shares of wealth of the
country.


CREATION OF NEW MONEY

Owners of gold coins deposited their gold at our moneylender who made
loans with that gold, charging interest. Our moneylender paid a part
of the interest to depositors. When people borrowed gold, they wrote a
promissory note, promising to repay the borrowed amount plus interest.
Suppose now, person A borrowed 100 gold coins to build a house, and
he gave a promissory note to the moneylender. Meanwhile, he deposited
those 100 gold coins back to the moneylender, and the moneylender gave
him a certificate of deposit for 100 gold coins.
Person A made an agreement with person B to buy a piece of land from
him for a price of 50 gold coins. Also, he hired person C to build a
new house for a price of 50 gold coins.
The three men went to our moneylender. Person A presented a

19

certificate of deposit to our moneylender and demanded 100 gold coins.
Our moneylender took back certificate of deposit and brought 100 gold
coins. Person A paid 50 gold coins to person B, and another 50 gold
coins to person C.
Both men decided to deposit their coins to our moneylender in order
to earn interest. Now the two men own certificates for 50 gold coin
each, and 100 gold coins are back on deposit with the moneylender.
This example illustrates that most of the gold coins never left the
place of our moneylender. When payments were made, new owners of the
gold would leave gold coins on deposit at our money lender in order to
earn interest, only ownership of gold changed from person A to person
B to person C in the books of the money lender.
Our moneylender discovered that since most of the gold never leaves
his place, he could make loans with excess gold. It was surely a
golden discovery. Our moneylender started making loans, charging
interest on other people's gold. Borrowers would write a promissory
note, promising to repay borrowed amount plus interest. Borrowers
accepted loans in the form of gold certificates, which stated that
they have gold coins on deposit at our moneylender. Those gold
certificates were exactly the same as those given to the real
depositors of gold coins.
In theory, gold certificates represented real gold. As long as each
certificate was backed by gold at 100%, paper certificates were as
good as gold. At any time depositors could exchange their gold
certificates for gold coins.
When moneylenders started to make loans with "fake" certificates,
those certificates were not backed by gold at 100%. If our moneylender
had 1,000 gold coins on deposit, but he issued certificates for 2,000
gold coins, it means that each certificate was backed by gold at 50%.
Had depositors decided to exchange their gold certificates for real
gold all at once, half of them would have been out of luck.

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