Tuesday, July 27, 2010

Creating Money

In the days of commodity money such as gold, the only ways to create more money were either to mine it, convert it from other uses, trade for it (that is to export more than you import) or steal it. The Conquistadors very successfully used the last method to increase the money stock of Spain. In fact they were so successful that the resultant increase in the money supply is thought by some (incorrectly IMHO) to have caused high inflation which wrecked the Spanish economy.

There are 3 main ways that fiat money is created: by Governments literally printing cash, via a process now known as ‘quantitative easing’ and by banks by a process known as fractional reserve banking. It is also possible to add to the money supply by exporting more than you import but it's quite complex and this is meant to be a simple examination of money.

Pretty much all Governments print more cash than they destroy because as the output of an economy rises, more money is required to buy those things. Sometimes Governments get a little carried away and print too much and the outcome of that can be seen in the monetary experiment in Zimbabwe.

From Zimbabwe we can see that more money chasing the same number of goods and services leads to the goods and services becoming more expensive. The Zanu PF Government was apparently hoping that printing money would lead to more output, the logic being that total money divided by prices equals output so if you free the money stock to expand, you free output to expand if you can keep prices the same by making price rises illegal.

I think it’s reasonable to say that experiment has failed.

Another way Governments can increase the amount of money in the economy is by a process known as quantitative easing (QE).

When output is falling, Central Banks often cut interest rates to try to stimulate people and businesses to borrow to consume and invest. At certain times, that doesn’t work either because interest rates are so low they can’t be cut further or because banks simply don’t have the money to lend, perhaps because they have lost money elsewhere on bad loans or other investments.

In this case, the Central Bank might resort to QE. The mechanism is fairly simple. The Central Bank creates money, usually electronically rather than by physically printing notes but it amounts to the same thing. The Central Bank then uses that money to buy up Government or other debt in the market. That has 2 impacts. Firstly by selling debt, the banks have more cash which they are able to lend. Secondly by increasing the demand for debt, its price rises. The price of debt rising is the same as interest rates falling so it makes borrowing cheaper.

The last way fiat money is created is via the banking system and a process known as fractional banking. I will cover this in the next article mostly because it's a bit mathematical and people sometimes find that intimidating. Also it stands alone as a topic quite nicely.

Monday, July 26, 2010

What is money?

Well I promised I’d do a series on the money supply so here it is at long last. I hope you enjoy it. I’ve split it into 4 sections to make reading easier. As I’m still working on the others, albeit they’re almost done, I’ll post them one-by-one. I’ll start by discussing what money is, what it was and what it needs to do for us.

Money serves 3 functions:

  1. A ‘medium of exchange’, ie you can swap it for other things
  2. A ‘store of wealth’, ie you can save it up to buy stuff with in the future.
  3. A unit of account, that is a standard yardstick to measure transactions, debts and values

So why is it good to have a medium of exchange? I work as a banker and I’m starting to get a little hungry; pretty soon I’ll want to get some lunch. If I was going to barter my services I’d have to go round the local noodle joints until I found someone who needed a little banking doing and then swap that for some lunch. That would take time and effort on my part, time I could be using to do productive work….or surfing the net at my employers’ expense of course.

Instead of that, I can use money as a standardized way across the economy to exchange people’s labour and property for other things. Using money I can compare prices quickly and simply and I can buy from who I want rather than being forced to use the person who happens to want what I have to sell. I sell my labour to my boss in return for money which I can then spend.

What about the store of wealth bit then? I want to take the wife and kids away to the Gold Coast in October. Under a barter system, I’d have to work my way up there as an itinerant banker, offering banking services to people on the way. I might be able to get food by telling humorous banking anecdotes in restaurants (perhaps not on reflection). With a system of money, I can put a little away from each paycheck and store up wealth which I can then exchange for my holiday essentials: petrol, meals, hotel rooms, budgie smugglers and cold beer.

‘A unit of account’ means that it is a standardized way to measure transactions. All money in a system must be easily exchanged for other money in the system and divisible without loss of value, for example a pound coin can be swapped for 2 50pence coins and those 2 50 pence coins back to another quid. As an addition to that, money is helpful as a standardized way to settle a debt. If agree to sell you a car on credit, with a barter system I may agree to receive a tonne of wheat. What if the wheat is of poor quality? It complicates things. However, as all money is the same or ‘fungible’, it doesn’t matter which particular bank note or coin you use to repay me.

Many things have been used as money in the past: cigarettes and phone cards are commonly used in prisons as money (or so I am led to believe); the shekel, now the name of the Israeli currency, was a unit of weight (typically for barley); and precious metals were used through much of the world at times.

In time, the direct use of precious metals gave way in the UK to paper money. A bank would hold some gold for someone in its vaults and issue a receipt for that gold. If the receipt was brought to the bank it could be exchanged for the gold so it became possible to use the receipt as a medium of exchange rather than the gold itself.

In time, banks realized that most of the time they wouldn’t be asked for more than a fraction of the money in their vaults to be returned. This meant that for each unit of gold lodged with them, several units of money could be issued. The biggest problem is that under the fractional reserve banking system, banks can have liabilities to their savers that exceed the cash assets held in the vaults. If everyone wants their money back at once, a so-called run on the bank, the bank can’t do it and will go bust. Fractional reserve banking is also a way to produce money from ‘thin air’, a topic to which I will return.

Mostly these days, people use a system of ‘fiat money’. Fiat (the Latin word for let it be done) means ‘by decree’ or ‘by order of the authorities’ so fiat money is money that exists by Government diktat. Rather than the money being exchangeable for something physical like gold or silver, it is backed by nothing more than a promise that the money has value because other people will take it in exchange for real goods and services.

Some people believe that all fiat money systems will fail in the end as all failed fiat monetary systems failed in the end! I have my doubts as this seems like a circular argument to me. Then again, the UK has only had the current system of fiat money since the 1930s so it could be seen to be the earlier parts of an experiment.