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Two Characteristics of Money

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Two Characteristics of Money

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This is the first of a couple of posts which will be directly related.

What is money anyway?

Money by itself is fundamentally useless as a true asset. Its value is the result of a societal construct. An asset is something that has value to the holder, and the funny thing with money is that it only has value in exchange – in getting rid of it, in swapping it for something else. A pile of dollars on an island is worthless by itself, it is only valuable if you can exchange if for, for example a boat to get off an island. Given the choice, it would be rational to choose to have a cheap rowboat with you if you get stuck on an island rather than 1mm in cash. Productivity is the key to value.

Cash is a negative carry asset that one temporarily holds – while it (slowly) consumes value – until its purchasing power has been swapped to either consume something or to purchase a productive asset.

Although money is an asset, it is really a sub-category that I would like to call a transient asset – it is a temporary hold of value during the transition to either another (productive) asset or to consumption. Because of its negative carry aspect society should have enough of it around to enable transactions with a reasonable buffer – but no more than that because money will just eat up more and more of your economic, real, production. To read more about it you may want to check out this post.

Where does money come from?

Exogenous money vs Endogenous money (not in the MMT sense)

Exogenous Money

Commodity moneys were – and still are – external to the productive engine of the economic system. Gold/silver etc. were used as money but were not really representative of economic activity. No matter how hard you work, smart you are, your efforts won’t create gold or silver(exception made for transmuting elements in a high energy collider of course). The most it can do is to create something – a good or a service – which then is purchased / exchanged for gold or silver that you can accumulate, but keep in mind that acquisition and accumulation are very different from creation. In that sense commodity money in those times was exogenous to the economy.

To make a long story short – physical gold/silver was eventually replaced by receipts for said gold and silver, which then in turn were replaced by notes against the holder of these precious metals. That did not work too well because it was very tempting to issue more and more notes against a fixed quantity of gold/silver, leading to all kinds of problems.  The agreement of Bretton Woods once again officially tied gold to the dollar at a fixed exchange rate but it also tied the dollar to other currencies. A short 27 years later however Nixon got the US effectively off the gold standard and officially floated the dollar, and thereby the rest of the world’s currencies as well. (As an aside, Nixon suspended the convertibility of dollars into gold, he did not stop it permanently).

The problems stemming from the connection of currency to commodities (gold/silver) can be broadly put in two categories. First, humans cheat. They print more currency while the amount of gold in the safe is unchanged without informing the users of the money, in order to enrich themselves.

The second problem is less obvious but much more important. The quantity of gold and silver in a vault somewhere has virtually no relationship to the productivity of an economy. For any individual participant that may not appear to be the case – the more widgets you sell (for gold) the more gold you will have, but for an economy as a whole it doesn’t work.

If the global economy is very productive and wants to sell its production while the quantity of gold remains roughly the same, or the mined quantity increases at a rate slower than the rate at which the economy is growing, distortions in price levels (expressed in gold) will occur. The supply constrained nature of precious metals is out of sync with economic demands for currency.

When the economy grows faster than the stock of gold there is only one way to meet the demand for currency and that is to tie more currency units to any unit of gold – i.e. increase the price of gold, or, to look at it from gold’s point of view, devalue the currency. These changes in exchange ratios between currency and gold however are not indicative of an economy in trouble. Quite the opposite actually. For an economy that is growing, and that requires more and more cash for various purposes, gold/silver will need to go up in price because the quantity of gold/silver is constant, but the number of dollars required in the economy keeps going up. Gold’s increase in price in a gold/silver based monetary system then is the sign of a healthy economy, not one that is in distress. Economic activity however neither, or barely, creates nor destroys gold/silver. These metals exists regardless, and outside, of economic activity. In other words, the quantity of commodity money is independent of the size and activity level of the economy in which it is used as money.

So, from a consolidated balance sheet point of view, gold/silver, or any counterparty free currency for that matter, exist IN ADDITION to other – productive – assets on the combined balance sheet of society.

Endogenous Money

In modern economies money is created through credit creation so it is endogenous. Under this system for every dollar created there must be a corresponding liability, and this is fundamentally different from a system where the supply of money is exogenous.

Money is created through the issuance of loans. Using the word “loan” to describe how a commercial bank creates deposits is an incorrect way to describe the transaction which creates money. “Loan” in this context is a holdover from the commodity money days. When you borrow money from your colleague in the office this is what happens: she gives you 10 bucks (and the IOU you scribbled on a napkin is an asset to her) and you owe her 10 bucks (a liability to you).  This is a true loan – you have a liability, and your co-worker has an asset. If you don’t repay the 10 bucks you owe her, she has a real loss because she cannot replace it and spend it on whatever she may want to buy.

If this is how banks I the old days made actual loans, similar to what happens when you borrow 10 bucks from your colleague in the office – the following would happen:

You go to a bank with an asset – say a house – worth $100,000. The bank would then put a lien on the house (so you can’t sell it without first repaying your debt and so the rest of the world knows that there is a loan on this particular property). The bank would then take 80,000 of its own money, its  equity capital, and give it to you to be repaid on a later date.

But this is what happens in reality:

You go to a bank with an asset – say the same house – worth 100,000. The bank would then put a lien on the house (so you can’t sell it without first repaying your debt and so the rest of the world knows that there is a loan on this particular property). The bank records an asset on the books for 80,000 the IOU you signed) and at the same time records the deposit in your account as a liability. That deposit comes out of nowhere – it is literally just a bookkeeping (debit an asset account for the 80k IOU and credit the customer’s checking account for 80k) but the bank’s equity account is untouched.

What the bank in effect did was to liquify an otherwise illiquid asset (your house) and turned it into a very liquid deposit that you can spend on anything, anytime. On a macro level not much has changed – although the bank created 80,000 out of nothing, it took 100,000 of free collateral out of the free collateral pool so no value was created or destroyed.  The only thing that happened is that something valuable was -partially – liquified.

In a modern monetary system only commercial banks are allowed to liquify assets – to convert illiquid IOUs into deposits (which are liquid IOUs of the bank).

If banks were only allowed to make actual loans, in the sense of how you borrow money from your co-worker, the system would run out of money the moment the asset account of the bank was depleted – even if there was a gargantuan pool of assets which do not have liens against them in existence.

To recap, commercial banks’ money creation occurs in the liquification business, not the lending business. In addition no money could be created and we would be stuck with a fixed quantity of money which would be no different from trying your monetary units to gold/silver/crypto. On a consolidated balance sheet money which has been created through the liquification of assets then is IN PLACE of the illiquid assets, not in addition to, as is the case when a society uses exogenous money. I’ll explore some of the consequences of those differences in a future post.

All the resources and work that go into producing exogenous money like gold or crypto have no utility or productive output aside from the gold/crypto that the labor and resources created. Credit money on the other hand is created at close to zero cost – credit money creation requires very few resources – and is created by providing credit against assets which have utility for society.

Both types of money though experience negative carry on an ongoing basis so the point made in an earlier post, that society should have as little money floating around as possible, still holds.

As an aside, counterparty-free assets like crypto currency – at least in it’s current form – are also exogenous to the monetary system and are not, and cannot be, created through the liquification of illiquid assets. As such they are not good candidates to function as money because they are not a reflection, or connected, to the real economy where goods and services are created and consumed.

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