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What is Bitcoin? – The Idea Behind Blockchain Technology

Recent months reveal a growing fascination with Bitcoin and blockchain technology in general.  The meteoric rise in dollar value of Bitcoin and other “crypto-currencies” contribute to this increase in exposure.  In this post, we examine Bitcoin, the idea behind blockchain technology and its potential.

What is Bitcoin?

Bitcoin is the name of a particular type of “cyber-currency”.  It operates worldwide and is also known as a digital payment system.  The currency was invented in 2009 by Satoshi Nakamoto, who is/are either an individual or a group of individual computer coding professionals.  The purpose of the technology was to facilitate entity to entity payments internationally and without an intermediary.  In other words, people all over the world can transact business in Bitcoin without a bank acting as an intermediary to verify the transaction.  With Bitcoin, the transaction is authenticated the block chain technology.

Some of the important characteristics of Bitcoin and other cryptocurrencies are:

  • Each unit has no inherent value – Unlike commodity currency (i.e. backed by gold or silver) or fiat currency (i.e. backed by a governement’s power to tax its population), cryptocurrency has no value outside its role as a medium of exchange.
  • Each unit is without physical form – Likewise, the unit of cryptocurrency exists only within the network (i.e. you cannot hold a bitcoin in your hand).
  • The supply of the currency is stable (in theory) – Because new bitcoins are “mined” by computers in the network and are payment for the authenticating processes they run, the amount of the currency is relatively stable.  Contrast this to modern currencies wherein a government can create literally trillions of dollars from a few key strokes.  Stable currency is an economic panacea according to some economists because it encourages thrift and investment.

 

How Blockchain Works.

The use of Bitcoin (and other block chain digital currencies) begins when someone requests to transact business using the cryptocurrency as payment.  The request is then broadcast to a network of independent computers (peer to peer network or P2P network).  The network then validates the transaction using certain algorithms which confirm the currency is available.  Once confirmed, the transaction is combined with other transactions in order to create a new block of data for the currency ledger.  This new data block is then added to the existing blockchain.  This addition completes the transaction.  Further, the new data is permanent and cannot be altered causing a permanent record of the transaction.  Every unit of currency has the history of transactions in its chain.

By developing blockchain, which stores blocks of information on independent computer networks, the currency cannot be controlled by any single computer in the network.  It is therefore decentralized because the process is a function of the entire network of blockchain nodes (independent computers).  These computers conduct the verification process for profit (i.e. the opportunity to earn (“mine”) bitcoin).

 

Why is Bitcoin Important?

Finance is the main application for Bitcoin so far.  International transactions are a primary example in which decentralization alleviates the need for the contracting parties to buy/sell different currencies to transact business across geographic borders.  Instead, the parties can just transact in Bitcoin and cut out the middleman.

Enhanced security is another byproduct of blockchain technology.  Because data is stored on multiple nodes within the network, there is no centralized point hackers can target.  Blockchain security uses “public” and “private” keys for security.  The public key is a random set of numbers which act essentially as ownership identification on the blockchain.  The private key is similar to a password that give the owner access to the Bitcoin.  The data point is as secure as possible, but it is important to note that the owner must NOT lose the private key or else the ownership cannot be authenticated.

These types of safeguards can give rise to a new variety of transactions and the validation of same.

 

What Blockchain Technology Means for the Rest of Us.

The implications of a global network acting to decentralize money have only scratched the surface.  Some new technologies have already emerged, such as:

  • Smart Contracts – Imagine a contract which can be programmed to execute automatically once certain conditions are met.  For example, a smart contract can automate payment once a product delivery is made, or an options contract can automatically execute once it reaches another predetermined price level.  The blockchain technology authenticates the transaction and automates the process.
  • Peer to Peer Trade – Blockchain facilitates direct transactions between parties.  Consider a vacation rental portal such as VRBO.com where “renters” can shop existing units and contact “landlords” for vacation properties.  Currently, users have to go through VRBO.com as an intermediary.  Through the use of blockchain, peer to peer payments are made directly, without paying transaction fees.
  • Document Recording – Blockchain can make the recording of documents much more efficient.  Court documents such as real estate titles, which historically have problems with fraud, can be authenticated and transferred in minutes, and without the need for title insurance or other authentication process.

Again, blockchain technology promotes efficiency.  Only time will tell what industries will be impacted.  What we do know is that this technology is gaining rapid acceptance and the dramatic rise in Bitcoin pricing over the last year increases its exposure to the masses.  Who knows what ideas people will come up with?  We are limited only by our imaginations.

Thanks for listening.

 

 

 

 

 

 

 

 

Banking and You, Perfect Together

As I spoke about in an earlier post, the type of money used in all current modern monetary systems is created through debt.  For purposes of our discussion, this means loans which originate at banks are the source of monetary creation.  Since private loans do not create money, we are only interested in money creation through the loaning function of duly sanctioned banks.

 

Fractional Reserve Banking

It is very important to understand how we have come to this place in monetary history.

Origins

Economic lore surrounding the genesis of modern banking suggests a discussion of medieval goldsmiths and their vaults.  Common sense dictates wealthy persons, possessing monetary metals as a valid store of wealth, would seek safe keeping for their valuables.  At that time, goldsmiths – those who actually worked gold into coin – were a logical choice for this task since they already possessed the vaults and other security measures.

When depositors left their money with the “original bankers”, they were issued a receipt which was redeemable on demand.  Soon thereafter, these receipts circulated as a medium of exchange among merchants.

We define money as some “thing” which served as a medium of exchange and a store of value.  Since the receipts were redeemable on demand from the banker, they were essentially as good as the commodity (gold) itself.  The receipts also functioned as a store of value for the same reason.  These receipts therefore, became a form of paper currency.

The original bankers were not stupid.  They noticed their receipts were circulating as a medium of exchange.  And they also noticed only 10% of their depositors ever came to regain the receipts for actual gold.  With this in mind, bankers decided to issue receipts and loan them at interest.  And fractional reserve banking was born.

Modern Fractional Reserve Banking

Whether the above account is accurate is not important because fractional reserve banking exists today, only with a different twist.  I again direct you to the Modern Money Mechanics essay.  I urge you to take repeated steps to familiarize yourself with that material.

So let us begin at the Federal level.  For example, the Federal government asks the Federal Reserve for treasury bonds in the amount of $1 billion.  The Fed then draws a check on itself and places this deposit in its own account.  The Fed then enters the amount as both an asset and a liability on its balance sheet.  In this way the government, through the act of borrowing, has increased the money supply by the amount borrowed.  Of course, if you or I did this, we would be thrown in jail, but that discussion is for another time.

The Federal Reserve then uses its “assets” to loan to other banks within the system.  These banks, borrowing money from the FED, offer loans to other banks and ultimately to the public at interest.  Keep in mind the amount of interest in NOT created but only the loan amount.

 

Debt Money and the Economy

Classical economic theory places the determination of the amount of currency in circulation in direct proportion to the amount of production present in the economy.  In other words, there should only be an increase in money supply if more production warrants the increase.  Today’s money creation has little in common with this practice.

By way of example, let us say the US Government is a little short this month, desiring to spend more than it takes in taxes. The Government goes to the Fed and asks for a billion dollars. The Fed gives them the equivalent of a check or credit for 1 billion dollars payable to the US Government.

Then, let us say the government official takes the check and deposits it into the government account, which is also at the Fed and begins to write checks on the deposit for things such as Medicare/aid, social security, government paychecks, government contracts, etc.

In the above scenario, the amount “needed” in the economy is NOT increased by a commensurate increase in production.  No new goods or services entered the economy.  Instead, the increase comes from debt.  Of course, it could be argued the debt will lead to production.  And that could be true in the case of business loans used to increase revenues.  But the opposite could also be true – that the debt will ultimately be used for consumption.  And we see this every day with government benefit spending.  We also saw it in the mid 2000’s when people were refinancing their homes and extracting cash to pay for consumables.

I do not want to get into a discussion as to the merits of this monetary system.  It is our system.  There is no use fighting it.  When its time comes, I am quite sure it will be replaced.  Maybe its replacement will change the investing rules – maybe not.  But for now it is still our system.

For our purposes here, we need only recognize that banks loan a great deal more than the money they hold on deposit.  We also need to recognize how the money is created through the act of borrowing because through this knowledge we can understand the effects of this system on asset value.

 

Inflation as a Monetary Phenomenon

Economic theory is consistent in the theory of adequate money supply.  That is, in any economic system, there needs to be an adequate supply of money to facilitate commerce.  This liquidity is necessary so trade within the economy can continue as quickly as needed.

When the amount of currency is consistent with the amount of production within the economy, we can conclude the value of any given unit of currency is stable.  Most economists, particularly those with an Austrian school background, view an inordinate increase in money supply as inflation, a sort of “stealth tax” levied on the purchasing power of the entire currency.  They regard inflation as a wealth transfer mechanism moving wealth from the productive class to the ruling class.

Although many view inflation as an economic phenomena caused by fluctuations of supply and demand, Austrians scoff at this view.  According to them, inflation can be caused ONLY by a disproportionate increase in money supply.  They argue if true supply and demand relationships were unaffected by governmental monetary policy (in other words, over printing of money), the price structure of almost any commodity would decrease due to better manufacturing, more efficient distribution, etc.

Regardless, inflation exists and it is important to understand this when investing your money.  High inflationary numbers are made possible by fiat currency and the creation of currency through debt.

The Effect

In a previous post, we discussed the idea of credit-based money.  And you will also remember fiat currency has no commodity backing.  However, please note that under a commodity standard 10% reserves (gold and/silver) was perceived ample stability since the currency was backed by real value and the money was already accepted in commerce.

The original Federal Reserve Notes were no exception to this commodity backing.  The notes were originally backed by gold.  In 1933 President Roosevelt in a declaration of national emergency confiscated the People’s gold.  He then set the price and supposedly put the Nation’s gold in safekeeping.  As a result of that transaction, Federal Reserve notes were no longer redeemable in gold or silver to citizens.

Foreign governments however still maintained this right until 1971 when a perceived overprinting of money for various Federal purposes (i.e. “guns and butter” and the Great Society) caused downward pressure on US dollar.  As a result, other nations, most notably France, demanded gold as payment for their US Dollar reserves.  Faced with a potential currency crisis, President Nixon refused to redeem dollars for gold and thereby “closed the gold window” for everyone including foreign nations. (See The End of Dollar Hegemony, Congressman Ron Paul’s (R-TX) testimony before the House of Representatives describing the history of Federal Reserve Notes).

Nixon’s closing of the gold window was the final step in removing any tangible value from the US dollar.  And if the power structure showed restraint in plundering the purchasing power of the dollar, no one might have noticed.  Instead, many people did notice and a decade-long bull market in precious metals and interest rates ensued.

Of course, I am painting broad strokes here but the point is that commodity money had become fiat money.  This changed the fundamental characteristics of the currency.  Had you been around at that time, and understood what was going on, you would have known what came next:  inflation across both consumer items and assets.

The reason these points are important is because by removing any tangible value from a unit of currency, the purchasing power of this unit was at the mercy of those in charge of printing it.  The result was an enormous increase in federal spending and subsequently an increase in central government.  And while many citizens gain benefit from the spending, the bill still must be paid. The payment comes from everybody’s pocket and in the form of inflation.

 Calculating Inflation

There are differing opinions on how to define inflation.  Austrian economic thought says that inflation is an increase in the money supply in disproportion to the increase in production.  Others define inflation as an increase in the general price level in the economy.  Regardless of the definition, there are different ways to calculate inflation.  Let us explore some of these below.

Consumer Price Index (CPI)

According to the US Department of Labor (DOL), “The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.”

So the purpose is to track a change in price either higher or lower.[1]  In most instances, and for the reasons set forth above, prices generally trend higher.  Accordingly, for most people, the CPI Index is largely used to measure inflation.  Even the Federal Government, when adjusting benefits payments, uses the CPI in calculating the adjustments. Here is the link to the FAQ page on the CPI website.

The index measurement is derived from “urban” prices for a specified basket of goods and services.  The basket includes the following:

  • FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
  • HOUSING (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture)
  • APPAREL (men’s shirts and sweaters, women’s dresses, jewelry)
  • TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
  • MEDICAL CARE (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
  • RECREATION (televisions, pets and pet products, sports equipment, admissions);
  • EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
  • OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Recently, the Federal Government has been using the “Core CPI” which excludes, or at least limits the use of energy and food prices in the calculation.  The reason for this is sketchy, at best.  The argument states the prices for food and energy are too volatile to give an accurate measure in price increases.  Because rapid price fluctuations may occur because of trading or other economic conditions, these items are minimized in their use.

However, the price of everything depends on energy.  And everyone must also eat (also energy).  So to exclude a line item in the cost of everything is suspect.  I can imagine multiple scenarios as to why the Feds shy away from the truth.  Government statistics have unfortunately become poor indicators of true economic conditions.

Money Supply

If we define inflation as an increase in the supply of the currency without a commensurate increase in economic production, then perhaps a look at the broad money supply as compared to the Gross Domestic Product (GDP) could lend a helpful hand in our quest to track inflation.

M3 was the broadest supply measure given by the FED (no longer reported).  Other measures include:

  • M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.
  • M1: M0 – those portions of M0 held as reserves or vault cash + the amount in demand accounts (“checking” or “current” accounts).
  • M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000).

Using the various series in comparison to the GDP can give a somewhat accurate picture of inflation.  Economagic.com offers a chart series entitled Velocity of Circulation.  This chart measures inflation by dividing the broadest money supply figures by the GDP.

Gold

Gold bugs everywhere think of gold and silver as monetary metals.  Since gold and silver were the primary backing for every successful currency throughout history AND every fiat currency has historically failed, gold enthusiasts say the best measure of inflation is the metal’s price.

I agree that the gold standard is a safeguard against inflation.  However, tracking inflation against the currency being inflated is ineffective.  I refer you to the chart below (courtesy of Kitco.com).  If gold were a true indicator of inflation, the price would probably look a great deal like the CPI line graph shown previously.  Instead notice the up and down action in the price of gold over the last several decades.

Chart of Gold Price

You can see the price explosion a couple of years after President Nixon closed the gold window.  But also notice the approximately 45% retracement which occurred since 2011.  The gold price in dollars does little to help us in our quest to measure inflation because of this volatility.

The Postage Stamp

My favorite method of calculating inflation, although perhaps not the most accurate, is to use the price of the postage stamp.  This is because the price of a stamp includes the price of energy.  However, arguments can be made that government enterprises are not efficient and therefore to measure inflation this way gives only a vague idea of inflation.  Of course, you could say any individual item would be a poor choice since things like supply/demand dynamics or governmental waste are always in play.  And I would agree.  I suspect that is the reason why the CPI tracks a basket of items.

I maintain that to understand inflation, you must see the purchasing power of the currency deteriorate.  With that in mind, the US Postage Stamp is as good an inflation indication as any other.  So let’s take a look.

You can see the deterioration of the US Dollar in this graph.  Notice the rapid increase in price after Nixon closed the gold window in the early 1970’s.

Overall, if the government agencies were in the business of telling the truth, I would just assume use the CPI.  I have my doubts however, that is why I use all of the above to get a “feel” for our inflationary climate.

 

Economic Imbalance, Waste and Bubbles – The Result of Monetary Policy

As we can see, inflation erodes the purchasing power of each unit of currency.  However measured, you also must understand how governmental policy effects money.

Money has always been the primary concern of governments.  Modern sovereigns are no exception.  When the supply of money is not commodity backed, social programs such as Medicare, Medicaid, unemployment insurance, welfare, and many others are possible.  And it is easy to see how it comes about.

Someone stands up and shouts, we should do something about drugs, crime, terrorism, health care, global warming, or just fill in the blank.  The government entity appoints a commission to conduct a study on the problem and make recommendations.  The commission studies and finds there is, in fact, a problem and makes recommendations.  The government then contracts with a third party to see through the recommendations, paid with borrowed funds or taxpayer money, or both.  Often time the commission and the contractors are the same people, appointed as “experts” in the field, so they are given the contract.  Many a connected person has generated a fortune in this manner.  It is just too difficult to resist.

Arguably the above scenario is played out thousands of times.  Not only is the overpricing of goods and/or services wasteful but worse, the money cannot be allocated to other productive ventures.  Yet the price must still ultimately be paid.  And that price is inflation.

Bubbles

Another result of monetary policy is the financial bubble.  Also known as a speculative bubble or financial mania, a “financial bubble” is characterized by large trade volumes at a price way out of whack with historical intrinsic values.

For example, a share of stock has historically traded at 10 – 20 times its Price to Earning Ratio (P/E Ratio).  In the late 1990’s, many stocks on the NASDAQ traded at 50 times the P/E at tremendous volume.  The average P/E for the SP500 shot above 40.  Current DJIA pricing is out of whack with traditional valuation models as well.

The cause of these bubbles is certainly disputed.  Some “experts” believe it is simply caused by human nature and greed – the nature of men to be overly optimistic in bidding up prices over short periods of time.  Once the mania begins, it generates its own momentum.

I submit to you however, this is just but one factor.  The main factor, in my opinion, is excessive monetary liquidity in the financial system.  By lowering interest rates, thereby increasing borrowing, the Central Bank (FED) causes an influx of liquidity in the system.  The money must find its way somewhere and always does.  The result of this type of monetary policy always results in inflation.  This is the beginning of the bubble.  In my opinion, without this rising of prices, the other explanations do not even come into play.  No one is becoming irrationally exuberant over stagnant prices.

The asset bubble usually features an exponential rise in the pricing in a relatively short period of time.  The drop is almost always as quick as a crash erases relative value.

Now there is good news and there is bad news.  The bad news is that there is a constant eroding of the purchasing power of the currency.  The good news is that this same inflation offers an incredible opportunity to those who recognize inflation and what it does.  We will explore some of these very opportunities in later posts.  For now, let us be sure of the following:

 

  • Fiat money is not backed by anything tangible. It is borrowed into existence and this process is ripe for abuse for people borrow and spend disproportionately creating money before it is warranted by economic production.  The result is inflation.
  • Banking is at the center of the Monetary System because through the banks money is created.
  • Inflation is an economic reality. And creates “asset bubbles” in various markets according to the conditions at the time.
  • A variety of methods exist to calculate the inflation rate. Perhaps a compilation of many different methods gives an accurate “feel” of the inflation rate.
  • Any evaluation of Rate of Return (ROR) must factor in the effects of inflation.

Thank you for your interest, and thanks for listening.

PP

What is Money? – Understanding the Money Game

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.

 

Commodity 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.

 

Monetary Metals

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.

 

Fiat Money

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.

 

Credit Money

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.

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