Money for nothing

Money is not what it seems. What it is exactly has changed a lot in the past, and continues to change today. Let's try to wrap our head around it.

Money is a conundrum. We deal with it every day, but few people understand what it is. Me included. Perhaps it's like the famous Schleswig-Holstein Question. The British statesman Lord Palmerston is believed to have said:

Only three people have ever really understood the Schleswig-Holstein business—the Prince Consort, who is dead—a German professor, who has gone mad—and I, who have forgotten all about it.

Money, to begin with, is a fiction and has been since the introduction of representative money that replaced commodity money. The latter had some kind of intrinsic value, or use value, like gold or other precious metals. Representative money only represents something that has value.

For example, there used to be enough gold reserves to allow people to convert their banknotes into gold. In 1971, the US government suspended this practice. As a result, the US dollar became fiat money. This kind of money has value because of government orders. Fiat is Latin, and fiat money literally means: let there be money.

Of course, people still need to trust the government and the money it makes. Without trust, it fades away. Typically, the result is inflation. This means rising prices. Prices rise wherever there is too much money and not enough stuff to buy with it.

Most money exists in digital form

But how do governments make money? Let's skip over coins and paper notes for a moment. Today, most money exists in digital form. It's not really important how many coins and banknotes there are. Governments have central banks issuing money, and these banks try hard to create enough of it for the economy to thrive, but not more, to avoid inflation.

There is another way for governments to make money, and that's called taxation. This way, they skim off some of the value the national economies create. The third way is government debt, and that's important for people to invest their funds in a relatively secure way. In many cases, people can trust governments to pay them back.

Printing money is still in use as a metaphor today, but in practice that's not what is done. Instead, central banks lower the interest rates they demand from commercial banks in exchange for credit, as well as the interests rates they pay commercial banks for their deposits. Interestingly enough, these rates are often negative these days.

Negative interest rates mean that commercial banks have to pay the central bank for storing money, and that commercial banks get paid for taking money from the central bank. Now we could discuss in great detail what this means and what the reasons are for this extraordinary trend. But that would probably be beyond the scope of this piece.

Creating money out of thin air

Let's instead focus on a very important detail. Commercial banks create money out of thin air. How dare they? If, for example, we obtain a €100 credit from our bank, the bank simply adds €100 to our bank account and puts us €100 in debt. There is no need for the bank to own that money before they lend it to us.

Commercial banks only need to deposit a fraction of the money their clients give them at the central bank. In the Eurosystem, it's just 1 per cent. That's all.

If money can be created this easily, why don't we have inflation? There are, of course, limiting factors. We still need to pay interest to the bank, and we need to pay back the credit. Both factors limit the amount of credit we can afford, and thus the creation of money by our bank.

Why do we trust money that's nothing more than bits and bytes? Because we can convert it into all kinds of things we need or want. As long as this exchange continues to work, we can trust money. That is commercial by definition. Commercium is Latin for exchange.

Now this is something neither governments nor central banks can guarantee. As long as we accept money in exchange for our work and spend this dough for other things, commerce continues. The pandemic hit the economy hard exactly because this exchange was disturbed in multiple ways.

Fixing problems with more money

Now, central banks and governments are trying to fix the resulting problems with more money. What's the reasoning behind that approach? Isn't there enough money? Well, there probably is, but the money is not where it's needed for the economy to work.

In many countries, people lost their jobs because of the crisis, and thus their income. They can't spend money they don't have (and couldn't get credit). Thus, businesses suffer from shrinking demand. But businesses couldn't produce as much because of the crisis, so the economy also suffers from shrinking supply.

The resulting shortage of money is an issue that can be addressed by pouring more of it over the economy. But this will only help so much. Economist John Maynard Keynes once wrote:

We cannot, by international action, make the horses drink. That is their domestic affair. But we can provide them with water.

During and after the Global Financial Crisis, there was a lot of debate about bailing out banks. This debate was of course justified, but people often underestimated the potential fallout of collapsing banks. The bailouts weren't really about the banks, but about everyone else who has bank accounts.

Imagine your bank collapsing. Your wealth would vaporise. Even if it didn't vanish completely, anything above a threshold defined by regulations and deposit protections would be lost. But even if you get your cash back through these mechanisms, losing your bank accounts would lead to tremendous hassle. This kind of disruption can do a lot of damage.

Why is there no inflation?

So, with all these bucks poured over our economies for more than a decade now, why is there no inflation? Maybe there is, and we're only looking at the wrong places. Assets like real estate and equity have seen their prices rising pretty fast. People look at their portfolios and are happy with the numbers they see.

But what if they try to buy other stuff with all that wealth? That's probably going to happen over the next decade, when baby boomers will retire. They will stop saving and might use their savings to consume more, or at least try to. This divestment process may lead to inflation, or maybe not. That's hard to predict.

When baby boomers decide to sell their assets — e.g. stocks or real estate — this may also lead to declining prices for these assets. So if there is a stock price or real estate bubble, this bubble may burst.

Another flavour of printing money is central banks pumping cash into the markets by buying treasury bonds. This way, governments can issue bonds without worrying about demand. In previous times, lower demand for government bonds would have led to lower prices, i.e. rising interest rates.

These days, central banks effectively solve this problem through buying bonds. If the EU decides to set up a coronavirus recovery package, like they did this week, they can do it because they know the central banks will buy up the new bonds they need to issue.

Whether all this is going to work sustainably in the long term remains to be seen. So far, all the financial engineering kept at least our financial systems afloat. Perhaps that's an answer to the conundrum: money is a financial system that works.

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