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July 16, 2012

What Is Money and Is the Definition Important?

There are two kinds of money, specie and fiat. Specie is coin money – usually gold or silver. Fiat money has not asset backing but is based on faith of the issuer. The Constitution refers to coining money which implies that coin or specie money was intended. Economics teaches that sound money drives out less sound money.

People who had lots of wealth started to keep their gold in a vault, usually at a bank which was the safest place. The bank then issued letters stating that there was gold backing for the letter. When bankers realized that they could issue bank letters for more than the value of the gold held, modern banking was born. Bankers were able to do this because it was extremely unlikely that people would call for all of the gold at one time. This situation led to panics every twenty years or so when too much paper was issued and prices got out of hand and people demanded gold.

The Federal Reserve Bank (FRB) was founded in 1913 to try and control the money supply preventing panics and wide price swings. The FRB is a private corporation that exists at the pleasure of the government. It had the right to issue gold certificates (currency) based on gold held by the government. The FRB could also purchase gold with money it printed. The additional gold was used as additional reserves. Under this system the price of gold varied. Or the value of the dollar varied. The FRB could issue currency in much the same way – based on gold held in reserve. It introduces money into the economy by purchasing financial instruments and loaning money to financial institutions. This means of creating new money gives the FRB control over the money supply. Bank notes were essentially stopped. However, the fractional reserves was preserved in a manner similar to the old bank notes based on gold in the vault except money was now based on gold held by the government. The FRB had control over creation of money by this process by specifying the multiplier, or fractional amount or reserves. Reserves were defined as coin, currency and non-interest paying FRB notes. In 2008 a law was passed permitting interest to be paid on reserves held by banks.

The US dollar has replaced the pound sterling in international trade. Gold, which is treated as a special commodity, was transferred between sovereigns to balance trade. In those years, the US had a positive balance of trade and accumulated gold. Gold was treated as a special account. Franklin Delano Roosevelt (FDR) took the nation off the gold standard in 1933 and forbid private holding of gold coin or bullion. He fixed the price of gold at 35 dollar/ounce for international trade. This occurred during the Depression when the money supply seemed to contract. The causes for this are still debated but we can note that it was at a time of dramatically increased regulations. The result was that the US had moved effectively to a fiat currency backed only by faith in the government. It freed the government to increase the money supply. However, there were few statistics kept and the effects are difficult to quantify and certainly beyond this note.

The Brentton Woods Agreement in 1944 stabilized international trade by defining the dollar in gold and other currencies in dollars with limited changes permitted over time; this had little effect on domestic trade. In 1971 Nixon took the US off gold completely; the US no longer provided gold to sovereigns for their currency. This made the dollar a pure fiat currency whose value was by dikdat of the FRB-US Treasury.

Inflation and significant borrowing has since reduced the value of the dollar from 1/42 dollars per ounce of gold to approximately 1/1600 dollars per ounce of gold. With no specie anchor the government through the FRB was turned loose to spend money by “printing money” and borrowing by the Treasury. At this point, the Treasury has borrowed about 16 trillion dollars from the FRB, China, Japan, US citizens and others. The FRB has purchased of Treasury instruments (loaned). The total debt is backed by the faith in the US government. Not only is the Federal government in debt, state and local governments as well as the private sector are all deeply in debt. In simple terms, we as a nation are spending more than we are earning. It comes from wealth earned by past generations.

The Gross Domestic Product (GDP) has grown little over the past three years. But the money supply has increased about 2 trillion dollars from 9.6 trillion to 11.6 trillion. One definition of money is called MZM (money at zero maturity), meaning no interest earned. MZM includes currency and FRB reserve money. The number of times that a dollar trades in a year is called velocity which is computed as GDP/MZM. Presently the velocity 1.6, the lowest velocity since the statistic was first recorded in 1959. This implies that the quantitative easing and stimulus did little to stimulate the economy. Much of the additional money was absorbed in MZM, increasing the denominator in the velocity calculation. This situation is similar to what happened in the Depression when the money supply appeared to disappear. The regulatory climate also is similar.

Because bank reserves are non-performing assets, banks typically hold few reserves more than required – excess reserves. They are balanced by inter-bank loans. However, excess reserves recently have rocketed to 1.6 trillion dollars. This occurred when the FRB created more money to stimulate the economy. However, the demand did not exist.

According to the Census Bureau the wealth of the average household has decreased by 35 percent since 2008. This is due mainly to the drop in housing values. Housing starts are low and housing values are lower so people cannot borrow against their house in many cases. If the multiplier is five, the potential exists to create 1.6 x 5 = 8 trillion new dollars. This can occur when demand for money increases. Many say this would be too terrible to contemplate and could only occur with a tremendous increase in demand. Others say it is like laying in a bed of dynamite and lighting a cigarette with a fuse. Since the situation is unprecedented no one can say with certainty what will happen, but there is some indication that the FRB is concerned and has suggested paying interest on the excess reserves, removing them from the reserve status.

On the other hand there is discussion about Quantitative Easing 3 (QE3). This comes about by the political wish to create jobs. It is doubtful that more of the wrong thing will make it the right thing. When companies have over 2 trillion in cash and refuse to invest in the uncertainty economy there is little the FRB can do to make them. We are in a similar place that FDR found himself in the 1930s except for the debt we have developed. The US is close to the tipping point of no return. We are dependent on China to continue to hold dollars and purchase new Treasury instruments.

There are discussions about an international trade currency derived from a basket of currencies including gold as a basis of international trade to replace the dollar. Should this happen, the demand for dollars will decrease and the ability to inflate dollars with respect to gold will become difficult. This would curtail the ability of the Treasury to borrow money and finance our prodigal ways. This would force interest rates on the national debt to increase that would introduce a spiraling inflation.

Governments at all levels must reduce expenditures and stabilize taxes. Americans must have more children and rear them with American mores. The baby boomers have had too few children to support their own entitlements.

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