Money

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. ...

Private individuals and businesses must either sell something of value to acquire money or expend time and resources to mine it directly (think of gold mining in the case of a gold standard). Governments, in contrast, do not obtain payment for goods or services they produce; they generate revenues through the seizure of assets. In the past, they might have sent their agents to seize grains, cattle, coins, etc. from people. But in a monetary economy, they simply seize monetary assets, which is a lot easier to do. ...

In a free banking system, various banks issue their own banknotes which are redeemable for the gold that they hold. The banks set their policies independently and compete with other banks in the free market. This is distinct from the central banking system we experience today, where a central bank dictates key requirements the chartered banks must obey, and these banks issue a single fiat currency. One important decision a bank needs to make in a free banking system is how much reserves it shall hold on to at any moment to meet the withdrawal demands of the depositors. If the reserves are less than 100% of the deposits, the bank engages in fractional reserve banking. (Setting aside the question of morality of such a system, free banks with fractional reserves have emerged in the free market and operated for a long time in the past.) ...

Before discussing fractional reserve banking, let’s go over the concept of full reserve banking. Suppose a bank takes in total deposits worth $100 million from its depositors. The bank promises the depositors that they may withdraw their deposits anytime. The bank, in this case, simply acts as a warehouse for the money deposited, collecting fees from the depositors in return. At any time, all deposited money remains within the bank; and at any time, any or all depositors may come to collect the money they have deposited. This is full reserve banking: all the deposits remain in reserve. ...