Modern Monetary Mechanics – a Primer

For my inaugural post here at DTOM I originally considered some deep philosophical post that encompassed some of my favorite subjects. Then, I put the cognac down, opened a beer and realized that I would bore the Hades out of my readers. Not a good way to introduce my writing. Instead I decided to provide the readers of this blog with a tool to reach some of their less knowledgeable friends and family members. Not everyone is a monetary wonk, this is a good thing, and not everyone truly understands terms that are used in day to day conversations, this is a bad thing. So here is the first of many articles (that is until I get my privileges revoked) on monetary policy.

 

Part 1 – Definitions:

I want to clear some misconceptions and misinterpretations of the actual nature of money. There are several terms that are generally used interchangeably and incorrectly so.

 

The first concept I want to define is currency. Currency is not money or wealth. Currency can be used to purchase money or wealth but it is not either by itself.

 

What is currency? Currency is any agreed upon medium of exchange.

 

Casino chips, Chuck E. Cheese bucks and airline reward points are all examples of currencies. The value of a currency is your ability to trade the currency for actual money or wealth. You can voluntarily accept this medium of exchange either by the perceived benefits of accepting the currency or by your desire to participate in an activity that requires the use of such currency to participate. Monopoly “money” is a good example of a currency. Although it has no value outside of the game of monopoly, while playing, you behave as if it had value because it has value for the limited duration of that activity.

 

The first disadvantage of currency is that it is generally based on faith; on your faith that you can exchange the currency, at a later point, for money or wealth. The problem is that the value of the currency is subject to the desires of the issuing authority and the agreement by the trading party of the value of it. You could choose a particular airline because you believe that you will accumulate enough miles to trade the bonus points (currency) for free flights (a tangible benefit). Of course, the airline has the ability to change the terms of the program, therefore the value of the reward points (currency) as it wishes and reduce the expected benefit that you based your original decision on.

 

Please understand that all currency is based on debt. When you accept casino chips as payment at the poker table you do so with the explicit understanding that the casino will redeem the chips into legal tender on demand. Similarly when you accept a Federal Reserve Note (no those are not dollars they are Federal Reserve Notes), you do so with the confidence that they will be redeemed by the labor or production of others.

 

I have no philosophical disagreement with currencies. As long as they are used by two parties in a free agreement to the value and usage, they can provide benefit to all parties involved. Casino chips provide the casino with a captive audience that fails to psychologically connect monetary losses in chips with losses in wealth. Casino patrons gain the advantage of the entertainment gained by participating in the casino.

 

My opposition to currencies begins when the currency becomes a fiat standard, a government imposed medium of exchange. Governments decree that a particular medium of exchange will be used for all transactions as “legal tender” and removes the voluntary element from the transaction. Let’s forget for a moment that government’s involvement in voluntary commercial transactions between free people is an abomination. The fact that a government can decree the method of exchange and the value of such method is ripe with the opportunity for theft.

 

Money, the second concept we need to discuss, can be used as currency and it is by itself a tangible good. As an example, in early colonial days, tobacco was used as money. Tobacco, a valuable export crop could be used as a method of exchange and then traded for gold or other goods. Since tobacco has an inherent value in and of itself, it is money fulfilling the role of currency.

 

In general money must have inherent, widely accepted value, it must be easy to recognize and divisible into smaller units and it must retain its value for a reasonable period of time. Beads, gold, silver, spices, tobacco and other consumer goods have been historically used as money. Please understand that for a commodity to be money, even if used as currency, it must meet its general value, divisibility and longevity requirements. It must also, ideally, be rare and require work in order to exist.

 

Sea shells picked up on the beach could be used as currency but are not money. The ease of collecting them and its wide availability make them inherently worthless. Diamonds, although somewhat rare and requiring work, are not easily divisible or recognizable (cubic zirconia anyone?)

 

Certain commodities fill the role of money better than others. Thru history, men have chosen gold and silver as ideal forms of money. Gold and silver are relatively rare, limited in availability (cannot be manufactured), divisible, durable and inherently valuable.

 

The next term that demands clarification is wealth. What is wealth? Wealth is not money or currency. Money and currencies are vouchers for future wealth.  Wealth is, in essence, the tools and supplies needed to support your quality of life. A plot of farm land is wealth, when owned by a farmer. A steel lathe is wealth, when owned by a machinist in the production of goods. A loaf of bread or a bushel of wheat is wealth. Any item that can keep man alive, healthy or assist in that man’s production is wealth. The can of beans in your pantry is wealth. The Federal Reserve Note in your pocket stamped “one dollar” is not. You use currency or money to purchase wealth. The car you fully own in your driveway is wealth. The $20k balance in your 401K is not.

 

At its essence, wealth is the product of your efforts.

 

Wealth is produced by you or traded for freely with those that produce other goods in exchange for yours. If you are a machinist, you trade the products of your labor (a new engine part) for the products of someone else’s labor (the wheat produced by the farmer who needed the new engine part). Since you still need to eat and the farmer does not always needs a new engine part, currency serves a valuable means to measure the value of your production to others and as a means to trade for the production of others.

 

Money, in the other hand, serves as a storage mechanism for future wealth. You store your surplus production as money in order to exchange it for someone else’s future production. That is why it is critical that the value of money be stable thru generations and free from outside interference. Let’s say that you spend 20 hours of labor in order to earn, by your production, 20 units of wampum.  You save these 20 units of wampum with the expectation that in a future date, the 20 units of wampum will purchase the same amount of wealth that it could have purchased when you earned them. If your wampum would buy you a bushel of wheat today, you know that 20 hours of your labor are worth one bushel of wheat. You should reasonably expect that one year from now, if you have an accident or disease, that you can still trade the stored surplus production, the 20 wampum, for a bushel of wheat. You should also reasonably expect that, at the end of your life, you are free to pass along you wealth (land, factories, cars) or your money, the accumulated wampum, to your progeny in order to build multi generational wealth. Your surplus production today can be added to the surplus production of your children to benefit your grand children. Their surplus production, when added to yours, can amount to a fortune of wealth in the benefit of their grandchildren.

 

When you take into account improvement in efficiencies of production created by the minds of men, the storage of your surplus production should actually be exponential. The farmer that could only plow 10 acres of farmland with a plow and an ox is exponentially more efficient than the savage that plowed 1 acre with a stick or a hand plow. The farmer that can plow 100 acres, in the same amount of time, with a tractor, is 10 times more efficient than the farmer with the ox and 100 times more efficient than the savage with the stick. It stands to reason, that as the technological efficiencies created by the minds of men increase production, generational wealth would also grow exponentially. Yet it doesn’t.

 

Credit or debt is a lien on your future production. A farmer that borrows in order to purchase seed or buy a tool to increase his production; does so on the expectation that he can pay back the debt with a portion of his surplus production. If the farmer is wise, his debt can be easily eliminated with the increased efficiencies gained by the wealth purchased on credit and his new efficiency will, within reason, improve all future production well beyond the extinguishing of the debt.

 

Debt is not wealth.

 

Debt borrows future wealth in order to provide it today. If the debt results in increased production above and beyond the cost of the debt, it is a useful tool. A man borrowing money from investors to purchase a factory that can reasonably be expected to produce many times more money than it cost, is engaging in productive borrowing and using an available tool efficiently. A bum borrowing money to buy a bottle of whiskey is not. Using your credit card to buy a new computer that can improve your efficiency as a writer or accountant is using debt wisely. Purchasing a new laptop on credit to surf for porn is not. A student loan taken in order to learn a critical skill that you can reasonably use to earn, by means of your production, many times more wealth than the cost of the education and the difference between having the skill or not having the skill can be a wise investment in your future. An $80,000 dollar student loan to get a degree in women studies in order to gain the “college experience” and ending up working in Wal-Mart is not. President Jefferson borrowing money to purchase the Louisiana territory from the French in order to gain a large amount of arable land for the nation is smart borrowing. The Federal Government borrowing 100 million dollars from the Chinese government in order to give it as a gift to the ” Palestinian” authority is not.
The last concept I want to discus today is investment. This widely misused word has a specific meaning.

An investment is wealth acquired today for the purpose of increasing future production or wealth.

The home you purchased on credit to live in is not an investment. The home itself is wealth and the mortgage is a liability (debt). A commercial property purchased as a rental unit that can reasonably produce long term residual income is an investment. Purchasing new clothing for a job interview is an investment. Spinner rims and a killer radio system for your Gremlin are not.

 

It is critical that you understand these concepts before we venture down the rabbit hole. The Alchemists of Money have worked very hard in confusing the real meaning of these terms to their advantage and are using your confusion to rob you blind.

11 comments to Modern Monetary Mechanics – a Primer

  • Clayton Davenport

    Good stuff, Goldsaver. Look forward to the future installments!!

  • Silverfox

    First of all, welcome. Now you got you feet wet.
    May I suggest you go back to the Cognac, perhaps a Camus Cognac Cuvee. Yes, what is money? What is important? When I think of these questions I think of Mr. Hanks in “Castaway” What if had a Billion dollars on the island, so what? What if he had a Million oz. of Gold, so what? What if he wasn’t alone and had a hundred people with him, still, so what. Bet the Cognac would have some value. Would the currency in this case be food and water? But as is seems you imply, everything is currency. If I barter a few beers to get someone to mow my lawn then the beers were the currency? Its value is what we agree it is. But with our money we have no say, its worth what our elected servants say it is. Or make it so by debasement. I really liked the line mentioning generational wealth. This is how all people should think. My belongings are not mine, I’m holding them for my children, grand children etc. Anyway, well written and provides a lot of clarity and a firm base to teach from. Thank you.

  • Silverfox, thank you for your feedback. In the deserted island scenario anything that can be used for barter is currency and anything that can hold its value across generations is money. Money can be currency but currency can not be money. Why? Money has the value assigned to it by mutual agreement of all participants based on its inherent worth. Currency has no value beyond what wealth can be had by trading in it and the confidence of all market participants on the future value of the currency. What is necessary to understand is that we are living in the wrong paradigm. Because we assume that currency, money and wealth are interchangeable terms we are easily fooled by those who control the currency. We will never build real wealth as long as we do not understand the true meaning and purpose of the different exchange mediums. Next article will deal specifically with the confidence game been played on all of us by those who stand to benefit by our ignorance.

  • rainmaker

    This is a link to a pretty interesting explanation of Money. Only 6:50 minutes. A penny for your thoughts:

    http://www.youtube.com/watch?v=_egBPM9tnzo

  • Wow, great write up, I liked it and will use it to wake some up. Is there a part 2 coming?

  • @rainmaker, thanks for the link, I inserted it into part 2

    @Andy V. part 2 posted for your reading pleasure

  • Prudentis

    I think the distinction of money and currency is a superficial one.
    The term “money” is used now by many gold money proponents like Mike Maloney and others to refer to currency with high intrinsic value.
    This distinction is unnecessary. Gold money for example is just currency with a high intrinsic value thus it is both, currency and a commodity.

    Noone has yet succeeded to tell me how the superficial reduction of growth to the limits of gold and silver production could solve the problems we face. After all we started with pm money. Look where we are now. Yes, you can limit money creation to some physical boundry, but why is this boundry good? Maybe it is still too much? Maybe we need contraction, would that be achievable with pm money? This superficial boundry (ammount of above ground PMs) is in no way able to address our issues. Very soon we would face the same or simillar problems, that lead to the fiat systems we have now.

    The “storage of wealth” may be better achieved with comodity money but any currency without a built in inflation could also serve the purpose with the additional benefit of being more elastic to recessions.

    The problems do not lie solely in the currency but the current economic and monetary models we use. What we need is a system so flexible, it can both allow for growth and contraction. For this we need two things
    1. Free markets
    2. competing free currency systems
    3. both freed from Keynsian deficit spending growth paradigms

    Would there be pm money systems? Of course. Fiat systems? Definitely.
    Only through competition between those systems could robust currencies emerge victorious through the normal free market mechanisms.

  • Prudentis

    Nice, just as I was writing my above comment, rainmaker posted a youtube video explaining what I wanted to say much better, than I could :)
    Watch the vid

  • Prudentis, the distinction between money and currency is crucial and I dont blame you for not seeing it right away.

    Currency is an agreed upon means of exchange that provides a measure of the value of the production been exchanged

    Money is a wealth storage mechanism that can be used as currency

    So, lets get into the differences. You and I can agree to exchange a service on casino chips. Lets say that you have a dozen eggs for sale and demand 1 wampum chip for the eggs. Lets say that I get paid 12 wampum and hour and find the price reasonable based on the amount of work it took me to earn the wampum and the savings in my time that purchasing the wampum from you bring. Great, we have a trade. Now, here is the problem with wampum. Since wampum has no intrinsic value, other than our agreement to the value of the wampum, I have no way to make long range planing. Lets say I can save 120 wampum a month (10 hours of my time) for the next 3 years. I know that after 3 years I will have 360 hours worth of my production saved, If I get sick or need additional capital, I should be able to know that I have a month or so worth of purchasing power stored. But, since wampum have no intrinsic value, I can not reasonably expect to have this labor saved or that the price of eggs will not double in three years. I need a storage medium that is liquid enough to store current surplus production for future needs and stable enough that I can store it for a lifetime and be assured of its value.

    Gold and silver provide that protection. Historically an day of hard physical labor has been sold for 1/10th of an ounce of silver or about $3.10 in current fiat measurements. You could say holly crap, I am not working for $3.10 a day! Well, you are forgetting that labor is not the only thing that gets adjusted, prices do too.

    In 1964 a gallon of gasoline costs an average of 27 cents a gallon or about a 1/4 of an ounce of silver, today gasoline costs 3.30 cents or about 1/10th of an ounce of silver. As you can see, the price of gasoline as it relates to silver, has actually gone down, even though we use much more gasoline today than we did in 1964. Why? technological efficiencies in everything from discovery to extraction, processing and distribution. The same is true of almost all consumer goods. When compared to silver and gold everything is much cheaper than it was in 1964.

    To your second point regarding the limitations placed by PMs to the expansion of the economy. Not so. The only thing that is restricted is the expansion of government. There are examples here in the US of economic restrictions under a PM system but those were caused by the government backed monopolies not by the free market. During the post civil war era, the Federal Government recalled greenbacks and force the use of only gold as money. This was done to benefit the banks that held the gold in their vaults. People fought to reinstate silver as a form of money in order to break the banks hold on the economy. But, without a government, people would have been free to trade in silver if they so wished.

    Would there be currencies without the Federal Reserve? I certainly hope so. These private currencies would be based on a voluntary system of exchange between individuals and be backed by whatever the particular company selling them can convince their customers its acceptable, There might be some currencies backed by silver, Others backed by gold and yet others backed by computer algorithms. Who knows? The point is that they will be voluntarily chosen by the market and subject to the laws of supply and demand.

  • Prudentis

    GoldSaver, I do perfectly understand your definitions and your points and I have read them many times on other occasions. My point was, that this definition is not widely accepted and although you may choose to use it, it will lead to confusion as long as there is no consensus.
    “Currency” is pretty foreward. Dollar, Euro, Yen are currencies.
    Are the coins or bits in your account issued in those currencies money? According to monetary theory, they are. According to you and other proponents of asset backed money, they aren’t.
    I think it is kind of pointless to argue semantics. It is much more important to address the real issue of the joined state / central bank monopoly over the money supply. Fiat money has its pros and cons, asset backed money also has pros and cons. Let the market sort this out.

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