Coin hoard

What is money?

Why do we have money?

Money was invented because trade would be difficult without it. For example, if you are a hatter in need of legal advice, then without money, you have to find a lawyer who craves for a hat. That is unlikely to happen. Maybe there is a fisherman dreaming of a hat, but he can’t give you legal advice. Maybe there is a lawyer in need of a hairdo instead of a hat. With money all these problems disappear like magic. You can buy the services of the lawyer so that she can go to the barber. After that the barber can buy some fish so that the fisherman can buy a hat from you.

Despite these mind-blowing advantages humans didn’t need money for a long time because they lived in small bands and villages where everyone depended on each other and everyone helped each other. This meant, for example, that when a fisherman needed a hat, you would make a hat for him, and if you needed anything, someone else would provide it to you. You did someone a favour so that he or she was obliged to do something back. Villagers produced most what they needed themselves. Trade with the outside world was limited and was done with barter.

Uses of money

Later cities, kingdoms and empires emerged. People living in cities, kingdoms and empires didn’t know each other so it became difficult to track whether or not everyone was contributing. Favours and obligations didn’t suffice. They were replaced by a formal system for making payments and tracking contributions and obligations. Commerce and tax collection needed a means of payment as well as administration. It is therefore not a coincidence that writing and money were invented around the same time in the same area. The earliest writings were bookkeeping entries. Money has the following uses:

  • buying and selling stuff (payment) so money is a medium of exchange
  • saying how much something is worth so money is a unit of account
  • keeping track of contributions and obligations (saving and borrowing) so money is a store of value.
catdog
Nickelodeon character CatDog

Money being a medium of exchange as well as a store of value is like your pet being a cat as well as a dog. The result is not really a success. The parts of the pet may often quarrel, for example because the dog part wants to play while cat part wants to sleep. If someone keeps money for a rainy day, and doesn’t spend it, others cannot use this money for buying stuff. And this really can be a big problem. A simple example can explain this.

Imagine that everyone decides to save all his or her money. Nothing would be bought or sold any more. All businesses would go bankrupt and everybody would be unemployed. All the money that has been saved would buy nothing because there isn’t anything to buy any more. This is a total economic collapse.

In reality it doesn’t get that bad because people will always spend on basic necessities like tablets and mobile phones, and perhaps food if they have some money left. When people only spend money on necessities there is an economic depression, which is not as bad as a total economic collapse but still very bad. Saving can make you poorer, but only when there are too many savings already.

The value of money

Money has no value when there isn’t any stuff to buy or when there aren’t any other people to trade with. Imagine that you get the offer to be dropped alone on a remote and uninhabited island in the Pacific with 10 million euros. Probably you would decline the deal, even if you can keep your mobile phone. It is other people and stuff that give money its value. But how? The answer is remarkably simple. The value of money is just a belief.

People are willing to work for money and sell their stuff for money. And because others do this, you do the same. For example, you may think that euro notes have an appalling design as well as an unpleasant odour, but nevertheless you desire to own them because other people want them too. The value of the euro is based on the belief that other people accept euros for payment.

This is just a belief as the following example demonstrates. Suppose that you wake up one day to hear on the news that the European Union has been dissolved overnight. Suddenly you may have second thoughts about your precious stockpile of foul smelling unstylishly decorated euro bank notes.

Smeagol from The Lord of the Rings

You may ask yourself in distress whether or not your precious bank notes still have any value. What is the value of the euro without the European Union? You may find yourself hurrying to the nearest phone shop in an effort to exchange this pile of bank notes for the latest model mobile phone.

And to prove this point even further, suppose that the phone shop gladly accepts your euros. Suddenly they become desirable again and you may start to have second thoughts about that latest model you are about to buy. It may not remain hip for much longer, so you may change your mind again and prefer to keep your precious euros because there may be a newer model next month. So, because the shop wants your euros, you wants them too.

Types of money

At first money was an item that people needed or desired. Grain was one of the earliest forms of money. Everybody needed food so it was easy to make people believe that others accept grain for payment. In prison camps during World War II cigarettes became money because they were in high demand. Even non-smokers accepted them because they knew that other people desired them very badly. For that reason cocaine can be money too.

Wares like grain, cigarettes and cocaine have disadvantages. They degrade over time so  they aren’t a very good store of value. This makes them a great medium of exchange because people won’t save them. An example can demonstrate this. Imagine that apples are money and you want to buy a house. A house costs 120,000 apples but your monthly salary is just 2,500 apples of which you can save 1,000. It takes 10 years of saving to buy a house. Soon you will discover that apples rot and that you will never be able to buy a house. Then you will spend all your apples right away.

Saving is difficult with apples. This is where gold and silver come in. Gold and silver have not much use, but humans were always attracted to shiny stuff. Gold is rare so a small amount of gold can have a lot of value because some people feel a strong desire for this shiny stuff. Gold and silver coins can be made of different sizes and purity so that they are suitable for payment and can be used as a unit of account.

More importantly, gold and silver do not deteriorate in quality like apples, grain or cigarettes. They do not even rust after 1,000 years. This makes gold and silver an excellent store of value. But this should make us suspicious. A perfect cat makes a lousy dog so a perfect store of value can fail the test for being a good medium of exchange. People can store gold and silver so that there is less money available for buying and selling stuff. And this can cause an economic depression as we have seen.

Governments create money too, for example by printing “10 euro” on a piece of paper. Governments require by law that this money should be used for payments and taxes. This makes people believe that others accept this money too. Government money is called fiat currency or simply currency. The authority of a government is limited to the area it controls so in the past government currencies had little value outside the country itself unless this money consisted of coins containing gold or silver.

In fact, another reason why gold and silver are attractive as money, is that the value of gold and silver does not depend on the authority of a government. This made gold and silver internationally accepted as money. In the 19th century most government currencies could be exchanged for a fixed amount of gold. This is the gold standard. The gold standard boosted trade because gold was internationally accepted as money.

Most money is debt

Debts can have value and so debts can be money too. This may seem strange or even outrageous, but money is just a belief. For example, money is the belief that you can exchange a hat for money and then exchange this money for legal advice. Hence, if you believe that the debtor is going to pay, you can accept his or her promise to pay as payment. And if others believe this too, you can use this promise to pay someone else.

So if the fisherman promises you to pay next week for the hat you just made, you could say to the lawyer that you expect the fisherman to pay in a week, and ask her if you can pay in a week too. The lawyer could then ask the same of the barber and the barber could ask the same of the fisherman. If all debts cancel out then there is no need for cash. Most money we currently use is debt. In most cases debts don’t cancel out and there are many more people involved so that it would be complicated to keep track of all debts and savings. That is where banks come in.

Featured image: Close up of coin hoard CC BY-SA 2.0. Portable Antiquities Scheme from London, England (2010). Wikimedia Commons.

Other images: Nickelodeon character CatDog, Smeagol character from The Lord of the Rings [copyright info]

Of Usury, from Brant's Stultifera Navis (the Ship of Fools)

The problem of interest

Compounding

Imagine that Jesus’ mother had put a small gold coin weighing 3 grammes in Jesus’ retirement account at 4% interest just after he was born in the year 1 AD. Jesus never retired but he promised to return. Suppose now that the account was kept for this eventuality. Imagine now that the end is near, and that Jesus is about to return. How much gold would there be in the account in 2018?

It is an amount of gold weighing 11 million times the mass of the Earth. The yearly interest would be a gold nugget weighing 440,000 times the mass of the Earth. There is a small problem, a fly in the ointment so  to say. It would be impossible to pay out Jesus because there simply isn’t enough gold.

It might seem that the bank had to close long ago because of a lack of gold, but that isn’t true. As long as Jesus doesn’t show up it can remain open, at least if the borrowers are allowed to borrow more to pay for the interest. And it may not be such a big deal if the economy grows 4% as the interest can be paid out of growth. The interest on Jesus’ deposit can be created out of thin air by making new loans that allow borrowers to pay for the interest.

There is a limited amount of gold while compound interest is infinite. As long as bankers can create money out of thin air to pay for the interest and people accept bank deposits for payment, everything is fine. Problems only arise when people demand real gold. A bank can go bankrupt when depositors want to take out their deposits in gold.

Central banks

Perhaps Jesus’ retirement account isn’t such a big problem after all. Our money isn’t gold but currencies central banks can print. Assume now that Jesus’ mother had put one euro in the account instead. One euro at 4% interest makes 22,000,000,000,000,000,000,000,000,000,000,000 euro after 2017 years. That may seem an intimidating figure, but the European Central Bank can take 22 pieces of paper and print 1,000,000,000,000,000,000,000,000,000,000,000 euro on each of them. And there you are. Something like this happened during the financial crisis of 2008. This is called quantitative easing. You may have heard that word before.

Central banks can print new dollars and euros to cope with a shortfall. In fact, this is what central banks often do. There is always a shortfall because of interest because most money is debt and interest on this debt needs to be paid. To make up for the shortfall, there are two options. First, people can borrow more. Second, central banks can print new currency. Both things can happen at the same time. Central bank decisions about interest rates are also about dealing with the shortfall caused by interest charges.

When central banks lower interest rates, people can borrow more because interest rates are lower. Central banks lower interest rates when people are borrowing less than is needed to cope with the shortfall. If central banks raise interest rates, people can borrow less because interest rates are higher. Central banks raise interest rates when people are borrowing more than is needed to cope with the shortfall and the extra money makes people want to buy more stuff than can be made. And if people don’t borrow at all, this is a crisis, and central banks may print more currency to cope with the shortfall.

Interest on capital versus economic growth

There is a problem central banks can’t fix by printing more currency. Interest is more than just interest on money. Interest is any return on investment. Throughout history returns on investments were mostly higher than the rate of economic growth. Most of these returns have been reinvested so a growing share of total income was for investors. This can’t go on forever because who is going to buy the stuff corporations make in order to keep these investments profitable? A simple example can illuminate that.

interestvers
Interest income (red) versus total income with interest income growing faster than total income

The graph above shows how total income and interest income (in red) develop with an economic growth rate of 2% and an interest rate of 5% when interest income starts out as 10% of total income and all interest income is reinvested. After 25 years the economic pie has grown faster than interest income and wages have risen. At some point interest income starts to rise faster than total income, and wages go down. After 80 years there’s nothing left for wages. This graph explains a lot about what is going on in reality.

In the short run it was possible to prop up business profits and interest rates by letting people go further into debt to buy more stuff. In the long run, the growth rate of capital income cannot exceed the rate of economic growth. Interest rates depend on the returns on capital so this can explain why interest rates went down in recent years. In the past interest rates below zero weren’t possible but from time to time there were economic crises and wars that destroyed a lot of capital. This created new room for growth.

Wealth inequality and income inequality

When interest rates go down, the value of investments tend to rise. If savings yield little this benefits the wealthy as most people have their money in savings while the wealthy own most investments. But it is important to know the cause otherwise you might think that interest rates should rise. The graph above shows that wealth inequality causes interest rates to go lower, hence redistributing income, for example via higher wages or taxes on the wealthy, can bring higher interest rates.

There is a difference between wealth inequality and income inequality. Your labour income and the returns on your investments are your income. If you are rich but make no money on your investments, your wealth doesn’t contribute to your income. In reality wealthy people make better returns on their investments than others because they have better information and can take more risk. Still, the graph shows that income and wealth inequality can’t increase indefinitely, and that returns on investments can’t exceed the reate of economic growth in the long run, hence interest rates need to go lower.

Most people pay more interest than they receive. The interest paid on mortgages and loans is the proverbial tip of the iceberg. Interest is hidden in rents, in taxes because governments pay interest on their debts, and the price of every product and service because investments have to be made to make these products and services. German research has shown that 80% of the people pay more in interest than they receive, while only the top 10% of richest people receive more in interest than they pay. Lower interest rates benefit most people despite some side-effects that work in the opposite direction.

Economic cycles

Humans are herd animals. They buy stuff and even go into debt to buy stuff when others are going into debt to buy stuff too. Suddenly they may realise that they have bought too much or have gone too deeply into debt, and all at the same time. One day they may be borrowing money, queueing up before the shops, and bidding up prices. The next day, they may decide to pay off their debts, leaving the shop owners with unsold inventories they have to get rid of at fire sale prices. So prices may go up when people are in a buying frenzy and may go down when sales dry up.

When there is a buying frenzy business owners are optimistic and do a lot of investments, and often they go into debt to make those investments. But if suddenly customers disappear, they may be stuck with unsold inventory and debts they cannot repay. Businesses may then have to fire people. Those people are then left without income, and cannot repay their debts too, so sales will go down further. If their debts are not repaid, banks could get into trouble. In most cases the economy will recover. In the worst case banks go bankrupt, money disappears, the economy collapses, and an economic depression takes off.

Interest can make things worse. Assume that you have a business and expect to make a return of 8%. You have € 100,000 yourself and you borrow € 200,000 at 6%. You expect to make 8% so borrowing money at 6% seems a good idea. If you only invest your own € 100,000 you can make € 8,000, but if you borrow an additional € 200,000 you can make € 12,000 (8% of € 300,000 minus 6% of € 200,000, which is € 24,000 minus € 12,000). The balance sheet of your business might look like this:

debit
credit
inventory
€ 250,000
loan 6%
€ 200,000
cash, bank deposits
€ 50,000
owner’s equity
€ 100,000
total
€ 300,000
total
€ 300,000

If sales disappoint and you only make a return of 2% on your invested capital of € 300,000, which is € 6,000, you make a loss because you pay € 12,000 in interest charges. You may have to fire workers. Businesses can go bankrupt because they have borrowed too much and have to pay interest, even when they are profitable overall. Sales often disappoint when the economy fares poorly. This means that more businesses face the same difficulties and make losses because of interest payments. They may have to fire workers and these workers lose their income. This can worsen the slump.

Interest, economic depressions and war

Silvio Gesell discovered that interest rates can’t go below a certain minimum because lending would then stop. Money would go on strike as he put it. Why is that? Low yields make investing and lending money unattractive because of the risks involved. Debtors may not repay and banks may go bankrupt. Depositors then prefer to take their money out of the bank and keep it with themselves.

This can cause economic crises and depressions. Silvio Gesell lived around 1900. Interest rates below zero weren’t possible because of the gold standard. Depositors could go to the bank and withdraw their deposits in gold so that they didn’t have to accept negative interest rates. From time to time there were bank runs, economic crises and wars that destroyed a lot of capital. And this created new room for growth.

There may be a relationship between interest, economic depressions and war. In 1910 the amount of capital income (the red circle in the graph) relative to total income (the two circles together) was close to what it was in 2010. This could have led to an economic depression. Before that could happen Word War I began. The war destroyed a lot of capital so that interest rates could remain positive.

A few decades later the Great Depression arrived. If interest rates could have gone below zero in the 1930s, the Great Depression might not have happened, Adolf Hitler would not have risen to power and World War II would not have occurred. The currency of Wörgl demonstrates that negative interest rates could have ended the depression. After World War II interest rates never came near zero again. Governments and central banks printed more money. This caused inflation, which eroded trust in money.

People feared that inflation would make their money worth less so interest rates rose. In the 1970s the link between money and gold was abandoned because there was a lot more money than there was gold to back it. In the 1980s governments and central banks started policies to bring down inflation and to promote trust in money. As of 1983 interest rates went down gradually as a consequence of a renewed trust in money and central banks. Debt levels rose and interest rates went near zero.

Promoting inflation might not be a good idea. The end result is unpredictable. The best one can hope for is a poor performing economy and a lot of inflation like in the 1970s. But if interest rates rise because lenders lose their trust in money and debts, people may not be able to repay their debts, and the financial system might get into serious trouble. This can cause another great depression or another great war. But if the alternative is negative interest rates, stability and prosperity, then why not opt for that?
eou_31_questions

Featured image: Of Usury, from Brant’s Stultifera Navis (the Ship of Fools). Albrecht Dürer (1494). Public domain.

Joseph interpreting the Pharaoh's dream

Joseph in Egypt

There is a story in the Bible about a Pharaoh having some bad dreams he could not explain. He dreamt about seven fat cows being eaten by seven lean cows and seven full ears of grain being devoured by seven thin and blasted ears of grain. A fellow named Joseph was able to explain those dreams. He told the Pharaoh that seven good years would come and after that seven bad years would follow. Joseph advised the Egyptians to store food in large storehouses. The Egyptians followed his advice and built storehouses for food. In this way Egypt survived the seven years of scarcity.

What is less known, because it is not recorded in the Bible, is that the storing of food resulted in a financial system. The historian Friedrich Preisigke discovered that the Egyptians used grain receipts for money and had organised a banking system with the use of those grain receipts. Farmers bringing in the food received receipts for grain. Bakers who wanted to make bread, brought in the receipts which could be exchanged for grain. According to the Bible, Joseph took all the money from the Egyptians. This may have made them to look for an alternative.

In this way the grain receipts may have become money. The money unit was an amount of grain stored at a storehouse. The degradation of the grain and the storage cost caused the value of the receipts to decrease steadily over time. This was like a holding tax on money similar to the stamps in Wörgl. It stimulated the Egyptians to spend their money. It is unclear whether there were loans made with this money. The actions of Joseph may have helped to create this money as he allegedly proposed the grain storage and took all the money from the Egyptians.

A few centuries later, during the reign of Ramesses the Great, Egypt was again a leading power. Some historians claimed that the wealth of Egypt during the reign of Ramesses the Great was built upon the grain financial system. The grain money remained after the introduction of coins around 400 BC until it was finally replaced by Roman money. The money and banking system were stable and survived for more than a thousand years, probably because there weren’t financial crises caused by interest payments.

Featured image: Joseph interpreting the Pharaoh’s dream. Illustrations for La Grande Bible de Tours. Gustave Doré (1866). Public Domain.

The miracle of Wörgl

In 1932, in the middle of the Great Depression, the Austrian town of Wörgl was in trouble and prepared to try anything. Of its population of 4,500, a total of 1,500 people were without a job and 200 families were penniless. The mayor Michael Unterguggenberger had a long list of projects he wanted to accomplish, but there was hardly any money to carry them out. These projects included paving roads, streetlights, extending water distribution across the whole town, and planting trees along the streets.

Rather than spending the 40,000 Austrian Schilling in the town’s coffers to start these projects off, he deposited them in a local savings bank as a guarantee to back the issue of a currency known as stamp scrip. The Wörgl money required a monthly stamp to be stuck on all the circulating notes for them to remain valid, amounting to 1% of the each note’s value. A businessman named Silvio Gesell came up with this idea in his book The Natural Economic Order.

Nobody wanted to pay for the monthly stamps so everyone receiving the notes would spend them. The 40,000 schilling deposit allowed anyone to exchange scrip for 98 per cent of its value in schillings but this offer was rarely taken up. That was because the scrip could be spent as one schilling after buying a new stamp. The money raised with the stamps was used to run a soup kitchen that fed 220 families.

Over the 13-month period the project ran, the council not only carried out all the intended works, but also built new houses, a reservoir, a ski jump and a bridge.
The key to its success was the fast circulation of the scrip money within the local economy, 14 times higher than the Schilling. This increased trade and created employment. Unemployment in Wörgl dropped while it rose in the rest of Austria. Six neighbouring villages copied the system successfully. The French Prime Minister, Édouard Daladier, made a special visit to see the ‘miracle of Wörgl’.

In January 1933, the project was copied in the neighbouring city of Kitzbühel. In June 1933 major Unterguggenberger addressed a meeting with representatives from 170 different Austrian towns and villages. Two hundred Austrian townships were interested in adopting the idea. At this point the central bank decided to assert its monopoly rights by banning scrip money.

One can only imagine what had happened if communities all over the world had been free to copy the idea. The Great Depression may have ended in 1936 and World War II may never have happened. It can be a lesson for the future. If another major economic crisis is about to plunge the world into another world war, this ‘miracle money’ may be able to prevent that from happening.

1. The Future Of Money. Bernard Lietaer (2002). Cornerstone / Cornerstone Ras.

Slums in Jakarta

From scarcity to abundance

At some point we may not need more products and services, and even if we believe we do, we may not be able to go deeper into debt to buy everything we desire. As a consequence businesses will find it more difficult to make a profit. Perhaps enough is enough. The writing is on the wall. The financial crisis of 2008 was a warning sign.

The crisis happened because some people couldn’t pay the interest on their debts. This nearly brought down the entire world financial system as well as the world economy. If there had been fewer debts, and if interest rates had been negative, the financial system as well as the economy would have been safe.

Interest rates have gone down in recent decades. In wealthy countries they neared zero in the aftermath of the financial crisis. Most people think they will go up again. But what if the opposite happens? What if negative interest rates become the new normal? That will turn economics upside down. Scarcity is at the basis of economic thinking. It is the belief that we need more stuff and more businesses to make all that stuff available to us.

The Justification Of Sufficiency
Title page of The Justification Of Sufficiency by Stohalm Foundation

So what has this to do with interest rates? If we need more stuff, we need investments. To make these investments possible we need savings. And to have savings, we need interest. Consequently investments need to be profitable to pay for the interest. But if we don’t need more stuff, a lot of things change. There would be abundance instead of scarcity, and interest rates could go negative as many investments make no sense.

Negative interest rates may happen first in wealthy countries where people already have enough. Investment money will then look for more profitable alternatives and move into poorer regions so that poor countries can build their economy too. To make that happen, interest rates in wealthy countries must be allowed to go below zero, and people in wealthy countries should not be lured into taking on debt they can’t afford.

Not allowing for negative interest rates could be a mistake. The alternative may well be an economic crisis like the 1930s. Scarcity will then become a self fulfilling prophecy. The era of abundance could then be pushed a few decades further into the future. That is, if the economic crisis is not followed by another world war.

Featuring image: Slums built on swamp land near a garbage dump in East Cipinang, Jakarta Indonesia. Jonathan McIntosh (2004). Wikimedia Commons.