Money: Orgins

To understand money, its uses, origins and inception is incredibly important. Money is a means of exchange and a store of value. There is a demand for it but contrary to popular belief it is not the demand for money that gives it its value, rather the collective assets that the paper currency represents.

As usual, Wikipedia puts it best.

"The origin of currency is the creation of a circulating medium of exchange based on a unit of account which quickly becomes a store of value. Currency evolved from two basic innovations: the use of counters to assure that shipments arrived with the same goods that were shipped, and later with the use of silver ingots to represent stored value in the form of grain. Both of these developments had occurred by 2000 BC. Originally money was a form of receipting grain stored in temple granaries in ancient Egypt and Mesopotamia. "

Money is a byproduct of evolution, as we lived in increasingly interdependent societies means of exchange had to be developed in order to facilitate survival in “village” life. The first such means of exchange was barter.

Both parties would sit down and decide how much they were willing to trade of what they had for the product they needed, for instance:

"I'll give you three chickens for four sacks of grain"

This would also be the first example of what we know today as a modern day currency exchange rate. The rate between Chickens and Sacks of grain would be 3/4.

Coins were later developed and stamped as some of the first types of “hard” currency. This is a good place to start the illustration of how money is a store of value. Since precious metals have intrinsic value: Rare, Shiney, Malleable, High refining and mining costs. They were convenient as a means of exchang; a small amount of gold would be worth quite a bit in real terms, people could simply carry around a sack of coins rather than a wagon of grain to do their village shopping. Coins were weighed and stamped with images so people could easily recognize their value and transact their business efficiently.

Just like our money today, the first gold currency suffered from inflation, although in a way you might not expect. Criminals would "shave" the edges of coins such that you couldn't tell gold had been taken off. After several many coins shaved, a person would have a respectable pile of gold dust in addition to their stamped coins. Quantity theorists say that those shaved coins would be just as valuable as a means of exchange, however that turned out to be quite the opposite. When store owners weighed their coins and they found that they were much lighter than the stamps on the front would suggest.

Because of coin shaving, the gold currency was devalued and we see our first instance of currency inflation. In response to this problem, minters created coins with grooves on the sides, that way if someone was shaving the coins anyone could quickly tell because the grooves of the coins would be worn away leaving a smooth finish. The grooves on our quarters today are just for looks but at one time they served as an anti inflationary tool.

Currency, Fiat Money and Inflation

The best way to think of paper currency is in the form of an I. O. U. An exchange is when one party needs to trade something of value for something else of comparable value. The keyword here is value.

Money is given its worth by the real intrinsic value of the assets or claim to assets that the paper represents. Inflation only happens if the underlying assets that the printed currency represent do not move in step with the printing of the paper money.

Let us first make a personal example. Say you’re out at a restaurant with your friend Rich McMoney and its time to settle up the bill. To Rich’s horror, it appears that he has forgotten his wallet on his fifty foot yacht, right next to Faberge Eggs and pile of diamonds. In exchange for you paying for lunch,Rich sign’s and dates an I. O. U. saying he will pay you back his share of lunch, with interest, the next time you see him.

The next day you have lunch with your other friend: Deadbeat Dave. Now Dave is an honest man but he lives at a men’s shelter, has nothing to his name and barely scrapes by making a living at McDonalds. He too has forgotten his wallet and creates the same I. O. U. that Rich did the previous day.

What has happened in both cases is creation of currency. They have both given their word that they will pay back the sum owed, so hypothetically both pieces of paper should be worth the same amount, but you and I both know that they are not, for obvious reasons.

The piece of paper isn’t given any value by either mans word, rather it is only as good as the man’s ability to redeem it for the real assets he has. Since both you and Deadbeat Dave know there is no way he will be able to afford to pay you back in this millennia, the piece of paper he gave you is totally worthless.

However, since Rich is known as a man about town, you could very easily take the I. O. U. to another friend or a local pawn shop that knows Rich and redeem it for the amount owed. Since the pawnshop owner knows that Rich can easily repay the debt, his I. O. U. is as good as gold.

Back in the real world this example applies since paper currency has been in use. Intrinsically it’s worthless; hence its worth is derived from the issuer’s real assets backing it. Currency is made everyday: by Banks, The Government and stores like Canadian tire (i. e. Canadian Tire Dollars) and the GAP (i. e. Coupons, Gift Certificates, etc).

Every case of extreme inflation in history can be traced back to a lack of backing:from the Free Banking days of the early Americas, to the French Assignat, to the great inflation in Germany.

But how does the US government back it’s currency you ask? Well, for starters, the United States has the biggest gold reserves in the world, but this pales in comparison to its ability to tax the American people.

In short, the US dollar is given its worth from the hard work and industrious exploits of the American people.

Paper shillings in Massachusetts

“In 1690, the colony of Massachusetts faced a financial crisis. The colony had sent soldiers to raid the French, but the raid had failed. The colony had expected to defeat the French and pay the soldiers with the spoils of war, but instead they were faced with an empty treasury, and angry soldiers demanding their wages.

In desperation, the colony decided to pay the soldiers with paper IOU’s. For example, the colony would print “1 shilling” on a piece of paper, and pay it to a soldier. To encourage the paper shillings to circulate at par with silver shilling coins, the legislature declared that paper shillings would be acceptable for taxes just as silver shillings were. To a colonist, this meant that if he owed 1 silver shilling in taxes, he could pay his tax with a paper shilling instead. It might not seem like these paper shillings were backed, but they were backed by taxes. As long as the tax collector had the ability to take one silver shilling from a colonist, and as long as that same tax collector was willing to accept one paper shilling in place of a silver shilling, the paper shillings were backed just as surely as if the colony held a silver shilling against every paper shilling it issued. ”

- Michael Sproul

To understand properly how taxes back dollars one must first understand how a balance sheet works. Think of it like Newtons law:“ For every action there is an equal and opposite reaction. ”It works the same for your finances in the forms of assets and liabilities. If you have a credit card and make a thousand dollar purchase of creamed corn, your balance sheet would read 1000$ worth of sweet, sweet creamed corn under assets and 1000$ worth of credit card debt under liabilities. Any transaction on a balance sheet must match.

Now as you can imagine life doesn’t always fall into neat piles of assets and liabilities – what if you just have a bunch of cash lying around?For the purpose of neatness on the balance sheet extra liquid assets are balanced in the liabilities column by counting them as owners equity. This won’t make sense unless you have taken a finance class, so just take my word for it.

Below, lets say is the balance sheet of the federal reserve and its interactions with Farmer John and some pissed off soldiers. The USD is currently valued at 1oz of Gold to 1 USD.

Exchange Rate:1/1

Now say everyone is happy in the economy, but some soldiers come back from far, far away land and they expect to be paid for their services. Now since the FED has no cash reserves to spare, it cannot readily pay their soldiers their wages of 5000 USD. If the government didn’t have the means to tax its citizens, they would be forced to print 5000 USD in order to pay their wages.

In this case the assets did not move in step with the liabilities of the FED as an issuer and in turn the each of the 15,000 issued dollars only have 10,000 worth of gold laying claim to them. Although everything balances, we see inflation.

Exchange Rate:. 66/1

However, the government does have the ability to tax its citizens, for neatness sake we will say that they fall due to the tune of 5000 USD. At present, the dollar is still valued as 1/1. Remember taxes are not taken in terms of number of USD per year, but in percentage of earnings. The government taxes a percentage of the intrinsic value of their citizen’s hard work as the price they pay for being a citizen. Because of this, taxes can be listed as a real world asset with intrinsic value.

Exchange Rate:1/1

Assets move in step with liabilities and the dollar remains at a 1/1 exchange rate. This is what happens every day but on a macro scale and infinitely more convoluted -- however, now you at least have a rudimentary understanding of how paper money is given its value.

I'm sure when people imagine the professional world of economics, they envision stout white men with male pattern baldness, sitting in a room jabbering about the Nikkei and suppressing the proletariat.

In actuality, it's more like a grown up version of the real world - cliques, disses and hookups are more common than people think. Like Coral was the real world roommate you love to hate, the "Real Bills Doctrine", the theory about the value of money and the cause of real inflation has been the whipping boy of the economics world for years.

Henry Thornton (1801), David Ricardo (1810) and Lloyd Mints (1945), espousers of the widely accepted "Quantity Theory of Money" and critics of the Real Bills Doctrine are the cast members that will stop at nothing to drive their pariah housemate into economic obscurity. However T.R.B.D. has the advantage of logic on its side.

For those who don't know, the Quantity Theory of money says that Currency as we know it only has value as a means of exchange and when you boil it down an American dollar is inherently worthless (See Fiat Money). Hence any creation of money, no matter the circumstances is inflationary.

M x V = P x T

The equation above is the backbone of the Q-theory. It stands for the quantity of money in circulation, multiplied by the velocity (the number of transactions in which the currency is used) is equal to the nominal price level multiplied by the aggregate real value of goods and services used in exchanges.

This is a tautology tantamount to " the rain that falls from the sky is the rain that hits the ground." There is no causal link in this model between the creation of money and inflation, it is just assumed that any creation of money is inflationary.

The conceit in this is that the types of money used to calculate inflation (M1 and M2) are just a portion of the money that is created in North America every day. Credit cards, food stamps, coupons, IOU's and sometimes even specially designed store currencies(Canadian tire dollars anyone?) exist and are exchanged for goods of real value, yet we don't have a huge unexplained jump in inflation due to the creation and use of these currencies.

How can this be while the quantity theory of money holds true? According to the Q-theory all of this currency creation should be incredibly inflationary and yet to date it remains ignored. Where the Q-theory of money fails the Real Bills Doctrine picks up.

In a nutshell, the Real Bills Doctrine says: Money created in exchange for "Real Bills" is not inflationary. Or, to put it another way, if you were to go to the US Mint and say "here is 100USD worth of gold" and they printed you 100USD, the creation of this money would not be inflationary. Why? Because the creation of money moved in step with the amount of assets under lock and key.

So you see, money that is backed by assets has worth because of the real value of the underlying assets. Doesn't that make more sense than magic worthless money that is somehow valuable because unconsciously we all agree that it's useful? There is no such thing as Fiat money.

Inflation happens when the underlying assets are destroyed or devalued. If a crazy US Mint employee destroyed half of the gold you gave for your printed money, there would only be 50USD worth of gold laying claim to 100 US paper dollars, hence the purchasing power of the paper dollars would be halved. Isn't that simple?

I've attached the paper that brought me to this school of thinking and it explains T.R.B.D. much more elegantly than I can. Most convincing are the historical examples that Sproul draws upon. I assure you if you read and digest it, it becomes very difficult not to see the logic staring you in the face.

http://129.3.20.41/eps/mac/papers/9711/9711001.html