Money is easy to understand, but most people have no idea what it is. We all know that barter is an inefficient way to foster economic growth and money is a good thing for the economy. But money isn’t a piece of paper.
Here is a fable to illustrate this.
Imagine a big isolated valley in a simple rural, pre-technology society, millennia past. People get up in the morning, farm, hunt, build homes, makes clothes, babies, cook meals, think of ways to defend the valley, party, the usual stuff.
Human nature being what it is, some people are better at some things than others.
Enter Khal. Khal hates farming and isn’t very good at it. But he loves to tinker and invents the plow which makes him much better at farming even though everyone knows he stinks at it. His neighbor Petyr notices Khal’s sudden farming success and asks Khal to make him a plow. Khal says he doesn’t have time, he needs to farm, save grain for the winter, yadda yadda yadda. Petyr says, “I’ll give you some grain if you make me a plow.” It didn’t take Khal long to see the opportunity and now he just makes and sells plows, eats well, brings his kids into the family business, forgets farming, and life is good. Barter and specialization of labor is invented.
What has happened here economically? Well, Petyr had to save up some grain and not eat it to get the plow. This is called capital or real savings. Remember this; it’s key.
Everyone hears about plows and Khal expands his business. He invents other farming implements which farmers are eager to buy.
Because of Khal’s inventions, farmers are more productive and have a lot of grain this year. Since farmers pay him with grain, Khal’s barn is bursting with it. He has so much grain that he can’t trade the grain fast enough for stuff he wants, and it spoils. Not good for Khal.
Khal thinks about his problem and notices that everyone likes gold jewelry: it doesn’t spoil, tarnish, rust, it’s pretty, scarce, and easily workable. People seem to covet the stuff. He has an idea. He sends Khal Jr. out to trade as much of the excess grain as he can for gold. Khal then purifies it and makes round disks of uniform weight and size. Yes, coins. He stamps on the coins “Khal Coins=One Ounce of Gold”.
You know what happens. He starts using coins to buy things he needs for his business, and because everyone trusts Khal, they recognize that gold is valued by others, and they accept them. Pretty soon the coins are spreading through the community and the economy grows. It’s so easy to trade for other things by using the coins. Khal also makes a little bit on each coin he mints.
Remember that people had to save something from what they produced to acquire other goods. This real savings/capital is what makes the economy run. The gold is just a medium to trade real savings for goods.
Everything is great. Trade grows with other valleys, coinage expands at a rate equal to demand which is directly in proportion to the production of grain and other goods. Peace breaks out with old enemies because trade makes everyone’s life better. Khal prospers.
Khal has branched out into other businesses and sends out his many kids to buy raw materials needed to make his products: plows with metal tips, swords, spears and arrows, and the like. He sends his kids far and wide but it was risky carrying around a lot of gold in strange places. So, knowing that everyone knows him and trusts him, he issues documents, certificates that say the bearer of the certificate is entitled to redeem a certain amount of gold coins. Khal stores the gold in a cave heavily guarded by his sons-in- law. Khal signs and seals each document and calls them “gold deposit receipts.” People know that if Khal says he’s got the gold, he does, and they accept them.
Khal’s kids spread the receipts around, sellers accept them, and he prospers even more. Pretty soon others see the advantage of letting Khal keep their gold safe, and for a small fee they deposit their gold in Khal’s cave and accept gold deposit receipts. He convinced some depositors that if they would allow him to lend some gold they didn’t need for a while he would share the fees (interest) with them. It worked out great and Khal realized he just created banking. The neat thing is that because the supply of gold was hard to find and supply was rather limited it was hard for Khal to flood the market with his paper receipts even if he wanted to. Other than supply and demand issues with goods, prices were stable.
Khal died and left his successful businesses to his kids; Khal Jr. gets the cave-bank.
Junior is smart too, but rather greedy. He is known to have a summer home in the mountains by the lake, and has lots of fine horses and carriages. Women find him attractive with his long hair tied up in a bun and his fine imported clothes and he parties a lot. Junior soon realizes that the banking business isn’t meeting his cash needs but he has a problem: gold can’t be mined and minted any faster.
Junior has a great idea. He notices that people only cash in small amounts of the gold receipts to take possession of their gold on deposit. What if, he thought, I start lending out the gold that’s just sitting there? He knew that people only demanded about 10% of the physical gold held at any one time. He realized he could lend 90% of the deposits even though he didn’t own it. “Eureka! I’ve figured out a new paradigm in banking. I’m going to call it ‘fractional reserve banking.’ This can’t fail!”
Junior began lending new “certificates” that said the Bank of Khal would pay the bearer in gold in the named denomination. He wasn’t saying it was a deposit receipt for a specific sack of gold coins, but that he would pay in gold when asked. He had one ton of gold deposited in the cave. Pretty soon he had lent 90% of the gold he held for safekeeping. His depositors had no idea he was doing this. And he was making a lot on these loans. But it wasn’t enough. He drew up certificates equal to five tons of gold—four more than he had—and proceeded to lend this new money to his customers. He increased the supply of money by 400%. There was no actual real savings or capital created by Junior. No one saved their production, created wealth, and deposited the gold equivalent in the bank; Junior just issued more pieces of paper. He created money out of thin air. “Hey”, Junior said, “who will ever know?”
People were pretty happy at first. The tanners, miners, lumbermen, cloth makers, and quarry owners who first borrowed most of the money bid up the price of wages and resources like hides, lumber, stone, iron, copper, cotton, and wheat. Trade expanded rapidly with the new certificates floating around. Then people started to notice that prices were going up rather dramatically. By the time the new money worked its way through the valley, the farmers, cobblers, tailors, and workers, who were last in the money chain, had to pay more for things like bread, clothing, shoes, and tools. Junior had just invented inflation.
But … some people noticed that gold coins would buy more than would the certificates. Petyr’s son, Petyrson, brought his certificates to the bank and asked Junior to give him the gold coins. Junior tried to talk him out of it but Petyrson was stubborn and got the coins. Other people noticed the same thing and ran to the cave to exchange certificates for gold. In fact, everyone ran to the bank to exchange the certificates for gold. Junior and the bank went bust because he issued certificates for 5 tons of gold but only had one ton. From then on most people avoided paper of any kind and kept all of their money in gold. Petyrson’s family motto became, “In Gold We Trust.”
You might notice that more pieces of paper didn’t create any wealth. Real savings, you recall, was some good produced that someone didn’t consume. They traded it for gold, a monetary commodity which retained its value. I mean, why would anyone trade their hard earned products for a worthless piece of paper? Just issuing more pieces of paper didn’t do anything except raise prices. It certainly didn’t create “wealth.”
Now leap forward in time. The village has become a big city in a large country. Petyrson10 is old money rich because his family kept gold and invested wisely over the years in things that produced profits. Khal’s family went into banking and over the centuries blew up many times. Khal10 went into academia and studied a new kind of economics that said money was whatever the government said it was.
Khal10 eventually became the head of the government’s central bank. He once told his mentor, Bernankie, that “we’ll never have an economic collapse again because I control money!” The first thing Khal10 did was to ban all forms of money as legal tender except the one that the central bank issued—paper “notes” called the dollar. The dollar was a pretty piece of paper with numbers on it. The second thing he did was to sever the relationship of the dollar with gold or any other commodity. The government had a big army to back up the edicts of Khal10.
People everywhere in the country loved the dollar but had no clue what it represented. People seemed to want these pieces of paper a lot. They were pretty, green things, well made, and looked very official. People just stopped thinking about what money was.
Khal10 kept printing dollars whenever he thought the economy needed a boost. Things were great for a while, and then, as prices inflated he stopped printing and the economy crashed. The government decided they needed to do something to stimulate the economy. Khal10assured the leaders that massive government spending would boost the economy. The leaders agreed and embarked on great new projects like dams, bridges, roads, stadiums, government buildings, and other things the leaders wanted. These projects cost billions. The leaders raised taxes but the more they took through taxes the poorer the economy performed. People started grumbling. “What do we do?”, they asked Khal10.
Khal10 said, “Leaders, you issue debt, I’ll buy it, and print dollars to pay you. Take the dollars and spend! The economy will recover and everything will be fine.” Which the government did. Pretty soon prices started going up and up and up and the central bank had to print more dollars to keep up with the demand. Folks seemed to be spending them as fast as they could as prices doubled. Who wanted dollars that depreciated in value?
Meanwhile, Petyrson10 had a very nice business farming and making food products. But his workers were getting poorer because inflation caused prices to go up and up. He couldn’t raise his prices fast enough to keep up with wage demands. He said to his workers, “Look, I can pay you in dollars, but wouldn’t you like gold instead?” He explained that the dollar was going down in value relative to gold, and gold would buy more. It didn’t matter what the government did to the money as long as they held gold. The workers liked that so he issued gold deposit receipts on the gold he held in a vault deep under his estate. Holders could come in and demand and receive gold in the amount of the receipts. The workers really liked this because the gold held its value and inflation didn’t bother them at all and they all prospered. People started using these receipts all around town.
Khal10 heard about this and had Petyrson10 arrested because he violated legal tender laws. Petyrson10 was convicted and thrown in jail and his gold was confiscated. Before he was hanged he gave a speech on the gallows:
Fellow citizens, you work every day for what? A piece of paper? That piece of paper isn’t wealth or capital. Like our ancestors ten generations back, real wealth was the wheat and iron they produced and saved some for the future. They exchanged their savings for something of value: gold. Gold is money because people value it as a medium of exchange. You’ve forgotten what money really is and now you trade your labor and goods for pieces of paper worth nothing! Now Khal10 and his cronies print paper at will to pay for what the government wants. They use it to bail their friends out when they go bust. Their legacy is inflation, just another tax on your labor. Gold, my friends, is the only thing that can prevent the government from inflating the money supply and stealing your wealth. They are destroying our economy. Rebel and demand we go back on a gold standard and have real money. Don’t let …
There were murmurs of discontent in the crowd and Khal10 quickly pulled the trap door and Petyrson10 was left hanging in the wind. People forgot all about Petyrson10 in a few months because the government gave them some cash called a “rebate.”