In part 1 of this series, we looked at a basic macro model of the forces of how supply and demand interact, which can lead to increased price levels. In part 2, we looked at how changes in the money supply can affect the price level. In this blog post, we’re going to think more deeply about how money works. But to begin, we need to understand how money becomes money at all. Carl Menger (one of the three independent creators of what came to be known as Neoclassical Economics), offered this description of the emergence of one commodity as “the most marketable commodity”:

As each economizing individual becomes increasingly more aware of his economic interest, he is led by this interest, without any agreement, without legislative compulsion, and even without regard to the public interest, to give his commodities in exchange for other, more saleable, commodities, even if he does not need them for any immediate consumption purpose. With economic progress, therefore, we can everywhere observe the phenomenon of a certain number of goods, especially those that are easily saleable at a given time and place, becoming under the powerful influence of custom, acceptable to everyone in trade, and thus capable of being given in exchange for any other commodity.

Under a free market system, whatever commodity that is used as money naturally emerges as an outcome of individuals self-interest: the desire to trade the excess of personal production for goods/services that others produce. But to consume from others’ production, one must exchange something of value, and if you don’t produce what the other person wants, then you quickly realize that perhaps you should trade what you produce for another item that you don’t want, but is much more likely wanted by many others. Thus one commodity will emerge as the social community’s preferred exchange media. But a key component of this process is that what emerges as money is something that must be produced by others: all exchanges take place from the vantage point of production being exchanged for some other production. Note what this means: no one can demand without previously supplying. Supply as a logical necessity must precede demand, as production must be prior to consumption. It is this central truth from the classical economists to today that politicians routinely ignore with their fetish of demand and consumption.

Our current system is one where money creation only occurs when a borrower agrees to go into debt. Most of us think that when someone goes into a bank and asks for the loan, that the bank will evaluate the customer for fitness to repay, and then give them some of the money the bank has in its vault (even if a digital vault). But that is not what happens in much of the time, as the bank does not have to have “savings” in a vault to loan out money–they simply create the money “out of thin air” and are only required to have a fraction (~10%) in reserves. And the reserves are the $$ that the Federal Reserve has created by expanding its balance sheet.** So the Fed creates reserves, and the banks loan out the reserves when people are willing to go into debt. So every creation of new money is a claim on purchasing power today, with a promise to pay back in the future. This shows us the nature of the problem of inflation–every new monetary unit created is necessarily inflationary, in the sense that it is increasing the potential purchasing power without directly creating any new products for that money to buy. If we had a fixed money supply, we would expect to see a gentle deflation annually, ~equal to productivity growth.*** But generally, if we have money supply increase proportionally to economic growth, we will have stable price levels. This is because as new money creation is inflationary (more demand), the debt-financed projects from previous periods create new supply in the current period, which is deflationary (more supply). So modern central banking, even with debt-based money, can have stable prices.

Yet with the abandonment of the gold standard (coupled with fractional reserve banking) and central banking, money (essentially) no longer has any cost of production: the Federal Reserve can simply “print money out of thin air” by buying assets (currently $120B per month of U.S. Treasuries and mortgage backed securities). The liabilities of the Fed (which balance their assets) become the monetary base which can enter the economy through the banking system. With no physical constraining limit*** to money production, we are reliant upon the policy makers to get this right. Yet we should have little confidence of this, as F.A. Hayek notes:

Though an indispensable requirement for the functioning of an extensive order of cooperation of free people, money has almost from its first appearance been so shamelessly abused by governments that it has become the prime source of disturbance of all self-ordering processes in the extended order of human cooperation. The history of government management of money has, except for a few short happy periods, been one of incessant fraud and deception. In this respect, governments have proved far more immoral than any private agency supplying distinct kinds of money in competition possibly could have been.

Friedrich A. Hayek, The Fatal Conceit: The Errors of Socialism (London: Routledge, 1988), 103–4.

This “immorality” that Hayek notes has been the over-issuance of money in excess of what the market needs. In the next post, we’ll start bringing this all together.

* Trying to describe the whole monetary process in a single blog post is…challenging. As I’m sure this is not entirely clear to you, for further explanation, please see my online textbook in chapters 11 & 12. You can also listen to several of my YouTube videos on that as well.

** But very important, that deflation would not be even–prices would fall only in those areas of the economy that experience productivity growth. Don’t expect the price of haircuts to fall. These relative price changes are the continuing signals to steer capital in a market economy.

*** Except the very low costs of printing up currency, and most of the money in the U.S. is simply electronic digits and not even currency.