What is Money?

on Sunday, May 8, 2011

Is money wealth?

Yes. It is an IOU from a bank, which is wealth in the same way that an IOU from your neighbor is wealth.

Except your neighbor doesn’t pay the IOU with another IOU he can print in unlimited supply....

The government can’t print IOUs (dollars), only the federally protected bank-monopoly (Federal Reserve) can do that. Dollars are backed by real wealth because each IOU comes into existence in exchange for homes, cars, businesses, and government securities. The IOUs are "paid" in those assets when bank loans are repaid.

What is the IOU for? I brought a dollar to the Federal Reserve, and they wouldn’t give me anything in exchange!

The dollars are backed by the assets the bank takes in exchange for its IOUs. If I go to a bank and take a loan against my $10K car for 10K IOUs, the bank takes ownership of the car (holds the title), and agrees to return the ownership of the car to me in exchange for the 10,000 IOUs at any time. Dollars are backed by the cars (and houses and businesses) of which banks take ownership when they issue new loans.

Not all loans are collateralized – revolving credit card debt, for example and unsecured loans for another. So, not every loan is backed by real assets. The value of underlying collateral changes. When house values drop, the mortgage lender finds that he essentially owns an only partially collateralized loan.

Financial or “paper” assets are wealth, as per the economic definition of wealth, which is “anything valuable that can be exchanged.” Revolving debt and unsecured loans are a promise to pay, and are issued to people who have a good reputation (credit rating). Their debt can be bought and sold making their promise a form of wealth. Bank loans issued for revolving and unsecured loans are “backed” by the assets and promise of the borrower. They have pledged their assets even if it is not a formal arrangement. If the promise to repay is broken, the bank can still sue or lay claim to his assets in bankruptcy court.

If banks loan recklessly to people unlikely to repay the debt, they devalue the currency issued to make the loans. They fail to take an equivalent asset in exchange for new dollars, which inflates the currency. A responsible bank, making a loan to a credit worthy borrower, is issuing new dollars backed by the promise of a credit worthy person and the assets he owns. That person’s IOU (a form of real, exchangeable wealth) backs the new dollars.

When housing values drop, the debt of that credit-worthy borrower still backs the dollars issued. Because one of the borrower’s assets declined in value does not release him from the IOU to the bank, and does not remove his other assets from possible seizure by the bank.

When banks make responsible issues of new currency to trustworthy people, inflation is not a problem, and the dollars issued are backed by real wealth. The Fed holds a monopoly on currency creation, and its member banks are routinely reckless issuing currency and judging the credit worthiness of borrowers. If any entrepreneur were permitted to issue currency, the best bankers would rise to the top, and eventually there would be a few stable currencies with very low inflation, all backed by real assets in the same way. There is no need to “abolish the Fed,” per se. We need only return the business of creating currency to the free market.

What about when the Federal Reserve purposely purchases an asset from a failing bank at high above its “real” value? In that case, you are being given an IOU for, let’s say, $100k that is only redeemable for an asset that is worth $50k.

Issuing loans for overvalued assets, or to people who have poor credit is one cause of inflation. It devalues the dollars issued. This is why the Fed monopoly is harmful. It can get away with inflating because it has no competition.

You are confusing checks with dollars. If I hold Federal Reserve notes, nobody owes me anything. And no one is obligated to trade for my notes. Federal Reserve notes are not IOUs. That is why it is called “fiat money.”

The Federal Reserve Notes are an obligation to return your home to you if you return the notes to the bank. They could easily say “The Fed owes you 1/100,000th of your home” on each note. They owe you the house. You owe them 100,000 of their notes, called “dollars.”

Put another way, if you returned with 100,000 notes, the bank would be willing to offer you one note stating “The Fed owes you one house.” When you return that note to the bank in payment on the loan (not deposited to a checking or savings account), you own the house again.

This is an absurd contrivance. A debt always stipulates repayment. If a debt stipulated repayment with one million bushels of flax, that does not mean that the flax I grow and store for repayment are IOUs.

A paper silver certificate “dollar” (dollar was an imaginary term, like unicorns) was in 1792 an IOU from the mint for 24.056 grams of silver. If you held one million “dollars,” the mint owed you 24.056 million grams of silver. If you pulled more silver out of the ground and stored it, that new silver would not be an IOU any more than new bushels of flax.

The mint issued paper “dollars” if you brought raw silver to the mint for coining. It would take the silver and give you paper IOUs in return, in exactly the same way that a bank takes ownership of your assets (homes and cars) and returns paper dollars.

The silver certificate, when returned to the mint, yielded a specific amount of wealth (silver) in the same way that US dollars today yield a specific amount of wealth (a house) when returned to the bank.
There are two ways that currency comes into the world. Most of it comes into existence via bank lending, but some comes into the world because of “quantitative easing,” which is analogous to the US mint printing up “fake” silver certificate dollars and spending them. They are still IOUs (they can still be used to get silver at a fixed rate from the mint), but they are not backed by wealth and they lower the value of existing dollars. When the Fed creates new dollars “out of thin air” and buys treasuries, they are still IOUs, because they can be used to take ownership of a house at a fixed rate from the bank.

If we put you and a friend on a deserted island with just a sack of money, where would you spend it?

If I hold an IOU from my neighbor and you move me to a desert island (without the neighbor) the IOU would become worthless as well. Holding an IOU carries risk, but an IOU from a trustworthy person or company is valuable in the same way as other paper assets: loan agreements, stock certificates, bonds, etc.

The Federal Reserve is not inherently trustworthy. We are all forced to use dollars and using anything else if forbidden, thus creating an artificially high valuation of the dollars themselves, which would be worthless if they weren’t backed up by force.

They are trustworthy in as much as they have not ever defaulted on their promise to return an asset as agreed when its notes have been repaid. And it has a giant thug on its shoulder (the government), who has agreed to support it and its monopoly, which does not create an artificially high valuation of the currency, per se, but allows them to inflate dollars without worrying about losing customers. In a free market people would be free to choose from myriad currencies, judging each bank’s trustworthiness and its inflationary history.

The dollars would hold value without government force. For example, say I forget my wallet one day and walk into your store. I say “I forgot my wallet, will you accept this IOU for a bottle of whiskey?” If you accept, you now hold currency issued by me, backed and denominated in whiskey. (You could presumably trade that IOU with others who trust me.) I take ownership of your whiskey and you take ownership of my IOU in the same way that a bank issues IOUs in exchange for your house.

My whiskey IOU holds value without the use of force, and it is backed by my assets and credit worthiness. I may not even hold whiskey in my house, but because I promised to pay, that IOU continues to be worth a bottle of whiskey and would fluctuate in tandem with my wealth, credit history, and how much people in town trust me.

Later, if I come to your store with a bottle and offer to repay you, you might say “I forgot the IOU at home.” And I would say, that’s fine, keep the IOU and the bottle, but pay me a little interest until you find that IOU. If this were to happen, the exchange would be similar to a bank issuing new dollars for a home, and then allowing you to live in the home if you pay interest until you return all the dollars. They have agreed to return the home to you when you return the IOUs to them in exactly the same way that I agree to return that bottle of whiskey to you when you return the whiskey-IOU to me.

Your goal in trade is obtain wealth. Some goods are called “intermediate goods” because they do not satisfy that goal. Money is a universal intermediate good, with the possible exception of currency collectors.

The term “intermediate good” is only useful in discussing the calculation of macroeconomic numbers, like the GDP, and are useful in avoiding double counting inputs to manufacturing. The term is not useful in deciding weather or not money is a form of wealth. Dollars are not inputs to a final product. They are debt obligations that can be owned, held and traded by people who consider them valuable. Wealth is anything of value that can be owned and exchanged. Money is valuable and can be owned and exchanged. Therefore, money is wealth.

The only value anyone has for money is in its ability to trade for something else. Everything else has some value to someone other than its trade value. Money was invented to obtain those things. It has no other value to anyone.

If I borrow a pound of sugar from you and give you an IOU in exchange, what is the value of that IOU? It has three purposes for you. You can trade it with someone other than me, using it as currency, or you can turn it in and get your pound of sugar back, or you can keep it  indefinitely as a low-cost method for storing wealth. There is no fundamental difference between money and goods that are useless to you and valuable to others, like raw mineral ore. You can use mineral ore for its trade value, turn it in to the mineral extraction factory, or keep it as a store of wealth, but you would not use it for any other purpose because the factory will pay a lot for it. To you, there is no difference between mineral ore and gold coins. Both are useless to you but can be used as money.

A Federal Reserve Note is an IOU promising another IOU from the Treasury.

Federal Reserve Notes are a promise from a bank that agrees to accept the notes in trade for the loans on its books. The note does not promise treasury securities. The people that hold loans against their homes, cars, and businesses can always pay back the loans using the notes. If you take a loan against a $100K home, you can always take ownership of the home for 100 thousand Federal Reserve Notes. If rampant inflation makes the notes worthless, you are still permitted to take ownership of that home with the same (now worthless) notes.

The notes are also a promise by the state to remove its gun from your head; if you earn 100,000 notes per year you can always have the gun removed by paying about half the notes in taxes. Even if the notes become worthless before April 15th, you can still remove the gun by paying with worthless notes.
If you do not owe the state any taxes, and you do not hold any outstanding loans from any US bank, you are accepting the notes in the same way that I might trade an IOU issued by my neighbor. If my neighbor borrows a case of wine from me and writes an IOU, and I offer to trade that IOU for an ounce of gold, you would accept the IOU only because you trust my neighbor to keep his promise. In the same way, you only accept Fed Notes because you trust the US government and banks to keep their promises.

USD have value because people before you accepted them in trade, and people before you accepted them for trade because they were redeemable in gold or silver. Stating that “money is debt” is quackery. Dollars are not exchangeable for wealth anymore, they are a fiat currency that only holds value because people believe in them.

The first step to creating a paper currency is creating wealth (homes, cars). The second step is trading that wealth with another person in exchange for an IOU which can now be traded as currency. Dollars hold value because they can release you from a bank loan. No matter how badly the dollar is inflated, you will still be able to take possession of your home by paying off the loan at face value.

USD today serve the same purpose as gold coins to the ancients. They are not in any way whatsoever IOUs. I ask you again, what does the Federal Reserve owe you?

The Federal Reserve does not owe; its member banks owe. When member banks issue loans, they create currency “out of thin air,” and promise to trade collateral (homes, cars) for the new dollars. When the Fed purchases treasuries it creates currency as well, but does not make any promises. Dollars spent by the Fed are alway inflationary. Dollars created by member banks are not.

The IOU arrangements that you describe are not how USD work or get their value. New USD enter circulation when the Fed prints money from thin air and buys US Treasury debt. You have it backwards; the Treasuries that the Fed holds are the IOUs. A Treasury is a paper that says: “the government owes you US dollars.”

There are two ways that USD enter the world. One way is via bank lending, which involves taking an asset in exchange for new USD, in the same way that the US mint used to take an asset (silver) and return paper US dollars. The old dollars could be returned to the mint for silver, and new dollars can be returned to the bank to take ownership of a house. When dollars are created in this way, they are backed by wealth, and they are IOUs from any bank that issued a loan.

The second way new dollars enter the world is via quantitative easing, where the Fed spends new dollars and buys Treasuries or other forms of wealth on the open market. When new dollars enter the world in this way they are not backed by wealth, but are still IOUs, because they can be returned to a bank in exchange for a house. When the Fed does this it is analogous to the old US mint printing up “fake” silver certificates and spending them. They are still IOUs that can be turned into the mint for silver, but they are inflationary.

If the old US mint, in the 19th century, purchased silver on the open market with silver certificate dollars (IOUs for silver), there would be no harm done. All the IOUs could still be honored for silver held at the mint.

Today, when the Fed purchases assets on the open market, it is analogous to the old mint purchasing silver, because modern USD are backed by myriad assets, but some trouble arrives when we realize that USD cannot be returned to the Fed in exchange for those assets, which are held by the Fed. All profits derived from them goes back to the US Treasury each year, so those assets are effectively owned by the US government and cannot be recovered by citizens holding modern US dollars. In 1792, the silver in the US mint was still owned by the US government, but all of the silver was “spoken for.” All of it could be recovered by people holding silver certificate US dollars.

The Fed will later sell its assets back to the open market in exchange for US dollars, which is done to “raise interest rates” by selling treasuries. In reality, this lowers the supply of “fake” US dollars in circulation (dollars are paid back to the Fed, removing them from the money supply) and has nothing to do with interest rate manipulation. It deflates the currency by removing some of the IOUs from circulation.

Whenever the Fed holds a large amount of assets, there are extra inflationary “fake” IOUs in circulation, and when the Fed holds little or no assets (treasuries) there are little or no “fake” IOUs in circulation that are generated by the Fed. However, there can still be effectively fake IOUs in circulation if banks are careless in estimating the value of the assets that they accept in exchange for the new dollars they create (each time they issue a loan).

If banks suddenly begin issuing million dollar loans for lumps of coal, tulip bulbs, and tremendously overvalued homes and educations, this will also cause inflation because the supply of new dollars will begin to outpace the supply of new wealth. Issuing loans to extremely poor credit risks is another inflationary activity, because new dollars are backed not only by existing wealth, like homes and cars, but the good credit of the people borrowing the new dollars. If the people can be expected to repay the loan even if their lump of coal turns out to be worthless tomorrow, there is little harm done. If the person cannot be reasonably expected to repay, the new money is not matched by appropriate wealth or credit, and is inflationary.

Wealth is not the mere possession of goods and services, it is the ability to command and control goods and services.

Wealth is anything valuable to human beings that can be owned, controlled, or exchanged. A wealthy person owns or controls a lot of things, valued by humans, that can be exchanged. There is no fundamental difference between a “paper” asset and a “physical” asset. Both are valuable, and can be owned and exchanged.

Why is money designated by a different term if it is not a different concept? If it is a distinct concept, then what is the distinction? 

It doesn’t matter what we call an asset. We could call money many other things, but money is the word we choose. Because we call some foot coverings “sneakers” and others “boots,” does not mean they are fundamentally different. They are both shoes, in the same way that money and wine are both “wealth.”

Each person has his own purposes for the goods he acquires. But of all goods, money is unique in that each and every one of us has only one and the same use for money – trade.

Goods have two values: they can be traded and they can also be consumed. Currency can also be traded and consumed.

If I borrow a case of wine from you and write an IOU on a piece of paper, and hand it to you, you now hold a piece of paper that has the same two functions as any other “good.” When you return to my home next week, hand me the paper and I hand you a case of wine, what do I do with that IOU? I destroy it. The IOU has been consumed. The same thing happens to the IOUs (Federal Reserve Notes) when I return them to the bank to make a mortgage payment. The bank destroys the dollars I use to pay down the debt. The dollars I pay not longer exist, until new loans are issued by the bank.

You held an IOU denominated in wine, but I could just as easily handed you an IOU denominated in anything else. We could have agreed to write the IOU in gold, pigs, dollars, or even unicorns. It would not matter. I could have agreed to pay you one cow for your case of wine, and written you an IOU for one cow. When you turn in the IOU, I burn it and give you a cow. The IOU is a good that has been consumed. 

The wine IOU has two purposes. It can be “turned in” at face-value for a case of wine, which I would argue is the note’s “purpose.” It can also be traded to someone else, in which case the note finds use as “currency.” Money is the “most liquid” asset; a financial asset like any other. It is as valuable as stocks, bonds or loan agreements, and finds use as “money” only because it is the most liquid asset available. (In early times, the Chinese expressed their notions of money by a term meaning literally “current merchandise.”p55 Hayek, Denationalization)

Even if we accept the conclusion that US dollars are only valuable because government says they are, and that USD are not IOUs, they would will be defined as “wealth,” by any reasonable interpretation of the definition. Wealth is anything valued that can be exchanged. Money, any way you look at it, fits that definition. To think of money as anything but wealth leads to confusion, and is the main reason that most are so confused regarding inflation, world trade, local economies, taxation and so forth. If money is considered to be wealth, much of the confusion falls away.

Financial assets are not “real” assets. Financial assets are fungible. Most real assets are not. Financial assets are easy to store. Real assets require physical accommodations and insurance. Financial assets are liquid. Real assets usually aren’t. Money itself is not wealth. Wealth is what money can be exchanged for – goods. Stuff.

The line between financial and “real” wealth is very blurry. Financial assets require maintenance, storage, and insurance costs in the same way that “real” assets do, but many of those costs are paid for by government when it creates rule of law, property rights, courts and police. I would have to pay to have my paper assets protected were it not for the protection of government and rule of law. The costs are socialized, but they still exist.

I would have to purchase insurance on my neighbor’s life if he made a verbal IOU large enough, and I would need to pay to have the insurance documents protected from fire and theft in the same way that I might have to pay for the protection of my wine collection or brick of gold.

Financial assets are now incredibly easy to protect from damage and theft because they are digital, but it isn’t as if there is a black and white line between “financial” and “real” assets. It is a gradual change from large illiquid assets like factories to ultra-liquid assets like currency. Wine, gold and a handshake IOU all fall somewhere in the middle. Currency is simply the most liquid asset available.

It’s true that “wealth” is an ambiguous term, but the ambiguity is shattered by the phrase “Money is not wealth.” Money is only valued for its ability to acquire other things.

Money is valued for its ability to pay bank loans tax debts denominated in dollars. Banks and the US government accept only US dollars, and it is fundamentally for this reason that they are valued.
Dollars are also valuable as a store of wealth and as a “universal” unit of wealth, useful in trade, but they remain valuable only because banks accept only dollars if you wish to pay off your mortgage, and because the government accepts only dollars for tax debts.