The Crash Course: The Unsustainable Future of Our Economy, Energy, and Environment (9 page)

CHAPTER 7

Our Money System

Before we begin our tour through the economy, energy, and the environment, we need to share a common understanding of this thing called
money
. Money is something that we live with so intimately on a daily basis that it has probably escaped our close attention, much like the distinction between growth and prosperity.

Money is an essential feature of our lives. Were all of our paper money to disappear, a new form of money would rapidly and necessarily arise to take its place. People in practically every culture ever studied, in every region of the world, have used money in some form or another, which indicates without a doubt that money is a very common attribute of civilization. More precisely, trading, greatly facilitated and enhanced by money, is the essential human activity that gives money its meaning.

By way of example, in Federal correctional facilities in the United States, prisoners pay each other with “money” in the form of plastic-and-foil pouches of mackerel, which they call “macks.”
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Prisoners use “macks” to pay for haircuts, get their clothes pressed, and settle gambling debts. The “macks” work because they are inexpensive (they cost about $1 each), but few inmates actually want to eat them, so they remain reliably in circulation. Their use arose shortly after cigarettes were prohibited in federal facilities in 2004, dethroning the former currency of choice.

In the great economic crisis of 1999–2001 in Argentina, circulating dollars evaporated practically overnight and people were left with rapidly depreciating pesos. Many businesses closed and imported products became virtually impossible to buy. Within a relatively short period of time, farmers began using soybeans to trade for new vehicles and individual provinces rapidly issued their own forms of paper money.
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Money is essential, especially to complex societies. Without money, the rich tapestry of job specializations enjoyed today would not exist, because barter is too cumbersome and constraining to support a lot of complexity.

Money must possess three characteristics. The first is that it must be a
store of value
. Gold and silver historically filled this role perfectly, because they were rare, took a lot of human energy to mine, and did not corrode or rust. The “macks” in federal prison use fit the bill because they last a long time without degrading, so they have staying power. Just as gold and silver stick around because they don’t rust, “macks” stick around because nobody wants to eat them. These forms of currency represent excellent stores of value.

A second feature is that money needs to be accepted as a
medium of exchange
, meaning that it’s widely accepted within and across a population as an intermediary for all economic transactions. Here again, “macks” work as a currency because everybody has agreed they do. In the rest of modern culture, paper currencies obtain their value by fiat, or by law, and so they’re termed “fiat currencies.” Governments declare that these pieces of paper (and their electronic equivalents) are legal tender, that you have to accept them in settlement for debts, and that taxes can only be paid with them and nothing else. The “medium of exchange” feature is enforced by government decree for fiat money, whereas the “macks” are legitimized by a form of cultural consent. But in all cases, money is an agreement between people. We agree that
these
bits of paper, but not
those
, have value. The prisoners agreed that foil pouches of mackerel are valuable, but not gym socks. If you think of money as simply an agreement between people, then you understand the essence of money.

The third feature of money is that it needs to be a
unit of account
, meaning that each unit must be equivalent to any other unit. Along with this idea comes the characteristic that money should be divisible, meaning that you can make it into smaller parts, which can then be recombined without harming the value.

The “unit of account” in the United States is the dollar. Each dollar has exactly the same utility and value as the next, and you can take a dollar and exchange it into four quarters and then back again without losing value. Diamonds have a very high value, but they’re not good at being money because they are individually varied and are therefore not perfectly equivalent to each other. Diamonds fail at being a set unit of account, and dividing them causes them to lose value. “Macks,” on the other hand, are all exactly the same, so they score high in that category, but presumably they don’t divide very well, so they’re not as useful for transactions that cost less than one “mack” or require a partial “mack.” So “macks” are reasonably good at being money, but they’re not perfect. But, hey, this is federal prison we’re talking about, so close enough is apparently good enough.

So what is money, really? I believe in a very simple definition:
Money is a claim on wealth
.

As we will see in Chapter 9 (
What Is Wealth?
), primary wealth represents the abundance of the earth. If you move some electronic digits from your bank account to another person’s account and gain an oil field in the process, you have just used your
claim on wealth
to secure some
actual wealth
. Now it’s up to the recipient of your money to decide where and when they’d like to claim some wealth of their own, too. This idea of money merely representing a claim is important, especially when we consider that these claims have historically been growing exponentially, which we’ll discuss in more depth later on.

Full Faith and Credit

Literally anything can fulfill the role of money in a given culture: Cows, bread, shells, beads, and tobacco have all served as forms of money in the past. Once upon a time in U.S. history, a dollar was backed by a known weight of silver or gold of intrinsic value and came directly from the U.S. Treasury. Of course, those days are long gone. Now dollars are the liability of the Federal Reserve, a private entity entrusted to manage the U.S. money supply and empowered by the Federal Reserve Act of 1913 to perform this function.

If you pull out a physical U.S. dollar and read it carefully as though it were a contract (which it is), you’ll notice that modern dollars no longer have any language on them entitling the bearer to anything. Dollars are no longer backed by any tangible substance sitting in a vault, warehouse, or silo. You can’t demand something from the Federal Reserve or the U.S. Treasury in exchange for a dollar, other than a replacement dollar. Rather, the “value” of the dollar comes from the language on the front, which reads
Legal tender for all debts public and private
, which means that it’s illegal to refuse to accept dollars for debt settlements and that you can’t pay taxes in anything else. Dollars have value because they’re backed by the “full faith and credit” of the U.S. government, but what this really means is that they can legally be exchanged for wealth created by its citizens.

It is therefore vitally important that a nation’s money supply be well-managed (particularly if it’s fiat money), because if it’s not carefully administered, the monetary unit can be rapidly destroyed by inflation. Thousands of paper currencies have come and gone throughout history and now no longer exist. A few examples from the United States include Confederate money, colonial scrip, and the infamous greenbacks issued during the Civil War, which still lend their nickname to modern money despite having lost all of their monetary value long ago. The value of some currencies simply erodes slowly over time until they’re no longer useful, and then they’re replaced. But a smaller yet noteworthy number suddenly lose all of their value in dramatic, hyperinflationary episodes.

How Hyperinflation Happens

A relatively recent example of hyperinflation comes from Yugoslavia between the years 1988 and 1995. Pre-1990, the Yugoslavian dinar had measurable value—you could actually buy something with a single dinar. However, throughout the 1980s, the Yugoslavian government ran persistent budget deficits and printed money to make up the shortfall. By the early 1990s, the government had used up all of its own hard currency reserves, and turned next to the private accounts of citizens as a source of funds. As the dinar slowly and then more rapidly began to lose value to the process of inflation, successively larger and larger bills had to be printed, finally culminating in a rather stunning example of the use of zeros on a piece of paper: a 500 billion dinar note.

At its height, inflation in Yugoslavia was running at over 37 percent
per day
. This means that prices were doubling roughly every two days, which is hard to even imagine. But we can try. Suppose that on January 1 of this year you had a single U.S. penny and could buy something with it. Inflation running at 37 percent per day means that by April 3 of this same year, you’d need a billion dollars to purchase the very same item. Using the same example, but in reverse, if you had a billion dollars on January 1, by April 3 you would only have a penny’s worth of purchasing power.

Clearly, if you had attempted to store your wealth in the form of Yugoslavian dinars during the early 1990s, you would have lost it all, which is how inflation punishes savers. It literally steals value from their saved wealth while their money sits in storage. Inflationary regimes promote rapid spending by people concerned about using their money while it has the most value, and increase the amounts wagered on speculation in order to at least try to keep pace with inflation. Of course, investing and speculating involve risks, so we can broaden this statement to make the claim that inflationary monetary systems require the citizens living within them to subject their hard-earned savings to risk. There’s really no escape. You either opt out of the game by holding onto your money and lose for sure, or you play the game by speculating on stocks and bonds and risk losing it in the markets.

Even more important, since history shows how common it is for currencies to be mismanaged, we need to keep a careful eye on the stewards of our money to make sure that they’re not being irresponsible by creating too much money out of thin air and thereby destroying our savings, culture, and institutions by the process of inflation.

Money Creation

What do we mean by “creating money out of thin air,” and how exactly is it that money is created?

John Kenneth Galbraith, the famous Harvard University economics professor, was active in politics and served in the administrations of Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy (under whom he served as the United States Ambassador to India), and Lyndon B. Johnson. He was one of only a few two-time recipients of the Presidential Medal of Freedom.

Clearly, Galbraith was a pretty accomplished kind of guy, one whom you would correctly suppose was a rather calm and collected fellow who wasn’t given to hyperbole. He once famously remarked about money: “The process by which money is created is so simple that the mind is repelled.”
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What he meant by this is that the gulf that exists between the effort required to obtain money by working for it and the ease of creating money by creating it out of thin air is too enormous for most people to fully accept on the first go. Some find it just too unfair to believe.

To begin with, let’s look at how money is created by banks.

Suppose a person walks into town with $1,000, and lo and behold, a brand new bank with no deposits has just opened up. This is lucky for the town, because prior to this person arriving, there was no money anywhere in the town. The $1,000 is deposited in the bank, so now the depositor has a $1,000 asset (the bank account) and the bank has a $1,000 liability (that very same bank account).

There’s a rule on the books, a federal rule, which permits banks to loan out a proportion—a fraction—of the money deposited with them to other people who wish to borrow some money. In theory, that amount is 90 percent, although, as we’ll see later, banks often loan out much closer to 100 percent of their deposits than 90 percent. As the thinking goes, it is very unlikely that all of the bank’s depositors would demand all of their money back at the same time, so most of it can safely be lent out under the assumption that only a fraction will be demanded by depositors at any one time. Because banks retain only a fraction of their deposits in reserve (10 percent), the term for this institutional practice is “fractional reserve banking.”

Back to our example. We now have a bank with $1,000 on deposit, which it is itching to loan out. After all, banks don’t make money by holding on to it; they make their living by paying a lower rate of interest to depositors while lending to borrowers at a higher rate. Banks live on the “spread” between these two rates.

Because federal rules permit our bank to loan out up to 90 percent of deposits, our bank seeks out and finds an individual who wishes to borrow $900. This borrower then spends that $900, perhaps by giving it to their accountant, who, in turn, deposits it in a bank. It doesn’t matter which bank; it could be the same bank or a different bank. All that matters is that the money goes back into the banking system, which all money eventually does. For now, to keep things simple, suppose the accountant deposits this money at the very same (the only) bank in town.