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What is Money?

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From the Archives : Originally published June 30th, 2002
963 words - Reading time : 2 - 3 minutes
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Category : History of Gold





"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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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.
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