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The Nature of Money

This is a more complete discussion of the nature of money than we could cover within The WelderDestiny Compass newsletter. It is part of a wider discussion to predict if we are headed to a utopian or dystopian future. You can read the complete edition #004 of The WelderDestiny Compass e-zine by clicking here...

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The Nature of Money

The world did not always use money. In earlier times, a barter economy was in operation. The problem with a barter economy is that the person that wanted your product did not necessarily have the product you wanted in return. This lead to a lot of complications in trade. These complications were resolved by the introduction of money.

Theoretically money can be anything, as long as all the parties using it for trade have agreed that it is a viable “currency” for trade. The earliest forms of currency had the disadvantage that they were not “permanent” in nature. In other words, the articles used for currency would degrade over time, losing their value.

When precious metals started being used, this shortcoming was largely eliminated. Once “permanent” forms of currency such as gold were used, something miraculous happened. Over time the amount of money would “build up” in the system without being destroyed. The same money could be traded over and over without being “used up”.

We now see that money has taken on the form of a score keeping system. The person that played the economic game the best, ended up with the most points on the financial score board, which means the most money in their pockets. If we think about it, money, even gold, has no inherent value. We cannot use it as food or drink. We cannot use it as clothes or shelter. In short, it has value only because we have agreed that it has value, and it is therefore a claim on future assets that could be used for the necessities in life. Or the wants in life!

Over time, the amount of money would also increase, so each successive generation had more currency at their disposal than the previous. In essence, past value creating efforts could be transferred to future generations, not only as hard assets but also as a “claim on assets”.

Our money has in the meantime been changed to a fiat monetary system. This means that the money is no longer backed by precious metals like in the past. Money is created by “declaration” rather than having to mine gold. The only difference between gold backed money and fiat money is that gold cannot be created by declaration, but if we assume that the supply of money is controlled in a similar way to that under a gold backed system, then realistically there is no difference. The issue is how the authorities implement the “assumption” we have just made that paper money is controlled in the same way as gold backed money.

It is important to note that seeing as money is just a score keeping system, no physical form of money is actually necessary. If we kept a central register of transactions, we could see exactly how much money each person has. Well, come to think of it, this is actually what we already have. Most money is just an entry in the computer of a bank. There is not nearly enough physical cash in this world to represent all the money shown on the electronic accounts in banks. This brings us to the subject of electronic currencies, such as bitcoin, but that is a subject for another day.

OK, so where does this electronic money come from then? Some of it is "printed" by central banks. (In this context, the money is not necessarily printed physically, but central banks create "credit" by buying credit instruments such as bonds from governments, or extending credit to banks.) Most money is however "created out of thin air" by banks, in the form of credit.

How do banks create money? It is through the fractional reserve banking system. Here is how it works: Say person A deposits $1000 into their bank account. The bank then has this money at their disposal to lend out to person B that asks for a loan. The banking regulations do not allow the banks to lend out all the money. There is a regulatory requirement to keep a "reserve" amount. In some countries, there are not officially "reserve requirements", rather they have "capital requirements". The effect is however much the same, so we will not differentiate between these for the purpose of our discussion. Officially this is around 8% here in Australia. This reserve amount is different over the world, (a Google search reveals that this can be as low as 2% in some European nations) but to make our calculations easier, we will just say that a 10% reserve requirement needs to be met. This means that the bank can lend out $900 of the deposited $1000.

This $900 is deposited in person B's account. For ease of explanation, let us assume that the account is with the same bank, but in reality this is not material in our discussion. Now that the bank has this $900, it can again lend this out. Person C can then borrow $810 from the bank, ($900 minus the 10% reserve requirement) which is placed in person C's account. Person D can then borrow $729 from the bank. The bank can continue with this "cascade" until they run out of "reserve". In essence, the bank was able to extend almost $9000 worth of credit, based on the initial $1000 that was deposited with them.

Now we can hear the cries of protest from our dear readers. There are exclamations of: "That is not how it works, because people do not just borrow money to leave it lying around in their bank accounts. They actually buy stuff with it." This is true, but given that we understand that the money is just a means of keeping score, we understand that the money does not "get used up" when it gets spent. For instance, if person B buys a nice wide screen TV from a retailer, then person B's money will end up in the bank account of the retailer. It is not "used up". It has merely changed hands. In essence then, unless we take the money out of the bank in cash, and store it under our bed, that money remains "in circulation". As such, it will be available to the banks to do their "cascading money out of thin air" conjuring trick.

Another interesting economic phenomenon is that value is expressed in monetary terms, but it is not necessarily money. To see this in action, consider the New York stock Exchange (NYSE). It has a market capitalisation of around $18.5 trillion. Let us say that on any given day the NYSE has increased in value by 2%, then there has been the “creation” of $370 billion in value. Did somebody “print” that much money on that day to reflect this gain in value? When the NYSE drops by 2%, did somebody draw that money out of the system and destroy it? The answer to both the questions is obviously no.

It therefore becomes clear that the value ascribed to assets are not directly related to the amount of money around. The value is ascribed by sentiment. It is psychological. The value is based on what the holder of the asset could realistically sell it for on the open market. In the case of stock markets, less than 1% of shares are traded on any given day, but the prices achieved on those trades set the “value” of all the shares.

While I have shown the relation (or lack thereof) between value and prices in terms of company stocks, the same principle holds for all assets. The classical example being property. Over certain time periods, property prices tend to gain value at a rate much higher than inflation. Where did this “money” come from? It did not come from anywhere. The value of the property increased, not the money.

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