Monetary theory: everyone’s
favorite dinner topic? Probably not. Monetary theory can seem complicated to a
non-economist, and even when it is understood by parties over dinner, it is
likely to fall into the two most forbidden categories of conversation: religion
and politics. I realize writing this that I am probably a terrible dinner party
guest, an incorrigible lunch time acquaintance, and a downright nuisance at
family functions, because religion and politics is the only thing I really
prefer to talk about. Well, from my perspective it’s philosophy and truth, and
I consider politics merely the game of sociopaths and the morally contemptible,
but we have not the time for such digressions; it’s time to jump into some
monetary theory.
The truth is most people would benefit
greatly from a deeper understanding of what money is, how it works, who
controls it, and what outcomes monetary policy has on their daily lives. They
might be more willing to change the way they spend and invest, how they feel
about political spending, or more willing to see politicians as the slimy,
corrupt, evil psychopathic busybodies most of them are. I’m going to do my best
to shy away from often-used and more often misunderstood concepts like “inflation,”
“deflation,” and “gold standard.” and instead talk about the kind of things
that happen, or may happen, under different sorts of money systems.
What is money?
Above is a very straightforward
video explaining what money is, and also giving a few criticism of the current
American model. I’ll use a much simpler definition to speed things along, but
if you have the time, it’s worth the watch, as well as Shane’s Bogosity series.
Money, quite simply, is anything
that is used as an intermediary of exchange instead of direct barter. It is the
middleman between production of one good or service, and consumption of another.
It allows finer and more graduated division of labor, which increases
efficiency across an entire economy. Without money, you would have to trade
your services directly for other services, limiting your ability to provide
services only to those who had a service you desired, and vice versa. If you were a basket
maker, you could only get your plumbing fixed by a plumber who wanted baskets,
or you would have to invest time and energy learning the skill yourself. With a
system of currency, you can sell your baskets to whoever wants them in exchange
for money, then use that money on whatever you need, either that day or later
on.
This allows a lot more division of
labor, especially as markets become broader. You can specialize in something
very niche, like writing gay erotica or making pants out of hemp, and not worry
about whether or not the owner of the corner store wants to trade you milk and
bread for your novels or pants.
Contrary to common belief, money is not
the root of all evil. It’s just a medium of exchange. It could be anything, as
long as it is commonly accepted in trade, though different things can make
better or worse money. Currency can be a commodity with its own value alternative
value (like gold), a series of hashes, like a bitcoin, or be printed on paper.
It’s nothing magical, and it’s nothing desirable for itself. It’s not wealth;
wealth is things, not money. Money is only useful in helping you turn your
specialized production into the many diverse goods and services (wealth) that
you need and use.
So now, let’s take some time and run through a few different
types of monetary systems, and see what we can expect from an economy using
them. In the examples that follow we will take a few things for granted:
Divisibility- How divisible the money is, meaning how finely
we can chop up the individual units and still find the medium useful, is
important when currency becomes very valuable. With certain modern commodities,
such as gold, lack of divisibility can make the currency unusable by those who
are conducting transactions below the divisibility threshold (the point at
which the currency can no long be divided). We will assume either infinite or
near infinite divisibility of the money.
Counterfeiting- We will assume that counterfeiting is not
present in sufficient enough quantity to make an impact.
Banking systems- We will assume a free banking system,
capable of making high-risk and low-risk loans, using either full or partial
reserve according to market demands.
Condition 1: Static Money Supply
In a static money supply, the total quantity of money,
whether divisible or not, is fixed. This means that no new money can enter the
marketplace, and zero growth of the money supply occurs relative to all other
factors. With this condition, we can expect the following things:
Money increases in value relative to goods and services-
this is because the amount of “stuff” available grows over time, the amount of
producers providing services grows over time (typically), and the demand for
goods and services typically increases over time. There is less money per
person, or per unit of demand, and so money is more valuable relative to
everything else.
Prices generally fall- The inverse to the above, the prices
of goods and services fall over time due to increased and additive production
of goods (the quantity of cars or working TVs, for example), as well as because
economies over time become more efficient at producing goods and services. Capital
improvements such as mechanization cause the production per capita to increase
and thus further drive down prices.
Interest rates vary- Interest rates are variable between a
negative amount (for full reserve banking, which is viable in a static currency
situation) and a high amount depending on risk. Since money increases in value
over time, it may be worth it to a person to pay a bank to keep their money
secure (a negative interest rate) in a full reserve bank, secure that its
buying power will be stable even if they end with less money than they put in. They may accept very low interest rates for
partial reserve systems, or take risks for higher interest rates in capital
investments and bank-proctored loans.
Banking- Banks generally serve consumer demands, since
people can avoid the banking system entirely with no loss of value in their
money.
Is this kind of money possible?- Yes. It could technically
be possible in a fiat system, though highly unlikely given political
machinations, and is the end state of bitcoin’s (a type of electronic crypto-currency)
“soft cap.”
Condition 2: Precious Metal Money.
There are several advantages to the use of precious metals
such as gold and silver as money. First, the money has value besides being
currency, meaning its value is more secure than fiat currency. If the value of
the money as currency falls below its industrial usefulness, the money will be
melted down and used, thus stopping the devaluation. Second, the cost of
extracting the metal from the earth will keep a check on the amount of money
introduced into the economy. If it costs more to mine gold than what you can
get out of it in the market, it won’t be mined. With this condition, we can
expect the following things:
The value of money fluctuates, but is stable over the long
term- Due to the supply checks listed above, the value of money relative to
other things will rise and fall according to the supply, but in the long term,
say over several years, the value of money will be consistent and stable, if
not increasing slightly over time.
Prices fluctuate, but remain stable over the long term- The inverse
of the above, prices will generally stay stable. Producers of currency (miners,
in this case), are motivated to create more money when there is high demand for
it from growing consumer bases, or the price of goods falls due to efficiency,
giving the money new buying power.
Interest rates- Interest rates are generally low to high;
generally higher than a static system. There may be some full reserve systems
due to the easy theft of money metal, but because prices are stable, consumers
may be just as inclined to put their money into high-reserve or low risk
investments over the short term. Investments require even payout or slightly more to
be worthwhile, causing interest rates to be slightly higher than in the static
system, but still variable according to risk.
Banking- Banking is a more attractive option under a metal
standard, partially because of security concerns, but mainly for the divisibility
factor. Since physical gold cannot be divided enough to be used on small-cost
goods such as food or drink (think about trying to buy a soda with 1/1000 of an
ounce of gold), a mixed system would likely emerge, consisting of some physical
gold with a majority of currency being issued as bank-backed notes. The banking
system would, therefore, be more present than in a static system.
Is this kind of money possible? Yes. This was the preferred
standard for economic trade for thousands of years. Unfortunately, once the
government took over the money trade during the 20th century, making
it illegal for banks to print gold notes, the system’s demise through
mismanagement was inevitable.
Condition 3: Monetarist System.
In this proposed system advocated by the great economist
Milton Friedman as an alternative to the actions of the Federal Reserve, the
growth of money would be regulated centrally, and be at a predictable rate each
year, say 3%. This system presupposes either a fiat currency, or total control
over a commodity system. The point is to produce a high degree of market
confidence in the predictability of the money supply, solving the fluctuation problems
associated with a metal standard, and having the additional advantage of
providing alternate utility to the economy the resources that would be invested
in digging metal out of the earth. Under this condition we can expect the
following things:
The value of money is highly stable relative to other
things- ideally the rate of growth would be pegged in such a way to the money
supply at an equilibrium with growing demand, thus making the value of money
stable even over long periods. However, even if the rate is off, and the value
of money increases or decreases, it will be by a fixed, predictable amount.
Prices remain very stable over the short and long term-
Since the money supply is growing, and not fluctuating, it will off-set the
lowering of prices due to increased efficiency and supply, making items like
candy bars cost the same years apart. Some argue this has “consumer confidence”
benefits, allowing people to predict revenue streams better.
Interest rates are moderate to high- Because the money
supply grows over time, and the price of goods remains stable, investors must receive
a better than even return on their money. Usually, the lowest interest rates,
for the safest investments, will be slightly more than the pegged rate of monetary
growth.
Banking- Banking will seem very attractive to savers and
investors under the monetarist system. Since the value of money stays the same
or goes down over time, full reserve systems will be rare or non-existent.
Partial reserve systems with a high reserve rate will seem most attractive for
short-term savings. Savers are motivated to “put their money to work” with
investments to maintain or grow its value over time.
Is this type of system possible? Yes, although it is
unlikely given that it necessitates a central authority to plan monetary growth
and central authorities generally have a terrible track record when it comes to
being trusted not to print money. Depending on who you talk to, monetarism was
tried under the Reagan administration, but this mostly false. Interest rates
were raised and the inflation of the 70s stopped, but a full monetarist system
has never been implemented, nor is it likely to be.
Condition 4: Fiat Money
Fiat money is money, usually printed upon paper or made of
cheap metal coins, that is declared to have value by a central authority. The
current US dollar, and most other world currencies, fit into this category. The
usability of Fiat currency can only be maintained by force. The central
authority makes it illegal to use competing currencies, and declares that
anyone doing a business transaction must accept their fiat money in lieu of
other things. If you look at a US dollar, it will say, “This note is legal
tender for all debts, public and private.” Fiat money is generally the least
appealing to the average consumer, but is the world standard because it is the
most attractive to those in power. There is no need to mine gold, or have
legitimate rates of taxation when you can print up the money you need and force
the population to give you goods and services for it. The government also has
an advantage in not suffering the effects of inflation; since they are the
first ones to spend the money, it has the value of the money before the new
currency enters circulation. Even a totally devalued fiat currency is still
attractive to use by the population, since people must accept cheap money
instead of dear money. The US uses a special variation of fiat currency that we
will get into next. Here is what you can expect from Fiat Money:
Decreasing value of money- Because more money exists every
year (in the vast majority of fiat systems), the value of that money decreases
relative to other things. This can be by a little or a lot, depending on how
much money the government is printing to finance things.
Increasing prices- The inverse of the above, prices
generally increase, even as the economy gets more efficient over time. This can
upset or confuse consumers, who cannot reasonably plan for future expenses, or
who think revenue streams will always increase when they actually may be losing
money to inflation.
High interest rates- Because inflation is high, bonds,
loans, and other investments must promise high rates of return to make up for
value lost to inflation. High risk endeavors become more promising as a means
of recovering lost value.
Banking- Full reserve banking will be non-existent, since
all savers will require a rate of return on their money just to match inflation.
Partial reserve systems will tend toward more risk and lower reserve rates in
order to meet the demands of savers for their returns. Bank failures can
happens swiftly and catastrophically as small reserves can be quickly depleted
by a sudden need for liquidity.
Is this kind of money possible? Possible, yes. Sustainable,
no. Eventually the money printing process will so deface the value of the
currency that it must be revalued, or new currency introduced that is more valuable,
and begin the cycle again. This is the current world standard due to the huge
advantages it gives governments in the political process, but can only be maintained using violence.
Condition 5: Debt Money
This is the monetary system that is currently in use by the
United States, and offers some significant value to the government over other
types of fiat. Under most fiat systems, the government prints new money, then
spends it on goods and services, increasing the money supply (I’ll leave dismantling the
Keynesian argument of the benefits of this for another article). Under the debt
system, all new money enters the economy as loans from the central bank (the
Federal Reserve in the United States), which is owned by the government and has
the power to print money. The government gets a great deal of its money, the
money it would like to spend but taxpayers are unwilling to pay for directly,
by issuing bonds. The vast majority of these are purchased by the central bank
using newly created money. Money has been moved from one hand to the other,
obscuring the inflation spending the government relies on to maintain its size.
In this way, it is little different from a standard fiat system. The extra
advantage (from the government’s perspective) comes from the fact that the
central bank can also make artificially cheap loans to the banks and private
parts of the economy. These entities also benefit from the lack of inflation
that comes with being a first spender, and entices them to support the
continuance of the debt system. Many of these loans actually have a negative
real interest rate, meaning the value of money has gone down enough by the time
they pay it back that they have made money just by taking out the loan. Eventually,
the system can be expanded to include voters, who receive cheap home and auto
debt, among other things. Here is what to expect, and some of the current
conditions of the US economy:
Decreasing value of money- The value of money continues to
go down as more debt is issued, but the value decreases fastest for the
consumer, and the slowest for the government and banks, which are the first
spenders of the new money.
Increasing prices- Prices generally increase, sometimes
enough to entice consumers to purchase things with debt in anticipation of
increased value. This was especially true of the housing boom of the 2000s.
Prices increase slowest for the government and the banks, since they are first
spenders.
Low interest rates- This is very beneficial for banks, who
can acquire loans from the central bank for a very low price and invest the
money accordingly. It is good for the government, since it has to spend little
of tax revenue and new debt to service the interest on old debt. It may be good
for people who acquire a home through debt, since debt will make a smaller
amount of the cost of the home than it otherwise would if inflation were taken
into account. It is, however, very bad for those who wish to save and invest.
Since banks can acquire funds from the central bank very cheaply (often at far
below inflationary rates), they have little incentive to offer savers the high
interest rates that are necessary for them to maintain the value of their
money. At the same time, more people are forced into banking to minimize their loss
due to inflation, even willing to put up with rates far below inflation. Risky
investments are very attractive as a means of maintaining the value of money.
Banking- Full reserve banking is non-existent. Partial
reserve banking is the norm, with less and less held by the bank in reserve,
since the money necessary to pay depositors can be acquired cheaply from the Federal
Reserve. Almost all individuals must use banking systems or lose even more
value on their money.
Is this kind of money possible? Yes, and the United States
has been using it for decades. Lots of people get concerned about the national
debt, but the number really just represents the amount of money that has been
printed to finance the government. This amount of money will never be repaid. This,
of course, amounts to a tax, since subjects lose the value of money they
already have. The sustainability of the system is uncertain at best, but at
some point the value of the currency will become so defaced that it will have
to be re-valued to some degree.
Conclusion
There you have it! Over three thousand words of monetary
theory, as clear as I can explain it. What system do I recommend? Free currency,
of course! This allows the collective marketplace to make all relevant
decisions at the point of sale. Metal, bitcoin, or other currencies all have
their relative advantages, and the marketplace can decide how to use them.
Bitcoin is cheap and transportable for online transactions, gold and gold
certificate for in-person transactions. If one type of currency becomes unfavorable, there
are many competitors to step in and be used instead, leading to true monetary
stability, and above all, economic freedom.
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