Help Me Understand Money - Where does it come from?

Great Debates
41

[QUOTE=LinusK]
Err, I still have questions. I understand how banks increase the money supply. But leaving aside for the moment injections of new money by the Fed, isn’t Kevbo right - that debts + interest > all the money in the economy?

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I think Freddy the pig sorta answered this in post #37

[QUOTE=LinusK]

I also have a question about the process by which the Fed exchanges bankers’ book-keeping entries for cash. It appears the Fed only exchanges bank reserves for cash, not other entries (for example - the ones that represent customer deposits). Is that about right? If so, that would explain how bank runs could still occur.
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Sorry, I don’t quite remember enough from college to answer this question, but that sounds right

[QUOTE=LinusK]

I also don’t exactly have an answer to the question of whether it’s the loan or the deposit the represents the ‘new’ money in process by which banks create new money. But perhaps the question doesn’t have an answer, or the answer doesn’t matter.
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Well, first of all, what do you mean when you say money? Do you mean actual bills and coins? or do you mean value/wealth?

Value/wealth is added to the economy any time someone produces a good or a service. To take the previous example:

You deposit $100 in the bank. The bank lends me $90, and keeps $10 on reserve. At this point, there is$190 in our economy. Your deposit that you can get to at any time, and the $90 that the bank just loaned me. Now, I didn’t borrow money just for fun. I intend to do something with it. I buy $90 worth of wood and nails, and I build a birdhouse. I then sell the birdhouse for $100. I pay off my bank loan - $91 (original $90 + $1 of interest).I now have $9 more than when I started. The bank received back 91. They pay the interest on your account .50. You now have 100.50 in the bank. The bank has a profit of .50, and I have $8. A total of $109 from an original $100 deposit. The value was created when I took $90 input (would and nails) and created $100 worth of output (the birdhouse). Now the bank is free to loan out $90.45 ($100.50 - %10 that needs to be on reserve).

Another thing to note is that there is a difference between assets and cash flow. In the example above, the bank has assets of $100 ($10 cash and $90 IOU from me). However, they could run into a cash flow problem if you came and wanted to withdraw $15. This is kinda what a bank run is. More people want to pull their money out then the bank has cash on hand.

Hope this helps. Feel free to ask more if I didn’t explain well enough.

42

[QUOTE=CurtC]
My limited understanding is that the Fed is not the entity that sells Treasury Bonds. That would be the US Treasury, who finances the government’s debt by selling the bonds. The Fed just backs up the banks. Is that right?
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The Treasury sells bonds, and the Fed buys some of them. The Treasury works through primary dealers who act as underwriters for the federal government. The Fed buys from the primary dealers, transferring funds into their accounts in return for bonds and thereby creating money.

Oh my God, yes. The figures aren’t even close. Total government and private debt in the American economy is on the order of $50 trillion, versus an M1 money supply of $1.4 trillion. So what? Most debt creation has nothing to do with monetary creation (as in my Freddy-to-Linus promissory note example).

43

No, you can’t create money through asset appreciation, or even wealth, for that matter. When you sell an asset, the amount of money you get for it exactly equals the amount someone else pays. It’s a zero-sum game.

Suppose I buy a rock from you for $10. You buy it back for $100, and then sell to me for $1000. How much money (or wealth) has been created?

Edit: I agree that asset appreciation can create the illusion of wealth. In the rock illustration, for example, you’ve got $1000, and I’ve got (what I think is) a $1000 rock. But the fact that it’s an illusion can be shown by the fact that I can only get $1000 from my rock by selling it to someone else - in which case, someone else is exactly $1000 poorer.

I mean M3. Currency + checking + savings + whatever else is in M3. Basically, anything that you can use to buy something, without having to sell it first. M3 does not include stocks, bonds, or real estate.

Value is certainly created by work - by the production of goods and services. The money supply, however, is unaffected. There are no more units of money in the economy after you build a birdhouse than there were before. You may have more units, but it’s the distribution that’s changed, not the total supply.

The total number of units of money available to pay the aggregate debt is unaffected by the number of birdhouses people build.

M3 is around $11 trillion or so, if I remember right. The US GDP is around $13 trillion. Would it be fair to say that something around 25% of all the money that’s made in this country goes to service debt?

44

[QUOTE=LinusK]
M3 is around $11 trillion or so, if I remember right. The US GDP is around $13 trillion. Would it be fair to say that something around 25% of all the money that’s made in this country goes to service debt?
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That would probably be a fair guess–considering “money made” in the GDP sense of “money paid for final goods and services”, not in the profit-and-loss sense.

45

[QUOTE=LinusK]
No, you can’t create money through asset appreciation, or even wealth, for that matter. When you sell an asset, the amount of money you get for it exactly equals the amount someone else pays. It’s a zero-sum game.

Suppose I buy a rock from you for $10. You buy it back for $100, and then sell to me for $1000. How much money (or wealth) has been created?

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That’s not true either. First of all money is not the same as wealth. Second, wealth can be created through asset appreciation. If I buy a house, and that house increases in value by 20% and inflation is 5%, I have increased my wealth 15%. That is to say, if I sold the house, I would have more money in real terms than I bought the house with.

46

[QUOTE=msmith537]
That’s not true either. First of all money is not the same as wealth. Second, wealth can be created through asset appreciation. If I buy a house, and that house increases in value by 20% and inflation is 5%, I have increased my wealth 15%. That is to say, if I sold the house, I would have more money in real terms than I bought the house with.
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You have more money, but whoever buys the house from you has less.

47

Everything you should know about Economics, as written by myself.

Essentially, the answer is that we are borrowing from the future, based on the assumption that we can earn that money back through labor. To do that, we go into debt. I.e. the economy runs on an ever depening hole that is equal to the sum of all money loaned out (and that it appears exists in the economy.)

This works without collapsing because, a) most people don’t understand that all the banks and governments in the world are going into debt loaning them money–so they don’t rise up in civil war, and b) enough people pay back their loans (plus interest) to cover the ones who don’t that over time each individual loan is paid off.

48

[QUOTE=msmith537]
It sort of evolved. People used to trade pigs and chickens. Then some king decided that gold was valuable, so they used that. ..
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Not so much valuable as stable, specially when engraved. And it’s a lot easier to transport than live chickens. Seashells, which were used as currency in some locations, share with coins the advantage of being compact and stable.

49

[QUOTE=LinusK]
You have more money, but whoever buys the house from you has less.
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The point msmith537 and I were making is where does the money come from? It’s not all from debts, though, at least not directly. If you want to argue that it’s “direct” enough, I won’t argue, as I could care less if I’m completely right (ignorance be damned :)), but it’s close enough. The problem with defining money is that anytime anything becomes a medium of exchange of value (or wealth), then it becomes money. With that in mind, msmith537 and I are correct.

50

[QUOTE=Elendil’s Heir]
An old joke:

Jack Benny and a friend are walking down the street. A robber steps out of an alley and pulls a gun on them, snarling, “Gimme everything you’ve got!”

Benny turns to his friend, hands him some money and says, “Here’s that $50 I owed you.”
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Let’s not forget…

Robber: “Your money or your life!”

Benny (who was known as a tightwad): “I’m thinking, I’m thinking…”

51

[QUOTE=Sage Rat]
Everything you should know about Economics, as written by myself.

Essentially, the answer is that we are borrowing from the future, based on the assumption that we can earn that money back through labor. To do that, we go into debt. I.e. the economy runs on an ever depening hole that is equal to the sum of all money loaned out (and that it appears exists in the economy.)

This works without collapsing because, a) most people don’t understand that all the banks and governments in the world are going into debt loaning them money–so they don’t rise up in civil war, and b) enough people pay back their loans (plus interest) to cover the ones who don’t that over time each individual loan is paid off.
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No, it works without collapsing because you are conflating money and wealth. If I go into debt for $10 I don’t have to worry about the system collapsing if I’ve got lots and lots of valuable goods and services that would be worth much more than $10 if I sold them. If I paint the Mona Lisa tomorrow, I’ve created wealth. The wealth creation doesn’t happen when I sell that painting for $1,000,000, it happens when I create the painting.

People really have to understand that money is different than wealth. You can have much more wealth in your economy than you have money. You don’t need one unit of money for each unit of wealth, you just need approximately one unit of money for every transaction of one unit of wealth, and perhaps not even then. Take for example two companies that merge by swapping stock. Company A buys 1000 shares of Company B, Company B buys 1000 shares of Company A. Except if they exchange/barter those shares directly they don’t need money at all.

Now, of course the existance of money is very useful to facilitate that barter, because if the shares are publicly traded it is easy to set the value of those shares. But privately held companies are bought and sold every day, without any stock on the stock market to “objectively” value the company. In the case of private companies experts will give their opinion about what the value of the company should be, and if the buyer gives a higher value than the seller then the transaction takes place. Of course, again, the existance of money makes this a bit easier, because even though there’s no price tag on the various parts of the company, the existance of money makes it easier to keep score.

Money is just a particular kind of key good that facilitates transactions. The fact that nowadays we use worthless pieces of paper or entries on computer hard drives instead of lumps of gold or cacao beans doesn’t mean anything. If back in 1532 all the gold and silver in the world mysteriously vanished it would have created a financial crisis, but most people would barely have noticed. It wouldn’t have destroyed all the wealth in the world, just one good among many. So a virus that destroys all bank ledgers, cancels all debts and destroys all paper money won’t leave us destitute, because we’ll still have the cars, farms, buildings, factories, pokemon cards, and all our other real wealth.

52

[QUOTE=Honesty]
Someone once told me that money is backed by the stock market but that doesn’t make any sense to me. I thought money was backed by gold supply but I don’t think it is anymore.

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As a bit of trivia, actually a very tiny percentage of the paper money in circulation is actually backed by gold, in a way. The paper money we use every day is accounted as a liability of the issuing Federal Reserve Bank–just as any banknote would be, and the 12 FRBs together hold gold certificates against the federal government’s entire gold stock. These certificates are booked as assets, and as such can be thought of as “backing” a minuscule portion of the FR Note liability.
*The gold certificates are counted at the final official price of $42/oz and come to around 11 billion. The market price of the actual gold, of course, would be much more than that.

53

That’s assuming that you can sell goods and services, and that you can sell them for enough at or before the time the loan comes due.

Where this becomes a problem is the situation in which the total amount of money created by banks is less than the the total amount of money people owe. In this situation, it’s impossible for everyone to pay off their debts at once. And as the gap between the supply of money and the amount of debt widens, it gets harder for people as individuals to pay off their loans, as well.

The debtors are effectively competing with each other for a pool of dollars that’s too small for them to buy as many dollars as they need.

As is always the case when the demand for a thing outstrips the supply, the debtors bid the price of dollars up.

They may have plenty of goods and services, but their goods and services become ‘worth’ less and less, and there are fewer and fewer buyers.

Under those circumstances, which were common up until 1933 or so, having lots of valuable goods and services won’t save you from bankruptcy, unless your banker will accept chickens, or birdhouses, or paintings, in lieu of cash.

54

Right, this is a situation where the supply of “money” is tied to the supply of gold and you get long periods of deflation, like what occured pre-Depression.

Nowadays with fiat money we can have as much “money” as we like, and the problem is usually the reverse, that we have inflation rather than deflation.

55

And note that inflation is good for debtors, deflation is good for lenders. During inflation borrowers borrow expensive money but get to pay back in cheap money. During deflation borrowers borrow cheap money but must pay back in expensive money. Of course what happens is that interest rates try to discount this, which is why interest rates were sky-high during the inflation of the 70s-80s. But if the lender miscalulates and there’s more inflation than expected then the borrow gets a windfall. If the opposite happens and there’s less inflation than expected (or more deflation, same thing) then the lender gets a windfall.

56

[QUOTE=Lemur866]
No, it works without collapsing because you are conflating money and wealth. If I go into debt for $10 I don’t have to worry about the system collapsing if I’ve got lots and lots of valuable goods and services that would be worth much more than $10 if I sold them.
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I was just being humorous. To be certain, money = a stand in for wealth, and the ever increasing amount of wealth necessitates the expansion of the money base. But given as they are in a sort of feedback loop, it’s somewhat pointless to separate them. While as in a real world sense, money comes from the creation of more and better products, in a mathematical sense, it comes from borrowing on a future that assumes there will be more and better products.

57

Money comes from banks, mostly, who loan it into existence. The rest comes from the Fed, through ‘open market operations.’

Wealth comes from the production of goods and services. Increases in wealth come from working harder, or from improvements in technology or efficiency (greater productivity).

Wealth does not come from asset revaluations. People feel wealthier when the market prices of their assets increase, but their wealth doesn’t change until they sell. At which point, the increase in wealth comes at the expense of someone else. To the extent an asset has real value, that value is created at the time the asset is created (or improved upon), not at the time it’s bought or sold, or at the time the perceived market price goes up or down.

Were it not for the Fed’s injections of new money into the economy, the economy would still be subject to the periodic expansions and panics that characterized the economy up through the 1930’s.

The money supply must grow at a rate that approximates the growth of the economy. If it grows too slowly, deflation, recession, and financial panic is the result. Too fast = inflation. Both are bad, though deflation is much worse.

Left to their own devices, bankers (collectively) would bankrupt first their debtors, and then (often) themselves.

58

Read Francisco D’Anconia’s (sp?) monologue about money in Atlas Shrugged by Ayn Rand.