The Price Of Money

1. Money is a social construct designed to facilitate trade and store value

Money only exists to facilitate the transfer of value between people and through time.

Functions of money. Money serves three primary functions:

• Medium of exchange: Allows people to trade goods and services easily
• Unit of account: Provides a standard measure of value
• Store of value: Enables wealth preservation over time

Evolution of money. Money has taken many forms throughout history:

• Commodity money: Items with intrinsic value (e.g., gold, silver)
• Representative money: Tokens representing a claim on commodity (e.g., gold certificates)
• Fiat money: Government-issued currency not backed by physical commodities

The key characteristic of effective money is scarcity. Without scarcity, money loses its ability to store value and facilitate fair exchanges. This principle underlies many of the challenges facing modern monetary systems.

2. Modern currencies have lost significant buying power due to persistent inflation

The pound has lost 99 per cent of its value over the last 100 years.

Defining inflation. Inflation is a persistent increase in the general price level of goods and services in an economy over time. It erodes the purchasing power of money, meaning each unit of currency buys fewer goods and services.

Causes of inflation:

• Increase in money supply outpacing economic growth
• Rising production costs (e.g., wages, raw materials)
• Increased demand for goods and services

Impact of inflation:

• Reduced purchasing power for consumers
• Encourages spending and borrowing over saving
• Benefits debtors (including governments) by reducing the real value of debt
• Creates uncertainty for long-term financial planning

Governments and central banks typically target low, stable inflation (around 2% annually) to promote economic growth while avoiding the negative effects of high inflation or deflation.

3. Central banks control money creation, primarily through commercial bank lending

The process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent.

Money creation process:

1. Commercial banks create most new money by making loans
2. Central banks influence this process by setting interest rates
3. When a bank makes a loan, it creates a new deposit in the borrower's account
4. This new deposit is "new money" that didn't exist before

Central bank tools:

• Setting the base interest rate
• Adjusting reserve requirements for commercial banks
• Open market operations (buying/selling government securities)

The ability of banks to create money "out of thin air" is counterintuitive and often misunderstood. This process allows for a flexible money supply but can lead to excessive credit creation and financial instability if not properly managed.

4. Government debt and private borrowing have exploded since the 1970s

Since the 1970s, most major governments have routinely spent more than they've generated in tax revenue.

Government debt explosion:

• Many countries consistently run budget deficits
• National debts have reached historically high levels
• Low interest rates have made borrowing cheaper

Private debt surge:

• Household debt-to-GDP ratios have increased dramatically
• Corporate debt has also risen significantly
• Easy credit and low interest rates have fueled borrowing

Consequences of high debt levels:

• Increased financial fragility
• Potential for debt crises
• Limits on future economic growth
• Greater inequality as asset owners benefit from low rates

The abandonment of the gold standard in 1971 removed a key constraint on money creation, enabling this unprecedented growth in both public and private debt.

5. Quantitative easing: A controversial tool to combat economic crises

Central banks can't claim that QE is a finely calibrated exercise that's designed to give the economy a targeted boost while avoiding any ill effects.

Quantitative easing (QE) explained:

• Central banks create new money to buy financial assets
• Primarily used to stimulate the economy during crises
• Aims to lower interest rates and increase money supply

QE implementation:

1. Central bank creates new money electronically
2. Uses this money to purchase government bonds and other securities
3. Increases liquidity in the financial system
4. Intended to encourage lending and spending

Criticisms of QE:

• May lead to asset price bubbles
• Potentially increases wealth inequality
• Risk of future inflation
• Effectiveness is debated among economists

QE has become a standard tool for central banks since the 2008 financial crisis, but its long-term consequences remain uncertain.

6. The current financial system is built on confidence and may be nearing its limits

It's no longer the backing of a precious metal that keeps the global economy afloat – it's confidence. And when that confidence is shaken, extreme and seemingly improbable things can happen faster than anyone expected.

Signs of systemic stress:

• Unprecedented levels of global debt
• Persistent low interest rates
• Increasing frequency of financial crises
• Growing wealth inequality

Potential triggers for a systemic crisis:

• Loss of confidence in major currencies
• Sovereign debt defaults
• Collapse of significant financial institutions
• Geopolitical shocks

Historical perspective:

• Financial systems typically last 40-70 years before major restructuring
• Current fiat money system has been in place since 1971
• Past transitions often involved significant economic disruption

While predicting the exact timing or nature of a systemic crisis is impossible, understanding the fragility of the current system can help individuals and policymakers prepare for potential changes.

7. Strategies to protect and grow wealth in an inflationary environment

In principle, this means there's nothing to prevent governments from creating as much of their own currency as they want to – and naturally, as they have throughout history when the opportunity presents itself, they do.

Investment strategies for inflationary times:

• Minimize cash holdings beyond emergency funds
• Invest in real assets (e.g., property, commodities)
• Consider taking on strategic debt for asset acquisition
• Be cautious with fixed-income investments like bonds
• Diversify across global stock markets

Key principles:

1. Think in real (inflation-adjusted) terms, not nominal values
2. Focus on investments where you have some control or expertise
3. Alternatively, diversify widely to hedge against uncertainty
4. Understand that no one, including experts, can predict the future accurately
5. Provide value to others as the ultimate hedge against economic changes

By understanding the nature of money and the current financial system, individuals can make more informed decisions to protect and grow their wealth, regardless of economic conditions.

Last updated: November 24, 2024