News and politics, Pontifications

Financial Crises for Dummies, Part 2: Where does Money Come From?

I had considered making part 2 of this series about the Fed, and its (unconstitutional) control of interest rates, and the monetary system. However, to truly understand our economic and monetary problems, one must first understand what money is, where it comes from, and how it’s created. I’m not talking about the giant printing presses owned by the Federal Reserve, I’m talking about the intrinsic value that your paper dollar conveys when used to purchase goods and services.

In US history, we’ve had two different types of currency: the gold standard (which we departed from in 1971), and our current fiat currency.  Fiat Currency works sort of like your parents’ rules when you were a kid . . . it works because “They said so.”  With a currency that is backed by some tangible good with intrinsic value (gold, silver, etc), the dollar is set at a fixed exchange rate with the unit of the good.  For instance, when we were on the gold standard, one ounce of gold was worth $35.  What happened if the value of Gold went up like it has over the last few years?  The value of our dollar went up.  Which meant that we could buy more with the same amount of money.  If the value of gold went down . . . the same thing happened.  We could buy less with our money.

Then our world changed in 1971, and we went to a fiat currency.  The dollar had value because the government ordered that it be used in monetary transactions.  But with nothing of any real value backing it, it could fluctuate up and down, based on what the market said its value was.  Basically, if a Briton looked at America, and saw our financial systems, corporate power, and strength of our economy, and decided that it didn’t compare favorably to the past, he could say, “Yesterday, I was willing to trade 1 pound for 1 dollar.  But today, if I give you a pound, I want 1.25 dollars instead.”  So, in that way, the international money market determined the value of the currency.

But that’s only part of the equation.  In addition to market forces determining our dollar’s buying power, inflation was also at work.  Inflation is the economic force that causes things to be more expensive tomorrow, than they are today.  That’s why you used to be able to buy a candy bar for 5 cents, now it costs 69 cents.  It’s a by-product of economic growth.  Prices are based off of supply and demand.  If the supply for something is low, and the demand is high (Imagine if there was very little water), you will pay more for that good.  If the demand is low (no one wants it), and the supply is high, companies will basically give it away, just to get it off their shelves.  If you’re making more money, you have more to spend.  If everyone has more to spend, demand for goods rises.  If demand is high, as we just learned, prices go up.  So, there’s more money in the economy today, than last year, and year before . . . etc.  But where does this money come from?  What underlying value is increasing, to allow us to have more real money in our monetary system?  The answer may surprise you.

It turns out that the very thing we despise the most, debt, is what makes the world go ’round.  Money, in our economy, is created by debt.  I just want you to take a minute and let that sink in.  Ben Bernanke will tell you, somewhat obfuscating the point, that the Great Depression was caused by a lack of credit.  This was certainly a contributing factor, and was the primary cause of the length and severity of the depression.  Our monetary system was collapsing.  The banks simply didn’t have the money to give their customers when they asked for it (sound similar to Part 1’s situation?), and with no credit, there was no way to create money.  When the U.S. abandoned gold in 1933, (not to be confused with our abondonment of gold in 1971), we were able to begin recovering more rapidly, by issuing loans, and allowing the amount of money in the economy to rise.

I’m sure right now, if you’ve stuck around to this point, you’re scratching your head and saying, “huh?”  Let me invite back Jim Bob to help us demonstrate how this works.  Jim Bob needs a loan.  He’s been feeling lonely lately, and wants a nice hot new car to get himself a woman (We already know Jim Bob makes bad financial decisions).  So he goes to his local bank, and takes out a loan for $25,000.  As we discussed yesterday, that $25,000 belongs to you, the person depositing money at the bank.  Now, Jim Bob buys a convertible sports car with his money, gets himself a little hot blonde, and rides off in to the sunset.  But take a look at what happened.  Jim Bob had $25,000.  But YOU still have $25,000.  If you went to the bank to take your $25,000 out, it would be there, and you could do that.  When Jim Bob pays back his loan, he still has a car worth $25,000, the automobile company, still has his $25,000.  Let’s follow the money:

You have $25,000 —> You put $25,000 in the bank —> The bank gives $25,000 to JIm Bob —> Jim Bob gives Chevrolet $25,000.

At this point, the bank is owed $25,000, which Jim Bob repays.  At the end of this scenario, you have $25,000, and Chevrolet has $25,000.  $25,000 was created by Jim Bob’s debt.  Good boy, Jim Bob.

And that’s where money comes from.  That’s what our economy is based on.  It’s a very large and complex system, that balances debt, risk, inflation, market pricing, supply, and demand.  Manipulating one or more of those factors, impacts the money flowing freely in the economy, and the value of that money.  If confidence in the bank industry erodes to the point where people don’t put in their money, or the banks have no more money to lend out, the system freezes up, and collapses.

Remember the $700 Billion (read $2 trillion) bailout?  Where will that money come from?  That is the wrench in this system:  The Federal Reserve.  If you manipulate any of those factors, you manipulate the value and amount of money in the economy.  If the Fed floods our system with $2 trillion dollars that it just printed up from no where, what happens?  Remember our supply and demand scenario?  If the supply of something goes up, people will pay less for it.  If the supply of Money goes up, it’s worth less.  This makes inflation sky-rocket, and screws up the balance of our economy.  But what happens if we do nothing?

Part 3 will be coming up soon, on the Fed, interest rates, and what I think will happen if we convince congress to pass on this bailout.

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