How money works

(a massive, 100-part essay)

I recently finished this excellent short book titled What Has Government Done To Our Money. It’s available on the Internet for free and I highly recommend reading it. But in case you want the key insights, here are my notes.

Money as a medium of exchange

1/ In an economy, there’s a variety of people. Different folks specialize in producing different things and each one of them desires different things.

2/ If there are only two people, they can barter (i.e. directly exchange) what each one of them has with what the other one needs. Even with two people, an exchange rate emerges (e.g. how many loaves of bread you both agree on for a pair of shoes?)

3/ But with more people involved, barter collapses because of two reasons: indivisibility and lack of coincidence of wants.

4/ Indivisibility means that if you’re a shoe-maker, you can’t barter half a shoe for a loaf of bread (if that’s all that you need and you don’t want to overpay).

5/ Lack of coincidence of wants means that you may want a loaf of bread but the other person doesn’t need shoes, he needs a shirt and you don’t know how to make one.

6/ Of course, this can be solved via an indirect exchange. You can find a shirtmaker who wants shoes and use your newly acquired shirt for a loaf of bread. Problem solved?

7/ Yes, for now. But as you can imagine, this doesn’t scale well. As the number of people who want to trade expands, the lack of coincidence of wants becomes a bottleneck for general prosperity. Transaction costs of finding someone who wants what you have becomes too high.

8/ To solve this problem, people gradually start accepting a commodity that is divisible into smaller units and which they believe are widely demanded. Take butter for example. You accept it in exchange for the shoes you’ve made because you know you can find someone who wants butter easily and can pay him with a fraction of the butter weight you think is worth what that person is selling.

9/ Butter gradually becomes a widely used medium of exchange. But butter is not the only possible medium of exchange. Salt, tobacco, wheat and many other commodities have been used as mediums of exchange.

10/ When multiple possible commodities are being used as a medium of exchange, only a few emerge as winners. Which one wins depends on two factors: a) marketability of the currency; b) network effects.

11/ Marketability is simply how good a commodity is in functioning as money. You need money to be easy to store, transportable, divisible, and durable. Some commodities fare better on these criteria than others.

12/ Network effects mean that the more widely a currency is accepted by others, the more likely is it to get accepted by others. (This is also why bitcoin is the mother of all network effects).

13/ Gradually, because of better marketability and network effects, during the course of history, metals like gold and silver emerged as preferred mediums of exchange.

14/ A commodity like gold gets established as money when all other commodities have a relatively stable exchange rate with it.

15/ Nobody decides how many grams of gold is a cow worth. The market gradually determines this exchange rate by accounting for supply and demand for both commodities: gold and cows.

16/ The key to understanding money is to remember that it is a commodity whose utility is in facilitating exchanges, just like leather is a commodity whose utility is in making shoe soles.

17/ To drive home this point, consider money as a commodity (like milk) that you can buy. What do you pay to “buy” money? Your goods and services. What do you get in return when you “sell” money? Other people’s goods and services.

Benefits of money

18/ The biggest benefit of money is in expanding the trade between people, and hence rewarding specialization. Increasing specialization creates prosperity as now you don’t just have shoes, you have sports shoes, party shoes, formal shoes, and so on. So, multiple types of shoes can exist because consumer desire for everything can now be measured in money.

19/ This money-driven price discovery helps foster innovation because entrepreneurs can race to produce goods and services that fetch more money, thereby creating things that wouldn’t exist otherwise.

20/ A stable price of goods also helps businessmen plan ahead in the future. They can allocate their resources effectively because they know a profit will emerge from the investment.

Money as purchasing power

21/ Just like goods and services can be measured in money (how many ounces of gold is this house), money can be measured in terms of what kinds of and how many goods and services can money get you (what can I afford if I have an ounce of gold?).

22/ It’s useful to imagine money as a commodity just like any other commodity (glass, TVs, English language classes, Facebook stock and so on). In an ideal world where price discovery is perfect, all commodities have an exchange rate with each other (how many hours of English language classes for a TV).

23/ Money is simply a commodity with the widest price discovery against all other commodities and because of that everyone accepts it. That is what gives money its purchasing power.

The business of making money

24/ What if a fairy comes and doubles the money that everyone has? Does everyone suddenly become twice as rich?

25/ No. Because money is a medium of exchange, it doesn’t get consumed in the process. If at all, money has very limited consumption uses (gold used in industrial uses or in dentistry). Except for those limited cases, double the amount of gold currency would simply double the prices of everything else.

26/ To understand this, imagine another commodity like milk. If via any method, we have twice the amount of milk in the world, its price will drop in half.

27/ Similar dynamics happen with money. Only by increasing the amount of money, no prosperity happens. Prosperity happens via innovation – when there are more (in number and type) goods and services available for people to enjoy.

28/ What about gold miners? Are they richer than others? Not really. Like any other business, mining of gold involves a cost. There’s a cost of discovery and acquisition of land rights for gold, people cost, machinery cost, and so on.

29/ Markets drive returns for any type of business to average returns (returns enjoyed by any other business). So, in the long run, gold mining doesn’t make the owners richer than say making butter. (Don’t believe me? Bitcoin mining offers real-world proof. It’s no longer profitable to mine bitcoins).

The takeover of money

30/ Kings and rulers of the past depended on direct confiscation of commodities as a way to sustain their armies and lifestyle. This is how taxation came along.

31/ Citizens have an incentive to evade taxation, and it’s also an operational nightmare. An easy and convenient alternative to taxation is controlling the money supply in the state. You can call it indirect confiscation.

32/ It starts by labeling a certain weight or volume of currency with a specific name. So, instead of saying something is worth an ounce of silver, you say something is worth a dollar. Similarly, a pound sterling is a name for a specific weight of silver.

33/ Under the hood, a dollar was (supposed to be) nothing but a silver coin that weighs an ounce. But labeling it with a dollar abstracts that reality a little bit and sets the stage for people in power (the government or the king) to steal money from the general populace via coin debasement.

34/ Here’s how the coin debasement works: you stamp coins with your brand, you outlaw all other coins, you require taxes to be paid in stamped coins and when you get coins, you literally melt them and make more coins, each with less weight than before. You keep some of the newly invented coins for yourself and release the remaining.

35/ Such coin debasement is a subtle way of stealing (or redistribution, depending on how you look at things). In other words, debasement leads to inflation. You have more coins in circulation for a similar amount of “stuff” in the world so the prices of “stuff” rise.

36/ With debasement, over time, people notice that coins are getting lighter, but this is where naming a coin helps. Through the legal tender, you declare all coins to be at par with each other. So by force of law, you require people to treat a dollar that’s an ounce of silver similarly to a dollar that’s worth less than that.

37/ The result of this is what’s known as Gresham’s law: bad money drives good money out of circulation. As debasing of coins starts, people hoard coins that are debased and pretty soon only debased coins remain in circulation (which get debased even more by the kings). Over a period of time, this leads to coins being so light that they’re unusable.

38/ What also happens is that the non-debased, good quality coins get exported out of the state to other regions because they’re worth a lot more somewhere else. This leads to a flight of silver and gold out of the state, something that kings don’t desire.

39/ So the physics-based limits on how light coins can get keeps infinite debasement in check. And because debasement is in check, new money can’t be created indefinitely, so inflation is in check. But that game is about to get changed when governments and kings discover paper money.

Banks as money warehouses

40/ When you have a lot of coins, you’d want to store them at someplace that can protect them. That place can be called a warehouse for money, which is what a bank really is.

41/ Just like any other business, a bank makes money for providing a useful service – which is warehousing of money in the bank’s case.

42/ Upon depositing coins, the bank issues a warehouse receipt which is also called a banknote. When you want to redeem your money, you hand over the banknote and get your coins back.

43/ For transactions with others, instead of first redeeming your coins and handing over them, it is much easier to hand the banknote directly to the other party for goods and services. Now they can go and redeem the coins whenever they want (or simply pass on the banknote).

44/ This way, a banknote becomes a substitute for coins. It’s important to understand that banknotes were not money but a money-substitute. Papers were merely a placeholder for the real thing.

45/ This warehousing of coins at one central place opens up the possibility of another debasement type of scam. Banks over time realize that because everybody doesn’t redeem their money at once, they can print and issue more banknotes than the coin reserves they have in their warehouse.

46/ Such a fractional reserve system lets banks steal from the public by issuing more notes than their reserves and profit from the interest paid on loans. Of course, the prices of goods go up due to more number of notes in the market but the bank doesn’t care about this inflation-driven stealing from the common good. Bank cares about its profit.

47/ Doing this is justified by suggesting that a banknote doesn’t give claim to a specific coin, but a coin in general. So the coin you get back upon redeeming your bank note is different from the coin you deposited. Banks use the fungibility of money to their advantage.

47/ However, for any private bank, the number of banknotes they can print and release in the wild is limited by its number of clients. Imagine two people transacting, buyer banks at Bank A and the seller banks at Bank B. If the seller gets notes from Bank A and deposits them at Bank B, the bank B will redeem the note from Bank A for coins in order to store those coins in its own warehouse and issue its own notes to the seller.

48/ This inter-bank redemption for coins places a natural limit to how much “phantom” bank notes can circulate in the system. If banks could form a cartel and not redeem each others’ bank notes, they all can keep on growing their profits together.

Central banks as cartels

49/ Before central banks came along, governments used to finance their extraordinary expenses (such as war expenses) by taking loans from private banks (warehousing citizens’ money) who were willing to lend them money. But because these loans are in the form of banknotes (and not gold/silver), private banks could give the government huge amounts of loans even if they didn’t have a corresponding amount of gold/silver in their warehouses.

50/ But when the government takes a loan, citizens panic and usually call for redemption of their notes to coins. If the loan to govt is huge, different banks call for redemption for coins from the bank that issued a loan to govt. This is how “runs” on banks happen.

51/ If there is enough coins backing up the notes, these runs are not an issue. After all, the holder of a bank note has a legal right on such coins. But, in reality, there were not enough coins for all the bank notes and a “run” could bankrupt a bank and leave the late redeemers high and dry.

52/ Instead of letting such over-leveraged banks fail during runs, because such over-leveraged banks lend to the government, what governments have done in the past is from time to time declare a “bank holiday”. This legal-decree means that for a certain time such banks can stop redeeming notes for coins.

53/ Temporary measures that benefit an entity in power soon become permanent, so such temporary abandonment of backing paper money with reserves set the stage for a more permanent abandonment of the gold standard later.

54/ Also, these crises of confidence in banks (which was often due to government actions), legitimize the government’s case for the establishment of central banks.

55/ Here’s the pitch of the govt to its citizens: a central bank will be established that will hold all the coin reserves of the public. By law, private banks couldn’t keep their reserves as coins but had to hand them over to the central bank. The central bank in return would give its own banknotes which different private banks will keep as reserves.

56/ The central bank also runs on fractional reserve, which means it can print more bank notes than the coins it has. Because the redemption between banks now happens in the bank notes from the central bank and because the central bank can print new notes at will and loan it to private banks, there’s no longer a possibility of a bank run.

57/ Central banks are called “banker’s bank” because banks deposit public money in its warehouse in exchange for its notes. However, the important point to note is that a central bank is not a “bankers’ bank” by choice but by legal decree. The government outlaws all other bank’s notes and outlaws banks keeping their reserves in anything but the central bank’s notes.

58/ The success of the central bank rests on the public turning in their metal coins to get the central bank’s notes. The public got lured into doing this exchange with the promise of the central bank keeping their money safe. After all, what bank can be safer than a government? Plus, a government never fails, does it?

59/ Little did the public know that by doing this they’re setting themselves for the erosion of their purchasing power. Originally one dollar was one ounce (~31 grams) of silver. Today, that value has eroded over 96% and for one dollar you’ll only get 0.04 ounces of silver.

60/ This willing loss of 96% of purchasing power of money by exchanging metal coin for central banknotes was perhaps the worst trade (and the smartest con) in history.

Interlude: how banks work

61/ Where did this 96% of the money (as purchasing power) vanish? Short answer: to government, its spending, its inefficiencies, and its preferred parties.

62/ With the central bank, the government gave itself the literal license to print money. The dilution of purchasing power of money happens in two steps: a) central bank runs on fractional reserve so it can print more notes than the reserves it holds; b) private banks also run on fractional reserve but their reserve is central banknotes.

63/ Whenever you deposit $100 cash into your bank account, what happens is that your cash goes into the bank’s reserve and what you get in return is a deposit account (i.e. a database entry that the bank owes you $100).

64/ In contrast, when you loan $100 from a bank, they don’t hand you over cash. Instead, they hand over you a deposit account (a database entry) in exchange for a promise from you will return them $100 + interest.

65/ Now, if you’ve used the borrowed $100 to pay to someone who holds an account in the same bank, what the bank does is debit your account and credit the other person’s account. So, your database entry will now say $0 and the other person’s account will be increased by $100.

66/ Note how no currency/cash was involved in the entire transaction and yet for $100 for central bank-issued cash, there’s now $200 worth of money in the economy. This is called money multiplication.

67/ However, if the person who you’ve paid to has an account in another bank, inter-bank settlement happens. This is where the cash held in one bank’s reserves gets transferred to another bank’s reserves. Because of inter-bank settlement, each bank keeps some central bank currency in its reserves.

68/ How much reserves do banks keep? Failure of keeping enough reserves can cause a run on the bank which can cause insolvency of a bank. So, the central bank requires keeping a certain fraction of entire deposits made by the bank in reserves. This ratio is called reserve requirement.

69/ So, for example, if the reserve requirement is 10%, if a bank’s entire deposits (across all account holders) totals $1000, it must hold $100 in central bank currency.

70/ By manipulating these limits on reserves and via other regulations (such as deciding interbank loan rates), the central bank (which is an arm of the government) directly determines how much money is out there in the economy and hence control the rate of inflation in the economy.

Central banks as a way for government to steal

71/ Inflation is stealing from the public because newly created money is slow to propagate in the economy. For example, if central banks lower reserve requirements and enable banks to loan out more money in the economy (and hence dropping interest rate), the initial loan borrowers enjoy a higher purchasing power for their money because prices take time to increase in response to the increased money supply.

72/ Who suffers is the people who’ve been saving in the past (pensioners and so on). Their deposited $100 now commands less purchasing power than before (because prices have risen).

73/ The central bank also helps the government to cover its revenue shortfall (from taxes). The inefficiency of govt operations and subsidies to favorite parties are funded by the central bank by continuing to print new money and loan to govt in exchange of a promise from the government to pay back its debt.

74/ What’s convenient is that govt cannot default as the central bank can keep on printing money and with the increased supply of money, govt debt becomes cheaper (due to increased inflation). This way govt can keep borrowing forever. When inflation balloons, govt can tax the rich to curb spending (and hence control inflation). This sounds shocking but in fact, this idea behind the so-called Modern Monetary Theory.

75/ All this sounds like it can make things spiral out of control, but there was still one physical constraint that limited the consequences: it was the requirement of central banks to keep gold/silver as reserves.

76/ Central banks had to keep reserves due to international trade. The central bank of country A can keep printing money but the traders in country B didn’t necessarily accept (or trust) the banknotes of country A’s central bank. So they demanded payment not in notes but gold/silver and to facilitate international trade (and import what the population wants), central banks needed to keep reserves in precious metals.

78/ This is why even with central banks coming into existence, for a long time, all economies had some sort of gold standard. A dollar meant an obligation of the central bank to pay someone a particular weight of silver or coin.

Choose one: print more money nationally or keep gold standard

79/ Imagine your country’s central bank loves printing money to cover for the government’s inefficiencies or favorite subsidies. But also imagine that your country is into international trade. What you’ll find here is a situation with multiple private banks and the limitation of their money printing due to potential redemption by other banks.

80/ The existence of trade (where redemption happened in gold or silver) meant central banks had to maintain a portion of all money they printed in precious metals. This suggests that as the central bank releases more money into the economy, its precious metal reserves dwindle because other countries redeem its money for these metals.

81/ This is troublesome because it means central banks (and hence govts/countries) can default when they run out of precious metals. To solve this, instead of tempering new money creation, central banks across the world colluded and gave up on the gold standard altogether.

82/ Today, there’s no currency in the world that’s backed by gold. Amazing, isn’t it?

The arrival of the fiat currency and its troubles

83/ With the the abandonment of gold standard, the currency of a country became what’s called fiat currency. Unlike gold which was decided by the market to be used as a medium of exchange, the central banknote becomes the medium of exchange by fiat.

84/ With currency no longer redeemable in gold or silver, the exchange rate between international currencies becomes a key factor in international politics.

85/ One of the key reasons for US dollar hegemony in international trade is that US was the last major country to go off the gold standard. So while US dollar was on the gold standard, other countries’ central banks kept their international reserves in US dollars.

86/ This was made possible by the promise from the US that its dollar can be redeemed for gold internationally (even though they made it illegal for US citizens to do the same exchange domestically). However, gradually US limited such conversion and then eliminated it.

87/ Even without gold backing, the reason the US dollar is still the global reserve currency is that they require oil-producing middle east regions to price their oil in dollars (in exchange for “protection” and “good relations”?). Since most nations in the world import oil, the demand for dollars (even though it is not gold-backed) persists.

88/ Today, the demand and supply for different fiat currencies is either freely determined in the market (freely-floating exchange rates) or is determined by the country (like in China where its central bank determines the Yuan-USD exchange rate).

89/ If currencies are freely floating (like USD-INR), such constantly fluctuating rates adds distortion and uncertainty in international trade. Imagine if the trade happened in gold coins, the only variable you had to account for in international trade was supply and demand of commodities that are getting traded. Now, because the money supply is unbacked by gold and responds to domestic politics, you ALSO have to account for politics and the monetary policy of the trading country.

90/ Such geopolitical effects of fiat currencies are particularly acute for currencies where rates are set by the central government. For example, the major bone of contention between the US and China is that the exchange rate set by the Chinese central bank is artificially low (e.g. 1 dollar fetches 6 yuans). If under the free market, 1 dollar may only fetch 3 yuans, what the Chinese govt is doing is making its exports cheaper on the international stage.

91/ For example, if a widget costs 3 yuans to make, under free-market conditions, you can only buy one widget for one dollar from china. But because of the Chinese central bank’s artificial undervaluing of yuan, you can now buy 2 widgets. Hence Chinese exports surge.

92/ Such politics-driven interventions by the central banks in international trade actually lead to less efficient trade, bitter trade wars and potential geo-political consequences. Needless to say, the ultimate cost of this inefficiency is on the common citizen.

93/ It’s important to understand that this was avoidable. International trades still used to happen before the paper currency was even invented. With a common global medium of exchange (such as gold), there was no scope for govt meddling and private parties could do trade easily and efficiently.

94/ But now with fiat currencies and central banks addiction to inflation, it seems there is no going back to that world.

Should the government control our money?

95/ The answer to the question depends on who is asking the question, which ultimately depends on whether they see money as a medium of exchange or as a store of purchasing power.

96/ As an economy grows, we have more products and services to consume. If money was gold-based (and hence not easily controllable by the government), over a period of time you should expect a decline in prices of things. People would be willing to give up less gold-backed currency for stuff because there’s more stuff than currency.

97/ For the individual with lots of gold-backed currency, this is good news. His money gets him more things in the future than it did before. However, for someone with debt, this is extremely bad news as he’ll have to work harder and produce more to pay back debts that have become more expensive now.

98/ For our modern economy that’s dependent on loans and is highly interconnected, a sudden decline in prices (deflation) will be devastating. Businesses make less money, salaries go down, defaults happen and people stop lending to each other. So, sudden deflation is bad for the economy but great for people with money.

99/ A gold-backed economy also leads to an extremely high wealth concentration as entities that produce stuff that’s desired collect all the gold and slowly they become the ones who lend it because nobody else has the money.

100/ If gold is concentrated in a few hands and the populace is suffering, the government cannot do a lot about it because unlike fiat currency it can’t invent gold out of thin air. (It can directly confiscate gold as wealth taxes, but then most productive members of the population emigrate elsewhere).

101/ What fiat-based currency allows a government to do is to indirectly take money from the rich and, in theory, distribute it across the economy to make it stronger. So from the point of view of the average citizen, it’s a good thing because it allows the government to spend on social security (which otherwise the government will never be able to do without enough gold).

102/ Fiat currency also helps the government battle crisis-of-faith which happens in gold-based deflationary environments. Whenever people with money become skeptical and stop lending to each other, the central bank can always step in as a “lender of last resort” and start the flow of the money again.

103/ So, fiat-based currency helps the government manage the economy, which is great for the economy and actually helps money move faster and do its job as a medium of exchange. However, because government can interfere at will, it can be counter productive to people who’ve worked hard and accumulated money. Their historically earned money’s purchasing power will go down as government helps the economy by injecting more money.

Summing up

104/ These notes became longer than I anticipated but it was important to understand how we reached a place where a global pandemic and associated millions of deaths caused historic highs for the stock market (and bitcoin prices).

105/ The lesson I derive from all this is that because central banks control the money supply and as they don’t think long term, they’ll always think short term during a crisis and print more money. So, it’s extremely foolish to hold cash or interest-bearing instruments.

106/ Rather, the prudent thing is to hold assets that lay a claim on some portion of the economy. The best example of such a claim-on-economy is stocks and within stocks, index funds have the best tradeoff for the amount of time you’re willing to invest in researching and returns you’re able to generate.

107/ Remember: money is nothing but a medium of exchange. It’s a commodity whose utility is in granting you purchasing power. If amount of stuff remains finite in the world, more money will equate to less purchasing power (over that stuff). And whoever controls the supply of purchasing power will do it for their own benefit.

108/ However, also remember that the amount of stuff is not finite in the world. In fact, technology has a commoditization effect. It makes more stuff available and hence has a deflationary effect.

109/ The consequence of more stuff available in the world and more money available in the world is that anything that’s rare and valuable becomes astronomically more expensive. This means expect land, Harvard degree, Apple stock and bitcoin price to go up while the price of a McDonald’s burger to not increase substantially.

110/ This means, over time, the rich get richer (in purchasing power) but the poor get less portion of the purchasing power and hence the wealth gap rises. However, the poor can afford more things and hence poverty reduces over time.

111/ But, of course, economy is not a zero-sum game. When production and GDP increases, it’s stealing from nature and such stealing is biting us back in terms of climate change. Maybe there really is no global free lunch, except for local manipulations?

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