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Misconception #2: Money isn’t Backed by Anything

August 25, 2012 3 comments

If I had it to do over again, this would be number 1.  Even most economics textbooks don’t get this right.  They usually say something like “The only reason a dollar, or a franc, or a Euro has any value is because we have a stable system in which people are known to accept these pieces of paper in return for something valuable.”  This creates an impression of money as this worthless paper that is out there circulating around which, although it has no particular value to anyone, is somehow magically able to be exchanged for things which do have value.  There are two main intellectual consequences of this.

The first one is that many people come to the conclusion that this doesn’t really make sense which is true.  The second one, is upon coming to this conclusion, most people further conclude that because it doesn’t make sense, it won’t be able to go on forever and that when it fails, it will be because people, for some reason, become no longer willing to accept the money, having no particular value, in exchange for goods and services.  Or in other words: the money will become worthless.  Or in still other words: we will run into hyper-inflation.

This reasoning I find to be a fascinating study in what people are willing to question.  The thinking seems to be something like this:

1. Textbooks are correct.

2. A textbook says that this is why money works.  Therefore, this must be why it works.

3. But it doesn’t really make sense that money could work this way.

4.  Therefore, at some point, it must stop working.

As usual, the flaw turns out to be a false premise more so than false reasoning (though there is a bit of both).  If it doesn’t make sense for money to work like that, it wouldn’t be working now.  The real problem is that that explanation of why money works is completely bogus.  Once you relax the premise that the textbook must be right, things change dramatically.

The reality is that money is backed by debt (see misconception number 1).  Nobody owes you anything in return for your dollar (like they would if there were a gold standard for instance), but instead you most likely owe somebody dollars.  This serves a similar purpose.  For instance, if you have a $100,000 mortgage, then you can “convert” your dollars into your house at the rate of $100,000/house.  You don’t take the dollars down to the bank and turn them in for a house but if you fail to turn in your dollars for a few months, the bank will come to you and take your house.  This is not the same as a gold standard of course, but it is far from a situation where “money isn’t backed by anything.”

Now ask yourself: “if everyone else suddenly stopped being willing to accept money and the value of it plummeted, what would I do?”  Would you shrug and say “well I guess the dollar is worthless now” and start using your cash to blow your nose, wipe your butt and start fires to keep warm until the bank comes and takes your house?  Or would you go out and trade a loaf of bread for $100,000 and pay off your loan?  If you answered the latter, then consider that everyone else with a mortgage/car loan/boat loan/student loan/credit card debt would probably reason along similar lines and that the number of people finding themselves in that category comprise nearly the entire population of these United States and then realize that this is precisely why the dollar never suddenly becomes worthless.

Once you notice this fact, this should start falling into place.  Number 3 should go a long way toward explaining why recessions happen.

Misconception #1: Money is Debt

August 22, 2012 Leave a comment

I was going to write a long post about how nobody understands monetary economics, but I’m not moving very fast tonight so instead I will do it as a series.  This way it will keep you coming back for more.  Besides, this is probably the biggest thing that people don’t get, and don’t get that they don’t get.  So take the time to mull it over and the next time you read something about hyperinflation, ask yourself whether you think the author understands the difference explained below.  So without further ado, the first thing that people don’t understand about money.

Misconception #1: Money is debt

Money is not debt.  It is, in fact, the opposite of debt.  There was a time when you could deposit precious metals in a bank and they would give you a bank-note which was a promise to pay you precious metals in return for the note.  At that time money (bank notes) was debt.  Now money is created differently.  The Federal Reserve creates money by “printing” it and buying government debt with it.  The debt must be repaid with the same type of money.  In other words, if you have a dollar, you are not holding a promise by someone else to pay you something, you are holding the right to repay $1 worth of loans.  Money is anti-debt.

The same thing is true if your dollar was created by a lesser bank.  These banks don’t print money, they create bank credit.  They do this through fractional reserve banking.  In other words, they can loan more money than they have on hand.  So if they have 100 Federal Reserve dollars in the vault and the reserve requirement is 10%, then they can support $1000 worth of loans.  So if you want a loan, you go to the bank and say “I want a loan.”  If they say yes, then they assign you an account with, let’s say, $200.  You now have an account worth $200 and you owe the bank $200.  The $200 in your account is capable of extinguishing the debt you owe.  But it can also extinguish other debts.  Because of this you can use it to buy a boat and the boat-maker can use it to pay off his loans.  Of course, then you have to get another $200 from someone else later to pay off your debts.  More on that later.

Categories: Macro/Monetary Theory Tags: ,

Penn Jillette on Government

August 15, 2012 Leave a comment

Trying to help this go viral.  If you had to say everything we need to know about government in 250 words, I don’t think you could do much better than this.

It’s amazing to me how many people think that voting to have the government give poor people money is compassion. Helping poor and suffering people is compassion. Voting for our government to use guns to give money to help poor and suffering people is immoral self-righteous bullying laziness.

People need to be fed, medicated, educated, clothed, and sheltered, and if we’re compassionate we’ll help them, but you get no moral credit for forcing other people to do what you think is right. There is great joy in helping people, but no joy in doing it at gunpoint.

People try to argue that government isn’t really force. You believe that? Try not paying your taxes. (This is only a thought experiment — suggesting on CNN.com that someone not pay his or her taxes is probably a federal offense, and I’m a nut, but I’m not crazy.). When they come to get you for not paying your taxes, try not going to court. Guns will be drawn. Government is force — literally, not figuratively.

I don’t believe the majority always knows what’s best for everyone. The fact that the majority thinks they have a way to get something good does not give them the right to use force on the minority that don’t want to pay for it. If you have to use a gun, I don’t believe you really know jack. Democracy without respect for individual rights sucks. It’s just ganging up against the weird kid, and I’m always the weird kid.

-Penn Jillette

From an August 2011 editorial on cnn.com.

The Argument Gary North Has Been Waiting For Since 1933

August 8, 2012 2 comments

The nice thing about patronizing a not-so-popular blog: you get a lot of individual attention.  “Anonymous” (a very popular name here in the blogosphere…) directed me to this post by Gary North so I thought I would address it.  Here is the heart of his argument:

. . . (I)t is not possible for depositors to take sufficient money in paper currency notes out of banks and keep these notes out, thereby reversing the fractional reserve process, thereby deflating the money supply. That was what happened in the USA from 1930 to 1933. If hoarders spend the notes, businesses will re-deposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is FED policy to decrease prices. Read more…