Apr 13, 2017

Understanding Money: Where Does it Come From?

There are things in science that are awfully hard to explain despite not entirely being hard. We are wired to reason in a certain way, which might be detrimental when it comes to understanding an intricate system.

Richard Feynman, the celebrated physicist, had an interesting anecdote regarding it. In one of the interviews, he narrates how his father asked where the photons come from when the electrons transit from higher quantum state to a lower one. “Photons don’t lie inside the electron, they are just released during state transition. It’s like speech; spoken words don’t come out of bag in the throat.”, he explained. Understandably, his father wasn’t satisfied with the analogy, but there wasn’t much Mr Feynman could have done better.

In the past few months, I got an answer to the basic question I had about money: where does it come from? If I got money from James, who got it from Tim, who got it from Ken, then, who sits at the top of the chain?

To get the answer, I had to realise, after plenty of confusion, that the question is fundamentally flawed. There are two vital things that are amiss —

Initial hunches told me that money begins as a better form of precious metals. A person who mines Gold takes it to the central bank, and they exchange the Gold for more convenient but less-precious cash. In the financial history, this kind of system, called Gold Exchange Standard, existed for a decent period but was slowly abandoned during the 20th century.

Here’s where my understanding broke down. If the precious metals are the fundamental unit of our monetary system, how are we able to do without them? The simplistic answer is, they aren’t money, or better say, wealth. There’s no better way to understand it than to read the story of collapse of the Spanish empire.

After the conquest of the new world, the Spanish army started importing massive amount of Gold to Spain. Elated with the new-found riches and mistakenly equating it to wealth, inflation soared, and the value of Gold declined. Soon enough, Spanish empire became the first state to have a sovereign default, not once but four times. It’s an archetypal case of misunderstanding economics. Increasing the supply of Gold only made it less valuable as the economic output remained constant.

The real question now is: if money isn’t precious metals, printed paper, minted coins, salt, or four-tonne stones, then what is it? To answer this, we’ll try to create a small monetary system of our own.

Building a Monetary System from Scratch

Suppose, I purchase a wooden furniture from a store priced around ₹5000. Instead of handing him over the real money, I offer my business card with the denotation of the amount I owe. I tell him that the card is trustworthy and he can cash it anytime with me in the future. The store owner agrees.

Soon enough, the store owner desires to purchase something himself. He goes to another shop and in lieu of cash, he hands over the card and tells the owner about its convertibility to regular currency. The article is priced around ₹4000, and to return the remaining amount, the owner gives him ten IOU cards, ₹100 each. The usage grows gradually as the new money slowly drives out the old money.

Sounds familiar? It’s similar to the beginnings of the paper-currency system that runs the world today. Banks began lending paper-notes in exchange of existing forms of currency—most prominently, Gold. People started transacting in the paper-notes, and not before long, they became the norm.

If you notice, the paper note clearly states the money the central bank owes to you. Obviously, it’s impossible to carry it to the central bank and ask the money in another form but at a point, it was a legal right. In present times, we rarely care about our money’s conversion to Gold because we trust the printed paper.

There are three things to learn from this anecdote:

Creating Money

There is an obvious issue with our fictional monetary system. If everyone is allowed to create their own cards, it would be difficult to establish faith in the newfangled currency. People would issue cards for the money they don’t have which will make our monetary system useless.

In fact, creating more money than one is possibly solvent of is a textbook recipe for hyperinflation. Despite the proverbial hazards of monetary oversupply, even today, countries (recently, Zimbabwe and Venezuela) heighten the currency printing operations to address financial problems and thereby, aggravating the financial instability.

Money can exist in any manner as long as people trust it. To trust it, it’s imperative that its value doesn’t decline significantly over time. To ensure this stability, the inflation needs to be kept under control, meaning, the money supply needs to grow at a moderate pace.

It is one of the reasons why Gold survived as a standard currency for centuries. There is a slim chance that its supply would grow out of control (unless, of course, in case of Spaniards looting a vast supply of Gold in a short time).

The money as we use today began as a claim for the coins that were deposited but because of the ease with which they could be transferred, they became a medium of exchange. In contrast to today, most commercial banks in the early 19th century issued their own banknotes. In US, it wasn’t until 1862 when the first federally backed currency was issued. Gradually, central banks overtook the role of issuing paper-currency and establishing monetary policy.

As depositing money got popular, banks realised that depositors don’t need all their money back at the same time and some of it could be lent to others. Fractional Reserve Banking, the practice of only keeping some part of deposits in reserve, became the cornerstone of credit creation.

If a person deposits $100, only $60 might be necessary for his withdrawal in near future. The remaining $40 could be lent out, creating $40 that never existed. The radical transformation that FRB enabled was moving the financial system a step away from precious metals; the newly created $40 didn’t need an equivalence in Gold to exist. In other words, FRB made it possible to create money out of nowhere.

Banks create money and they do it by issuing debt. Banks need to make sure that they can meet the withdrawal requirements and there are aren’t loan defaults that can be damaging to bank’s financials. If these two conditions are met, banks can create money without any adverse consequences.

But in modern times, the majority of money is created by central banks through the purchase of assets (bonds) from Government. When central banks make the purchase, the Government is obliged to pay it back over a period through tax revenue. Following the liquidity crunch during the economic slowdown in 2008, Federal Reserve Bank started a program for large scale asset-purchases and amassed nearly $4.8T in its balance sheet. The colossal public debt has been a cause of major concern but then again, the US Government has never defaulted on its debt—although has come close—in the last 237 years.

Money = Trust

The whole system invokes a slight feeling of disingenuousness—banks are actually lending money that is someone else’s. In fact, FRB has often been cited as a system that will lead to a financial disaster.

But there is a better way to think about it: imagining economy as a complex web of trust.

The depositor trusts that the bank would take care of the money, and he can withdraw it anytime he needs. Banks trust that most of depositors won’t immediately need their money back. People trust that the currency they have won’t lose its value in a short time (and, indirectly that, Government won’t do something inane like recklessly printing money to pay off debt). Banks are entrusted with not piling up bad debts that can wipe out people’s deposits (although, almost impossible with US Federal regulations). With imports, businesses trust that other country’s monetary system moves with same principles as theirs.

When we are transacting with our notes, we rarely fret over the public deficit, and how it may affect credit rating of our country, and consequently, how it may affect our currency’s value. For good reasons, we take the web of trust for granted, and trust our Government to do a good job governing it.

It works as it benefits everyone in the long run. Lending makes sense because if the economy is growing, the borrower will have a good chance of paying the money back, making a profit for the lender. It’s a financial innovation that accelerates the pace of economic output by banking on the future growth. As long as default doesn’t occur on a majority of debt, this system will sustain itself.

So what is money? It’s a collective trust that what you, and everyone, holds is valuable and would be valuable in the future. The piece of paper is solely a symbol of that.

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