Thursday, October 8, 2015

Misunderstanding Money

I received an amusing panic email, trying to sell me some financial advice service, which made an unusual, and amusingly misguided, mistake. According to this pitch, the problem we are facing is not government spending, or inflation, or any of the normal financial issues, but a shortage of physical dollar bills! Well, to be fair he argued because dollars are being held overseas, or hoarded at home, the small number of dollars forces us to use credit, and when that collapses, the shortage of legal tender will be a crisis. Oddly, in a way, this is right, but not because of a shortage of paper money, but rather because the system faces a potential crisis should anyone ever stop to ask what precisely IS legal tender.

There are two problems with this scaremongering, or rather three.

First, there is a very pragmatic one, the fact that, being simply pieces of paper, there is no technical problem with the Fed printing more, should they be needed, converting demand deposits, treasury holdings or anything else into paper if we run low. Granted, it would be an inflationary pressure, but there is simply no way we will ever run out of paper dollars, it would be to much of a political disaster.

Second, he also mistakes precisely what represents credit and what represents a transfer of money. Paper dollars do not have to change hands for real money, not credit, to be exchanged. In fact, thanks to the use of bank cards for so many exchanges, transfers of money are becoming ever less common. Allow me to explain. If I have $100 in my bank, and pay you $100 on a bank card, it is not credit, I really exchanged $100. But my bank does not send $100 to yours. Instead, all the banks in a given region tend to get together, and balance out all their transfers, and then make exchanges of real money only to settle any differences, or maybe not even then, instead taking a credit against future debts. Thus, though the nonsensical Keynesian measurement of "velocity"* remains low, much money can exchange hands without involving credit at all.

And there is a second issue. He also forgets that the same money can be both involved in direct exchange and loaned out, that is one physical dollar can be counted twice, or even more times. How? I deposit, say, $1000 with a bank. The bank allows me to draw on that account and spend that money as I wish. At the same time, since it is unlikely I will draw it all out, and since bank exchanges usually take place with few or no cash transfers, they can loan out part or all of that money to someone else. Thus, my money can be counted twice. Or maybe more! Imagine the borrower doesn't need to spend it all right now, but borrows to have cash for future expenses. He may deposit that money in an account until he needs it, and, in turn, some or all of that deposit may be loaned out once more. In the end, though many imagine otherwise, it is very difficult to determine precisely how much money there really is, how much is being exchanged, and all those other measurements in which Keynes and is descendants place so much stock.

But by far the greatest problem, his biggest mistake, is imagining those paper bills as the only legal tender, that they are "real dollars". In truth, they are, and always have been, Federal Reserve Notes, entitling the bearer to one dollar from the Fed. Granted, they are now to be accepted as legal tender, but so were silver certificates, and Federal Reserve Notes when still backed with gold, that does not make such notes into actual dollars.

So, what is a dollar?

I asked this before, and the answer is a bit troubling. ("What Is Money?", "What Is A Dollar?", "The Free Market Solution") In the past, a dollar was easy to define, it was a certain amount of gold or silver, sometimes different amounts of both, though most often it was a given weight of gold. Bank notes, and token coins -- those not made of gold or silver -- could be redeemed, either from private banks or the Federal Reserve, depending upon the era, for a set amount of precious metal. And it was that quantity of metal which was a dollar.

In 1934, FDR banned the holding of monetary gold by ordinary citizens. Certain institutions, and foreign citizens, banks and governments could still redeem notes for gold dollars, and thus, though citizens could not, the dollar was still convertible. It was only in the period of 1971 to 1973, when Nixon gradually reduced the classes of entities which could redeem notes, eventually entirely closing the "gold window"that the dollar lost its ties to gold.

So, what is a dollar?

In short, it is nothing. It is an imaginary entity which is represented by paper bills, entries in ledgers and so on. But, in truth, it is absolutely nothing. Of course, other nations have equally imaginary currency, and all impose this fantasy upon their citizens, decreeing those who refuse to accept these imaginary dollars have surrendered any claim to a debt. Yet, despite all the force of government brought to support this imaginary currency, the truth remains, the dollar is nothing at all.

Which is the mistake made in this scare email. Those paper notes are not dollars, they are notes giving one the right to claim a dollar. Unfortunately, since a dollar is nothing at all, such claims will never be made, and people will continue to confuse the paper with the imaginary thing. Which, in a way, bothers me. After all, if more of us realized a dollar is literally nothing, those of us fighting for a renewed gold standard might not hear so many absurd objections. After all, is the gold standard really such an "anachronism"? Such a "barbarous relic"? Especially when compared to a monetary system that amounts to nothing more than a world-wide game of "let's pretend"? Which system seems more sensible when viewed in those terms?

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* Velocity is meaningless for any number of reasons, mostly because money does not "circulate". People hold money, and at times exchange it for goods, but that is hardly "circulation". The same is true of food, of clothes, of every good. But would we consider them as "circulating"? Yet, because we imagine money is somehow different we can believe it just jumps from person to person at some absurd "velocity". Worse, we accept the really nonsensical conclusions Keynes drew about inflation from this. But, I have criticized Keynes elsewhere, so I will skip it here.


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