Wednesday, July 2, 2008

What is money? Do you know?

What is money? You might say, "it's a medium of exchange" and it is that, but it's begging the question... what is a medium of exchange? So what is money? Is it power? Is it the root of all evil? Is it "legal tender for all debts public and private"? Is it gold? Is it a representation of land? Is it a representation of labor? What exactly is money?

Here is a great video which breaks down the origins and nature of money in a simple, entertaining way. I had not really grasped just how enmired in debt our monetary system is until I watched this video.

I will note a few mistakes I think the video makes. First, the author suggests that returning to gold as money cannot be the solution because the supply of gold is too fixed and it would leave only those currently holding gold (a tiny minority of the population) with any money. I think that gold has to be money because every other candidate (including the ones he mentions in the video, such as LETS) ultimately rests in the good will of the currency issuer and is, therefore, subject to counterfeit. It is impossible to really counterfeit gold (though it is always possible to swindle people), but it is always possible to counterfeit a fiat currency - by those issuing the currency expanding it. At most, the value of gold in a free market is subject to tiny fluctuations as a consequence of variations in mining prospects and the occasional surprise massive treasure find.

Second, his proposed solutions to the problems created by the Federal Reserve (fully nationalized banking systems) already exist in other nations and create exactly the same problem: inflationary money. The reason that the author is incorrect on both the first point (gold cannot be money) and the second point (nationalizing the banking system will solve the problem) is simple: any fiat monetary system, no matter how organized, ultimately rests in the goodwill of the fiat money issuer. Since people and organizations, on balance, act more in their own interest than in the interest of others, inflation (counterfeiting) is the inevitable result of any fiat money system.

Third, the author suggests that usury (interest) is the root problem, but this is also mistaken. You cannot have credit without interest and it is beyond coincidence that the explosion of industrialization in the 18th century occurred contemporaneously with the cultural normalization of interest at around the same time. If you have a boatload of (real) money not doing anything useful, and I have a great business idea or technological which I can't implement or develop because I don't have money, we can advantageously trade with one another. But, clearly, that will never happen if you have no prospects of earning some money on the risk you're taking by lending your money to me. This is the fatal flaw of Islamic banking (though they have some interesting ways of working around it...)

As for the arithmetical problem the author notes (I/(P+I) people must default on loans if there is a strictly conserved money supply where P is the principal and I is the interest on loans), it is not a problem. Storing value in money is just one of the many uses each individual in an economy can make of their wealth. The incentive to store value in money is dictated by the price of credit. That is, if banks are paying 1% on savings deposits but I can build widgets with my wealth and sell them for 10% profit, I will do the latter. If however, banks are paying 15% on savings deposits, I may consider depositing my wealth at the bank instead. The variability in the percentage rate banks are willing to pay depositors is directly proportional to the percentage rate creditors are willing to pay banks for loans, which in turn reflects the overall demand for capital. By allowing lenders to earn interest (and allowing bankers to earn interest by providing an economy of scale), capital itself can flow to its most valued uses, whether making widgets, building factories or hiding under mattresses.

Fourth, the author expresses concern that if usury is permitted, the lenders will end up owning everything. This is not a problem where all free people are permitted to hold wealth (gold, real money) in deposit at non-inflationary banks, since everyone benefits from the process of credit creation - borrowers and lenders (depositors). That is, an honest banking and credit system results in exactly what the author says, "... all the people have to share the interest." Depositors benefit from the bank's extension of bulk credit in proportion to the size of their deposit, just like a stock investor benefits from his stocks in proportion to the number of shares he holds. Bankers benefit from the profits they can earn by providing an economy of scale in lending (combining many small deposits to make large capital investments.) And creditors benefit by expanding their profit opportunities through financing new ideas.

The money never "runs out" and never ends up in the hands of one person as a consequence of interest for the same reason money doesn't "run out" or end up in the hands of one person as a consequence of businesses making profit between the price they paid for something and the price they sell something - the interest charged on loans by lenders is just competing with other alternative uses to which potential borrowers could put their money. Prices in terms of honest money should be continually falling* (effectively earning interest even on wealth stuffed under the mattress) as a consequence of economic progress. Overall, profits and the charging of interest (usury) result in a constant decrease in the demand for money (and/or an increase in the demand for goods and services, which is the same thing) because less money is required to purchase the same goods and services as prices fall as a consequence of economic progress.

In fact, we could say that the "L-curve" wealth distribution, where a tiny minority of individuals control the vast majority of the world's wealth, is exactly the symptom of cartelization, monopolization and nationalization of the banking industry. In an honest banking system, bankers have no special benefits except insomuch as they can attract depositors to increase the available pool of bulk credit which they may loan out (economy of scale) - which is exactly what bankers should get paid for. What our system effectively does is legalize counterfeiting by the government and banking industry (a point that the author of the video does not bring through clearly enough). It is counterfeiting, not usury, which is the culprit. Debt just happens to be the means by which governments and bankers today get away with legalized counterfeiting.

It should be obvious why an economy based on a currency controlled by a counterfeiting monopolist (the Federal Reserve or national central bank) results in an L-curve wealth distribution. As the counterfeiter runs the counterfeiting presses (or "creates money from debt" ala the video), he dilutes the value of all holders of his currency. This has the effect of surreptitiously "sucking" the money out of the hands of everyone and into the hands of the counterfeiter. Those individuals and businesses most closely associated with the counterfeiter then benefit from the fountain of stolen wealth which pours out from the counterfeiting operation. A national bank is no less susceptible to this problem than the private Federal Reserve. The problem with the Federal Reserve is not that it's "private" but that it's a fiat currency monopoly with the power to legally counterfeit.

I suspect that any economic system will result in the characteristic negative exponential curve that economists find in all developed countries. What legalizing a currency monopoly with the power to counterfeit does is to increase the sharpness of that curve.

Please watch the video (at least the first half, though the whole thing is pretty good). Here is a more scholarly, though less entertaining, presentation of some of the same concepts.

*This is probably offset by the increase in population, as when there are more people there is an increased demand for money even as economic progress results in decreased demand for money. Economist Steven Landsburg argues in his book, More Sex is Safer Sex, that population growth is the direct consequence of economic progress (and vice-versa) If that is true, then there may be a relationship between the decreased demand for money (economic progress) and the likelihood of childbirth (population growth). Overall, however, I think there still has to be a net drop in real prices if economic progress is more rapid than population growth (and, so far, it is) since for there to be more, wealthier people with a strictly conserved money supply implies that prices for goods and services must be lower.

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