Monday, January 24, 2011

The Invention of Money

Episode 423 of This American Life features insightful analysis of money and the economy. I made the following notes whilst listening to the podcast to help it sink in. Well worth a listen!

When x number of dollars are lost on the stock market or when the housing market collapses, where does that money go? The answer: money is fiction, it's value can simply disappear. Money is simply worth what people agree it is.

Can we track how much money is in circulation? It would be an infinite series of calculations between savers, banks and lenders.

Money started with the exchange of gold, then came paper bills which represented the amount of gold held in banks. In 1933 the gold standard ended and paper bills simply became the idea of money. Now money often does not change hands or even exist, we just exchange electronic numbers or information when we are paid or buy things online.

In Brazil in 1990 inflation was 80% a month. Prices were increasing every day. To pay for the building of Brasilia in 1950 the government began printing money and inflation began. Successive governments made attempts to fix the problem such as price freezes or confiscation of money. Four economists were approached in 1993 to address the root causes of the problem: the printing of money and importantly people's faith in money. People needed to be tricked into thinking money had value. A new virtual currency URV Unit of Real Value was introduced. People were paid in URV and prices were in URV. The rate to exchange URV to cruzeiros would change daily as advertised by the bank, but prices would stay the same so that people would start to think in URV. Once things settled down the Real was introduced with the same value as URV and from that day the virtual currency became real and the people believed in it's value stabilising the economy.

In most modern countries the people who decide how much money there should be by creating or removing money is the central bank e.g. the Federal Reserve in USA, the Bank of England in the UK. This is an independent institution and cannot be controlled by the government. The balancing act between sufficient money to loan to businesses and create jobs and not too much money as to increase inflation is voted upon and decided by the central bank. To increase the amount of money in the economy treasury bonds are purchased from the banks by the central bank. The banks will then loan this newly created money out to people typically at a lower interest rate. The central bank also has the power to become the lender of last resort "opening the fed window" by providing emergency loans to banks
and large corporations to prevent the banking system from collapse. The central bank will demand assets in return for these emergency loans, however recently the central bank has taken on potentially toxic assets such as mortgage backed securities. Any losses occurred from the central banks risky investments do not become part of the
government deficit as they are separate entities. In fact the central bank always make a profit and any reserves are granted to government to reduce the deficit. The creation of money via the central bank comes with the risk of devaluing money causing huge inflation like in Brazil pre-URV and the Real.

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