The Source of Money

on Saturday, February 19, 2011

Imagine we travel back in time to a primitive cave-dwelling tribe. They have no money and trade pigs for cows, a knife for some honey, etc. The tribe is doing well but is having trouble trading. Sometimes a farmer wants to buy something smaller than one whole pig, and home builders (a new development; cave space is running out!) want to sell their products but it’s hard to save up 1,000 pigs to buy a home!

So we decide that we will introduce money to this economy. How would we do it? We can’t simply “print” a bunch of coins or dollar bills – how would we distribute them to the people?

We can’t give equal shares to everyone in the group – some people have no pigs and no honey, while others have large farms with many animals. How do we decide who gets how much money?

We could have the chief buy pigs and honey and cows from the tribespeople in exchange for the newly minted dollars; a pig farmer might sell a pig to the chief for a dollar. This would set the value of each dollar at one pig.

But this system would eventually end up with the chief’s cave containing all the products that the tribe had produced. No one would be able to use the homes, pigs, cows and knives. So how do we get money into the hands of tribespeople without taking all the valuable items and storing them in a cave?

There are a few ways to do it, but we’ll use the method still used today. When a pig farmer grows a pig, he goes to the chief and asks for a loan of one dollar. The chief says “show me the pig,” and issues a loan to the farmer at interest.

Now we have dollars in circulation along with all the goods produced. So as we can see from this example:

Pig = Dollar

Dollars are money, so where does money come from? It comes from pigs and all the items produced by the people. At its most basic level, money is simply a representation of valuable things.

Money cannot come into being without the goods, because money represents the goods themselves. The chief only issues loans to someone who has produced a pig.

This is how the Federal Reserve works. It issues loans to people who have already created something of value, or issues money to people who are trustworthy and in the process of creating something valuable.

In a similar way, a respected tribesperson could ask the chief for a loan to build a house. The house and the money come into being at the same time – the money comes into the system only to represent the house that is being created.

In a simple cave-person system it would be relatively easy to track how much money goes into the system – the leader would only loan money to people who had already created something valuable, or was certain to create it soon. His purpose in issuing loans would be to mirror the amount of goods created with the amount of money loaned out.

Today the Fed does the same thing on a grand scale. It attempts to look at how much valuable stuff is being produced by the United States, and issue loans (through banks) to mirror the goods produced.

From this basic understanding of the source of money, we can see what would happen if the chief began spending the money he coined; there would be no goods produced to mirror the new money coming into the system.

Let’s imagine that he loans a dollar to the first pig farmer because he has created one pig. Now the farmer has the dollar and the pig. The chief then makes another coin and purchases the original pig. The chief ends up with one pig, and the farmer ends with two coins. Each pig now effectively represents two coins instead of one. This is inflation, or "inflationary spending."

Similarly, when the Fed overestimates the number of “pigs” that have been produced, it allows banks to issue too many loans and the value or price for each pig goes up.

When one thinks about money, it need not be some mysterious idea. Money is not something imagined, but a very real representation of value – value that someone produced.

If you lived in the cave-tribe, each dollar you spend would be there because someone worked to create something of value for the society. The more valuable things the tribe manages to create – the more money they will have in society. And remember, each dollar introduced represents real value. It represents a house, pig, or knife that someone created.

All of the complex things we hear about money can be reduced to this simple idea. Wealth is destroyed when we consume something. If we eat a pig, a dollar is destroyed. Wealth is created when we produce something of value – something that someone else wants and is willing to pay for. When we grow a pig, we create money.

If I take a raw forest, cut down some trees, and build a house from scratch, I have created money. Very real money; I can now go to the bank (chief), ask for an estimate of my home’s value in dollars (pigs) and receive a loan.

It’s unfortunate that so many of use do not understand the raw source of money. Many seem to be lost in a world where money is seemingly randomly distributed; we don’t understand why some are so rich and some are so poor, and there is a disconnect which causes hardship and confusion about how one becomes rich.

We suspect that wealth is created by luck, or by buying real estate, or investing in the stock market, or playing the lottery. There is often some voice in the shadows of one's mind urging him to work hard and save, but the television says money is imaginary, or that one need only open their heart chakra and accept wealth, or that money is created when the government spends (the chief spending money).

From our simply example, it’s easy to see that money doesn’t simply flow to farmers who have open hearts, and it is not created when the chief spends it. Wealth is created (and profits earned) when people make something that other people want – something that improves the lives of the people around them.