Where Does Money Come From?

[Wonk]

Wonk,

How would you respond to someone who said that energy is actually the only money there is, and that gold is just a proxy for energy?  In other words, it is energy that is really the closest way of capturing a unit of human labor in a portable package that has intrinsic value.

By "energy" I mean fossil fuels in an industrial economy, but I also mean food and livestock in a pre-industrial economy.

Notice that gold never seems to go anywhere without oil following it...or is it vice versa?

I'd probably substitute "energy" with "value,"  although the term "value" is an abstract idea that a lot of people have a hard time getting their heads around.  I wouldn't totally disagree with the idea that energy is a form of money though.

[moda0306]

Wonk,

I'd disagree that all money build' its value off of gold.  Gold just happens to be a very weather-proof metal that has all the traits of something that would make a nice medium of exchange.  

Silver is less like that.

Beaver pelts, tobacco and salt are even less-so.

Imagine a world where no metal like gold exists, and my government has an army and sends me 1,000 non-counterfeitable green bills in the mail, and attached is a note that I have to pay into the government 10 of those every month.  If I don't pay them, I go to jail.

This government has now issued money and it has value.  No gold exists.  How do you reconcile with your thought that gold is the source of all money.  It would seem to me the threat of force is (though I won't discount the value of a central bank having gold on hand to preserve its clout).

Gold made an excellent medium of exchange for its time, but the fact that we even need a medium of exchange to engage in efficient commerce implies that it's an odd and unfortunate market failure to have to have one thing accomplish that... one that was reasonably patched by a yellow metal that had a lot of the traits you'd want in an older society.  Eventually, we grew out of the ability for a yellow metal to act as that market-failure patch, and government became a more efficient issuer of currency.  Some may value liberty to the degree that they don't want government handling the monetary system, but that's their opinion, and doesn't change the fact that gold was simply "the best the market could come up with," when it came to a useful medium of exchange.

[MediumTex]

This government has now issued money and it has value.  No gold exists.  How do you reconcile with your thought that gold is the source of all money.  It would seem to me the threat of force is (though I won't discount the value of a central bank having gold on hand to preserve its clout).

On what does the credible threat of force depend?

Normally, it's superior access to energy flows, which form the basis of power in most societies.

Thus, the green pieces of paper and the implicit threats that are attached to them are ultimately derivative of the control of energy flows.

Just something to think about.

[moda0306]

MT,

Totally agree... the buck stops somewhere... and it's probably natural resources.

[moda0306]

So I guess I need a little guidance here... since the expansion of credit is ALWAYS the result of a willing saver allowing someone to earn interest off their deposit vs stuff it under a mattress, what leads to the expansion of credit where it otherwise wouldn't exist in a free society?

Fractional-reserve banking may be the cause, but this is want banks do... even if the populace doesn't 100% realize they are lending their money (they should, if they're earning interest... duh), it's still part of a free-market operation, with the exception of FDIC insurance, but can we really blame much of credit-expansion on a user-fee based premium?

Even a gold-reserve system could be (and has been) fractional reserve and can have various layers of private negotiations going on so people can earn interest.

Some would say that the fed lowering rates encourages people to borrow, but if lowering rates increases the demand for loans, would it not decrease the supply, since people won't accept too-low a return if they expect inflation?  This is still a two-sided free transaction to expand credit.

Maybe it's Keynesian stimulus in and of itself, creating positive future expectations, that make people more comforatable either loaning out their savings or going into debt...

[Wonk]

Imagine a world where no metal like gold exists, and my government has an army and sends me 1,000 non-counterfeitable green bills in the mail, and attached is a note that I have to pay into the government 10 of those every month.  If I don't pay them, I go to jail.

This government has now issued money and it has value.  No gold exists.  How do you reconcile with your thought that gold is the source of all money.  It would seem to me the threat of force is (though I won't discount the value of a central bank having gold on hand to preserve its clout).

"Give me control of a nation's money and I care not who makes the laws"

Mayer Amschel Rothschild

The Rothschilds were by some accounts the wealthiest family of the last 1000 years.  They (among others) were known to finance both sides of war in Europe--obviously enriching them further.  It didn't matter who ultimately won.  Fast forward to today: Muammar Gaddafi had his assets frozen by the international community, but he still fights with a sizable standing army.  Why do they fight?  They get paid in gold.

Money is a power that can often defeat the threat of force all by itself.

Gold made an excellent medium of exchange for its time, but the fact that we even need a medium of exchange to engage in efficient commerce implies that it's an odd and unfortunate market failure to have to have one thing accomplish that... one that was reasonably patched by a yellow metal that had a lot of the traits you'd want in an older society.  Eventually, we grew out of the ability for a yellow metal to act as that market-failure patch, and government became a more efficient issuer of currency.  Some may value liberty to the degree that they don't want government handling the monetary system, but that's their opinion, and doesn't change the fact that gold was simply "the best the market could come up with," when it came to a useful medium of exchange.

Periodically the world goes through these experiments with fiat money that's redeemable for nothing.  Proponents always point out that "we don't need that barbarous relic anymore."  Here's an article on it:

http://mises.org/daily/3238

It usually ends badly.  After that, some form of truly convertible money comes back--only to see it manipulated and taken away.  It's just human nature, unfortunately. 

[moda0306]

Your example of Gadaffi is nice, but c'mon.  Your assertion that all money is built on gold implies that we could have no functional medium of exchange if we didn't have gold as an element.  Gold is a convenient metal but is hardly necessary to have a working monetary system.  It's an amazing hedge against those monetary systems collapsing, but it's not the source of every country's power to manipulate currency.

It wouldn't surprise me that a collapsing government would also have a collapsing currency as well.  Sounds like a governmental problem to me, not a currency one.  Since our government is still in tact, I'll prefer to use something a little more efficient and hold gold on the side if I wish.  I'm sure plenty of gold-backed countries and currencies have collapsed as well.

Any of us are free to take as many dollars at the end of every month as we wish and go buy gold because we believe so strongly in currency collapse.  Holding enough greenbacks to engage in daily commerce will not bankrupt you if the dollar collapses.  This is where all the harping about the collapse of the dollar falls flat... if you know something that most others don't, especially regarding the collapse of the world's reserve currency, you should be quietly cheering to yourself that you'll one day have the opportunity to be insanely wealthy, not advertising on Glen Beck's radio show.  You still have the right to buy gold, as does every other free American.  Why don't they buy much?  Because banking on the dollar collapsing probably isn't a wise investment with too much of their wealth... not because the government won't let them buy it.

[Wonk]

Your example of Gadaffi is nice, but c'mon.  Your assertion that all money is built on gold implies that we could have no functional medium of exchange if we didn't have gold as an element.  Gold is a convenient metal but is hardly necessary to have a working monetary system. 

There have been many objects that have acted as a store of value throughout history.  We just haven't found anything more reliable than gold yet. 

Any of us are free to take as many dollars at the end of every month as we wish and go buy gold because we believe so strongly in currency collapse.  Holding enough greenbacks to engage in daily commerce will not bankrupt you if the dollar collapses.  This is where all the harping about the collapse of the dollar falls flat...

I don't think a dollar collapse is inevitable.  I see 1979-1981 as a good example that poor monetary policy can be corrected with the right decisions.  But I also don't think you need to have a currency collapse to make gold an attractive store of value.  Let's say I make you a proposition: give me $1 at the beginning of the year and at the end of the year I'll give you .97.  Now multiply that several trillion times and repeat 5-10 years.  Bad deal, right?  Well that is exactly what has been happening for the better part of 10 years.

In the age of a gold standard, asset bubbles needed to collapse to find a floor.  In the absence of a gold standard--such as the 70s and 00s, all you need to do is devalue a little bit each year to keep asset prices propped up long enough for the floor to rise up to the asset level.  Sort of devious, but it is what it is.

[Gumby]

Doesn't this still come back to private sector lending as an important factor in the money supply?

Absolutely it's a factor. But, again, those are loans. Bank don’t create net financial assets. They create debt based money with an asset and liability.

Doesn't the government do the same thing by borrowing treasuries into existence?

It seems like it would be a lot more convenient if we DID just print money, with no evidence left behind in the form of t-bonds.

Yes, that's true. And it certainly would be a lot more efficient to simply print the money. With a fiat currency, the government doesn't need to have any liabilities to fund itself. But, long before we had a fiat currency, Congress mandated that all "funding" come from Bond issuance. The liabilities were necessary because we did not have enough gold to back our expanding money supply. When the dollar became fiat, the laws were never changed. So, that's how it's done. Additionally, Congress has no interest in changing the "funding" laws because A) few people (and very few Congressmen) understand that the liabilities aren't necessary anymore, and B) the liabilities are so easy to politicize (i.e. debt ceiling, spending cuts, etc). Furthermore, many people would agree that the liabilities keep officials (somewhat) accountable and (somewhat) restrained. So, for whatever reason, we have a system where Primary Dealers are required to funnel our savings (their excess reserves) back into the Treasury for recycling and the Fed uses that entire process to target interest rates.

[Gumby]

This may clear up the confusion that many people seem to be having with MMT and how it views the creation of money:

MMT is based on a horizontal and vertical view of money. This is important in differentiating between the public and private sector and how each impacts the money supply. The vertical component describes how the consolidated government (Fed and Treasury) transacts with the banking system in an exogenous form. The horizontal component describes how the banking system utilizes state issued money to transact within the banking system. It’s very important to make this distinction because only the consolidated government can create net new financial assets. All horizontal banking transactions net to zero. As Randall Wray says:

“Credit money (say, a bank demand deposit) is an IOU of the issuer (the bank), offset by a loan that is held as an asset. The loan, in turn, represents an IOU of the borrower, while the credit money is held as an asset by a depositor.”?

Banks merely leverage the currency introduced into the system via vertical transactions. The following description of this horizontal and vertical relationship comes courtesy of Warren Mosler:

When the government “spends,”? the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,”? or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability”? is not “debt.”? The husband-wife analogy for Central Bank-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Treasury’s. That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating Central Bank and Treasury as “government”?).

When the Treasury’s are sold or redeemed, the reserves that were “stored”? at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,”? as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase non-government net financial assets, and taxation withdraws net financial assets from non-government. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the Central Bank to hit its target rate.

Source: Understanding Modern Monetary Theory

In other words, banks create money entirely within the banking system...

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

So, contrary to what we are all taught in school, loans actually create deposits and not the other way around as the money multiplier would have us all believe. When a bank makes a loan it debits the Loans Receivable account on its books. To balance this transaction it will create a new liability in the name of the borrower. This loan will create a deposit somewhere else in the banking system (possibly at the same bank) which will cause this new bank to also account for its new liability (the deposit) and change in reserves at the Fed.

Courtesy of: Cullen Roche