Friday, 13 March 2009

Printing Currency, Not Money

This sounds like an academic distinction but it is not. Especially at times like these, knowing the difference is key to understanding the behavior of financial systems.

What is Money?
Let's start with a textbook definition of money and proceed from there. Most definitions include two parts, some add a third. According to them, money is:
  1. a medium of exchange
  2. a store of value
  3. a standard of value or unit of account (widely but not universally accepted)

If you look closely at the first two definitions, you will see that money exists in the minds of those who use it. This is partially true for the third definition as well. (note: For all of you monetary theory geeks, please relax. These are deliberate simplifications designed to make the ideas accessible to a general audience, not a detailed exposition of precise financial models.)

  1. I can exchange my money for stuff.
  2. I can exchange my money for stuff later.
  3. I can exchange my money for a predictable amount of stuff later.

Let's think about what is happening here. Money has value because people will give you stuff for it, both now or in the future. But why will they do that? They have to believe that they can trade it onward in turn for stuff they want. So the utility value of money is based on a set of collective beliefs - what Carl Jung referred to as the Collective Unconscious. This is the set of beliefs that are widely held by a group of people at a deep level and upon which they will act without thinking about it. One can think of this as the unstated assumptions of a society. In the US, the dollar has had a stable or relatively stable value for so long that few would ever consider NOT accepting it in exchange for stuff. The dollar as money is a deeply embedded part of our Collective Unconscious, both here and around the world.

Though there are many who are beginning to question the value of the dollar as money, the number is still miniscule as a percentage of society. Even if a person were to cease to believe in the dollar as money in their own mind, they would still accept it as long as they believed that others would accept it from them in exchange for goods. So externally, they would act as if the dollar was still money, even if they no longer held that belief. That is what puts the collective in unconscious. At some point, things deteriorate sufficiently that everyone KNOWS that everyone else is just pretending. That is the point of universal hypocracy just before the belief system breaks down.

The great Adam Smith said it well:

"All money is a matter of belief."

Printing Money?

Now we get back to the title of this entry. It is clear that from a purely physical point of view, a central bank can create as much currency (physical or electronic) as it wishes - subject of course to certain practical constraints such as logistics. But MONEY exists solely in the minds of people. It is essentially a matter of faith and faith is not something a government or central bank can print or conjure from thin air. The value of the dollar is the credibility built up over two centuries of the US Treasury always meeting its obligations. The money, is the widely held belief that the US government will guarantee that dollar holders will always be able to get things of value in return for their dollars, which is backed by generations of positive experience.

Now, please ask yourself "Does creating more currency enhance or damage that belief system?" The answer should be self-evident. The very act of creating more dollars ensures that the purchasing power of every existing dollar is diluted. There is only one scenario under which this will not damage the purchasing power of the dollar - if and only if those created dollars can be used to add a roughly comparable amount of value to the pool of available goods and services available for purchase. That is precisely the role of well-functioning credit system: to allocate capital to useful expansions of capacity and new business ventures in order to create that added value. This is why such a credit system can actually create money through credit. Because the act of printing dollars would have no such offsetting value-added, the arbitrary creation of more dollars undermines the faith which is at the root of money's very existence.

A central bank like the Fed can print currency but it cannot print belief - which is what money really is. A central bank can assist money creation by making the commercial credit system (banks) more credible with a backstop during normal times but that is a supporting role. When it takes the lead by acting unilaterally, it can only destroy money.

Printing dollars destroys money.

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