Way back before there was paper money, people traded with whatever was available that others wanted. Barter was fair, but inconvenient. Soon people realized that gold and silver were easily identifiable, easily divided, and accepted everywhere. So gold and silver became the standard for trade.
The village goldsmith, due to the nature of his job, had a vault to deter thievery. Being a shrewd businessman, he realized that people would pay him to store their excess gold. It wasn't long before people were trading their gold receipts instead of actual gold, due to convenience.
Enter: Fraud. (read on...) At some point, the goldsmith realized that people weren't redeeming their gold receipts very often, and that even if some of the receipts were being redeemed, there were others bringing in their gold for storage at the same time, so the number of receipts out in circulation was fairly constant. What the goldsmith discovered was that he could write up a few "extra" gold receipts and spend them out in the marketplace, and no one would ever be the wiser. What he also discovered was that he could write up a few "extra" receipts to loan to people, and receive interest on those loans. This is what you and I know as banking, and it is conceived in greed, and born in fraud.
For a while this arrangement would work well, both for the goldsmith and for the village. Over time the money supply (circulating gold receipts) would grow, loans would be available, and the economy would boom. There was plenty of money and people felt rich. But there was a drawback... If the growth of the money supply outstripped the growth of goods and services available in the economy, inflation would result. It would take more and more gold receipts to buy your groceries, to pay your employees, or whatever. At some point, people would get wise to the game, and realize that there wasn't enough gold in the goldsmith's vault to cover the redemption of all the receipts. And so there would be a run on the bank, and the goldsmith would be run out of town.
Eventually the bankers, for bankers they now were, got the stamp of governmental approval on their fraud. The governments discovered they could get a piece of the action by borrowing from the bankers for their projects. Governments find that the people revolt if the taxation is too heavy, but no one complains if they just borrow the money, until it is too late.
During the 1800s bankers were free to perpetuate their fraud issuing their own notes, but people got tired of the boom/bust cycles, so in 1913 the government stepped in and commissioned a lender of last resort, the Federal Reserve Bank, which could create money to lend to banks to promote liquidity in the system. The government forbad banks to issue their own notes, and required the bankers to keep at least a certain fraction of United States Notes on hand, for people who wanted to withdraw from their account. They had to keep a "fractional reserve". At that time the notes were still redeemable for gold.
By 1933 having to redeem United States Notes at $20.67 / ounce of gold had become odious to the government, so President Roosevelt issued an Executive Order stating that everyone had to turn in their gold. They received for it $20.67 in United States Notes. Once all the gold was in, the government devalued the currency by making it redeemable for gold at the rate of $33 / ounce of gold. But that redemption was possible only if you were a foreign government. This rate held steady until 1971, the year Nixon "closed the gold window." From that time on Federal Reserve Notes (no longer US Notes) were not redeemable for anything by anyone. Their value has been predicated solely on people’s belief that they are worth something. And for that belief to remain in place the Federal Reserve Notes must remain relatively scarce.
This is why bailouts won't work. For the government to commit $700 billion for a bailout requires it to either tax $700,000,000,000 from the people, borrow $700,000,000,000 from the people and or foreign governments, or to simply create it out of thin air. Taxing won't work, because at this point any increase in the rate of taxation will kill the economy and cause tax receipts to fall. Borrowing the money from people or governments will require an increase in the interest rate to get people to tolerate the risk and pony up the money. It will also redirect money that would otherwise have been invested in other projects, thus slowing the economy. This leaves creating it out of thin air, also known as having the Federal Reserve Bank buy T-bills. When the Fed buys T-bills, it creates the money to buy them by adding dollar amounts to accounts. Of course, they charge us interest on this newly created funny money. (Remember the goldsmith?)
With all this NEW money in circulation, all the old money is devalued and at some point people catch on to the fact that there is way too much money in circulation, all chasing after the same amount of goods and services. The Fed was supposed to make sure the growth of the money supply didn't outstrip the growth of the economy, but the drunken sailors in congress made sure that was an impossible task, by borrowing wildly. Congress borrowing to spend directly causes an increase in the money supply.
At this point you're probably asking, "Well if we've borrowed $10 trillion since the 1970s, where's the inflation?" Good question. Here's the answer: The excess currency has been gobbled up by foreign countries that need to hold US dollars in order to buy oil on the world market. This is why it is IMPERATIVE for the US economy that oil not be traded in anything but dollars. The day China can buy oil in Yuan or Euros is the day that they (and every other country) send their jillions of dollars home to the US, and the day we see hyper-inflation and the end of the dollar. And, of course, that day is only held back by people's trust that the US dollar will retain its value.
So there is the rub: The more wildly the world sees us spend and borrow and devalue our currency, the more likely they are to decide it's not trustworthy, and dump it. That is why a bailout is like a game of Russian roulette… except that at this point there’s likely a bullet in every cylinder.
(Also posted at www.thepolymathreview.blogspot.com)