8 – MONEY
It was but last winter I came up to Town,
But already I’m getting a little renown,
I get to good houses without much ado,
Am beginning to see the nobility too.
So pleasant it is to have money, heigh ho!
So pleasant it is to have money.– Arthur Hugh Clough
It’s so much better to have money! One’s desires can be indulged with safety, security and power. Having more money is good. But philosophers have always said that money is not real wealth. If it’s not wealth, what is it? Its nature has been tangled, confused and argued about through most of history. Wild, conflicting attitudes exist between different people and from one era to another. Today it’s the same as ever.
When I was ignorant about economics I was doubly ignorant about money. That wasn’t a disgrace because I found that most others were in the same boat. Money seems to be one of the most confusing concepts in the entire world. Textbooks define money as “anything used as a medium of exchange, a unit of account, and a store of value.” Examples are given of the things that have been used as money around the world. Cowrie shells were the strangest. As a medium of exchange money must be accepted by all. To serve as a unit of account it has to be countable and recordable as well. Handshakes won’t do. And, if a unit-of-account money is to be a store of value, there must certainty about its future value. Its purchasing power has to be stable. To us, living in a commercial society, all of this makes perfect sense. The textbooks go on to define ever-larger categories of money M1, M2, and M3 which include everything we think of as money: coins and bills, checking and savings accounts, CDs, bonds and stocks, and institutional arrangements of all conceivable kinds up to transactions between governments.
These definitions lead us to think of money as a thing, a substance: a commodity you can spend like water; it fills your bank account. Gold, a commodity, was once officially money. “All the gold in Fort Knox” meant gigantic wealth. Coins were real money while checks merely represented money. This made sense because the precious metals couldn’t be counterfeited, nor could cowrie shells, thus guaranteeing their stability and future value. But there are other ways of thinking about money. It took me a while to understand that money doesn’t need to be treated as a substance. What, really, is a dollar today? What is modern money? It has actually become a unit of measure, like an inch or an ounce. It measures the value of commodities but is not one itself. It is insubstantial and immaterial. Money is now a type of credit. When we buy something we are indebted to the seller and we pay off with an equivalent credit – a bill, a check or charge card – expressed in terms of this intangible standard. A dollar bill itself is a promise to pay, like a private IOU. It bears the words, “This note is legal tender for all debts, public and private.” It is hard for many people today to understand that money itself is not the actual thing; a coin or dollar bill. Digital bits in a computer are money too. It’s true. No one can see or touch these dollars of money. They, along with those we can touch, are promises to pay, to satisfy a debt due, for an amount called a dollar.
Looking at the forms of money today, one sees that they are all promises to pay. For example, John gets a haircut and owes Barbara for her service. He pays his debt with a personal check written: “Pay to Barbara, $35.00” signed “J. Smith.” The check is obviously only a promise to pay. But it’s money to Barbara. She takes to the bank, converts it to cash, and uses that to satisfy another debt when she buys groceries. Later, John takes his girlfriend to the theater. When he buys tickets his swiped credit card is obviously only a promise to pay but the theater treats it as money. The box office’s computer sends it to the bank’s computer.
Money is not a commodity. It passes from hand to hand paying debts as it goes. There’s the old story of how Alice checks into a hotel, paying $100 to Bob the clerk. He uses the money to pay his tab at the bar and Charlie the bartender uses it to pay Daisy the barmaid. She then checks into the hotel and pays the money to Bob. Alice doesn’t like her room and leaves, getting a $100 refund from Bob. Everyone’s debts are paid and no one has any more money than at the beginning of the story.
Both checks and credit card charges are forms of money. They function as money; they satisfy obligations, pay off debts. All forms of money, including cash, have the same purpose. All purchases including food, gas, rent, and borrowings, are debts incurred. They must be repaid either on the spot or later, with coins, bills, banknotes, checks, credit cards, company stock, personal IOUs, etc. Anything that is acceptable as payment of a debt functions as money. It may not be widely acceptable but it is money to those who use it as such. It is their medium of exchange, their unit of account and store of value. Such money is an asset to those who have it. Gold bugs think they have the only true money. Financiers think the dollar, the world’s reserve currency, is de facto money. But it is really anything that functions as money: gold, dollar bills, Argentine pesos, cattle, cigarettes, and yes, cowrie shells. Money is a many-splendored thing.
Money, though a promise-to-pay, has value. If it didn’t it wouldn’t be accepted in exchange for other things of value. One can’t get assets for nothing, except perhaps by gift or inheritance. You must give up something in return. The money you used to buy a TV was usually obtained from something you sold or from labor you sold to your employer. You can also obtain promise-to-pay assets in exchange for another promise – a loan – a promise to hand over more assets at some point in the future.
A very important way of paying debts is to pay with the debt of a third party. Suppose I’m a bit short of cash and I get a friendly $100 loan from my buddy, John. He’s a good guy. I give him a note that says, “I agree to pay John Johnson or the bearer of this note $100 on demand.” Also suppose John has a $100 debt at the corner tavern. John might attempt to pay his tab with my IOU. If the tavern owner accepts it then John has paid a debt with a debt. Once I have signed that note and John has accepted it, I have a liability and he holds an asset. And since it’s ‘payable to the bearer’ John can sign it over to a third party. It is said to be “negotiable.” If the tavern owner accepts it he becomes a “holder in due course” of my negotiable liability. At that point, John no longer has a debt to the tavern. I do.
Where did the original IOU come from? I created it. I made a promise to pay and it was accepted! That makes my IOU real money, and at no cost to me – poof – it appeared out of thin air. There seems to be no limit to my ability to make such promises to any number of people. But making promises is easier than making them believable, and those who accept them will find it harder to pass them on to others. They must be able to convince others they’re credible. But no matter who is holding them, my IOUs are adding to the money supply and are circulating in the economy. By creating money out of thin air I’ve done everyone a favor. But I’ve also created liabilities out of thin air. I should remember that once I’ve made a promise and it’s been accepted, any succeeding holder of the promise has a legal claim on my assets.
If I can make money out of thin air surely Warren Buffet could do it too. Everyone would accept his notes without question. He’d be good for it, right? The trouble is he’s not. All the billionaires in the world put together don’t have enough money to support our economy. Sooner or later people would lose confidence and they wouldn’t be worth the paper they were written on. It was tried in the American West before the railroads had reached town. The local bank’s notes were the town’s money and it worked just fine. The banknotes were liabilities of the bank and it stood behind them. More banknotes appeared in town, out of thin air, when needed. They weren’t good in the big city but that didn’t matter. When the railroad arrived everyone had to switch to dollars, to real money, government money that could be depended on. Lots of little banks went bust. The U.S. dollar was backed by gold by the constitutional amendment of 1787. It gave people great confidence in the dollar and stabilized its value.
Counterfeit currency is another kind of money made out of thin air, not worth the paper it’s printed on. But it functions as money, and is thus real money, until it’s no longer accepted. Large amounts of counterfeit money can destroy a legal currency which is why the FBI and Treasury Agents react quickly. In earlier times counterfeiting was a hanging offense.
An international gold standard for monies was established in 1900 in order to manage the currencies used in international trade. Gold was specified as the common store of value. Every national currency had a gold-price and could easily be converted to any other by comparing their gold prices. Currencies were said to be convertible. They were backed by gold and were as good as gold since they could be sold for gold at any time. This was a comfort both to bankers and the man in the street. The system improved trade because it eliminated haggling over exchange rates – one need only check the latest quotes from the London foreign exchange market. Unbalanced trading flows between countries were settled by offsetting flows of gold between them.
The international gold standard worked for many years. It was good for trade-surplus countries like Britain which accumulated huge gold reserves. It was not so good for trade-deficit countries which lost gold. It was best to be a trade-surplus country, or at least to have balanced trade. A trade-deficit country would sometimes devalue its currency (change its gold price) to be in a better trade position, causing other countries to do competitive devaluations, leaving no one better off. It’s not possible for everyone have a trade surplus at the same time. The gold standard would be ideal if all countries had balanced trade or if surpluses and deficits did not become chronically unbalanced. In the real world it never happened because some countries were resource-rich while others were not. The gold standard lasted a long time because the supply of gold rose fast enough to accommodate the world economy’s need for it.
The international gold standard was abandoned during the 20th century because it pinched in too many places. There was no grand switchover moment – first one country and then another dropped it. The United States did so in 1971 and all currencies became non-convertible, i.e., no longer exchangeable for gold. Exchange rates between currencies then floated; they varied from day to day, sometimes from hour to hour. Depending on the time of day one had to consult the Forex markets in London, New York or Tokyo. The dollar became a ‘fiat’ currency, to the great distress of the man in the street. The same was true of every other currency.
The change from convertible to non-convertible currencies affected how governments were financed. Today’s heated arguments about the U.S. government’s debt and deficits arise from a misunderstanding of this change. Many feel that the dollar is still somehow fixed as if on the gold standard; that there are only so many dollars to spend so that the government budget must be managed like a household budget. Expenses should not exceed income except in emergencies and the national debt should be paid. This was the case when the government’s currency was convertible into gold. It had to balance its budget and when the money was spent there was no more. To balance the books it had to raise taxes, cut spending, borrow, or draw down reserves. Under the gold standard its reserves were actual gold bars. If they were sold to raise cash, they were gone. Under today’s non-convertible currencies, government reserves are different. There are no gold bars. The government now keeps its reserves in U.S. dollars, the most widely used currency in the world.
The United States creates its own currency, as do many countries. All of the U.S.’s debt to other countries is denominated in dollars and more dollars are always available since the Treasury can create them when needed. It doesn’t need to pay off its international debts with Euros or Pesos. Other counties aren’t so lucky. Most of their international debts are denominated in dollars. They can’t print up dollars as the U.S. can. They have to scrape together enough dollars to pay debts owed in dollars. Another lucky break for to the U.S. is that many commodities, especially oil, are priced in dollars, worldwide. It would be inconvenient if we had to pay Dinars or Pesos when importing oil from Saudi Arabia or Venezuela, but there is no difficulty because oil is always traded in dollars. Companies and countries also trade in dollars with each other for many purposes, so that dollars are always in demand overseas. Huge amounts circulate around the world beyond the U.S. government’s reach. Finally, some counties peg the exchange value of their currencies to the dollar rather than let them float. These factors make the dollar the world’s reserve currency. The U.S. has world financial supremacy and responsibility, one of the reasons it has been able to build up its military power. Its national debt need never be paid off. Will it keep this position forever? Probably not. At one time Britain’s Pound Sterling was the world’s most powerful currency and the sun never set upon the British Empire.
Money must have one further property in order to serve as a medium of exchange, a unit of account, and a store of value. There must be enough of it to meet the needs of the economy. As prosperity grows the amount of money in circulation has to grow in order to keep its value constant. If there is too little each dollar will buy more stuff so that, effectively, prices fall. If there is too much money in the economy prices tend to rise. Thus, for money to have constant purchasing power there must be a way to create or destroy it when necessary. Naturally there have been arguments about how this should be done.
Some believed that the government should create new money by simply spending it. The Congress should appropriate the funds and the Treasury should pay them out as authorized. Others wanted the government kept out of it. They preferred using the commercial banking system. Banks making loans to businesses and individuals should be the way to create new money. The compromise was the Federal Reserve Act of 1913: banks would loan as they saw fit but must keep ten percent of their capital in reserve. They could borrow more reserve funds from the Federal Reserve Bank but it could (theoretically) refuse to lend, thereby keeping a lid on money creation. Bank reserves are now held in dollars and are adjusted through a relationship between the Treasury, the Fed, and commercial banks.
It is true, as alarmists say, that banks create money out of thin air. They do it by making loans. It’s called endogenous money creation because it happens entirely within the banking system. The government is not involved. A bank loan results in a liability for the borrower and a corresponding asset for the bank. The money loaned to a borrower is simply credited to his account. It is new money since it didn’t exist before. When withdrawn it circulates and increases economic activity. When the loan is repaid the new money disappears; it’s removed from the economy.
There is second, exogenous, method of money creation which involves the banks and the government. The law requires a bank to hold reserve assets, cash in the vault so to speak, of at least ten percent of its total assets. If a bank has made many loans its reserves might be below 10 percent of assets. It can borrow from the Federal Reserve to top them up. Money borrowed from the Fed is an asset to the bank, a liability to the Fed. However, the Fed can cancel its liability by transferring money from the U.S. Treasury into its own account. The Treasury does not incur a debt by doing this because the government can’t be in debt to itself. Money is thus generated in the bank with no offsetting debt anywhere. It’s called “printing money.” Amazing, isn’t it?
It’s easy to mistake what’s happening when comparing the endogenous (banking) money creation with the exogenous (government) system. At the banking level, the basis for money creation is debt assumed by borrowers. Therefore, it is often thought that debt must also be the basis for the creation of money by government. But this is not so. Money created by the government goes into bank reserves and doesn’t enter the economy until banks make loans. The credit which underpins economic activity is not created by savers’ depositing money into banks which then enable them to lend. Instead it is demand from borrowers that create loans, i.e., money created from thin air and deposited into borrower’s accounts. Loans create deposits, not the other way around. This is opposite the usual view. By far the largest amount of bank deposits are bank loans made to corporations, who then withdraw the loaned money and cause it to circulate it through the economy.
If demand for loans is high a bank’s reserves can run low but its policy is to always make more loans first and borrow needed reserves from the Fed afterward. The Fed will always accommodate a bank’s need for more money. A bank cannot go out of business by running out of reserve funds. It can only go broke by failing to make a profit.
There remains another way of creating money: the government buys things. The Treasury pays out for government employee’s salaries, supplies, military hardware, and innumerable public works. When spent domestically, these funds enter the economy as new money. This method of money creation is the prerogative of Congress as it wrangles over budgets and appropriations. It can vary wildly as the political winds blow. But this source of new money is vital to some parts of the economy. Millions of jobs depend on it.
As might be expected, there are several ways to destroy money, to remove it from the economy when necessary. The major one is, of course, taxes. The government can spend money into existence but it can also tax it back and remove it. Again, Congress decides these things, with much help from lobbyists.
The Fed can also destroy money when necessary by borrowing banks’ excess reserves. When the economy is weak and banks are making few new loans, their loan assets are shrinking and their reserves may exceed ten percent of assets. They can then loan the excess to the Fed, thus reducing reserves to the required level. The Fed has no offsetting asset, as described above. Money loaned to the Fed disappears from the economy.
A bank is a good place for your savings and checking accounts. It has an impressive steel safe and is a much better place for your money than under the mattress. How does a bank stay in business? It pays interest on deposits and it charges a higher interest on loans. Checking or savings deposits are really loans to the bank; debts which it will repay on demand. A bank could fail if funds were not available when asked for. It’s a risky business, borrowing short term and lending long. To reassure depositors, banks once created images of solidity and safety with stone buildings and impressive furniture. Bankers wore dark suits and carried gold watches. A bank branch in a supermarket would have been unthinkable. But Federal deposit insurance changed all that. The threat of default was eliminated for small customers. Banks became safe places and hired friendly folks. Today, near-banks such as GE Capital and General Motors Acceptance Corp. issue credit but have no government supervision or backing from the Federal Reserve. Wall Street firms do the same on a larger scale, creating derivatives which are loans based on bundles of other loans. When Goldman Sachs nearly failed during the financial crisis of 2008 it reorganized itself into a bank holding company in order to get help from the Fed.
Here and now, in the 21st century, confusion about how banking works lingers in the public and even among some experts. It’s incredible. Such misunderstandings should have been settled long ago but they persist. Books are published today with flow charts and tables showing how transactions move through the system. Their authors lay out simple examples, trying to explain to the dummies who can’t or won’t understand. It’s hard to believe. Why do economists continue to struggle with money and banking at this late date? I think it’s because they have yet to arrive at a satisfactory theory of credit and debt. Banks don’t fit into current theory because credit is their business, their reason for existing.
Our basic attitude toward money as a store of value is valid – until it’s not. Money becomes useless in periods of inflation or deflation. When inflation is low, small changes in purchasing power are not even noticed. People suffer from ‘money illusion.’ If food or rent costs rise by a tiny amount per year we think everything is OK. Only grandpa remembers penny candies and dime comic books. But if inflation reaches two or three percent, wages don’t keep up and we complain about the cost of living. At five to six percent the government “has to do something.” Those in debt are helped while creditors lose their shirts. At yet higher inflation people convert their cash, savings and checking accounts into goods and services as fast as they can. During deflation it all goes into reverse. Money is king. Lenders get more than their money back and debtors are squeezed or ruined. Prices and wages fall but debts do not. Forced sales and foreclosures multiply. Demand falls and businesses fail. Both inflation and deflation strongly affect the economy because the value of money, measured in goods and services, changes. The normal uses of money fail. It is no longer a store of value. Money’s promises to pay can’t be kept.
But these are the sicknesses of money, not its strengths. In normal times people use dollars, which are promises to pay, just like Warren Buffet’s IOUs. They go easily from hand to hand because they’re accepted everywhere. Buying and selling are so much easier when it’s not necessary to bite the edge of a coin to “test its mettle.” No one cares if a particular dollar has passed through a thousand previous owners. All dollars are alike, one is as good as another. They are said to be fungible. Commerce benefits enormously and society gets richer faster.
And finally, money must be used – it has to be in motion. It must circulate like blood in the body in order to keep the economy alive and healthy. Gross Domestic Product measures the nation’s buying and selling and it would decline badly if the money didn’t flow. Money under a mattress or in an offshore bank account is a loss to the economy. Economists measure money’s “velocity,” the average rate at which it changes hands. A higher velocity helps prosperity along. In a recession people hold their money back instead of spending it or spend cautiously so that its velocity slows. Either action makes the recession worse.
Truly, money is the lifeblood of our capitalistic society. But that’s because customs, laws and regulations have developed ways which keep it steady and under control.