A Lay Guide to Understanding Money & Monetary Systems

I get a fair amount of comments from clients, prospective clients, other advisors and other professionals about their macroeconomic outlook, monetary policy and the Federal Reserve and inflation.  It is not unusual for these views to be misinformed or lack a general understanding of money and the monetary system in the US.  So I want to lay out a brief framework not how I wish the world to be but how I see things as they are.

1) All money is a trust-based system.  If I use a US Dollar as money to purchase a good, the seller of that good is trusting that s/he will be able to also use that dollar to purchase goods and services.  This is true whether we have a fiat money system (like the current US) or a gold-standard (like the US pre-1971).  It is also true if you think that gold itself is money.  A seller will only accept gold as payment if s/he believes it can be used at a later date for payment.  US Dollars, gold, the Euro, even ancient forms of money such as cattle or shells are all part of a trust-based system. In fact, this is true of any asset: the value of the asset is only based on what other people perceive its value to be.  Your house, stock in a company, a bar of gold, the US Dollar, a corporate bond; they each only have value because we collectively value them.

2) “Money printing” is probably not what you think it is.  Since the US Federal Reserve began its first round of quantitative easing (QE) in 2008, hyperinflationists and gold bugs alike (along with many other categories of people who lacked an understanding of the monetary system) have been crying out for inflation that was lurking just around the corner.  But while QE caused the Fed’s balance sheet to balloon from roughly $800 Billion in 2008 to north of $4 Trillion today, inflation has run around 1.5% to 2% in the last five years.  The reason for this is that QE does not blindly drop cash into the economy.  QE is the process of the Fed trading its cash for the market’s securities (mortgage bonds and Treasury bonds).  The market experiences an influx of cash and a drop in holdings of fixed income securities.  This is why some (like Cullen Roche) call QE an “asset swap” – the Fed’s cash for your bonds.  Your balance sheet’s composition has changed, but the value has not.  QE increases demand for bonds, driving interest rates down, but it is not a helicopter dropping money on the masses.

3) Banks, not the Federal Reserve, create money in circulation. The Fed doesn’t deposit money into our bank accounts.  Deposits are created from lending, which is the domain of the private sector banks.  You borrow money, it creates a deposit in your account and you owe the bank the liability.  The bank has an asset (your loan).  Your new deposit was, in fact, created out of thin air by the bank that lent it to you.  Hyper-inflation is not caused by “money printing” but instead is the market’s reaction to a loss of faith in the currency.  If I doubt that tomorrow I will be able to buy a loaf of bread for $3 US Dollars, I may not take US Dollars as payment, which devalues the currency.  I want $5 US Dollars from you instead, which is how inflationary cycles begin.  (It is worth noting that this is not much different than the lending freeze that happened in the financial crises in 2008 – no one wanted to lend money for fear of it not being paid back.  Both situations can be self-fulfilling prophecies).

There is infinitely more to say on the topic but it is neither my expertise nor the purview of this blog. Suffice to say I think it is important that we are able to recognize what we do and don’t know about the economy and try not to let our political bias (mis)inform our economic understandings, and we certainly must refrain from allowing these misunderstandings to impact our investment decisions.  For readers who are inclined to expand their understanding of money and macroeconomics, I recommend the following as much better resources than myself:

Pragmatic Capitalism

Noah Opinion

EconTalk

Jim Pethokoukis

 

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