As the “global economy” grows more and more shaky, I thought it might be helpful to repeat some of my “basic money” posts. So here are a few of the most basic with a few advanced/semi-advanced concepts and issues tossed in for good measure – with minor editing being the only changes from the originals.
Some Monetary Basics (Part I)
(First published version – Wed Dec 24, 2008. Edited and expanded version May 9, 2011)
I’m reading around the internet things that don’t make sense to me. They don’t make sense because apparently the people saying them don’t understand how the international banking and finance system works, and perhaps don’t understand the foundation stones of economics and finance. So I’ll give a shot at conveying some basics – so that maybe some of what’s going on will make more sense.
Okay – first you must understand currency since it’s the basis of the system.
In the OLD days, currency was either “specie” (Gold, silver, copper, etc coins) or tokens that represented specie, or they bartered goods directly – one for so many of the other. If you borrowed a gold coin from someone, you had to come up with a gold coin or its equivalent value in silver, etc to pay it back. Specie is also known as “hard money”.
The main problem with specie is that there is only just so much of it. A story is told that England was once having a shortage of coinage that was crippling the economy. The king/queen was said to have summoned the religious leaders of the day and told them to bring their “saints” (statues) from the churches to be melted down to make coinage out of – the sovereign was said to quip “Let’s get them out of the church and put them into circulation!”
So a shortage of hard coinage can bring commerce to a halt.
This gave rise to “currency” – which started out as paper or some durable token that REPRESENTED specie. An example is the US Silver Certificate – paper dollars which you used to be able to present at the US Treasury and receive one dollar’s worth of silver for it. This fixed the value of the currency at an equivalent amount of a precious/semi-precious metal. If you didn’t have the metal to back up the currency, you couldn’t print up and hand out currency.
But you still only had just so much metal!
So some wag decided that since the currency was “as good as” the metal, they didn’t REALLY need to have as much metal as currency. So they started printing more currency and just maintaining a “reserve” of the metal for those malcontents and distrustful folks who actually wanted to trade the convenient paper for the heavy old metal.
The amount of currency flourished, and so did trade. But eventually, folks saw that there was so much currency floating around, there couldn’t POSSIBLY be that much metal to back it up. So the ability to trade the currency for the metal at a fixed rate – was ended. (In 1971 Nixon unilaterally abrogated the Breton Woods agreement and took the US off the Gold Standard.)
So… did the world come to an end? No.
Did currency disappear? No.
But as before, the world of finance and the use of money changed. The unchecked printing of money creates what is called “fiat” currency. (More on that later.)
If you have questions, please feel free to ask them. If I don’t know the answer… well… Ummmm….
Some Monetary Basics (Part II)
(First published version – Dec 24, 2008 (cont.) This part edited and expanded May 11, 2011)
But like specie, currency had limitations too. Have you ever seen a $10,000 bill? Nope. As far as I know, they don’t make them in the US. So spending a $million could be a tedious affair. (And as we all know, today’s Trillion is yesterday’s Billion!) With the advent of the electronic age it became possible to keep up-to-the-split-second track of transactions – so instead of changing the currency, electronic money/monetary transactions were created. I know people who don’t have check books, don’t carry money. They just have a debit card. I’ve always advised that diversity is good – and having diverse methods of paying for things is really good! One of the people I know who only have debit cards found out that I perhaps wasn’t as dumb as she thought when the power went out in Ontario for a week or three – and she couldn’t even buy a cup of coffee at Timmies!
So, trade goes on, and even though they are just making an electronic transfer of numbers from one account to another, people still talk about “dollars” because at least in the USA for the present, that is the word we use to infer the price/value of things.
FULL FAITH AND CREDIT
Since we don’t back the currency up with metals and such any more – what is behind the US dollar? Why do people accept it in exchange for goods and services? The US Currency is “backed by the full faith and credit of the United States Government.” Period. Nothing else.
Now – I used to think that that phrase meant that the US stands behind every dollar in circulation including the electronic ones, you know – sort of an honor-bound thing to provide value in return for dollars – to “redeem” dollars with something of real-world value. I was wrong. What I now believe that phrase means is that “as long as people have faith in the dollar (faith that it has value and that others will exchange real/tangible value for it), and as long as the US Government can borrow to back it up (the “credit” part), then the dollar is worth something.”
If people lose faith in the dollar – it’s worthless. It doesn’t even make good toilet paper ’cause it’s not very absorbent.
If the US government loses the ability to borrow, the dollar loses its value as a currency. If the people lose faith in the value of the Dollar, US currency becomes worthless. Those are some pretty shaky blocks to build a national monetary system on, eh?
WHAT USE IS A DOLLAR?
Now we take a leap from what a dollar is – to how it can be used.
– It can be used as a ruler – yes – the US Dollar is EXACTLY 6 1/8 inches long. So you can measure a fish with one and tell if it’s legal length.
– But mostly it is used to measure value – which makes it a medium of exchange. A pair of boots is worth how many chickens? Dunno? Well… if you have a Medium of Exchange (in this case the dollar), you can figure out how much in “dollars” the boots are worth to you, and then see how many chickens you can get with that many dollars.
But remember – the dollar itself has NO intrinsic value!!!
So since it functions as a medium of exchange, you use it as a commodity that REPRESENTS (symbolically) boots and chickens. You can PRETEND it’s a bunch of chickens and instead of trading 34 chickens for the boots, you can just hand over an equivalence in dollars and not bother with the chickens at all.
(First published, Dec 24, 2008 )
Some Monetary Basics (Part III)
Now things get tricky. (Some monetary/economic issues)
What happened was that a lot of clever people in governments (only governments are allowed to make currency) decided that they could just print up as much currency as they needed and spend spend spend. When they started doing that, there came to be LOTS of currency around, so the currency lost its value. (Value of a commodity such as currency is tied to scarcity or plenitude.) When you have more currency/money being created than is needed, it’s called inflation. It takes more inflated currency to buy things because since there is more of the individual units of the currency (“more dollars”), each unit is worth less than before.
Now, I’ve heard a lot of economists say that inflation is the result of “the wage price spiral” but they’re wrong. You can’t HAVE a “wage price spiral” if you don’t have enough money to allow for rising prices and wages. So inflation is NOT caused by wages and prices going up – the wage price spiral is a SYMPTOM of inflation. The ONLY cause of inflation is putting too much money into the economy. Period. And too much money in the economy will kill it just as fast as not enough money in the system. (Not enough money in the system causes “deflation” – where each monetary unit becomes more valuable than before.)
INTERNATIONAL CURRENCY & “PEGGING”
The dollar represents value, but again, HAS no intrinsic value. So… say you’re a new country. You can print up some currency – say some Zlotys – but how will people know what Zlotys are worth in exchange for the stuff they want to sell you? Exactly how many zlotys would a double dip chocolate ice cream cone cost?
You go back to the historical foundation of currency and figure out that you need something to “back the Zlotys” up – something of recognized value like gold or silver. But you don’t have any gold except in your teeth. What to DO? You get a loan from someone who gives you dollars (World Bank?). Then you print up Zlotys (with the president’s picture on one side, an ice cream cone on the other). For every dollar you borrowed, you decide that you’ll print up ten zlotys, making your exchange rate 10:1, zlotys:dollars. Now, instead of gold and silver you are using the dollars you borrowed as your “reserve currency.” You hold the dollars in “Reserve” – so the Zloty is now ALSO “backed by the full faith and credit of the US Dollar.” N’est ce pas?
You say – “We are setting the Zloty at a value of ten Zlotys per US Dollar – this will be a fixed rate of exchange until we get established here, and then we’ll do something else. We’ll allow the Zloty to “float” against the dollar.” In other words people will know how many Zlotys to pay for goods, and how many to get paid for work because EVERYbody knows what a US Dollar is. Then, once your economy gets established, the Zloty can set its own value by the amount of goods and services your economy is creating.
When you fix the value relationship of YOUR currency to another currency at a set rate, like the US dollar, this is called “Pegging” – in this case, “Pegging to the Dollar.” So if the US Dollar has ten percent inflation and loses value – then your currency also loses value, and so on. A peg of one currency to another fixes the value of the inferior currency in relationship to the other.
Well… we’ve talked about money – the different forms it takes, what can be done with it, and a few general economic things having to do with money/currency. But what we haven’t talked about until now is EXACTLY WHAT money/currency REALLY IS. Stay tuned for PART IV.
Some Monetary Basics (Pt IV)
Initially published, Dec 24, 2008 (Edited and expanded 5/17/2011)
Okay – NOW we get down to the IMPORTANT stuff… EXACTLY WHAT IS MONEY/CURRENCY?
Let’s start out with the illustration, then the definition/summary. I think it will be easier for you to follow the concepts that way.
So, let’s say that you decide to go into the lawn mowing business. Okay… you hoof it up and down the street, trying to get your neighbors to “hire” you to mow their lawns. You finally find one, and the two of you agree that you should mow and trim his lawn, and he’ll pay you $25 for the job. So you get busy and do a great job, and he hands over a 20 dollar bill and a 5 dollar bill – transaction complete.
But IS it? No.
What really happened in the above paragraph? You agreed to give up a part of your life and perform a service. Your neighbor agreed to give you a couple of pieces of paper that according to current convention, represented a certain value that you could exchange somewhere for something that you value. So you do that. You ran over your foot with the lawn mower while you were doing the guy’s lawn, so you need a new pair of boots. You take the $25 in paper money to the store and find a cheap pair with steel toes (so you don’t whack your toes off if you run over them again.) And for purposes of our illustration, those new boots cost EXACTLY $25, and there is no sales tax.
So you traded your time and lawn care skills for a new pair of boots. But you didn’t get the boots from your neighbor. What REALLY happened, was you did the work, and your neighbor gave you an IOU for the boots… or for something. Then you gave the currency to the shoe store clerk, who will then use it to pay an employee, or to buy a box of shoe laces or something. So your work has now purchased a pair of boots, and whatever the shoe store owner will in turn exchange your neighbor’s debt to you for something he needs.
But how did the shoe store owner know that your neighbor owed you a pair of boots? He accepted the currency/money as valid representation of the debt owed to you by the neighbor (or someone), and he presumed that the neighbor was good for the debt. BUT – he doesn’t KNOW the neighbor – so how could he trust the IOU?
So… having written at length as to how money/currency is used, and such, we now, FINALLY come to EXACTLY WHAT money REALLY IS!
Money/currency is “Nonspecific Debt.”
That means anyone can collect the debt, or transfer it to anyone else, and it’s as valid as if you wrote a contract with specific names and conditions in it. Why did you take the $25 from your neighbor? Because you ACCEPTED that someone else somewhere else would redeem those notes for something of reasonable value. And the shoe store owner did the same thing when you traded him the paper money for the boots. So you exchanged labor, part of your life, for some unknown person’s promise to pay you something of value in exchange at some time in the future.
So modern economies don’t just create debt by borrowing money – they RUN on debt.
So when you “save money” what are you doing? You are holding someone else’s debt. Can it evaporate? Sure can. How do you make sure that you have value instead of debt? You have to redeem that debt/money for something of (real world, tangible) value so that if the non-specific debt is defaulted on by the sponsor of the paper (government?) – YOU don’t get stuck holding the bag.
CAN you “save for the future”? No. At least not by hoarding money. There is a simple economic/accounting reason/law that it is impossible to “save for the future”, and it’s the reason Social Security can’t work. It is this;
CURRENT OBLIGATIONS MUST BE PAID WITH CURRENT RESOURCES.
If you have a US Savings bond, can you buy food with it? Probably not because like money the savings bond represents debt – but a different kind of debt than money. A US Savings bond is SPECIFIC DEBT – which is to say that the Government (one specific party) owes YOU (the other specific party – your name is on the bond). So before you can redeem that debt (spend it), you must convert it from specific debt to NONspecific debt (money) or change the specified parties. And since you have no way of knowing what the value will be, or will not be of future debt (due to inflation, deflation, default, etc), you cannot save for the future. If you seek to “save” for the future, to “put aside” the fruits of today’s labor/time for use at some time in the future – the ONLY way to do that is to currently redeem your non-specific debt, and your specific debt for some asset, some item of value, that will reliably return CURRENT income/revenue in the future that is likely to have an value comparable to it’s worth today. The classic such investment would be to buy a liquor store. Another classic strategy is to “think generationally” – which is you take care of your parents, and your kids take care of you, and you all build he family’s wealth through the generations.
And just as a sort of extra value thing here – gold, silver, precious metals, gems, etc are no different than corn, beans, and carrots. They are not magic, they do not “hold value” (ie they cannot be counted on to return a specific amount of a commodity in the future) any more than any other commodity. If you think gold is some mystical stuff that will hold value through the ages – you need to talk to the Saudis who decided to abandon the petrodollar for gold. (They refused to be paid for oil with US dollars and demanded to be paid in gold.) After a while of other nations paying for oil with gold, the price of gold went up and up as the Saudis held it – from somewhere around $200 USD an ounce, to over $800 USD. Then the Brits, who IIRC controlled the price of gold at the time DROPPED the price to back to around $200 USD. Again – IIRC, and the Saudis returned to taking USD for oil. I found the outcome of that situation highly amusing.
And it also illustrates another principle – just because a bushel of corn sells for $8 USD today, does not mean it will do so tomorrow. The value of commodities floats against other commodities and against currencies and according to scarcity and need. And always remember – metals like gold, silver, platinum, copper, etc are commodities. So the idea of hoarding gold to protect against a crash of the value of a currency would probably be an ineffective strategy since the dollar price of gold will fall with the rest of the commodity prices. Will it increase in relative value? There is absolutely no way to know that. (Aside – you would have a better chance of retaining value by holding gold than by holding boxes of cornflakes… but it’s a relative thing. :-D)
Do I own gold? Not an ounce. Can’t eat it, can’t use it to stay dry in the rain or warm in the winter. Unless someone else wants to trade me for something else that’s useful, gold is worthless. (Or as a person I know would put it, gold is an “Oooooo SHINY!). And besides – the mythos that has developed around the stuff over the ages makes it dangerous to own. I’ll take my commodities in non-GMO food. :-)
Generally, I think that people who understand the NATURE of money, and the role it plays in our economic lives, have a better chance of doing well when it comes to ordering their own economic lives, than those who don’t.
But that and the above stuff is just my opinion.