Friday, March 13, 2009

Printing Currency, Not Money

This sounds like an academic distinction but it is not. Especially at times like these, knowing the difference is key to understanding the behavior of financial systems.

What is Money?
Let's start with a textbook definition of money and proceed from there. Most definitions include two parts, some add a third. According to them, money is:
  1. a medium of exchange
  2. a store of value
  3. a standard of value or unit of account (widely but not universally accepted)

If you look closely at the first two definitions, you will see that money exists in the minds of those who use it. This is partially true for the third definition as well. (note: For all of you monetary theory geeks, please relax. These are deliberate simplifications designed to make the ideas accessible to a general audience, not a detailed exposition of precise financial models.)

  1. I can exchange my money for stuff.
  2. I can exchange my money for stuff later.
  3. I can exchange my money for a predictable amount of stuff later.

Let's think about what is happening here. Money has value because people will give you stuff for it, both now or in the future. But why will they do that? They have to believe that they can trade it onward in turn for stuff they want. So the utility value of money is based on a set of collective beliefs - what Carl Jung referred to as the Collective Unconscious. This is the set of beliefs that are widely held by a group of people at a deep level and upon which they will act without thinking about it. One can think of this as the unstated assumptions of a society. In the US, the dollar has had a stable or relatively stable value for so long that few would ever consider NOT accepting it in exchange for stuff. The dollar as money is a deeply embedded part of our Collective Unconscious, both here and around the world.

Though there are many who are beginning to question the value of the dollar as money, the number is still miniscule as a percentage of society. Even if a person were to cease to believe in the dollar as money in their own mind, they would still accept it as long as they believed that others would accept it from them in exchange for goods. So externally, they would act as if the dollar was still money, even if they no longer held that belief. That is what puts the collective in unconscious. At some point, things deteriorate sufficiently that everyone KNOWS that everyone else is just pretending. That is the point of universal hypocracy just before the belief system breaks down.

The great Adam Smith said it well:

"All money is a matter of belief."

Printing Money?

Now we get back to the title of this entry. It is clear that from a purely physical point of view, a central bank can create as much currency (physical or electronic) as it wishes - subject of course to certain practical constraints such as logistics. But MONEY exists solely in the minds of people. It is essentially a matter of faith and faith is not something a government or central bank can print or conjure from thin air. The value of the dollar is the credibility built up over two centuries of the US Treasury always meeting its obligations. The money, is the widely held belief that the US government will guarantee that dollar holders will always be able to get things of value in return for their dollars, which is backed by generations of positive experience.

Now, please ask yourself "Does creating more currency enhance or damage that belief system?" The answer should be self-evident. The very act of creating more dollars ensures that the purchasing power of every existing dollar is diluted. There is only one scenario under which this will not damage the purchasing power of the dollar - if and only if those created dollars can be used to add a roughly comparable amount of value to the pool of available goods and services available for purchase. That is precisely the role of well-functioning credit system: to allocate capital to useful expansions of capacity and new business ventures in order to create that added value. This is why such a credit system can actually create money through credit. Because the act of printing dollars would have no such offsetting value-added, the arbitrary creation of more dollars undermines the faith which is at the root of money's very existence.

A central bank like the Fed can print currency but it cannot print belief - which is what money really is. A central bank can assist money creation by making the commercial credit system (banks) more credible with a backstop during normal times but that is a supporting role. When it takes the lead by acting unilaterally, it can only destroy money.

Printing dollars destroys money.


Jason Kolb said...

But, destroying money increases its value as well.

You can't just look at one side of the coin or you'll have a distorted view of the bigger picture.

CLN said...

I agree that money, or better said moneyness attached to an issued currency, exist only in the minds of people, but printing dollars does not simply destroy money.

Excessive printing may destroy (lower) the standard of value of dollars (inflation) while leaving the liquidity component intact.

Also the standard-of-value component should be coupled with future expectations of evolution. If the dollar falls now in value (inflation by printing) but in an intermediate to long term the dollar is perceived to fare better than euro , yen etc. then, it may affect very little the moneyness of the dollar for those who use it in order to satisfy their intermediate to long term storage needs.

The moneyness of gold is not given by its liquidity or by it's current value content (standard of value price of gold) but by the perception it is the best medium for long term storage of value. Gold bugs may be unwavered by a fall in the gold price and not sell their gold in order to avoid loses because they are concerned more with having the maximum residual stored value and increased liquidity when/if the SHTF "will happen" and every other form of currency becomes worthless (hyperinflation of societal collapse).

The dollar as a major international currency is theoretically expected to fulfill all the four major needs: liquidity (low cost of exchangability), storage capacity, recognized standard of value, and safety expectation long term (and critical event conservation of liquidity and value).

The needs which ahve to be satisfied by the moneyness of the dollar are in fact represented by a vectorial dispersion of expectations and perceptions.

If the dollar takes a hit with respect to the current content of value (by excessive printing) it's moneyness perception may be changed but not destroyed, and those who are not satisfied by the new configuration of dollar moneyness can extend the perception of moneyness to something else.

Last summer the perception of long-term, slow-decay in the dollar's standard of value extended the perception of moneyness and created a huge demand for commodities based currencies (oil and commodities ETF's , shares of resource companies and equvalents) which had only indirect liquidity (could be easily exchanged on the market for dollars). That rush to commodities currencies was at least partly responsible for the commodities bubble.

The panic in the current environment has created a huge perception of risk and we have the flight back to the dollar. More demands for the current moneyness configuration of the dollar creates a strong dollar (at least stronger than the fundamentals would imply). The treasuries have become highly liquid benefiting for this new configuration of safe moneyness need satisfied by the dollars regardless the ridiculous low yields.

Printing dollars may not necessarily destroy money, but may simply shift moneyness to another dollar convertible medium of storage and exchange.

For example if there is a perception of economic revival pumped up by The Chosen One, this new form of currency benefiting from dollar printing, probably will be a currency form based on productive and corporate assets (stocks).

I believe that a correct conclusion would be: "Printing dollars may destroy money".

David said...

"But, destroying money increases its value as well.

You can't just look at one side of the coin or you'll have a distorted view of the bigger picture."

The idea of "money" here is that of trust; the faith in the system that you can trade dollars for something at a later date. So to destroy "money" is to destroy "trust", and once destroyed you also destroy the value because people will not want them. It's the demand side of supply and demand. Shrink the demand without changing the supply and value goes down.

As banks write down bad loans, as people's 401k's implode, as houses lose value currency is being destroyed leaving fewer and fewer dollars; so you are correct in that sense. It's the supply side in supply and demand. Shrink the supply without changing the demand and value goes up.

barnaby33 said...

Actually I disagree. Printing dollars does not destroy money. It does something worse. It dilutes money. As you say, money cannot be destroyed it is a concept, a belief. However in our world those "logistics" are extremely important. When money is printed, those who stand closest to the govt (ie banks and the military industrial complex) benefit disproportionately at everyone else expense. Nothing has been destroyed. If it were we would abdicate this money system immediately. Its just that the govt figures it can dilute, just enough, so thatyou won't do that, but it won't have to admit the problem its covering up.

Ultimately if this goes on long enough, then money is destroyed through systemic abdication.