The Story of Money

This is part of a series of "Growth Guides" I plan to create over 2019. If you'd like to be notified when each one goes live, join my email list - here.

Among the most helpful things you can teach your kids - or nephews and nieces, grandkids, or anyone else you care for - is about money.

Without all the "money is at the root of all evil" drama, of course!

It's funny - and sad - how little we really know about something that we all use every day of our lives.

Having spent quite a lot of time learning about (and figuring out) this abstract, intangible and seductively powerful thing called money, I'd like to share this Story of Money - that you can then tell others!

This will be a (sometimes over-)simplistic overview about money - what it really is, how it's created, who controls it, and why.

What is Money?

It's a medium of exchange.

And - this might shock you - the money you carry around in your wallet or purse (coins and currency) has NO INSTRINSIC VALUE.

At all!

It is only worth as much as your government declares it to have.

Now, while you chew on this in the back of your mind, let's explore the CONCEPT of money as a medium of exchange.

Let's Play Make-Believe

Imagine you're a farmer living in a village. You grow potatoes. You eat potatoes.

Your neighbor grows tomatoes. He eats tomatoes.

After a while, you both grow tired of eating the same old stuff day after day, for breakfast, lunch and dinner.

You say to yourself: "Hey, I'd love to taste some of those tomatoes the guy next door's growing."

So you take a bag of potatoes from your garden over to his house, and offer it to him... in exchange for a bag of his tomatoes.

He agrees - because he's growing sick and tired of eating tomatoes all day as well!

All's fine for some time. But soon, you both grow tired of eating just tomatoes and potatoes. You hear of a farmer in the next village who grows beans... and think of exchanging your produce for his.

In the 'barter economy' that's been alive for around 100,000 years, you'd lug a bag of veggies for miles to swap for a bag of other veggies - which you'd then lug back home with you.

Some bright spark came up with the idea of using a 'medium of exchange' - and called it MONEY.

You decide your bag of potatoes is worth 5 pieces of colored paper (currency).

You 'sell' the potatoes to your neighbor - for that money.

Then, you take the pieces of paper - which weigh much less than a sack of potatoes - to the next village... and 'buy' a bag of beans, handing over your money to the other farmer.

He, then, brings the money to your neighbor (or anyone else who sells potatoes), and exchanges the money for what he wants (potatoes).

It's a brilliant concept. Commerce now becomes widely distributed. I can sell potatoes in my village, and use money to purchase other stuff - anywhere else in the country!

And, as the concept caught on, anywhere else in the WORLD!

Wow!

But...

What's the True Value of Your Money?

Answer: "Whatever your government - and financial markets - say it is worth!"

Hard to believe? Well, it's true.

Ages ago, gold and silver coins were used as money. Their value in buying goods was determined by market rates - and bargaining power.

When the banking system evolved, with paper currency being printed, a method of determining equivalent rates became necessary... especially when it came to international commerce.

Remember how you fixed the price of your potatoes as being 5 pieces of colored paper? That was random.

How does it scale across a wider group of users? And with buyers and sellers from different parts of the country or world - who may have different colored paper?

That process of assigning value to money required a 'standard'. A reference frame against which to compare different currencies, and to arrive at equivalent values.

Countries agreed upon a 'gold standard', where each nation's currency was matched against how much gold it could purchase. If a gram of gold cost 100 rupees, and the same cost 2 dollars, then a dollar was equivalent to 50 rupees.

Another correlation of the 'gold standard' was that countries agreed to print currency notes only in proportion to the amount of physical gold they held in their vaults.

Internally, within a country, the value of currency broadly matches its economic productivity. When production is high and the economy thrives, the currency is stronger - i.e. it takes fewer notes to buy the same amount of gold.

So, when your country prints only enough currency backed by gold reserves, and the economic productivity is high, your currency will be stronger.

A lot of things changed over the years, though.

The 'gold standard' was abandoned by most European nations in the aftermath of the Great Depression, and by the United States in 1971. Today, the price of gold is determined only by market demand, and gold is not used as a standard.

The world has now moved to 'fiat money'.

This is money that is declared by the government to be legal tender, and which should be accepted as a means of payment. It is not backed by any physical commodity, and its value is determined by the demand for it in the market.

And like any other commodity, the more there is of it, the less valuable it becomes!

Before we move on to the interesting topic of how money is "created", a brief note about currency devaluation.

Understanding Currency Devaluation

Since a country's 'fiat money' is assigned a value by the central bank (which typically should mirror its overall economic productivity), it is possible for regulators to adjust this value from time to time.

If the economy slows down, and the currency becomes less valuable, it can be devalued suitably.

Such currency devaluation (or re-valuation, when it happens in the opposite direction) has an impact on imports and exports.

Imagine the Indian rupee being devalued. It means you'll pay more rupees to buy dollars.

This is bad news for companies which import raw material for their manufacturing processes - which they pay for in dollars.

But it's good news for those who export finished goods and get paid in dollars - because their dollar earnings will translate into more rupees in profit.

Sometimes a country will deliberately devalue currency to boost exports and limit imports.

At other times, a devaluation is forced upon a currency because it drops in value (and foreign exchange reserves are not adequate to defend the higher rate). Under such conditions, devaluation can be bad. Inflation rises. Foreign debts become costlier to pay back. And people lose confidence in their currency.

Devaluation is a double-edged sword!

So...

Who CREATES Money?

An obvious answer is: The Mint.

After all, it prints currency notes and coins, doesn't it?

But that isn't "creating money". That task is the preserve of...

BANKS.

You probably have a bank account into which you deposit your savings (and are paid an interest on it)

Your bank lends money to others who need it, charging them an interest to use their money. Borrowers include business owners, whose productivity boosts the economy through the manufacture of products, or by providing services.

Now here's the magic of how banks CREATE money.

When you deposit 1,000 rupees (or dollars, or any other currency) with your local bank, your bank is permitted to lend a MULTIPLE of this amount to borrowers... and it CREATES money!

Surprised?

I was when I first learned of this.

So, while you deposit 1,000 rupees, your bank may (on the strength of your deposit) loan out 5,000 rupees, or 8,000 or even 10,000 rupees to diverse borrowers.

It also charges them interest on the amount. (Still think the interest rate your bank pays you is 'fair'?!)

Can a bank lend as much money as it likes? Of course not!

The central bank places limits on lending capacity. A bank can only hand out loans in proportion to its own assets (this is called "capital requirement" or "capital adequacy ratio") so that no bank stretches itself out too thin.

Ok, so let's briefly recap what we've learned...

• Money is a medium of exchange whose value is in proportion to economic productivity and market demand. 
• It is created by banks, who make loans of a multiple of your cash deposits with them. That "new money" now enters the financial system. 

Let's talk about how that money flow is controlled, managed and used.

Monetary Policy

A powerful regulatory framework is in place to deal with money as it enters the economy. Monetary policy decided by the central bank controls:

* supply of money

* availability of money

* cost of money (rate of interest)

The goal is to manage:

* economic growth

* exchange rates internationally

* unemployment

* inflation

Here's how it happens.

Central banks have many different levers that they can pull (like reserve rates and monetary base) to control how much money the banks create and release into the economy.

Among the most powerful is the Interest Rate.

Banks offer loans, for which borrowers pay interest. When interest rates are lower, borrowers are more likely to take out loans for business expansion (and more money enters the economy).

They increase production by building more factories, or acquiring more equipment, or creating larger infrastructure.

They hire more people to work in these facilities, reducing unemployment and increasing income for more people.

These workers, who now have money to spend, consume more goods and services created by businesses.

Businesses sell more, and earn more money.

The economy grows, and the currency becomes stronger.

Central banks use this effect to kickstart an economy that's showing signs of stagnation.

But they can go too far.

Left unchecked, low interest rates will encourage businesses to keep on taking out loans for unnecessary expansion in capacity - just because the cost of borrowing money is so low!

They produce more things than the market demands.

Their workers are paid higher wages, leading to more disposable income - which leads them to buy non-essentials (luxury purchases), often at inflated rates.

An economic bubble is set up - and grows bigger.

Inefficiency creeps into the system.

Money is plentiful - and cheap.

Its value drops.

The result is... INFLATION.

Purchasing power of currency drops. The same commodities now cost more. The economy gets 'over-heated'.

But...

The central bank still has control of the levers.

It can raise Interest Rates once again.

This makes it more expensive to borrow money - and money supply drops.

Over time, efficiency returns to the financial system - and inflation is controlled.

The role of central banks in wielding these tools in response to trends in the economy is critical. Mishandling them can have serious effects - as we're seeing in the global marketplace.

Runaway Inflation - And Near-Free Money

Most monetary policy decisions are made by central banks to target a desired metric - maybe a specific interest rate or currency exchange rate.

Using the levers it has control of, the central bank can guide the economy in a particular direction.

Sometimes, though, things get out of hand.

For instance, what to do when serial decreases in interest rates fail to get an economy going? That's the situation which worried the US Federal Reserve in 2008 - and led to the sequence of events called Quantitative Easing (or QE)

What is QE?

As a last-ditch effort to salvage the economy when standard monetary policy has failed, central banks release more "base money"(actual asset-backed currency, not the 'chequebook money' created by commercial banks) into the system (more about this in another article).

This will increase money supply for spurring on economic growth and development.

They do this by a complicated series of steps that involve buying up assets from various classes. Several rounds of QE have increased the assets held by the US Federal Reserve from less than $1 trillion in 2007 to more than $4 trillion in 2011.

When even low interest RATES (almost zero) don't spark off productivity, central banks hoped that QE, by increasing the AMOUNT of money in circulation, might do the trick!

Borrowers can now get money from banks - at near-zero interest... and in huge quantities.

That's a dream come true!

The central bank's goal here is to avoid "deflation" (a drop in inflation rates below a pre-set target). It's the strategy adopted by the US Federal Reserve to counter the 2007-2008 economic recession, and it seems to have eased (or at least deferred) some of the adverse effects of the crisis).

Is it guaranteed to work?

Not always. On one hand, releasing too much money into the system can spike inflation. On the other hand, banks may continue to be reluctant to make loans to businesses and households - which would defeat the purpose of QE.

If banks lend to businesses, which then use the funds to increase economic productivity, the situation can stabilize and improve.

Economic growth would make the currency more powerful and valuable. This would permit the central bank to raise interest rates and gradually bring down the amount of 'cheap money' available in the system.

That was the hope that sparked off the first round of QE around 2008 - which then led to 2 further rounds.

What else could go wrong?

Well... borrowers could use the money for other purposes than boosting productivity!

The easy availability of abundant supplies of low/no cost money as zero-interest loans has encouraged reckless financial activity. Huge floods of money were directed into emerging economies (including India's), which aren't quite equipped to manage the influx of funds effectively.

There are some economists who believe the 'easy money' has led to creating surplus infrastructure that wasn't required at all. Without QE, this unproductive excess would have to be written off. Companies would have to book a loss, causing temporary financial pain, from which they would gradually recover.

But QE has encouraged them to keep on going - with the result that huge overages now exist, creating an excess supply that is unmatched by demand.

Sometime down the line, uncontrolled inflation could result, an indirect consequence of having too much money 'out there' in the system, with no way to rein in the supply.

As you've seen, then, money is really funny in a rich man's world.

Its worth is hard to tell - even for experts.

So I'll end with a quote from a plaque I have on my desk.

Charlie Brown says:

"Remember, money isn't everything."

To which Lucy wisely adds:

"But also remember to make a lot of it before talking such nonsense!"

This is part of a series of "Growth Guides" I plan to create over 2019. If you'd like to be notified when each one goes live, join my email list - here.