On Money, Part 3: Where Money Comes From

See Part 1 for a brief, simplified history of money and Part 2 for how money comes to have value.

Now, where does money come from? First, let’s retrace and fill in the ‘family tree’ as it were of money:

  • Direct Barter: Somebody has something – a horse, a sack of grain, a cloak – that you want; you have something he wants –some pigs, a field, a month’s labor. You trade.
  • Indirect Barter: Somebody has something you want, you have something of widely recognized value, such as silver or gold, that he is willing to trade for *for the purpose of other trading*. He will take your silver or gold in trade, because he knows many other people, people who have goods he really wants, will also trade for it.
  • Money: Turns out it is convenient for everybody if the silver and gold (or seashells or cowhides or cigarettes or whatever) are standardized into units – makes trading simpler. So coins are stamped with a stated amount of the stuff of value in them – gold or silver, in this case.
  • Paper bills: but carrying around a lot of gold coins can be risky. So we give the gold to a trusted man who keeps it and defends it for us. He gives us a note saying: I, a trusted person everybody knows, have 100 quizotles of my buddy here’s gold. I’ll hand it over upon request to a respectable person bearing this here note.”
  • State currency: Once many of these banks get set up, it become hard to tell who is who, who can be trusted, if the notes are genuine or counterfeit. So the state steps in and creates its own bank and notes: for florins, guilders, dollars, whatever. Now, the acceptability of currency is backed by the state, which then (in theory) holds all that gold the notes represent.
  • Fiat currency: eventually, all states get bored with having to play the game of promising to hand over the gold or silver upon request, so they stop. This is the state we are in today: paper money is worth what it is worth because the state says so. Or, slightly better, maybe: money has value because we all agree it has value.

Money Printing

We’ve all seen pictures of printing presses cranking out unimaginable numbers of bills. We are witnessing the creation of money! When the government wants more money, they fire up the presses!

Not really. Here’s what really happens:

For a comparatively small percentage of money, the Federal Reserve*, a quasi-private bank system set up by an act of Congress in 1913, can in fact print money (actually, distribute money printed elsewhere, but you get the drift). The Fed, as everyone calls it, is the official ‘lender of last resort’ for all the banks in America. We’ll delve a little into what that means in a future post, maybe.

Back to paper money: just as carrying gold is inconvenient and risky if you carry very much of it, paper currency is awkward in bulk. The Fed holds something approaching $4 trillion. Even if you used only $1,000 bills, there are not enough armored cars in the world to move around even a tiny fraction of that much paper money. So something else is going on.

The Fed holds the US government’s cash, lends money to banks, and holds deposits and reserves (think: savings accounts), but almost none of this is in the form of paper money. Instead, the Fed uses paper agreements just like the early trading banks, wherein one bank transfers to another huge amounts of ‘money’ with nothing, not even paper money, backing it up. The Fed just transfers ownership of, say $100M to Bank A, everybody sees the documents, and, voila! Bank A has $100M more.** Increasingly, the money is electronically transferred.

(I wonder how IT professionals feel about having the wealth of the nation be, essentially, arrangements of bits on electronic media. What could possibly go wrong?)

But the armored cars do roll out of Fed branches with large amounts of freshly-printed paper money. Part of the Fed’s job is to make sure there’s enough paper currency out there for retail sales activity. Paper currency represents at most about 10% of all the ‘money’ out there in the American economy.

Where does the other 90% of what we call money come from? It is created, for the most part, as loans under the ‘fractional reserve’ system. And that is English – bear with me.

Remember how Luigi, a guy everybody trusted, was holding on to your bag of gold florins for you, and how you had a nice note saying so? And how lots of people who knew Luigi (or, more likely, knew Luigi worked for the no-nonsense Medicis, who would make sure he did his job, or else), so that everybody you worked with would accept that note as payment? Well, Luigi and his Medici bosses were also the go-to guys for loans – they certainly had the money. So, banks then as now don’t just hold deposits, they lend money. Since they are lending *your* money, they pay you interest (or used to, at least). The bank makes money by paying you less in interest than they make in interest on the money they lent out.

The whole idea is that you are confident in the bank to hold your money and honor their note, and that you trust them to only lend your money to people they know will repay them, or, if not, that they will make you good. And they cut you a little piece of the action in the form of interest on your deposit.

But how much money to lend do they have? In our simple, naïve way, people might assume: as much as they hold on deposit. Ha! These are Italians! They are nothing if not creative geniuses. Here’s what they did, and every bank since, including your bank, does: they hold, or reserve, only a fraction of the money they lend out.

Here’s how it works: Say my bank is holding 100 guilders for its depositors. I go to the bank to borrow money, say, oh, 100 guilders. The bank checks me out, and decides that I am very likely to pay it back, and so they lend it to me – but, what that means is they issue me a note for 100 guilders. I don’t actually take the gold, because that’s way too much cash to carry about, and everybody will honor the bank’s note – good as gold, it is.

So far so good. Then, the next guy comes in, and he wants to borrow 100 guilders himself. The back checks him out, decides he good for it, and writes him a note, too.

Note the magic: 100 guilders worth of gold is now available to be spent 3 times – by the depositor, and by each of the 2 people who borrowed. If they all head for the market, they have not 100 guilders worth of buying power, but *300* guilders worth, because all the sellers there know and trust the bank. The bank just created 200 guilders in money out of thin air, by issuing notes.

You may be wondering why this isn’t pure insanity. If so, you have both a point and company, but here’s the good news: honest banks want to stay in business, just like any honest business. The way you do that, as a bank, is to be very careful who you lend money to. You keep very careful track of how much risk you’re taking, and insure against that risk in a number of ways. By lending money only to people and businesses you’re very confident will pay you back, and setting aside a prudent amount of money to cover losses, banks have for the most part made this work.***

Let’s tie this all together: We get currency from the Fed, which manages things to make sure there are enough 20s and 5s and quarters and so on available for routine retail commerce. But coins and paper money make up only a small fraction of money – mostly, money is stuff like a line of credit, or a house loan, or a business loan – things where no paper money ever changes hands. This kind of money is created through debt – a bank lending many times as much money as it actually holds in reserves, such as deposits.

In part 2, we described how money gets its value from the things you can buy with it. The total value of all money, following this reasoning, is the total value of all the stuff anyone can buy with it. So the real question is: does the money banks create through lending under a fractional reserve system have value in this sense? And, surprisingly, the answer is Yes.

The bank is very interested in the ability of its borrowers to pay back the money. What they are doing is measuring *value* – the borrower has or has a way to get the money to pay you back. To take a business example: a bank lends a manufacturer a million dollars to upgrade a plant. The bank gets repaid (ideally) when the manufacturer gets the plant up and running and creates things people want to buy! The loan represents some part of the value the manufacturer creates by making valuable stuff. The whole vetting process by which the bank decides who to lend to is, in fact, a surrogate measure of the borrower’s ability to create value. (Sometimes, the value creation seems a couple steps removed, such as lending me money to buy a car, but I have a good track record of creating value – my job. So it’s still value creation.)

Banks lending under fractional reserve are unlikely to create inflation, which happens when the amount of money grows faster (or shrinks slower) that the creation of things of value. By being prudent, their lending practices should mirror pretty precisely the value creation happening out in the world. All that means is that the supply of money created by lending should match pretty well the increase in valuable things being created by us people.

There’s tons more to this, but that’s a fair outline of the beast.

* The history and role of the Fed is way more complicated than just being a paper currency spigot, but that story will have to wait.

** This isn’t really as spooky as it may sound – think of your ownership of a house: you sign the papers, and in 30 short years of nice consistent payments, the house is yours! Chances any paper money changed hands in the deal are close to zero. The closest you might come are personal checks, and even these are fading away in favor of electronic transfers.

*** The other side of the equation: depositors must also be wise and reasonable. The late 19th century financial panics that the Fed was set up to stop were characterized by one or 2 banks really failing, but people in general panicking that their bank might go down, too, which became a self-fulfilling prophesy: no bank at the time could withstand a big enough run, even if they were being responsible in general.

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Author: Joseph Moore

Enough with the smarty-pants Dante quote. Just some opinionated blogger dude.

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