I'm getting very suspicious of anything which regulators think is "safe" collateral...

Fractional Reserve Banking is not responsible for the bad practice of 'creating money', writes Paul Tustain, founder and CEO of BullionVault.

It is a speed limit on money creation, put in place by a Central Bank to stop banks doing too much of what comes naturally to them.

The Central Bank used to leave lending decisions to bankers, and step in to liquidate them when they screwed up. But in a world of Deposit Protection Insurance and bank bailouts, the Central Bank picks up the tab for excessive money creation. To limit the risk, they impose the 'Fractional Reserve' to try to calm the commercial banks down. But it is only necessary because we have a timid central bank which lacks the gumption to swing its axe in the direction of bad banks.

Indeed the current set up - where banks are not allowed to fail - turns out to be even worse than I previously thought. It does much more than offer succour to the odd unfortunate bank which steps over the limit of safety. It actually forces banks to be dumb. They have no choice but to approach the safety limit until they are bound to step over it. Any bank which does not step up to the plate will underperform all the others, and be subsumed by a more aggressive competitor. It's how evolution works; the survival of the fittest, where fitness means adapted to the prevailing environment. If you do not compete in the skewed environment where the central bank is a wimp you will expire because of it.

That's why banks are forced to make rosy judgments on the value of collateral.

I think I can see how the Central Bank's turning a blind eye to bad banks' unwise money creation is going to lead to monetary catastrophe, and how it's all going to blow up and leave us in a really, really big hole. But we need to understand a bit more about the way money climbs a pyramid of clearers to see what is happening.

Imagine there is a fellow called Godfrey who earns his living building sheds. Let's see what happens when banks start accepting sheds as collateral for new bank loans.

People can now get two uses out of a shed. Sheds are materially more valuable to people who like to use both debt and sheds. Even people who have no garden tools, but who like debt, can suddenly see how useful a shed really is, even an empty one.

So Godfrey is busy building sheds, and he's building lots of them for people like Brad, who owes his bank a fortune with little prospect of it being repaid any time soon. Yet the bank believes it is making good profits, because it does not regard the loans collateralised by sheds as being doubtful or impaired. For the moment they are considered excellent collateral to 99% of their market value, and no bank in Brad's city will do any business whatsoever if it refuses to recognise the rock-solid resale value of collateralised sheds.

Godfrey takes on some more employees, and the customers' cheques don't bounce. There's soon going to be a heck of a lot more sheds, and Brad's bank will get a very big negative balance with Central.

Eventually, even with a wimp at the Central Bank, a memo from the Governor to the exuberant bosses of Brad's bank will question the collateralising of yet more sheds. Soon after that the shed which used to have two uses is once again useful only as a store-room for garden tools - which makes it intrinsically less valuable. The abundant supply of sheds extends the problem. It will be a very bad time to own sheds.

That's more-or-less how we got a sub-prime crisis, and all the problems which flowed from it.

You know, I'm starting to get very suspicious of stuff which achieves the bank regulator's seal of approval as tip-top collateral. I mean it's so blinking obvious that as soon as they say "this stuff is rock solid" that banks are going to go out and finance purchases which force its value to a ridiculous level, from which it will eventually fall, to generate huge and unsupported balances at Central.

But there's now a rock-solid approved form of collateral out there. It's already grossly overvalued, infesting the entire global financial system, and preparing to deliver us a real financial knock-out punch - not the sort of warm-up act we've just enjoyed with a few sub-prime houses.

I'm talking, of course, about sovereign debt.

This excerpt is taken from Paul Tustain's new report, Money Printing for Beginners (and Experts). To read the full PDF for free today, simply register your email address at BullionVault now.