Introduction and Medium of Exchange
Economics is often called “the dismal science” but it is not really dismal nor is it hard to understand. Economics can be made to look hard or boring but that is the job of government paid teachers and they do it to keep people from understanding how the state is screwing them over.
We are in hard economic times at present in the USA and some economists have called it a “recession”. It is called a “recession” because the word “depression” which was used for most of our history is so scary to the modern man, given “the great depression”, that we are afraid to use the word anymore. We are also seeing prices rise and that hurts everyone, but it hurts the poor the most. People wonder what causes these things, but before answering that large question one must first start with some basics and the first one might as well be “money”. So, what in the world is this thing called money? Why do we even need it? Have not many people called money the “root of all evil”?
Once upon a time people would use barter to obtain the goods and services they needed. That is, two individuals each possessing a commodity or a service that the other party needed would enter into an agreement to trade so that both would be better off than before the trade. It was not always simple even with just two people, consider if you had a horse and I had a dozen eggs — that does not seem to be a fair trade most of the time. This direct form of barter does not provide the transferability and divisibility that makes for efficient trading. Another example is the one if you have cows but want apples. Then you need to find someone who has apples and the desire for your beef. What if you find someone who has the need for beef but no apples and can only offer you shoes? To make the trade now the two of you need to go find a third party, or more people, who want to trade to see if something can be worked out. This is very confusing and inefficient.
What if most people wanted salt and you had extra salt? You could barter for needed goods by offering some of your salt for whatever you wanted or needed. If you wanted to get just enough beef for the week from the farmer in town, the two of you could decided on a fair exchange rate between salt and pounds of beef. This works if the farmer thinks that many other people, who have things he needs, also value the salt and will also take it in trade. In this way the salt would be traded just so he could trade the salt with others since everyone needs salt.
In the “new world” of colonial America colonialists used beaver pelts, tobacco, whiskey, dried corn, and other items as currency for transactions. These commodities were chosen for many reasons. These commodities were widely desired and easy to trade with, but just as importantly they were also durable, portable and easily stored. Tomatoes are the fruit of the gods, but they go bad so fast that one could not use the delicious tomato as a trading commodity.
Since these commodities were used to trade for goods and services, one could say that these commodities formed the basis for exchanges. Heck, one could even say that they were a “medium of exchange“. That, by the way, is how most experts define the word “money”. What would be the best commodity to be used as money? One needs to look for the commodity that is easy to exchange and it needs to not deteriorate for long time periods. The commodity chosen also needs to be easy to carry around and store.
What did the ancient world decide to use for money? Gold and silver. Both metals last a long, long time as they don’t rust away like iron. Both metals have inherent value in the arts and in the jewelry trade. Both items are in sort supply so that the law of supply and demand does not diminish the value of either for the most part. Gold and silver do have problems. How much do you have in your sack? How to weigh it? How pure is that “gold” anyway? Gold dust is easy to divide up and that helps a bit, but it is still a pain to have to weigh out gold every time you buy a darned happy meal for the kids at that fast-food joint.
Money, Coins, and Inflation
Consider How Much things cost in 1974
Year End Close Dow Jones Industrial Average 616
Average Cost of new house $34,900.00
Average Income per year $13,900.00
Average Monthly Rent $185.00
Cost of a gallon of Gas 55 cents
Average cost new car$3,750.00
Samsonite Case $62.00
It would be very difficult to talk the new car dealership out of a new car for only $3,750 today! Why do prices rise? The progressive often says it is simply “corporate greed”. That answer is wrong of course, but what does cause prices to rise? To answer that we need to look at “money” more closely.
If you take a look at the “coins” in your pocket change you will see that the dime, quarter, and the half dollar all have little groves on them. That was to prevent anyone (the government most often) from clipping off a bit of the edge before passing it along. No one would do such a thing today of course since the “coin” in not really a “coin”, but rather it is a token. The US government stopped issuing “coins” in 1965. They issue tokens instead.
The “coin” was invented by the ancients to overcome the problem of how to trade conveniently in gold or silver. The real coin is a disk of precious metal, usually gold or silver. This coin has three things stamped on it; the weight of the coin, the fineness of the metal, and the name of the mint where it was manufactured. The name of the mint is called the “hallmark” and it became the “brand name” and naturally some brands were trusted more than others just like today. Notice that the object did not need any government backing as the object itself was of a certain value regardless.
The Romans had a silver coin called the Denarius. It was a 940 fine silver coin, which means it was 94% silver and 6% base metal for strength. The Romans had a welfare program as well as a warfare program and continually needed money, so when they collected taxes they started clipping off a bit of metal from each coin and minting new coins. The groves on a coin called “reeding” is there to prevent this sort of theft of metal. That was not enough so they started counterfeiting by melting the coins and adding base metal to reduce the silver content which allowed them to mint new coins from the stolen silver. This is called “debasing” the money. The Denarius went from 94% silver in 54 AD to under 50% by 200 AD and then to 1% silver by 250 AD and therefore became nearly worthless. It would have to take 94 coins to equal the silver content of one non-counterfeited coin.
The middle ages saw a mint in Czechoslovakia introduce and then produce a coin called a Joachimthaler that was popularly called a “thaler” because, hell, who can pronounce those Czech names anyway? It was a one ounce silver coin and became so popular, trusted, and demanded that the very name “thaler” came to mean the same thing as one ounce of fine silver. As language changes the name “thaler” became “daler” and later on it became “dollar”. The “Dollar” was defined in the mind of the people of Europe as one ounce of fine silver.
Paper Money and Inflation
We have seen how government counterfeited by debasing the precious metal content of the coins when the government took in coins via taxation. Now we will look at “paper money” and the debasing of that commodity.
Once upon a time when real gold and real silver were the coin of the realm, it was difficult to keep all of your money with you. Gold and silver are metal and they are heavy! It is also dangerous to haul around all of your money due to the robber that might take it from you. There were money warehouses where one could store his gold and silver, and these became known as banks. There was a fee for the storage and you got a receipt for the metal that you deposited in the bank. These receipts became known as “bank notes“.
Sometimes two men would arrive at a fair price on a trade and one would just give the other the correct amount in bank notes rather than go to the trouble of going to get the actual gold or silver from the money warehouse. With reputable banks this worked out very well indeed. Thus the idea of “paper money”, which was just trading receipts (which were just claim tickets or IOUs) became accepted.
In the USA the government issued a one dollar bank note called a Silver Certificate up until the 1960s. The government promised to redeem the paper bill with once ounce of fine silver upon demand. Until the 60’s the US Dollar was valued throughout the world as very good money and the phrase “sound as a dollar” meant that one was in good shape. In the 60s the US government started issuing fake coins (“token” is the technical term) that you can see in your own pocket today. The government also started issuing Federal Reserve Notes which were not backed by anything and could not be redeemed for Silver. Now you may wonder how this came to be. It was not just some experiment, rather it was necessary. You see, the US government had been engaged in a massive fraud and had issued far, far more Silver Certificates that it had silver to redeem the paper with. So, they changed the rules of the game by issuing paper backed by nothing. So what gave these pieces of paper any value at all? The “legal tender law” is what.
The idea of “legal tender” goes back to Kublai Khan who issued pieces of paper that said they were 20 ounces of gold! He passed a law that said if you refused to accept such a piece of paper you would forfeit your life. (the Khan’s were not very warm and fuzzy) Other governments after that time tried other versions of “legal tender” and the USA settled upon the idea that one accepts the unbacked paper for a debt or the debt is canceled. In other words, if I owe you $100 and offer US money for the debt you have to accept it or the debt is legally canceled! Neat, eh? This allows the US government to print up all the money they dare to print up. The only thing holding back the government from printing up Billion Dollar Notes by the truck load is the law of supply and demand leading to hyperinflation.
FDR stopped gold coins in the 30s, silver coins and paper Silver Certificates were done away with in the 60s, and the constitution says that all this is illegal. The document says the the government can not “make any Thing but gold and silver Coin a Tender in Payment of Debts”. But we don’t follow the constitution any more so few care about this small problem.
Paper Money and Runaway Inflation
We have looked at how governments could debase the currency and steal money even if the currency were gold or silver coins. This was a time honored way for the government to steal money to pay for wars and welfare, without high taxes which can lead to unwanted unrest among the population. Ah, but paper money, now there is a concept that turns out to be a wonderful concept for governments to loot the public. If a government prints more money, then the money already in circulation is worth less. With paper money not tied to any redeemable amount of precious metal, the government may print as much as it deems it needs to do. Heck, sometimes it prints too much money even if it has “promised” to redeem the paper currency for solid precious metal. Governments sometimes don’t tell the truth, perhaps you have noticed this.
Inflation is an increase in the money supply. Inflation leads to rises in price because the increase in the amount of money in circulation has made all the old money worth less than it did before. As an example, if I were selling apples for a dollar a piece today, and the rate of inflation were 10% then I would have to rise my price to $1.10 by the end of the year just to keep at the same level I was before. I have not raised my price in real terms; I have only kept up with inflation. So, how high can prices go? How fast can it happen? Has it ever happened in real countries on the planet earth before? Let us look to history for answers. Wikipedia has an excellent list of countries that have experienced hyper-inflation. See it here.
In Germany in 1914 the cost of a pound of butter was a little over one Mark. By 1918 the cost had risen to 3 Marks. By 1922 a pound of butter was 2,400 Marks, and the next year it went to 6,000,000,000,000 Marks. Yes, one pound of butter went from a Mark to six Trillion Marks in 9 years. One egg in 1914 was under a Mark and 9 years later it was 80 Billion Marks. This level of inflation is such a society killer that governments have tried to cause runaway inflation in the economy of their enemies during wartime.
In the 1920s the German government bragged about its efficiency at printing money. They had twelve printing operations running 24 hours a day pumping out new currency! How could anyone set a fair price for something? If I sold a farm for 3,000 marks to you one year, it might cost 3 Trillion to buy one like it a few years later! How can society run in this sort of chaos? I believe that most humans can understand the evils of runaway inflation. The only people who would want such a thing (mistakenly) are those so deeply in debt that forcing even a large debt to become mere pocket change is a “good thing to them personally”. (assuming they give up eating food that is)
Money, Inflation, and the Central Bank
Money is a crucial part of our economy and our society. Untold numbers of voluntary exchanges enable a division of labor in society. Everyone benefits because the division of labor allows for all of us to be much better off than we would be if we had to be self-sufficient which would reduce us to a pitiful standard of living.
As Rothbard noted:
Money is different from all other commodities: other things being equal, more shoes, or more discoveries of oil or copper benefit society, since they help alleviate natural scarcity. But once a commodity is established as a money on the market, no more money at all is needed. Since the only use of money is for exchange and reckoning, more dollars or pounds or marks in circulation cannot confer a social benefit: they will simply dilute the exchange value of every existing dollar or pound or mark. So it is a great boon that gold or silver are scarce and are costly to increase in supply.
But if government manages to establish paper tickets or bank credit as money, as equivalent to gold grams or ounces, then the government, as dominant money-supplier, becomes free to create money costlessly and at will. As a result, this “inflation” of the money supply destroys the value of the dollar or pound, drives up prices, cripples economic calculation, and hobbles and seriously damages the workings of the market economy.
The natural tendency of government, once in charge of money, is to inflate and to destroy the value of the currency.
So how does the American system of today work? In modern central banking in the USA, the central bank is called the “FED” The FED is granted by the force of law the monopoly of the issue of bank notes. These ‘bank notes’ are identical to the the government’s paper money. If the my bank needs to get cash for its customers, it must go to its own checking account at the FED which is, in effect, the bank’s own bank. It turns out that banks keep deposits at the FED in its checking account and these are its “reserves”. It may then leverage that amount by ten fold.
Here’s how the counterfeiting process works in today’s world. Let’s say that the Federal Reserve, as usual, decides that it wants to expand (i.e., inflate) the money supply. The Federal Reserve decides to go into the market (called the “open market”) and purchase an asset. It doesn’t really matter what asset it buys; the important point is that it writes out a check. The Fed could, if it wanted to, buy any asset it wished, including corporate stocks, buildings, or foreign currency. In practice, it almost always buys US government securities.
Let’s assume that the Fed buys $10,000,000 of US Treasury bills from some “approved” government bond dealer (a small group), say Shearson Lehman on Wall Street. The Fed writes out a check for $10,000,000, which it gives to Shearson Lehman in exchange for $10,000,000 in US securities. Where does the Fed get the $10,000,000 to pay Shearson Lehman? It creates the money out of thin air. Shearson Lehman can do only one thing with the check: deposit it in its checking account at a commercial bank, say Chase Manhattan. The “money supply” of the country has already increased by $10,000,000; no one else’s checking account has decreased at all. There has been a net increase of $10,000,000.
But this is only the beginning of the inflationary counterfeiting process. For Chase Manhattan is delighted to get a check on the Fed, and rushes down to deposit it in its own checking account at the Fed, which now increases by $10,000,000. But this checking account constitutes the “reserves” of the banks, which have now increased across the nation by $10,000,000. But this means that Chase Manhattan can create deposits based on these reserves, and that, as checks and reserves seep out to other banks (much as the Rothbard Bank deposits did), each one can add its inflationary mite, until the banking system as a whole has increased its demand deposits by $100,000,000, ten times the original purchase of assets by the Fed. The banking system is allowed to keep reserves amounting to 10 percent of its deposits, which means that the “money multiplier” – the amount of deposits the banks can expand on top of reserves – is 10. A purchase of assets of $10 million by the Fed has generated very quickly a tenfold ($100,000,000) increase in the money supply of the banking system as a whole.
All economists agree on how this process works. They might disagree on the effects of this process, but all agree on the above process as described.
The US Dollar is worth about 1% of what is was in 1913 when the FED was established. This comes about because the FED continually produces more “money” and the law of supply and demand will mean that each dollar is worth less than it was before.
The 1974 Nobel Prize in Economic Science went to the Austrian free-market economist Dr. Friedrich A. von Hayek. It was for the Hayek theory of the business cycle that puts the blame for the boom-bust cycle squarely on the shoulders of the government and its controlled banking system and it completely absolves the free-enterprise economy from the blame.
When a government’s central bank causes the expansion of bank credit by inflating the money supple it causes price inflation. But that is not all it does; it causes malinvestments, unsound investments in capital goods, underproduction of consumer goods and many other errors in economic judgment which are caused by all the “easy money” coming into the economy. Then, when that “easy money” stops as it always does — a depression is the result. By the way, in the ’20s the economist von Mises warned of the coming depression which was being caused by the intervention of the government. His call was on target, was it not?
Money Velocity and Inflation
We have seen that the central bank is the main engine of inflation and that inflating the currency leads to higher prices and the boom-bust cycle. But we need to look a bit closer at how the inflationary cycle works. That means looking at a thing called “velocity”, or fast money!
Economists talk about “velocity” and they mean the speed at which money is changing hands. For example, imagine I sit 20 people around a table; each has a dollar and a pencil. Each buys a pencil from the guy to his left with his dollar. Every dollar was used one time and so “velocity” was one. Now imaging the same situation but there is only one dollar. Mr. Jones has that dollar and buys a pencil from the guy on his right and the guy on the right does the same all around the circle. Twenty pencils have been sold and one dollar was used 20 times. Hence, “velocity” is 20. So we see that a small amount of money can do the same job as a large amount of money given the right conditions. Professionals define “velocity” as M/PQ but that hurts my head to think about. This post is about understanding the concepts not hiding them in econ-speak.
The dollar responds to the law of supply and demand and when demand for the dollar falls then people are more willing to spend the dollar than hold it. They buy more goods and services and keep less dollars. On the other hand, if demand for the dollar rises then people then to buy less and keep more dollars. Get it? So, we see money demand is what causes changes in velocity. Economists look at “velocity” to figure indirectly the demand for dollars at a given time. Simple really.
Now we can look at the three stages of inflation. Let us imaging you want to buy a new aluminum mountain bike.
If the prices are stable (1) and the item has been the same for a long time, say $600, then there is no real hurry to get one and you hope that the price might fall a bit and you can pick up a bargain. But instead the price rise (2) to $650 and you decide to buy the darn thing before it can go up any more! Your good friend does the same and he was not even going to get one until Christmas! Then the price goes up steeply (3) to $1,000 and you buy another one as an investment because bikes look to be a better deal than holding dollars.
In the first stage the velocity was low and you held on to your dollars. In the second stage velocity has gone up and you spend dollars. Velocity is going up. In the third stage everyone is looking to get “stuff” and not hold dollars and velocity is way up. Velocity is always very high in the third stage of inflation. There are many examples of this that a person could look at; the USA in the 70s would be a good example. The depression of the early 80s was the correction from the economic mismanagement of the 70s. Remember that inflation goes through three stages, caused by money demand, and one can look at velocity to see what stage a country is in.
Fractional Reserve Banking
It is impossible to understand our modern economy without looking at our fractional reserve banking system, so let’s first see how the fractional reserve process works without a central bank.
Let us imagine we start a bank, called Stolen Booty, and invest $10,000 of cash to get the darn thing going. I now “lend out” $100,000 to some people, for whatever purpose they have in mind. But how can I “lend out” far more than I have? It works like this; with my original 10,000 I then open up a checking accounts that add up to $100,000 which I lend out to customers. I can charge a lower rate of interest than savers would charge if they were handing out money that they had worked for. I don’t have to save up the money myself, but simply can counterfeit it out of thin air. Before the 20th century, I would have issued bank notes, but the Federal Reserve now has a legal monopoly on the issuing of note issues. Since demand deposits at the Stolen Booty Bank function as equivalent to cash, the nation’s money supply has just, by magic, increased by $100,000. The inflationary, counterfeiting process is under way.
But without government support there are some severe hitches in this counterfeiting process. Firstly, why should anyone trust me? Why should anyone accept the checking deposits of the Stolen Booty Bank? Why do they not just use RedState Bank instead? Or a bank backed by the Koch Brothers? But even if I were trusted and able to con my way into the trust of the gullible, there is another severe problem. Since the banking system without a central bank is competitive the people I loaned money to would spend it (why else did they borrow it?) in various places and the bank notes would end up in a competitor’s bank. Say RedState Bank had $50,000 of my bank’s paper and decided to cash it since they don’t want any bank notes from other banks. Now what? I don’t have $50,000. I only have my original “reserves” of $10,000 so I am finished. Bankrupt. I am out of the money supply game and should go to jail.
As you can see under free competition without government support and enforcement there is very limited opportunity for fractional-reserve counterfeiting and this is why under “free banking” in the past the reserves were supposed to be 100% and were nearly that at all times in honest, respected banks.
The bankers themselves set out to get the government to cartelize their industry. This was by means of a central bank. Central Banking began with the Bank of England in the 1690s. Central banking came to the United States by the Federal Reserve System of 1913. The FED was greatly welcomed, in particular, by investment bankers such as the Morgans who by this time were moving into commercial banking as well. Banksters were in on this idea from the get-go.
Today the FED, our Central Bank, is granted the monopoly of the issue of bank notes. These bank notes are now identical to the government’s paper money and so is money in this country. A bank puts a deposit in the FED and then can issue up to 10 times that amount because we have a fractional reserve system. The FED backs this scheme by law as we have seen. By the way, the originally written or printed “bank notes” were, in fact, warehouse receipts for gold or silver kept in a warehouse as opposed to the intangible receipts of bank deposits today. Neat how we bastardized that term is it not?
Who benefits? This system was set up to inflate the money; but who benefits? Why the largest debtor benefits by making a debt smaller in real terms all the time. So who is the largest debtor in our country? Why the US government is. Coincidence? The banksters also benefit by getting the money first before the inflationary effect; plus the effects of the FED scheme mentioned above. But the benefits also include the minions of the central government who are paid by the central government with the looted wealth.