Money

Richard Cantillon (1680-1734), an Irish-French banker/merchant predating Adam Smith, is arguably the founder of modern economics. The book he wrote shortly before his demise, Essay on the Nature of Trade in General, officially published in 1755, was an influential and highly citied document, before it was overshadowed by the retardation of economics that would follow in the form of Adam Smith’s Wealth of Nations (1776). Cantillon rescued economic analysis from its traditional conflation with politics and ethics. In the words of Friedrich Hayek, “this gifted independent observer, enjoying an unsurpassed vantage point in the midst of the action, coordinated what he saw with the eyes of the born theoretician and was the first person who succeeded in enterating and presenting to us almost the entire field which we now call economics.” ...

Passages From The Wealth of Nations The following passages from Adam Smith’s An Inquiry Into the Nature and Causes of the Wealth of Nations have received enormous attention over the centuries following their publication in 1776. “[A man] will be more likely to prevail if he can interest their self-love in his favour, and show that it is for their own advantage to do for him what he requires of them … It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity, but to their self-love, and never talk to them of our own necessities but of their advantages.” “As every individual, therefore, endeavours as much as he can both to employ his capital in the support of. . .industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. . .(B)y directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” “Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.” These passages are seen as evidence of Adam Smith promoting laissez-faire capitalism. Note the introduction of the “invisible hand” meme in the second passage, one that has been propagated around without much regard for context. These famous quotes convey the idea that it is through the selfish pursuit of our own goals that the good of the economy results, and this is more desirable than a direct, motivated pursuit of social good. The anti-free market positions advocated by Adam Smith, therefore, come as a shock to those who imagine him as the paragon of the laissez-faire paradigm. ...

There are two opposing thoughts regarding money I am considering at the moment. On the one hand, we have the idea that to the extent it serves a nonmonetary purpose, it is an inferior form of money. For example, gold, which is a form of money, also has various other use cases as jewelry, industrial raw material, etc. These use cases compete against the monetary use case. Until Bitcoin, there was no contender for pure money. That Bitcoin lacked any other utility was hurled as a criticism. The idea was something like this: gold has various other utilities (and corresponding demand), so its price is unlikely to fall below a certain level; Bitcoin, on the other hand, due to absence of such alternate uses, would see its price collapse to zero some day. ...

Statement The level of prices depend on the quantity of money. Early discussions on this matter can be found in the essays of John Locke, David Hume and Irving Fisher (see Reference). Discussion Provided that the item used as money can be divided and combined as necessary, any amount of money is sufficient for running an economy. Ideas about bringing lasting changes to an economy by expanding the money supply are invalid. Should the money supply increase, all else equal, the prices of goods and services would increase proportionately. Thus, the outcome would ultimately be neutral. ...

Free market interactions led to the emergence of gold as money. Gold was divisible, durable, recognizable, and most importantly, difficult to inflate. Thus, it maintained its purchasing power better than other commodities that were easier to produce. However, gold suffered from certain drawbacks. While it was divisible, dividing it physically was practical only to a certain point. Also, carrying it in large quantities was costly and cumbersome. Furthermore, verifying the authenticity of gold coins and bars was time-consuming. ...

Gresham’s Law stipulates thus. “Artificially overvalued money will drive out of circulation artificially undervalued money.” As terrible as the US Dollar has been at inflation in a century, other currencies have proven to be worse. Governments throughout the world have been egregiously inflationary. They have expanded their money supply and devalued their currencies. Entities in these countries have thus resorted to hoarding (a term without a negative connotation to me) US Dollars. The upward pressure on the demand for US Dollars is such that despite the massive expansion in US Dollar supply, we do not see the corresponding amount of price level rises in the US. The abysmal fiscal policies of the rest of the world allows the US to export its price inflation. ...

The following table depicts the major components of the fiat financial system from the Indian point-of-view. For the most part, it is similar to the table for the US case. The key differences are noted at the bottom. Components of the Indian Banking System ENTITIES LIABILITIES ASSETS EXAMPLES Individuals Mortgages, Loans, Taxes Deposits, Banknotes, Government Securities (G-Secs), Stocks, Bonds, Fund Units, SDLs, Benefit Payments High Net-Worth Individuals, Retail Investors, Family Offices, Other Individuals Businesses and Non-Profits Loans, Bonds, Equity, Commercial Paper, Taxes Deposits, Banknotes, Subsidies Tata Group, Reliance Industries, Infosys, Indian Red Cross Society, Small and Medium Enterprises Financial Institutions Deposits, Fund Units, Securities Issued, Taxes Loans, Mortgages, G-Secs, SDLs, Stocks, Bonds, Commercial Paper, Bank Reserves, Deposits, Banknotes, Bailouts State Bank of India, HDFC Bank, ICICI Bank, SBI Mutual Fund, Life Insurance Corporation of India Foreign Sector Deposits, Stocks, Bonds, Loans, Taxes G-Secs, Stocks, Bonds, Loans, Fund Units, Deposits, Banknotes Reserve Bank of Japan, Norges Bank Investment Management, Foreign Portfolio Investors (FPIs), Global Corporations Public Authorities, Government Trust Funds, State Governments Bonds, SDLs, Benefit Payments Government Securities, (State) Taxes Employees’ Provident Fund Organisation (EPFO), National Pension System (NPS Trust), State PSUs like NTPC, Indian Railways, Government of Maharashtra Reserve Bank of India (RBI) Banknotes, Bank Reserves Government Securities, Foreign Exchange Reserves, SDLs Reserve Bank of India (Mumbai, Regional Offices) Government of India Government Securities, Subsidies, Bailouts Taxes — Notes The components here are very similar to the Components of the US Banking System. Standard notes regarding the US system applies. There are some differences. ...

This is a simplified depiction of the fiat banking system. Here, we will focus on the US system. Note how each liability of an entity corresponds to an asset of another entity and vice versa. Components of the US Banking System ENTITIES LIABILITIES ASSETS EXAMPLES Individuals Mortgages, Loans, Taxes Deposits, Banknotes, Treasuries, Stocks, Bonds, MBS, Fund Shares, Benefit Payments High Net-Worth Individuals, Retail Investors, Family Offices, Other Individuals Businesses and Non-Profits Loans, Bonds, Stocks, Commercial Paper, Taxes Deposits, Banknotes, Subsidies Walmart, Caterpillar, American Red Cross, Powell’s Sweet Shoppe Financial Institutions Deposits, Fund Shares, MBS, Taxes Mortgages, Loans, Treasuries, Stocks, Bonds, MBS, Commercial Paper, Reserves, Deposits, Banknotes, Bailouts Bank of America, Vanguard, Fidelity Investments, Fannie Mae MBS Trusts, CalPERS Foreign Sector Deposits, Stocks, Bonds, Loans, Taxes Treasuries, Stocks, Bonds, Loans, MBS, Fund Shares, Deposits, Banknotes Bank of Japan, Norway Government Pension Fund Global, Foreign Corporations and Individuals Public Authorities and Government Trust Funds Bonds, Benefit Payments Treasuries Social Security Trust Fund, Medicare Hospital Insurance Trust Fund, Tennessee Valley Authority, Port Authority of New York and New Jersey Federal Reserve Banknotes, Reserves Treasuries, MBS Federal Reserve Bank of New York, Federal Reserve Bank of Chicago, Federal Reserve Bank of San Francisco US Federal Government Treasuries, Subsidies, Bailouts Taxes — Notes Flow Items Interests are implied: loans include interest, deposits include interest, and so on. Similarly, obligations like pension obligations and insurance obligations are implied alongside fund shares. Taxes include seizures, tariffs, etc. Bailouts, subsidies, taxes are flows, not balance sheet items (as are interests and other obligations mentioned above). Regardless, I’ve chosen to include them to maintain a sense of who is liable to pay these to whom. These flow items have been italicized. Perhaps the more appropriate terms would be tax liability, taxing authority, benefits entitlement, benefits obligations, etc. Although, strictly speaking, these are not balance sheet items. Financial Institutions include Commercial Banks, Credit Unions, Money Market Funds, Mutual Funds, Pension Funds, Exchange Traded Funds, Insurance Companies. Mortgage Backed Securities (MBS) are formed by pooling and securitizing Mortgages through MBS Trusts. Agency MBS Trusts are formed by government-backed institutions like Freddie Mac and Fannie Mae. Private Trusts or Special-Purpose Vehicles are MBS Trusts formed by large private financial institutions like Goldman Sachs and Merrill Lynch. Private Label MBS are much less common than Agency MBS. Treasuries and Agency MBS account for over 95% of the Federal Reserve’s assets. Foreign Sector This includes Foreign Central Banks, Commercial Banks, Sovereign Wealth Funds, Governments, Corporations, Households. The liabilities are • Foreign Stocks, Bonds, Loans held by US entities, • US entities’ deposits in Foreign Banks, and • Taxes owed by Foreign entities to the US Government. The assets are • US Treasuries, Stocks, Bonds, MBS held by foreigners, • foreign entities’ deposits in US Banks, • (not included in this table) taxes/obligations owed by US entities to foreign governments/entities. Financial assets are featured above. These are items that are someone else’s liabilities. Thus, items like gold, equipment, real estate, infrastructure (in the case of Public Authorities) which do not have corresponding liabilities are not listed here. Arguably, inflation should be included as well. An asset for the government, liability for anyone holding the currency. See also Components of the Indian Banking System.

In earlier posts, I have regarded inflation as counterfeiting conducted by the government. This is not hyperbole. It is merely calling an activity its proper name. The Illegal Case To understand this label, let us go over what happens when an ordinary criminal counterfeits money. Suppose these fake tokens are virtually indistinguishable from already circulating monetary units. The criminal and his associates are able to go to the market and buy goods and services at prevailing rates. These people benefit the most: they did not even have to part with anything of value to obtain these tokens. ...

Inflation (that is, the counterfeiting of money by the government) has several destructive effects on the economy. It transfers wealth from late recipients of newly issued monetary units to those who receive them relatively earlier. It hurts the ability of economic actors to perform economic calculation. It degrades the quality of goods and services produced in the economy. Furthermore, it causes boom and bust cycles in the economy. Wealth Redistribution The overall effect of the introduction of new monetary tokens is a general increase in price levels. But this effect is neither smooth nor instantaneous. Not everyone acquires an equal amount of these tokens, or at the same time. Also, not all prices rise proportionately, or at the same time. (See The Cantillon Effect). ...