What is Money?
I had an exchange with a commenter in the thread after my post about the Fed. Seems he saw a video (the link is in the thread, I don’t really recommend that anyone waste 47 minutes of their valuable time watching the thing) called ‘Money as Debt’ by Paul Grignon, a Canadian gentleman who is all up in arms about the concept of fiat money, especially of the type known as credit money.
You see, banks are given the right to create money, apparently out of thin air. From an initial deposit of capital with the Fed, the bank can issue loans in an amount ten times as much. So let’s say they deposit $1000 dollars with the Fed – they can then lend out $10,000, effectively creating new money just by putting it into somebody’s account. The borrower can then take that money and buy something with it – a car for example. The seller now has $10,000, and in thought-experiment world, where there’s only one bank, that seller could then deposit the money back in the same bank. Now the bank has $10,000 in depositor money, and they can make new loans with it. Not by multiplying by 10 again, fortunately, but they can lend $9,000 against the $10,000 deposit. That new $9,000 might come back into the bank again and be turned into a loan of $8,100, and so on and so forth until the bank has created about $100,000. This money wasn’t there before, and now it is. Hocus Pocus? No, fractional banking. This is how money is created – well, sorta kinda, but it’s good enough for illustrative purposes.
What Mr. Grignon is worried about is that this money appears to be backed by nothing more than the loans that were made – that it’s nothing more than debt. Which gives me an opportunity to do one of my favorite things in blogging, and that’s to quote Terry Pratchett. This is from his most recent book, ‘Making Money,‘ in which the Hero, Moist Von Lipwig (really), having recently rescued the post office, is given the task of updating the banking system of the Discworld’s most famous city, Ankh Morpork. He’s trying to figure out what gives money its value:
…on a desert island a bag of vegatables is worth more than gold, in the city gold is more valuable than vegetables.
This is a sort of equation, yes? Where’s the value?
It’s in the city itself. The city says: In exchange for that gold, you will have all these things. The city is the magician, the alchemist in reverse. It turns worthless gold into… everything.
How much is Ankh-Morpork worth? Add it all up! The buildings, the streets, the people, the skills, the art in the galleries, the guilds, the laws, the libraries… billions? No. No money would be enough.
The city was one big gold bar. What did you need to back the currency? You just needed the city. The city says a dollar is worth a dollar.
And that, my friends, is exactly the point. All those loans that the bank makes to create that money are accompanied by either collateral or a plain old promise to repay. Those things have real value – even an uncollateralized promise to repay. The borrower is pledging labor, creativity, future income – again, real value – against that loan.
Combine all that with a country that is serious about the rule of law, that has good banking regulators, and has a central monetary authority making sure that the banks don’t overdo – or underdo – the money creation, and you have the basis for money that has real value, even if it isn’t backed by gold like currencies used to be. Of course, a country that runs huge budget and trade deficits may find the value of their curreny dropping, but that’s for another day.
Now, if you want more formal education on money, like its role as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment, try wikipedia. It’s pretty good, and has further links to some textbooks. I just wanted to quote Terry Pratchett – whose books you should buy and read. Now.
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