Money - Intro

November 20, 2011

Money is a funny thing. It can bring tremendous joy or pain. It can set wild expectations, deliver an emotional punch, and make us feel better or worse about ourselves than we ought to.

As I get older, I’ve found myself thinking and learning more about money. I used to not care for it or about it at all. Erasmus, I thought, had it right:

When I get a little money I buy books, and if any is left over, I buy food and clothes.

More recently I’ve started to try to learn more about the concepts of money and economics, which can be deep and complex. This has been mostly abstract and historical; a subject outside of the practical. Now though, I’m married and have a baby on the way, and we want to buy a house. The idea of money is far more practical than it has ever been.

Being so personal right now, I’ve been inclined to think things out, which of course means writing. So what follows is a series of articles about money. There’s nothing new or original here, it’s simply a very high-level amalgam of what I’ve learned. And there’s no better place to start than with some definitions.

What Money Is

Money is actually an incredibly simple concept. It’s a medium to exchange goods and services. That’s it.

Long ago, two parties might have exchanged 4 hens for 2 goats and considered it a fair transaction. Once trade became prevalent enough, they broke this up into two transactions. To do this, they used a third commodity, say copper or silver, as an agreed upon standard and set a price. The hens had a set price and the goats had a set price, and if you wanted either you paid the set price.

The benefit of this was huge. With a direct trade, the fairness considered by both parties only reached as far as the one direct trade. But once you set a price, it’s agreed upon by everyone. So if you want cows instead of goats, you don’t have to renegotiate.. you just pay the set price.

This is actually a fairly fascinating economic concept. The fact that whole societies can universally accept a single standard of trade is phenomenal. Even thieves accept money as a fair standard, and use it prevalently.

Types of Money

There are actually several types of money, and the differences shouldn’t be taken for granted.

The original form of money was commodity money. The fair standard of trade was some agreed upon commodity, whether gold or silver or bags of wheat. This is only barely removed from barter.

Bags of wheat and gold bullion are hard to transport and easy to steal. So representative money was born right along with banks. Representative money “represents” some amount of an underlying commodity. For example, an early bank might have written a note that was redeemable by the bearer for one pound of silver. Instead of having to transfer the silver, the bearer could travel to another bank and safely redeem the silver, or use the note to pay for some goods or service. Banks were invented to hold these forms of money.

The United States had representative money up until 1971. All dollars could be exchanged to the government for silver or gold. After 1971, dollars became backed by “the full faith and credit of the United States government” and became fiat money. Fiat money has no backing by any commodity. It has no direct relationship to the price of gold, silver or anything else. It is mandated by law to be legal tender and its value is only as good as the trust of the entire population that the entire population uses it.

There are some really wild examples of fiat money. One of the craziest is the Rai stones of Yap. Rai stones are 12 feet wide rings scattered about the islands and used to negotiate land and wedding contracts. But the stones never move from where they are, they just sit and ownership passes from one party to another. Some stones are even sitting on the seafloor where they fell off the canoes that transported them! They’re still used as money though.

Fractional Reserves

Fiat money has a lot of implications for the Federal Reserve. The Fed is not a government agency. But it operates to print money on behalf of the US Government and controls the entire flow of new US currency. The direct reason money is cheap right now has its root in the amount of money the Fed has been printing. The money supply is large and so interest rates are low. When the supply of money is restricted and more scarce, the cost of borrowing is higher and interest rates go up.

Another implication is the fractional-reserve banking system we have now with our fiat money. Back when banks held representational money, if a bearer came to you with a bank note for a pound of silver and you didn’t have it, bad things would happen. Today, there is no commodity sitting underneath our money and all banks operate under the idea of fractional reserves. This means they only hold in reserve a small fraction of all the deposits on their books. The rest they lend out to make more money. When you deposit money in your bank, they immediately lend it out to make money for themselves (far more than the small interest you get on your savings account). You have a positive balance and can withdraw money at any time, and the only reason this works is because not everyone wants to withdraw their money at the same time. If they all do try to withdraw money - say because the public perception of the bank is rocky - then you have a bank run. There are lots of laws to protect against this, especially the FDIC which guarantees your deposit with, you guessed it, the full faith and credit of the United States government.

The entire fractional-reserve system is pretty complicated and operates based on the money multiplier principle. The central bank (the Fed in the US) loans money to commercial banks based on certain ratios. The commercial banks then create money to loan out based on their reserve ratios according to the equations deemed prudent by the money multiplier principle. They hold a certain amount of deposits as reserves and loan the rest out to make a profit. So if you have $2,000 in a savings account in the bank, they may only have $100 of it in reserves.

Since 2008 the entire world has been deleveraging - reducing the debt on their books - including (or especially) commercial banks. Before 2008, the banks operated pretty close to the maximum ratio of debt to reserves allowed. Since then, they’ve been maintaining excess assets. This is why people say that “credit has dried up”. It’s much more difficult to get a loan because banks have backed off on their debt/asset ratios.

Debt and Interest

Which brings us to the relatively simple concepts of debt and interest. Back in ancient history when a bank was literally a goldsmith willing to store an amount of gold for a period of time, a bank note for the gold was a form of debt. The goldsmith agreed that the bearer of the note could receive the proper amount of gold sometime in the future. Today, the exact opposite is far more frequent. A bank takes its deposits, according to the money multiplier principle, and distributes them to customers looking for a loan. The person accepting the loan agrees to pay the debt back, along with an interest charge. The interest is simply the profit on the transaction, based on the cost and risk to the bank.

Bonds and loans are really no different. When you take a loan out for a car, you’re agreeing to pay the bank back the debt plus the interest agreed upon in the contract. This is calculated with an amortization table, which is just a fancy way of stating the calculation of the debt and interest payments over time. When you take out a bond, you’re actually giving someone else a loan and they’re agreeing to pay you back. The only difference is that in both cases, the other party is the one setting the interest rate, which is the profit that either they or you make from the transaction.

Credit cards are just another form of debt. Where a car loan might hold the value of the car as collateral against the risk that the loan isn’t paid, a credit card has no asset to back it up. A credit card is really an agreement against the “full faith and credit of YOU” to pay it off, just like the government guarantees all our money with their full faith and credit. Keep this in mind when you use your credit card, your reputation is on the line.

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