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The Creation of Money, with comments related to Speculative Investment and BitCoins

The Creation of Money


In the movie "It's a Wonderful Life", Jimmy Stewart in the character of George Bailey gives a concise description of how money is created. It may not be what you think.

In the film, George Bailey is the president of a building and loan association. This is the about same as a savings and loan, except that the building and loan association focusses on using deposits to fund single owner construction projects. A savings and loan association has a broader reach, adding commercial startups and expansions, and other types of loans.

In the film's story, which is set in the year 1939, there is a panic about the supply of money. As a consequence, in a single day a large number of the depositors wish to withdraw their money, because they fear the bank will fail and their money will vanish. George, being well aware that the bank can not, at a single given time, return all of the depositors money, has to calm down the depositors, re-assure them that despite the financial uncertainty, their money is safe, being invested in ways that will ultimately return the money. Perhaps not immediately, but will do so because he, the banker, has chosen good sound investments that will return value over the course of time.

While some of the story's depositors are unconvinced, the majority decide to trust George, and take only the money they actually need for the time being. Thus the bank is saved.

How Savings and Loans Create Money


Consider this process for savings and loans in general. People deposit their money in the bank. The bank, based on a statistical estimate of when and how much will be withdrawn at any given time, has a certain amount that can be loaned out to borrowers.

The bank officers have chosen these borrowers based on the likelihood of the borrower being able to repay the money plus the agreed upon interest in the agreed upon time frame. Another way to look at it is to say the depositors deferred their own spending, giving that spending power to others, so that the resulting productivity will be shared.

Ideally, it is expected that in some fashion the borrower's productivity is increased by the loan, creating value of which a portion returns to the bank. Without too much of a stretch, this productivity principle extends to things like residential mortgages, auto loans, and even credit cards. Each of these can, unless abused, help productivity.

The bank pays the major portion of the interest obtained into the accounts of the depositors, with a small fraction retained as the bank's profit. Ideally, everybody wins. That ideal is often tarnished -- I will get to that later.

From this we conclude that productivity -- creating goods and providing services -- creates money.

Real Investment Versus Speculative Investment


Sound investment is to provide money to increase productivity. I like to use the phrase "real investments". A real investment is for tangible goods, productive services.

A real investment can be loan, or it can be the purchase of a share in the ownership of a productive activity. It can also be a contract to provide discounted services now, with expectation of shared profit in the future. For example a mill might agree to grind wheat now without payment, with the condition that a portion of the profit from selling the wheat (which might happen many months down the road) is returned to the mill.

The national productivity is measured by summing up, in a given year, all of a nation's productivity of goods into a lump value: the gross national product (GNP). A related value, the gross domestic product (GDP) might also be used. The productivity measurement does not include the value of services, because it is assumed that such services are folded into the value of real goods produced. Similarly, it does not include the value of investments.

Speculative investment is when productivity is only peripherally involved, and the perceived value of the investment is used to pull money from one person to another person. Speculation moves money around, but it does not create money.

Does Government Create Money?

So what does the government  have to do with this? Actually, very little. As a service to its citizens, the government prints monetary bills and coins. This service is not creating money, the service is simply providing portable transferable documents that represent the money on deposit with the banks.  The banks, via the Federal Reserve, tell the government when they need more bills and coins to hand out. Notice that the bills are clearly labelled "Federal Reserve Note" and "legal tender". Legal tender is a method of exchange, not the actual object of exchange. The bills and coins are commonly called money, but in fact are just the means to exchange money. Your money is in the bank.

This is not just playing with words. Because your money is actually in the banks, the bills can be replaced if damaged (still readable) or mutilated (no longer readable).  According to the US Treasury, "When mutilated currency is submitted, a letter should be included stating the estimated value of the currency and an explanation of how the currency became mutilated. Each case is carefully examined by an experienced mutilated currency examiner."

In fact, in some cases if the previous existence of the bills is provable and the total destruction is provable, you might get you bills replaced even if totally destroyed.

On the other hand, if the banks were to mysterious disappear, the bills and coins become useful as napkins and washers.

The System Has Its Faults

The system works so long as money is lent or invested in productivity. It fails when speculative investment overtakes real investments.

Prior to the 1980's, stock or share purchases of an entity would give the investor a partial ownership of the entity, assumed to be a silent partner in the enterprise of that entity. The entity would return dividends, a portion of the entity's profit, to the investor on a reasonably regular basis.

Then in the 1980's, something awful happened. Speculative investment became more active than real investment. Speculative investment has little to do with actual growth of a productive entity. Instead, it focusses on the perceived future value of the investment contract itself.

Historically, this was not the first time this had happened. The classic example is the tulip speculations of the years 1636 and 1637.

Extreme examples of speculation are the high frequency traders. These trades attempt to gain money by buying a share in a company at one price, and then as the price rises by a fraction of a cent, sell the share. This is done many times each second (literally), so that fraction of a cent of money gained will collect into a sizable gain for the trader. Of course, that money was lost by some other traders who were not as good at timing the buying and selling.

Always remember, speculative trading moves money -- the money one person gains was lost by some one else. It does not create money.(1)

So we have a fundamental problem -- people have stopped using investments to create money, choosing instead to speculate on the value of words on a contract.(2)

BitCoin

With the above in mind, let us look at BitCoin. BitCoin, similar to the monetary bills and coins printed or minted by the government, is just a portable transferable document intended to represent money held by an individual. Except that it is not.

For the banking system issued money, the dollars and coins in circulation are increased to match the increase of value on deposit, obtained from real productivity. For BitCoin issued money, the coins in circulation are increased by running a computer program, a process called "mining".

BitCoin supporters have tried to claim that the coins represent the value of the computation power expended to mine the coins. This is nonsense. Consider the absurdity if I were to crank up the heater in my home, wasting energy, and then issue certified documents representing the wasted energy as money. The initial creation of BitCoin is the same. The coins are initially backed by nothing, not productivity, not physical assets. The first person to accept a BitCoin in exchange for provided goods or services, did so on the speculative value of the BitCoin.

It is true that as time passes and BitCoins become regularly exchanged for goods or services, the coins will acquire that value. The real value will overtake the original speculative value.

However, the number of BitCoins in circulation is limited, by design of the BitCoin originator. Remember that the physical currency we use is controlled by the banks working in concert. As the GDP goes up or down, the circulating currency (remember: a portable transferable document representing money on deposit) can be increased or decreased, so that the value represented by a bill or a coin will be stable. (Okay, in practice, relatively stable.) By nature, BitCoin value will be unstable, because BitCoins do not represent money on deposit, but instead have a value according to people's perception of a BitCoin spending power.

I know that the BitCoin popular philosophy is to demonize the banks, claiming that BitCoin is some how a people's choice for currency, free of the "Man". But in fact currency is either tied to productivity or it is not. BitCoin is not tied to productivity. This will be its fatal flaw.

Notes

1. This reminds me of an old saying; "the only honest way to make money is by moving earth." This meant that you could mine mineral resources from the earth, you could create food with farming or ranching on the earth, you could make something from the earth. As I have been part of the industry that turns $10 per ton sand into $100 per ounce microchips, I can appreciate the latter.

2. A possible cure for out-of-control speculation is to by law require that any investment be held for a specified minimum period of time before being resold or exercised. A suitable period might be two weeks. This would calm the markets, and put an end to high frequency trading.


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