The building blocks of the economy - Part III: Money

A brief history of money

In the earliest societies, the economy was based on the exchange of goods. If you were a hunter, you would trade meat or furs for bread, for example. 

The problem with this system is that you need to find someone who wants your meat and at the same time can offer you bread. 

So, people started using IOUs (I Owe You). The baker would give you a loaf of bread now, and you would promise him to give him some meat later. 

This system required that all people honoured their IOUs and that you kept a good record of all promises.

To solve this problem, people started using tokens (stones, shells, precious minerals or specific grains). As long as everyone agreed what the value of a gold coin or a peppercorn was, you could quickly pay for things with these token. The key here is that these tokens are only worth something if people can agree on their value. Gold, for example, is pretty useless in everyday life. You can’t eat it, heat your house with it or dress in it. But it is valuable because we all believe so.

The next step in the history of money came when bank accounts were invented in the Islamic world in the early Middle Ages. And modern paper money appeared first in China in the 11th century.

States issue most of today's money and we call it currency (US Dollar, Euro, Yen, etc.). The government forces companies and banks to accept the local currency for payments and bank deposits.

Why do we need money?

Today’s money has three main functions:

1. A medium of exchange (i.e. you can use it to buy things)

2. A unit of account and (i.e. you can compare the value of different items easily)

3. A store of value (i.e. you can save your money to spend it later)

The basic idea of our capitalistic system is that the market place (two parties exchanging goods/services for money) is the most efficient economic system. It might be debatable if this is still the case in an age of increasing inequality. But the premise is that you offer your time (work) or savings (money) to others, which in turn pay you a salary or interest. And you can then use this income to buy the things you need and want. This way, we avoid the problems of a barter or IOU system.

What types of money exist?

Two types of money exist:

1. Physical money: Notes and coins that have been printed or minted by the Central Bank. They are the only organisation within a state that has the right to do so.

2. Electronic money: This is the vast majority of the money in developed countries. It encompasses all the money on bank accounts, on credit cards etc.

In the UK, for example, only a small percentage of the total money is actual cash.

Notes and coins only form 4% of the total money in the UK according to the Bank of England.

The vast majority of money in the UK exists only as Ones and Zeros according to the Bank of England.

Source: Bank of England (Retrieved 12 June 2019)

Who can create new money?

As mentioned above, only the Central Bank of a country has the right to create new banknotes and coins.

But the Central Bank also creates electronic money nowadays every time it makes a loan to a commercial bank. If Barclays wants to borrow money from the Bank of England, they receive the money via computer rather than in the form of bank notes.

But the vast majority of electronic money is created by commercial banks like Barclays, Citi Bank or Deutsche Bank. It works as follows:

1. You take out a loan of USD 100 from a bank

2. The bank then creates a record that you owe it USD 100

3. It then adds USD 100 electronically to your bank account

Et voila, USD 100 have been created in the form of the record that you owe money to the bank.

But this also means that every time you repay a loan, money gets deleted:

1. You have USD 100 in your bank account

2. You use this money to repay a loan of USD 100

3. The bank deletes its record that you owe them USD 100

Of course, banks can’t create as much new money as they want to. The Central Bank and various international bodies regulate that the maximum of money a bank can lend to others. It cannot exceed a fixed multiple of the money they hold in deposits and government bonds.

This system might sound strange to you and my wife thought I was joking. If you want to check yourself, just take a look at the website of the Bank of England, for example:

https://www.bankofengland.co.uk/knowledgebank/how-is-money-created

What are the problems with this system?

Our current system, like the previous ones, has some inherent flaws that you need to be aware of:

1. It creates instability

2. It promotes inequality

3. It gives commercial banks a lot of power

INSTABILITY

Banks are neither evil nor good. They are companies that want to make a profit. So, they tend to give out more loans when times are good (economic boom) and fewer loans when times are bad (recession).

So, when prices (e.g. for houses) and the stock market go up, banks give people more loans to buy homes, stocks etc. This drives prices up even further, eventually creating a so-called “bubble”.

But there comes the point when people realise that things are too expensive and prices begin to fall again (i.e. the bubble bursts). Banks then lend less. Therefore less money is available, and prices will fall even further.

INEQUALITY

The business model of banks is to lend money to other people against fees and interest. They want to make sure that they get all their money back.

Banks are doing this by assessing how likely it is that a person or company will repay the loan in full. This is called a credit risk assessment. Your credit score is such an assessment, for example. And the interest rate is the price you pay for being a riskier client.

If a person poses a low risk of defaulting on their loan and have lots of assets (savings accounts, houses, stocks), the bank will charge them a lower interest rate.

But if it is more likely that a person or company will not repay the loan in full, the bank with charge them a higher interest rate. You can think about it this way:

• the bank lends USD 100 each for one year to five people with a high credit risk

• each of these people has to pay USD 25 in interest at the end of the year

• So, if one of the five people can’t repay its USD 100 and the interest at the end of the year, the bank still got all its money back as the other four people paid USD 100 (4x USD 25) in interest

This system is not inherently evil and makes sense from an economic point of view.

The problem is that this means that rich people can borrow money for low-interest costs and poor people have to pay higher prices to borrow money. So, it is more expensive for poor people and creates more wealth inequality.

POWER

The ability to decide who gets loans, how much it costs to borrow money, and for which purposes money can be borrowed gives commercial banks a lot of power over the economy and society.

If, for example, lenders decided to provide new car loans only for electric vehicles, most people would have no choice but to buy an electric car.

How does this article help me?

To quote the International Monetary Fund (IMF):

most people in the world probably have handled money, many of them on a daily basis. But despite its familiarity, probably few people could tell you exactly what money is, or how it works.

Source: International Monetary Fund (Retrieved 12 June 2019)

Money makes the world go round, as the saying goes. It is therefore critical to understand what it is, who can create it, and why it can literally save you money to have a good credit score.

What will be the next article in the series?

The next article in the series will be called “Interest and the Time Value of Money”. I will explain to you:

• What is interest?

• How is interest calculated?

• What is the time value of money?