Monday, February 8, 2010

Economic Fundamentals: Money - Ari Paul

In this issue:
1. Wealth is Not Money, Money is Not Wealth
2. Gold and Other “Real” Money
3. Fiat (paper) Money
4. What is Money Really For?
5. Money Mismanagement

Economics is a strange science where even some of the most basic and critical tenets are still debated at the highest level. In this series of newsletters I'm going to build up a comprehensive understanding of economics. I'll try to present the most prominent theories and humbly offer my own synthesis. The stronger understanding we gain will be directly useful in navigating the world of investing.

1. Wealth is Not Money, Money is Not Wealth
We generally think of money as a way of measuring and storing wealth; this is accurate at the individual level but very wrong at the societal level. The world's wealth is determined by how much the world produces. The world consumes what it produces. If the world is producing 40 million cars a year, that's how many cars the people of the world can buy. If the amount of money that people have doubles, they still can't buy any more cars than are being produced. If half of everyone's money vanishes, we'll still be able to buy the same number of cars, the price of each car will simply drop.
Economists define wealth as “the ability to consume.” The world can consume exactly what it produces. Money is a way of measuring this production, but whether it’s measured in dollars, euros, or yuan, the number of cars produced is unchanged. Similarly, if we devalue the dollar, each car may cost more dollars, but the number of cars (and thus global wealth) is unchanged.

2. Gold and Other “Real” Money
The earliest human economies were based on barter; I’ll trade you a few gallons of cow’s milk for your chicken. Using precious metals as money was a drastic improvement - the metals are limited in supply thus making counterfeiting difficult, they are fungible (meaning the coins were interchangeable with one another), and they were far easier to carry around than chickens. Money greased the wheels of business.
Precious metals are of limited supply and therefore have properties of a commodity. For example, at any given time there is only so much gold around. When gold is used as currency, it is both “money” and a commodity that has its own supply and demand characteristics independent of its use as money. As people become wealthier they may desire more gold jewelry and increase their stores of gold. If the supply of gold cannot rise quickly, this may cause the price of other goods to drop in relation to gold. For example, yesterday it cost me 1 ounce of gold to buy a goat, but now that the farmer wants to hold more gold as jewelry he may only charge me only half an ounce of gold since he desires the gold more than before. The goat has not become any less valuable, but it costs less in terms of gold.
Under the economic system of “mercantilism” countries believed that accumulating gold made them wealthy. They exported usable goods like silk and spice to other countries and stockpiled their new gold. One advantage that comes from exporting is the development of domestic infrastructure, so this did produce some benefits, but ultimately money is only useful if you buy something with it. Imagine that Portugal keeps exporting clothes to Brazil in exchange for gold. Eventually Brazil runs out of gold. Now what? Portugal's clothing industry is devastated because they don't have anyone to sell to, and the gold is nearly worthless because no one has anything to export to Portugal in exchange for the gold. This is almost exactly what's happening right now with China and the USA. For a decade China sent us toys and furniture and we sent them US dollars. China is sitting on $4 trillion US dollars and they have few options. China can't spend that money because we don't produce enough goods to send them $4 trillion worth of product. The most likely outcome is that China will keep sending us products for dollars but the dollar will devalue vs the Yuan, so effectively we'll be paying China less and less for the same goods over time, and the dollars we've already given them will be worth less.

3. Fiat (paper) Money
Today “money” is defined by the government. Like it or not, you must pay your taxes in US dollars. Most of the “money” that exists today is not physical currency, but numbers in banks' computers. It is impossible for the government to run out of money since most money is simply a number in a computer system controlled by the Federal Reserve. All banks and even the US Treasury have accounts with the Federal Reserve. When the Federal Reserve wants to increase the money supply, they simply increase the number in the account of the Treasury or a bank. Usually the Federal Reserve will require that a bank give the Reserve treasury notes in exchange for the new money, but not always.
It's critical to note that the Federal Reserve does not need to receive anything in exchange for the newly printed money. There are two separate actions occurring. The first is that the Federal Reserve creates money out of thin air by electronically increasing the number in an account, and the second independent action is the Reserve collects securities. The purpose of collecting securities (which the Reserve sometimes chooses not to do) is to limit inflation and prevent moral hazard. Through these actions, the Federal Reserve directly controls the monetary base.
Money is also created by the fractional reserve banking system. When you deposit $100 in your checking account, your bank can loan out some percentage of that money, let's say 90%. Now the bank loans Jon $90. Then Jon deposits the $90, and the bank loans Frank $81. At this point, you still have your $100 (in your checking account), Jon has $90 in his checking account, and Frank has $81 in cash. Through this system, money has been created. The amount of money that gets created is dependent primarily on two things – the required reserves (the percentage of each deposit the bank cannot loan out), and the velocity of money (how quickly every dollar is spent and deposited). The way that the banking system creates money is not intuitive and most people need to read several examples before understanding it. Wikipedia has a good entry on the subject: http://en.wikipedia.org/wiki/Fractional-reserve_banking
In the last 15 years, many new forms of “money” have been created that have no reserves. For example, savings accounts and money market accounts have 0% reserves. The bank can loan out the entire $100 of each $100 deposit. Theoretically, a hundred dollars could become a trillion dollars if it was deposited and loaned out fast enough over and over. Realistically, the pace of money creation is limited by the demand for loans from businesses and consumers, the supply of loans by banks, and the technical limitations on the time required to initiate a new loan.

4. What is Money Really For?
Money is a way of allocating capital efficiently and rewarding productive behavior. By “keeping score”, we effectively give greater control of the economy to people who produce things that society wants. For example, Ingvar Kamprad, the founder of Ikea, became very wealthy by selling home furnishings of higher quality and at a lower price than competitors. As Kamprad succeeded and his money grew, he was able to make ever larger investments and open new stores. In contrast, Kamprad’s inefficient competitors were likely to run out of money and be unable to sap society's resources. The most capable managers and investors gain greater influence and they are incentivized to be as good at their jobs as they possibly can be.

5. Money Mismanagement
When the money supply is mismanaged, there are side effects that inhibit wealth creation. For example, under severe inflation, banks are reluctant to make loans because the value of the money they lend out may decrease substantially by the time they get it back. Similarly, businesses are reluctant to borrow at the extremely high interest rates that are likely to prevail. As a result, there is less investment in future production.
When the government engages in unproductive spending, they are reducing the efficiency of the economy by wasting human and physical capital. For example, Ingvar Kamprad runs his stores more efficiently than any of his competitors, so he can then hire more people and continuously increase production. Kamprad’s efficiency means that he can sell more furniture than anyone else using the same number of workers and stores. If the government creates new money and builds new stores (or subsidizes other stores), the managers of those other companies will not make as good use of the country's resources. Instead of each worker selling 10 chairs a day, they may only sell 8. As a result, the total number of chairs produced in the world will decrease and we will be poorer for it.
Another example of a mismanaged money supply is when the money supply is not allowed to grow. For much of the 19th century, we effectively used precious metals as money. The supply of the metals grew slower than the production of goods. The result was deflation. Under deflation, consumers expect prices to continue dropping over time so they delay purchases. Businesses are reluctant to invest in new production because if the prices of their goods continue to drop, they may not earn a return on the investment. Deflation frequently causes a cycle of high unemployment and slow wealth creation.
Economists generally agree that to optimize wealth creation, we want a slow and stable growth in the money supply. This can be a challenge for the Federal Reserve, since as we discussed earlier, money is also created by banks. During recessions or the bursting of asset bubbles, bank lending may suddenly drop precipitously requiring strong Federal Reserve intervention to maintain a stable money supply. Finally, there can also be political pressure on the Federal Reserve to increase the money supply faster to create higher short-term growth and reduce unemployment.

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