Before we can solve the problems of the economy, it is important to understand the nature of money. What is it really? Where does it come from? How come there seems to be lots around but I can't get enough? The purpose of this chapter is to demonstrate the nature of money and how it has changed.
Many things, ranging from gold to dead rats to entries on computer hard drives, have been used as money. Therefore, it must be defined by the functions it serves:
1. To act as a medium of exchange.
2. As a standard of value.
3. As a store of wealth.
As a medium of exchange money is simply an item used to make it easy to exchange things. In primitive economies, and in some isolated cases in a complex economy, people barter goods and services. Barter is very inefficient. It requires that one locate someone who wants the particular good one provides, and just by coincidence happens to have available for exchange a particular item one wants. In a modern economy with millions of products it would require an extensive search to locate such a person
However, the use of money as a medium of exchange allows one to split this barter process into two parts. All one has to do is locate a person who wants one's particular good, receive money in exchange for it, and then locate another person who has available the good one wants and who is willing to take money in payment for it.
As a standard of value or unit of account, economic values are usually expressed in terms of money. This standard-of-value function is important because a modern economy requires numerous comparisons of values. It is convenient to use the same item both as a medium of exchange and as a standard of value, and modern money normally fulfills both roles.
As a store of wealth, money is quite handy. This is not an exclusive function of money, but while money itself has no intrinsic value, it has certain advantages as a store of wealth. Unlike other forms of wealth, it has no transaction costs. Someone who decides to hold wealth in, for example, corporate stock has to undergo a certain amount of trouble and cost, the broker's commission in this case. First to buy stock and then to sell it again in order to buy another item. All of these costs and inconveniences can be avoided by holding one's wealth in the form of money. Economists term this ease of using money, as opposed to other forms of wealth, as "Medium of Exchange Liquidity".
What is money? Dollars, Marks, Yen, Francs, etc. are essentially points awarded to you by society for being useful or having something useful to sell. Having these points themselves is not wealth and does not directly create wealth. The economy of our society is based on trade, usually exchange of goods and services for money. A dollar or any other unit of currency in your pocket or bank account is merely a way of expressing that society owes you certain amount of goods or services that you receive when you care to pass these currency units onto someone else. No one person or agency determines exactly how much goods and services a dollar is worth. This is set, in most cases, by the invisible hand of supply and demand.
Gold is no longer money since the value of gold is expressed in dollars and not the reverse. Gold is merely a commodity that is only worth whatever someone is willing to pay for it in some currency unit or other. Ever since fractional reserve banking started and the introduction of fiat money, dollars are not expressed in amounts of gold. Gold has become irrelevant and has no intrinsic value as money. If gold were as common as iron it would be worth less than iron as gold has only a few practical uses.
The value of a dollar depends on the supply of dollars and the more there are, the less each one is worth if supply (of goods and services) is fixed. Through this principle, increasing the dollar supply beyond the increase of growth in actual wealth in the economy causes something called inflation(1) and in some ways a little bit of inflation is a good thing though too much inflation is bad. A small amount of inflation makes you invest or spend your dollars, keeping them in circulation rather than letting them pile up unused and depreciating.
The more useful your goods or services are to society, the more points, currency units or dollars you are awarded.(2) Since most of us exchange only our labour for money, the overall desire for this labour is never as great as we like and most of us want to make more points or dollars. However, even if you accumulate plenty of points, you are not wealthy.
You only have wealth if you exchange your points or dollars for goods, services or revenue producing assets (investments)(3). This is the crux of the matter. We are only wealthy in goods and services by the action of exchanging money. Holding it is only potential wealth. The faster the money circulates the wealthier we all are. Economists call the number of times a given unit of money changes hands each year "The Velocity of Money". Recessions occur not because there is insufficient money (currency and bank deposits are over $200 billion) but because the circulation or velocity slows down.
Why does the circulation of money slow down? There are several reasons. One is that the demand for goods and services by the public declines. One may feel that this should not occur as we can all think of lots of things on which to spend money and our industries have been particularly ingenious in making sure the stores are full of neat things to buy.
Demand goes down when people's disposable income drops. This can also occur when income rises slower than the rate of inflation. In Canada, disposable income dropped in the 1980s for two main reasons. The cost of housing and the amount paid in taxes increased faster than people's incomes. Actually, this was not just limited to the 1980s. It started in the 1960s. The effect was not noticed until the late 1980's. The velocity of money also drops when workers have been put in fear of losing their jobs. That describes almost every worker in Canada in 1990's. When your job may be eliminated any time and job security is considered a thing of the past, you are not going to spend as freely no matter how well the stores do their marketing. Demand stagnates.
This brings us back to money. We need money to get the goods and services required to live and the economy uses money to act as the lubricant to measure the amount of goods and services each of us deserves for the value of work they contribute to the economy. You may not agree that a professional athlete may be worth millions but someone who has accumulated a whole lot of dollars thinks so. In a market economy, it counts as a valid contribution to society if someone is willing to pay give that kind of dollars for the work. Remember the new golden rule: "Those who control the gold make the rules".
Remember that wealth is more accurately measured by counting the amount of money you can get to pass through your hands and not the amount you have on hand now or even the amount you own.
It is convenient to classify the numerous moneys that exist into three types. One is full-bodied commodity money. Money that has a value as a commodity (gold or silver, for instance) fully equal to its value as money. Because coins can be awkward to carry, representative full-bodied money was developed, which consists of paper money that is freely convertible into full-bodied money. Neither of these types of money, however, now exists in most of the world. This occurred when Richard Nixon took the USA off the gold standard in the early 1970s. Almost all money is the world is credit money, or fiat money.
This is money that does not have a value as a commodity equal to its face value and that cannot be exchanged for full-bodied commodity money. It is only worth what people are willing to give for it at the moment.
After all, look at the introduction of the $2.00 coin in Canada. Why are people willing to give goods and services in exchange for this metal disk and not for washers I pick up at the hardware store. Because, someone in higher authority declared the disks made by the government to be money and we are willing to go along with it as money makes conducting business easier. However, society won't give me $2.00 for a washer as I am not a recognized issuing authority. Also, supposedly, there must be some "magical" process that makes government issued metal disks into "money" isn't there. If anyone finds out what this magical process is, please tell us.
One might wonder why people are willing to exchange valuable goods and services for pieces of paper or even sillier, data entries at banks. The answer is that these pieces of paper and data entries are valuable because we know that other people are willing to take them in exchange for their goods. The same is ultimately true of gold. It is considered valuable because we know that other people treat it as valuable. Hence, many of those who advocate a return to the gold standard do so primarily because this would limit the government's ability to create money rather than because of any inherent value attached to gold.
The writer feels that it is primitive thinking that would limit the money supply to the rate we can extract a limited element from the crust of the earth. That's why the writer agrees with Nixon taking the US dollar off the gold standard. The world economy was suffering a "liquidity crises" as the rate gold was being produced did not match the demands for new money created by growing world trade, the costs of the Viet Nam war and the oil crises of 1972. Money is not a tangible thing, but rather a concept.
As economies developed, money was used more and more for ordinary trade and tended to consist of metals. Coins may have been invented in ancient China and reinvented around 700 BC in what is now Turkey. Paper currency was also invented in China, perhaps as early as 300BC. Ancient Babylon had a highly developed monetary system with banks and credit, as did ancient Greece and Rome. However, in early medieval Europe the money economy went into a decline and barter reemerged. During the 9th century, however, Europe started to become monetized again.
One is tempted to try to sketch monetary history as an evolution from a system of concrete objects, such as ounces of precious metals, to more and more abstract units, such as checking deposits. However, this evolutionary explanation is somewhat of an oversimplification. As an example, the stone money used on the Pacific island of Yap was more abstract than modern money because the large stones that served as money could still be used as such even if they had been lost at sea.
Beyond this basic definition, however, there is disagreement. Some economists prefer to define money by its essence, the fact that it is a medium of exchange and is liquid. According to this criterion, money is can be narrowly defined as currency plus chequeable deposits.
On a more practical level, what specific items should be included in money? Since 1980, the US Federal Reserve System defines money as one of the following:
M-1A - currency and checking deposits.
M-1B - M1A plus checkable deposits in savings and loan associations and savings banks and credit unions.
M-2 - M-1B plus savings and time deposits below $100,000, shares in money-market mutual funds, and some other very liquid items.
M-3 - M-2 plus savings and time deposits of more than $100,000 plus a few minor items.
As you can see, only some of M-1A is currency. The rest of the money supply is simply bookkeeping entries on someone's computer. Currency itself is simply a form of marker to indicate a bookkeeping entry in the Bank of Canada's computers. Paper money is merely a coupon not intrinsically worth any more than a coupon for money off a purchase of Tide detergent and issued by Proctor & Gamble(4). The value of the money indicated on a piece of currency is only worth anything as long as confidence is maintained in the dollar and the monetary system. This is aided with the use of massive buildings, conservative names for banks and relatively somber people in the banks. This fools a lot of people but the system was taken for a ride by many of the Savings & Loans Banks in the USA in the 1980s.
Canadian currency is issued by the Bank of Canada but they do this in a passive way. They provide banks with as much currency as banks want, debiting the banks' account with the Bank of Canada Reserve in exchange. A tight monetary policy is never carried out by restricting the quantity of currency because banks must always be provided with enough currency to meet public demand. Instead, the Bank of Canada controls the volume of bank deposits in the banking system. This is done by Bank of Canada purchases and sales of securities, which alter bank reserves. Because banks keep reserves against their deposits, increases in reserves allow banks to increase loans, causing the money supply to increase.
The way this works is that the banking system can create more than one dollar of deposits for every dollar of reserves it has. This is possible because deposits are not physical objects but, only numbers on a hard drive in a computer somewhere. No physical object is moved or created. It is all a matter of accounting. If someone deposits $l,000 in a bank, the bank credits the $l,000 to the depositor's account and then lends most of it out. However, it cannot lend all of it. The law requires that it keep a reserve against the deposit, say l0%. It therefore lends out only $900. The borrower then buys something with this $900, and the seller deposits their $900 cheque in the bank. The bank then keeps $90 as a reserve against this $900 deposit, and lends out $8l0, which then becomes a deposit and so on. Ultimately, all of the original $l,000 is held in reserves in one bank or another. Because reserves are l0% of deposits, total deposits will then be ten times the original deposit, or $l0,000. While this is the theoretical case, the actual multiplier is closer to 2 than to l0. For every $1 held as deposits, the system creates between $2.00 and $10.00 in "new" money.
However, if the original $1,000 was withdrawn from the first bank, only that amount is taken away from the system at first. Eventually, all the other debts are paid, the other funds would tend to go backwards as well but since each back usually has a growing savings base, the money supply will keep on growing. However, don't everyone pay off their debts at the same time. OK!
The point I am trying to make in this chapter is to show that the money supply has absolutely nothing to do with gold reserves or any other intrinsic, immutable law. There is as much money in circulation as the people in charge of the Bank of Canada feel the economy can handle without causing inflation. In addition, their job is to maintain confidence on the dollar so that the system we use of trading dollars for things of value will continue. Both confidence and inflation control require careful monitoring and constant adjustment of the levers they have at their disposal to control the supply. What it comes down to is that money has no intrinsic value.
As a side point here. How come Bill Gates is worth so much money. Who gave him $20 Billion or whatever he is worth this month. The answer is that by and large, he printed it up himself and the money he printed is held in high esteem by some people in New York, that they pegged it at this value in dollars. Howzat again!
Bill Gates owned a big chunk of a private company called Microsoft in the early 1980's. The company at that time did several hundred million of dollars in business a year but Bill Gates shares were worth next to nothing as almost all the profits were plowed back into the business. The shares were worth no more as the company was not for sale. However, some shares were given to employees but these were worth little as they could not be sold except back to Bill. Bill Gates arranged the company so that there were many millions of shares issued and he and his buddy Paul Allen had most of them. Within a privately held company you can issue as many or few shares you like and distribute them as you like between the partners.
However, to reward the loyal employees who were given shares as a reward for too many 90 hour work weeks, there had to be some way to give the shares a value. This was done by releasing a small portion of Microsoft shares to the public stock markets. Normally a share offering is done to raise money. Microsoft did not need to raise money as it has a sufficient profit margin to be self financing.
The small per centage of Microsoft shares that were released were bought by the investment community who prized them very highly as Microsoft makes a ton of money each year. The employees who received shares as a reward could now sell those shares and reap their rewards for their hard work. However, this means that the stock market "values" all the shares held by Bill to be worth as much per share as those being traded. By multiplying the share price by the number of shares Bill Gates and Paul Allen gave themselves, they both became instant billionaires. However, the actual number of shares given to Bill and Paul before the public offering was determined by no other than Bill Gates and Paul Allen.
Where is the money they have. No place. They own shares they printed up themselves(5) which the stock market has valued at a certain amount. Bill Gates does not have any more money than if he never took Microsoft public. He only has his salary and the dividends those shares pay from the profits. He can only cash in his supposed billions if he sells out. However, if he sold out all at once his 23% (in 1997) of Microsoft stock would dilute the market so badly, the price per share would plummet and we believe Bill and Paul are too smart to do that.
The point I am trying to make is that the vast majority of money is merely bytes in cyberspace and we, as a society, are impoverishing ourselves because the hard drives at the banks and the federal government have the wrong combinations of bytes. There is NO inherent shortage of dollars causing us to destroy our social systems. There is no "natural" limit we are hitting against preventing society as a whole to have the things it feels it needs. The problem is a lack of political will to change.
2. This means that Madonna and Jim Carrey are highly valued by society and single mothers are considered of low value by society.
3. No, in spite of what the Honda salesman says, a new Accord is not an investment. An investment is either something that will produce a stream of revenue or something you hope to sell someday for more than what you paid for it now.
4. Since money and coupons are both things that can be traded for good or services, store coupons are basically privately issued currency.
5. They are not even really printed up but are held merely as bytes of data on their stock underwriter's computer. Certificates are available on demand but for most shares, no physical certificates exist. They are printed up on demand.