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  • Writer's pictureJohn Ikerd

Unraveling the Mystery of Money

As an economist, I’m continually amazed at the importance people place on money. Money is the source of all problems or the means to all solutions. It is a symbol of all good or the root of all evil. To some people, money is like magic: “It is created out of thin air.” It’s a meaningless illusion that has value only because people think it has value. Obviously, money brings forth many emotions that have little if anything to do with the actual economic attributes of money.

I can’t change people’s emotional attachments to money, but perhaps I can help unravel the mystery of money by explaining the economics of money. The standard economic functions of money are: “a medium of exchange, a store of value, and a unit of account.” Unfortunately, the typical explanation of these functions seem to have little meaning to most people.

At the most basic level, money is a “promise.” In fact, U.S. currency was once called promissory notes. Economists talk about money being created by making a loan, which is true. However, the money that is loaned is actually a promise by the borrower to repay the loan. The uniqueness of the promise made with money is that the obligation to repay can be transferred from one person to another. In other words, the loan can be repaid by anyone who will accept the money rather than only by the person made the initial promise.

When we spend a dollar, we are claiming the repayment promised when we accepted the dollar as compensation for something we did. When we borrow money rather than do something to earn money, we are promising to do something in the future that will allow us earn money to repay the loan. Money – in all of its various forms – simply represents claims to unspecified economic goods and services.

Money is a “unit of account” because it states a specific amount to be repaid. It is a “medium of exchange” because it allows us to exchange generic claims to goods or services with anyone, rather than exchange specific goods or services with specific individuals. Money is a “store of value” because we can save money, rather than spend it, and redeem the promise of repayments at some time in the future.

When I was growing up on the farm, a frequent expression of my Dad’s was: “Much obliged, until you are better paid!” He would be thanking neighbors for doing something for him and expressing his personal promise to return the favor later. A favor had been accepted, and a promise to repay it had been made. No money was involved because my Dad and his neighbors had personal relationships of trust. Without money, we would be limited to meeting all of our economic needs through “personal” or face-to-face relationships. The miracles, mysteries, and unintended consequences of money arise from the impersonal nature of its promise of repayment.

Money is not a meaningless illusion. It’s true that money only has value as long people believe money can be exchanged for things of actual economic value. Money loses its value whenever people lose confidence in the promises or claims represented by money. As long as people have confidence in its claims, money has real value. And, those claims can be printed on paper currency, written on checks, recorded in bank accounts, or stored and transferred digitally.

A primary responsibility of any government is to maintain the integrity of its currency. Most money in circulation is “old money.” It represents claims to economic value that have been circulating from one person to another for some time. The value of money in circulation, like the economic goods and services it represents, is determined by the supply and demand for money. So, a primary responsibility of government is to either “create of new money” or remove money from circulation whenever necessary to maintain its value. The process by which new money is created seems that blows peoples’ minds.

When banks loan out money someone has deposited with them, the bank is simply keeping the money in circulation, not creating new money. However, U.S. banks are given the authority to loan out more money than they have on deposit, since everyone isn’t likely to need the money in their bank accounts at the same time. This is where the process of creating money gets a bit controversial. However, as long as the government ensures that the currency in circulation maintains its ability to claim goods and services of actual value, it really doesn’t matter how it is created. Problems arise when governments lose control of the money supply.

The federal government can create “new money” by making loans to banks that are members of the Federal Reserve System (FED). The banks then have new deposits available to support new loans. The government adjusts interest rates to affect the amount of money FED banks are willing to borrow.The new loans represent “new money.” When the federal government wants to take money out of circulation, it simply reverses the process by borrowing money from the FED and taking the money out of circulation.

The government must get the money it loans to FED banks from somewhere. When the government borrows the money by selling bonds to U.S. residents, the money borrowed and loaned balances out; there is no net increase in the total money supply. When the government borrows the money from foreign governments, new money is put into the U.S. economy. This new money represents claims or promises of payment to be made “by U.S. taxpayers.” These claims are real, regardless of when or how they are repaid.

People seem most bothered when the government “creates money out of thin air.” In this case, the government makes loans to Federal Reserve banks on behalf of U.S. tax payers. This results in promises of repayment or claims that are ultimately repayable “to U.S. taxpayers.” These claims are real. If banks loan this money to borrowers who are unable to repay their loans, U.S. taxpayers ultimately suffer the consequences. We incur additional federal debt when our government compensates banks for loans that have defaulted, as we did during the financial crisis of 2008. Or we may pay in terms of inflated prices or devalued currency because nothing of value was produced to buy with the new money created out of thin air. Creating currency “out of thin air” works as long as the economy is growing, but not so well otherwise.

Regardless, money is not meaningless. Every dollar represents a claim or a promise that has consequences if the promise is not kept. Likewise, money has no “economic” meaning beyond its claim to actual physical goods and services. Money simply allows us to meet our economic needs and wants through impersonal transactions. This is no mystery. There are serious consequences of the depersonalization of our society resulting from relying on money to meet needs that could have been met through personal relationships. This too is no mystery. The good or evil is in the hearts of those who earn, spend, save, or want more money — not in money itself. Other meanings and emotions associated with money remain in the realm of mystery.

John Ikerd

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