Have you ever wondered why investing and the topic of money and general leads some people in an emotional tizzy?
In my opinion, money is an emotionally charged topic because of a fundamental lack of understanding. So, the first step in our quest to understand the topic is to demystify the game of money.
Why do I say “the game of money”?
The reason why I phrase money as a game is because virtually any venture where there is gain and loss can be described as game. The prerequisites of any game are the rule makers, objectives, players and the rules themselves. For example, sometime ago a group of individuals set forth rules outlining a game of checkers. This group of people sat down, labeled a game checkers. These rule makers set down the game’s objective, participants and how to play.
This seems straightforward and you may be thinking to yourself what does this have to do with money?
The problem with people and money is that people do not understand they are playing a game. Further, because they do not understand the game they do not believe there are any rules that need to be ascertained before playing. Investing in this manner is like playing checkers and not knowing the rules. Further, you opponent is under no duty to inform you of the rules. What would be your chances of success given the above conditions?
People ordinarily trade their labor for a wage and use those wages to purchase what they want. But the game of money is not that simple. I will not go so far as to say it is complicated, but there are more variables than most people realize. Accordingly, a refresher course on the essence of money and monetary systems is in order.
What is Money?
Merriam-Webster Online defines “money” as – “something generally accepted as a medium of exchange, a measure of value, or a means of payment”. Dictionary.com defines the term as – “any circulating medium of exchange, including coins, paper money, and demand deposits.”
These definitions are only the first entries of many. Dictionary.com has 20 entries for definitions of money, Merriam-Webster has 36 entries.
More important than any of these definitions is the realization that money is an idea. The reason we can describe money in this manner is because the idea of value is what money symbolizes. This symbol is the medium of exchange.
Merriam-Webster online defines a “medium of exchange” as — “something commonly accepted in exchange for goods and services and recognize(d) as representing a standard of value”.
Specifically omitted from this definition is the form of the “something commonly accepted in exchange.” In fact, we see this everyday. Two little boys trading baseball cards at the playground use baseball cards as this “something”. An attorney and dentist exchanging services representing value is another example. Examples are as endless as there are people willing to trade in an effort to better their situation. This is the “free market” system conceptualized.
Taking this analysis further, almost anything can be used as money. Historically, skins, beads, sticks, food, livestock, gold, silver, even people have all been used in trade. Therefore, all have been used as a “medium of exchange” or money.
You will notice that most of the above mentioned items are commodities. Items such as food, livestock, metal, animal skins, etc. all have value and all have been and continue to be traded on the open market. Those items which were not themselves commodities, represented the commodity itself. That is, the value of the item was “derived” from the value of the commodity. The item was basically a promise to redeem all or part of a commodity on demand.
This was very convenient for merchants, since acceptance of a promise to pay allowed them to avoid delivery of the commodity, which could be burdensome in large transactions. Economists label this type of money, “commodity money” and it usually took the form of a coin or other proof of entitlement such as a receipt.
Eliminating the problem of delivery did make it easier to conduct business. However, shrewd men realized they could produce fake money (receipts) and pass them along as real at little to no cost. This was an expected occurrence but was also outweighed by the ease in which the transfer of receipts made commerce flow.
One might think the party accepting the false currency was swindled out of his merchandise and/or services. And this would be true if the fake currency was uncovered. But that was not exactly what happened. In actuality, many of the fake receipts simply circulated in the economy thus swindling everyone (the whole economy) in the process.
This increase in currency inside the economic system and effectively debased the existing money in circulation. An increase in redeemable promises meant more units of currency were chasing the same amount of goods and services. This imbalance caused an increase in prices based upon the law of supply and demand. The result was inflated prices without a corresponding increase in production. This phenomenon is otherwise known as price inflation – a topic we discuss in other posts.
Yet the benefits of circulating currency outweighed the problems and commerce benefited from the its use. As discussed above, various forms of currency did and still do circulate in different economies.
Eventually, money evolved. And widespread use of monetary metals, specifically gold and silver, was the norm. Gold and silver coin was the “medium of choice” for several reasons. The first touches again upon the idea of inflation.
Mining efforts eventually reached a level which yielded only small amount of metal per year – about 1 %. This consistency in output was perfect for the metal’s use as money because the amount in circulation could not be artificially elevated. Put another way – since the money was backed by a commodity with stable output, the value of that output would also remain stable. The price of anything, then, would be equivalent of the amount of energy (labor, capital, planning, etc.) it would take to extract that equivalent of gold from the earth. In this way, trade is fair, and the relative value of the underlying commodity remains stable. This is the essence of a strong currency and basis for many national success stories historically.
Relief from inflation is large reason for the choice of gold and silver as money. Other reasons included its durability and divisibility. Yet the importance of monetary metals as it pertains to stability cannot be overstated.
Over time, ruling classes realized the power of creating something for nothing. Their ability to counterfeit has always been a goal. As such, these parties’ creative efforts evolved money into what it is today.
Most modern currencies today are deemed fiat currency. The term fiat is defined as an official decree and is derived from the Latin meaning “let it be done”. In the modern world, the entity that does the “decreeing” is sovereign governments. That is, the state decrees something has value, and so it is done.
You might be questioning the legitimacy of such a decree and you would be right to do so. Yet despite having no intrinsic value at all, fiat money world wide is the norm. How can this be?
You see, the government has an incentive to use this decree since enables it to borrow money in the name of the people virtually without limit. (In actuality, there is a debt ceiling but it is increasing every year). This of course, is beneficial to you if you belong to those groups of people connected to government also known as the “ruling class.”.
A modern example exists in the United States where the nation’s currency is issued by the Federal Reserve. The value of the currency is based on the fact that the United States Government only accepts Federal Reserve Notes as payment of tax debts. We know, of course, what happens to a citizen who fails to pay his taxes. This threat is essentially the incentive to use the currency. It stands to reason that even though you do not have tax liability, those around you most likely do. Essentially, fiat currency in the United States can be regarded as a tax credit that is widely accepted as a medium of exchange between parties. Once accepted in the market place, no more legitimacy is needed.
And now we can understand why normal, law abiding citizens will accept this medium of exchange. And it is precisely their cumulative confidence in the medium that gives it value.
While commodity money as perceived value in the form of cost already expended (as in the case of mining gold and silver coin), the value is still derived from something tangible, like labor, mining costs, storage, overhead etc. The concept of value is based upon this outlay of value in producing the underlying backing.
However, fiat currency is made with the stroke of a pen or a punch of a keyboard. This is the extent of the value used to produce it. Intrinsic value, therefore, is almost zero. The value then must be derived by the issuer’s threat of force and the confidence of those using it for transaction.
We discuss the effects of fiat currency in other posts. What is important to remember is with this type of money, a great deal of its creation is based upon the decisions of government officials. Placing this type of power in the hands of individuals is ripe for abuse. When certain privileged parties are permitted to create an amount of currency disproportionate to the amount needed within the economy, you essentially erode its value. Historically, all fiat currencies have returned to their intrinsic value – 0.
Creation is often a spiritual subject. Logic dictates that for something to come into existence, it must be created. The same is true for money. The mechanism which all modern monetary systems utilize is debt creation. That is, all money which comes into existence is borrowed into existence. The money simply did not exist prior to the loan. The borrowing is the act of creation.
So why did the system set itself up in this fashion?
The first thing that you must realize is that the Federal Reserve Act was written by bankers specifically for bankers. Everyone understands bankers make money from loans, how convenient for bankers that every piece of currency is a loan.
Let’s take an example.
“Modern Money Mechanics” is a workbook on bank reserves and deposit expansion published by the Federal Reserve Bank of Chicago. (The book is out of print but you can download it here). I suggest you take a long look at the process outlined in that pamphlet. If you understand what it is saying, then you will have an incredible edge over those who do not understand the banking function.
What does it all mean? It means loans are the mechanism in which money is made. But, while a $10,000 loan creates $10,000, it does not create the interest on the loan. That money must come from the other loans already in existence or future loans.
Now theoretically, the problem with this type of monetary creation is that it is run by humans. And you know humans are susceptible to instant gratification. What I mean is that if you take the creation process to the logical conclusion, ultimately, one entity must control all of the money in circulation. That is why restraint is of the utmost importance. If too much money is created, the value of the existing money will revert back to its intrinsic value. So far, this system has held up for over 100 years. But now, we have a mathematical situation on our hands.
In 1974, the US money stock was $1 trillion. So, between this country’s inception and 1974, $1 trillion was needed to build every building, street, highway, school, sewer, etc. in existence. Meanwhile, in the last year, trillions of new dollars were created. The situation has gone parabolic.
Since all new money must be borrowed into existence and interest on this money also be borrowed to pay existing interest, the result is a textbook example of the exponential function.
Further, if all money in circulation is loaned into existence then if every loan or payback all of the nation’s money supply would disappear. Literally every dollar can be traced back to a bank loan somewhere. For one person to possess money means other persons owe a similar sized debt to other banks.
This part gets tricky because the interest must be paid from additional loans. In other words the money supply must expand larger and larger in order for the system to continue. With every year the money supply must expand at least equal to the interest charges due on previous loans. At first this process starts slowly. Then it gains momentum. Ultimately, the increase in money supply goes parabolic. There are many who believe we are at this stage presently.
Why This is Important
There are many who believe the existing monetary system as dictated by the federal government and the Federal Reserve Board is immoral. When the system started, I surmise, nobody really considered the wisdom of employing a system which require protect perpetual growth in order to function properly. Yet there was much opposition to the passing of the Federal Reserve act in 1913. Nevertheless, this is the system and the economic reality.
The unfortunate result of this type of monetary system is inflation. Often misunderstood as an economic phenomenon, inflation is entirely a monetary phenomena caused by a disproportionate increase in the supply of currency relative to goods and services. Once the money supply goes parabolic, there is simply no way for the economy to keep up. The result is an ever increasing number of currency units chasing the same goods and services. The laws of supply and demand dictate an increase in the overall price of goods and services. And this is exactly what we have seen. Since 1913, the dollar has lost 98% of its value. Inflation is a recurring theme throughout investing. You had better get used to it.
The importance of debt-based money cannot be overstated. This knowledge can be used to gain an advantage in investing. It means investing in a rising tide of money in a system with a fatal flaw. These types of investors utilize various techniques to manage this risk and profit for their efforts.
Thanks for listening.