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"Without the price system that arises through
the voluntary interactions of individuals, no one would be able to know what
objects other people desire and, therefore, would not know what could be
produced to satisfy their wants." (Jacob Halbrooks,
Value and the Environment)
Money is necessary only after member of the
marketplace have achieved a high level of productivity and long-term control
over their lives. In its essential form, money is simply a commodity that is
so generally desirable that it is acceptable to virtually anyone in an intermediate
exchange.
Money so simplifies the process of exchange that
direct barter becomes unnecessary. By accepting dollars (or gold) an
individual relies on its buying power in the future, whether it be minutes, days, or years. Thus money is a product that
serves as a medium of exchange and a store of value.
Credit is a market innovation created to utilize the
otherwise idle savings of individuals. In the early days of credit, when
gold/silver were the accepted money, the metal
itself was loaned (usually secured by specified collateral) in return for a
promise to pay the original amount borrowed plus interest. This led to a new
innovation - the money certificate or bank note.
Fiduciary Media
Lenders discovered that a certificate promising to
redeem to the bearer a specified amount of gold or silver was a suitable and
convenient medium of exchange. Once these certificates were recognized as
acceptable due to the soundness and reputation of the financial institution
that issued them, it was realized that more certificates
could be issued than actual deposits of hard currency.
These certificates and bank notes are a form of
artificially created money and are known as fiduciary
media. They are, in essence, a form of fraud for they represent a good
that does not exist.
As long as the issuer carefully scrutinized the
prospects of repayment and maintained a reputation of soundness with
depositors, it could create money substitutes (bank notes and money
certificates) by extending credit beyond the limits of its hard currency
notes.
In this way, and for the first time, the rate of
growth of wealth could be accelerated beyond that possible by loaning hard
currency - all based on the lender's judgment of the borrower's ability to
produce and trade in the future. The growth of fiduciary
media was regulated primarily by market factors. The bank was
ultimately liable to redeem all outstanding notes in gold or silver, so the
quantity of precious metal deposits provided an objective standard and a
check on the limit of credit expansion.
Like any other business, some banks prospered and
other banks failed; and some depositors earned interest on their savings and
other depositors lost everything. But overall, the innovation of extending
credit beyond actual savings dramatically accelerated the growth of money.
Fiat Money
Today, fiat money - paper
declared to be legal tender by the government - is the accepted medium of
exchange. Fiat money is similar to fiduciary media in the sense that the
currency itself has no use except as a medium of exchange, but it is
different in that there is no objective value backing
it!
In a fiat money system the government, not market
factors, determines the supply of money and credit. The objective limits are
gone, replaced by the subjective limits imposed by government bureaucrats.
The banking system holds reserves not as precious
metals, but as demands for government notes secured by the power to tax and
print money. By stipulating fractional reserve requirements for lending,
buying, and selling government money market instruments, and manipulating
interest rates, government central banks set the limits of credit
availability.
These largely determine the level of borrowing by
businesses and consumers, which in turn sets the rate of growth or decline of
the money supply. Even though the supply of money and credit are government
controlled, market principles still govern the purchasing power of money and
the cost of credit. Money and credit are still subject to the law of supply
and demand.
Savings is still the basis for sound business
expansion through the prudent extension of credit. Money saved is a claim on
unconsumed goods. Savers choose to forgo immediate consumption in favor of future consumption or investment.
Through the advent of credit, they can make a deal,
either directly or through the institution holding their money, to let others
borrow their savings for consumption or investment in return for a promise of
greater purchasing power in the future.
Borrowers use the loan to purchase unconsumed goods
either for consumption or investment, but either way they are obliged to
create enough new wealth to pay back the loan plus interest. The lending
institution creates new money when it makes the loan, but if the money is not
repaid out of newly created wealth, then actual
savings are consumed.
Resources:
- Methods of a Wall Street Master by Victor Sperandeo.
- Mises.org a website devoted to the Austrian School
of Economics, a school of economic thought founded by Carl Menger (Feb 28, 1840 - Feb 26, 1921) with his work Principles of Economics published in 1871.
- Money,
Banking, and the Federal Reserve System is a great video that examines the
formation of credit and the Federal Reserve System.
- The Federal Reserve
Bank of Chicago used to publish a pamphlet entitled Modern
Money Mechanics, which explains M1, M2, and M3.
Mike Hewitt
Mike Hewitt is the editor of www.DollarDaze.org, a website
pertaining to commentary on the instability of the global fiat monetary
system and investment strategies on mining companies.Disclaimer: The
opinions expressed above are not intended to be taken as investment advice.
It is to be taken as opinion only and I encourage you to complete your own
due diligence when making an investment decision.
© 2007 DollarDaze
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