We have forgotten what money is. 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. These savings are “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 Khal is a man of his word, everyone trusts him, it doesn’t take long for everyone to see that gold is valued by others, and they accept gold coins. Pretty soon the coins are spreading through the valley 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.
But first, and most important, you have to produce something and save some of it for future use. This real savings/capital is what makes the economy run. Then comes money. The gold coins are 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. If Khal makes too many coins than people need, he’s wasting his own labor and capital if the coins sit idle in his vault. People can sell grain or goods for gold, and hold the coins for future needs. Peace breaks out with old enemies because trade makes everyone’s life better. Khal, Petyr, and everyone else, prosper.
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, kitchen utensils, 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, Khal 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 certificates around and people in the valley see the advantage of the certificates. People like the fact they don’t have to haul around heavy gold coins. They deposit their gold in Khal’s cave and accept gold deposit receipts. Khal charges them a small fee to store their gold and he prospers even more. Pretty soon their economy expands, the certificates of deposit are a handy way to do business, and people are happy to let Khal keep their gold safe.
As Khal’s business grew, he had a lot of gold and he didn’t need all of it for his businesses. Some young folks came to him with a great idea on how to store grain so it didn’t rot or get eaten by mice. They asked him if they could borrow some gold to build new granaries. Khal thought it was a great idea and told them he would charge them a small fee for the use of his gold. Their idea was a big success, farmers flocked to the new granaries, and these entrepreneurs happily paid him back plus his fee which was what Khal called “interest”.
Soon others came to Khal with ideas that Khal thought made business sense and asked to borrow gold. Khal’s own gold stockpile was running low and he didn’t want to risk it all. He thought about how he could take advantage of these new businesses and then he had a flash of insight: if he could convince some of his depositors to allow him to lend some of their gold savings they didn’t need for a while he would share the fees (interest) with them. Depositors liked the idea of making money on their savings and soon it became a smashing success. New businesses popped up, depositors received interest on their savings, and the economy really took off–just about everyone in the Valley prospered.
Khal realized he just created banking and interest accounts. The neat thing is that because it wasn’t easy to mine, refine, and produce gold coins the gold supply was rather limited and Khal couldn’t 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. got the cave-bank. Junior is smart too, but rather irresponsible. As Khal’s favorite, he was spoiled. He was known to have a summer home in the mountains by the lake, and he had lots of fast horses and sleek chariots. Women found him attractive with his long hair tied up in a bun and his fine imported clothes. He partied a lot.
Junior wanted to build a palace to impress his friends and admirers but the banking business wasn’t meeting his cash needs. And, as we know, gold can’t be mined and minted any faster. Junior had a great idea. He noticed that people only cashed 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 granary and quarry owners who were first in line at the bank borrowed most of the money and quickly bid up the cost of labor and resources like hides, lumber, stone, iron, copper, cotton, and wheat. Trade expanded rapidly with the new certificates floating around. Since the production of goods hadn’t increased yet, supply was limited and the cost of goods went up as others competed to buy the same products. Pretty soon people noticed that prices for materials and consumer goods were going up rather dramatically. By the time the new money worked its way through the valley, the farmers, blacksmiths, cobblers, tailors, and laborers, who were last in the money chain, had to pay more for things like bread, clothing, shoes, metal, and tools. Junior had just invented inflation.
Some people started noticing 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 the certificates entitled him to receive. 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. Junior just invented a bank run.
From then on most people avoided paper money of any kind and kept all of their money in gold. Petyrson’s family motto became, “In Gold We Trust.” You might have noticed 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 businesses that produced profits. Khal’s family went into banking and over the centuries blew up and went broke many times. Khal10 went to a college 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, Caynes, 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 green 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. Khal10 assured the leaders that massive government spending would boost the economy. According to Caynes and other economists they thought if the government buys a lot of stuff or builds a lot of things, the economy would revive. They thought spending, not savings, is what drives 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. “When will the government stop this damn depression? Why don’t they do something?” The leaders asked Khal10. what to do. He 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 and tripled. Who wanted dollars that depreciated in value?
Meanwhile, Petyrson10 had a very nice farming and food products business. 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. He told them it didn’t matter what the government did to the money as long as they held gold. “The government can’t print 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 while people with dollars were getting poorer.
People started using these gold receipts all around town. The economy started to improve. Khal10 heard about this and had Petyrson10 arrested because he violated legal tender laws which Khal made sure was a capital offense. Petyrson10 was summarily 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 printed up some more dollars and gave them some cash called a “rebate”.