How the US Dollar Actually Works
And why you feel like a hamster running in a wheel
“By this means the government may secretly and unobserved, confiscate the wealth of the people, and not one man in a million will detect the theft.”
John Maynard Keynes, The Economic Consequences of the Peace
Alright, let’s dive into something that sounds dull but is actually pretty wild: how money, or more accurately currency, gets made. You might think it’s all economist jargon, too complex for regular folks. But peel back the layers, and it’s like discovering the rules to a game you didn’t know you were playing. It’s a crazy game, one that hits your wallet, taxes, and pretty much everything else. So grab a coffee, and let me walk you through the wizard behind the curtain in a way that won’t make your head spin.
The Setup: IOUs and Deficit Spending
Here’s the deal. The U.S. monetary system, like most modern ones, is a magic trick where dollars appear out of thin air. Since the U.S. dollar is the world’s go-to currency, let’s use it as our example.
It all starts with politicians promising goodies to voters, like better roads, healthcare, or a shiny new bridge. Sounds nice, except there’s no free lunch. To pay for these promises, the government spends more than it collects in taxes. This is called deficit spending, and it’s where the trouble kicks off.
To cover that gap, the Treasury issues bonds. Think of a bond as a fancy IOU, a piece of paper saying, “Lend me a trillion bucks, and I’ll pay you back over 10 years with some interest.” The catch? Those bonds are our national debt. You, me, our kids, and their kids are stuck paying it back through taxes. It’s like taking out a loan against your future self to buy a new car today, except it’s the whole country doing it.
The Shell Game: Banks, the Fed, and Fake Checks
Here’s where it gets weird. The Treasury holds auctions to sell these bonds, and big banks swoop in to buy them, knowing they’ll earn interest. Then, through a process called open market operations (sounds boring, but stick with me), the banks sell some of those bonds to the Federal Reserve for a profit. The Fed pays for them by writing checks from an account with zero dollars. Seriously, nothing’s there. As one Federal Reserve branch put it, when you or I write a check, we need money in the bank. When the Fed writes a check, it’s just poof, new currency is born.
The banks take these checks, and just like that, money springs into existence. The Treasury gets that currency, deposits it into government accounts, and spends it on public works, social programs, or whatever else was promised. The banks keep buying more bonds, and the cycle repeats, stacking up bonds at the Fed and currency at the Treasury. It’s a never-ending IOU swap, with banks pocketing a cut every step of the way.
Fractional Reserve Lending: Multiplying Money Like Magic
Now things get really crazy. When you deposit your paycheck in a bank, you probably think it’s safely tucked away. Nope. The bank treats it like a loan to them. They keep a small fraction, say 10%, in reserve (called vault cash) and lend out the rest. So if you deposit $100, the bank holds $10 and loans out $90. Your account still shows $100 because they’ve swapped the $90 for bank credit, digital IOUs they type into a computer.
It gets wilder. That $90 gets spent, deposited into another bank, and they lend out 90% of it ($81). This process repeats, and with a 10% reserve ratio, your $100 deposit can balloon into $1,000 of bank credit. About 92 to 96% of all currency comes from this banking trick, not the government. It’s like a casino handing out chips they didn’t earn, and we all agree to treat them as cash.
The Nixon Shock: Cutting the Gold Anchor
You might wonder why the government can keep borrowing like this. Well, things got looser in 1971 with the Nixon Shock. Back then, the U.S. dollar was tied to gold. Your paper money was basically a receipt for real gold in a vault. You could walk into a bank, slap down a $20 bill, and walk out with a $20 gold piece. But President Nixon changed that. Facing pressure to fund things like the Vietnam War and domestic programs, he took the dollar off the gold standard. Suddenly, dollars weren’t backed by anything tangible, just the government’s promise. This gave the system more room to create currency, but it also opened the door to some serious shenanigans.
Inflation: The Silent Thief
All this new currency flooding the system might sound fun, more money, right? Except it’s why your coffee costs $5 instead of $2. Inflation isn’t just rising prices; it’s the expansion of the currency supply. The more dollars floating around, the less each one is worth. Prices rise to soak up the extra cash, like a sponge. It’s a slow, sneaky tax that erodes your purchasing power over time.
Here’s the gut punch: a big chunk of what you pay the IRS doesn’t go to schools or roads. It’s used to pay interest on those bonds the Fed bought with its fake checks. Before the Federal Reserve was created in 1913, there was no personal income tax. That same year, the Constitution was amended to allow it. Smells like more than a coincidence, doesn’t it? Your hard-earned money is siphoned off to keep this debt machine humming.
The Debt Ceiling: A Total Farce
You’ve probably heard politicians argue about the debt ceiling, that supposed limit on how much the government can borrow. Here’s the truth: the system needs more debt to survive. Every dollar out there has interest attached. If you borrow $1 and owe $1 plus interest, where do you get the extra to pay the interest? You borrow more. There’s always more debt than currency to pay it off. If we stopped borrowing, the payments on existing loans and bonds would eat up the currency supply, and the economy would crash in a deflationary collapse. So politicians keep raising the debt ceiling, kicking the can down the road. Nobody wants the system to tank on their watch.
The Petrodollar: Why the World Plays Along
You might be thinking, how does the dollar stay so powerful if it’s just made-up numbers? Enter the petrodollar. After Nixon ditched the gold standard, the U.S. struck a deal with Saudi Arabia in the 1970s. They’d sell their oil only in U.S. dollars, and in return, the U.S. would provide military protection and other perks. Other oil-producing countries followed suit. This means anyone buying oil globally needs dollars, keeping demand for the dollar sky-high. It’s like the U.S. convinced the world to treat our IOUs as gold, giving us a free pass to keep this currency-creation machine running.
The Big Secret: Who Owns This Mess?
Here’s the part that made me double-take. The Federal Reserve isn’t a government agency. It’s a private corporation with stockholders, mostly big banks, who get a 6% dividend every year. They profit from selling our national debt to the Fed, from interest on bank reserves, and from that dividend. We work our tails off, trading our time for numbers someone typed into a computer, only to have it taxed away to pay for this rigged system. The Fed’s website even admits it has stockholders, but good luck figuring out exactly who they are. It’s like trying to crack a secret code.
It’s a scheme, plain and simple. Economist John Maynard Keynes said this system lets the government secretly and unobserved confiscate the wealth of the people. It’s built to funnel money from workers to banks and the government, all while inflation chips away at what’s left in your pocket.
Recap: The System in Six Steps
Let’s break this down into simple steps so you can see exactly how this machine works:
Government Promises and Borrows: Politicians promise goodies to voters, leading to deficit spending. The Treasury issues bonds (IOUs) to cover the shortfall, adding to the national debt we all pay back through taxes.
Banks Buy Bonds: Big banks buy these bonds at auctions, earning interest and knowing they can make a profit.
Fed Creates Currency: The Federal Reserve buys some of those bonds from the banks using checks from an empty account, creating new currency out of thin air.
Banks Multiply Money: Through fractional reserve lending, banks lend out most of your deposits, keeping only a fraction in reserve. This creates more digital currency (bank credit) as the process repeats, ballooning the money supply.
Inflation and Taxes Take Your Money: All this new currency causes inflation, making everything pricier. Plus, your taxes go to pay interest on those bonds, not just public services.
Debt Keeps Growing: The system needs more debt to keep running because every dollar has interest attached. Without new borrowing, the economy would collapse, so the debt ceiling keeps getting raised.
That’s the whole racket: a cycle of IOUs, fake checks, and bank profits that keeps us all on the hook.
Impact on the Average American
How does this hit regular people? It’s why everything feels more expensive every year. In 2000, the median home price in the U.S. was about $165,000. By 2025, it’s closer to $450,000. That’s not just because houses got better; it’s inflation from an ever-growing currency supply shrinking what your money can buy. A gallon of milk that cost $2.50 in 2000 now pushes $4 or more. Healthcare? A single hospital visit can hit you with a bill that looks like a car payment.
Your paycheck doesn’t go as far because the dollars you earn are worth less every year. Inflation acts like a hidden tax, quietly eating your purchasing power. Then there’s the actual taxes, a big chunk of which goes to paying interest on the national debt, $1 trillion in interest alone in 2024, by some estimates. That’s money that could’ve fixed roads or schools but instead pads the profits of banks holding those bonds. Meanwhile, you’re working harder just to keep up, maybe taking on credit card debt or a bigger mortgage, which feeds right back into the system’s need for more debt. It’s a treadmill, and the average American is stuck running it, paying more for less while the banks and the Fed keep the game going.
Why This Hits Home
This system is why your paycheck feels like it’s shrinking. It’s not just numbers on a screen; it’s your time, effort, and life being diluted by a machine that thrives on debt. To break free, or at least get some escape velocity, you’ve got to own assets that outpace inflation, like real estate or stocks, and steer clear of debt, especially high-interest credit card debt that can trap you in a cycle of payments.
The Founding Fathers knew the dangers of centralized banking. They wrote in the Constitution that only gold and silver could be money because you can’t print those. But since the creation of the Federal Reserve and later the Nixon Shock and petrodollar deal, we’ve been running on a system of pure faith in numbers, numbers that benefit the banks and the government way more than you or me.
The good news? Knowing how this works is half the battle. If more people understand the game, we can start asking tough questions about why we’re stuck with it. It’s not about fixing it overnight; it’s about seeing the system for what it is and pushing for something better. Until then, every dollar you earn is a reminder: you’re fueling a machine rigged to keep you in debt.
Check out the The Monetary System Visually Explained on YouTube for a nice walkthrough. In 22 minutes, you will understand more about the American economy that 99% of other people.
Credits: Thanks Grok, created by xAI, for helping me edit and flesh out this essay.