A lot of people don’t think much about the economy in their day to day lives.
Most people spend the majority of their time working, and when they aren’t doing this, they are distracting themselves with popular culture.
Yet every time we pay for something we are contributing to the economy. Whether it be buying the groceries, having lunch with a friend or purchasing a property – we are building the economy with every transaction we make.
But even though we are the creators of this economy, many of us don’t understand how the money system actually works.
Here’s a quick test to see how much you know:
1) Is money worth more than the paper it is printed on?
2) How can household debt be considered an asset?
Think you know the answers? Read on for a short lesson on the money system.
Money is paper.
Technically speaking, money has no intrinsic value. Notes of currency are essentially just pieces of plastic coated paper. If it wasn’t for the money system, they would have no more value that other types of paper.
But, isn’t money backed by a commodity such as gold? A commodity that has value because it can be used in so many beneficial ways?
The short answer is no.
The long answer? Well, it started back in 1971.
Removing the gold standard.
Prior to 1971, the US Dollar was backed by gold. That meant that every dollar equated to a certain amount of the precious metal. Each bill was like a placeholder for that amount – which is what gave the currency its value.
In 1971, US President Nixon removed the gold standard from the US Dollar, severing the currency’s link with the commodity.
So, what gives the US dollar its value now? We do. By agreeing that our money is exchangeable for goods and services, and upholding the government’s declaration that it is legal tender, we uphold the value of the dollar.
The problem with this is that the value of the currency is much less stable than it was when it was tied to gold. Because it is a fiat currency, more money can be created anytime out of thin air. The value of money can depend on how well the economy is going.
Fiat currency is subject to inflation.
Since central banks can print more money if needed, fiat currencies are subject to inflation.
Inflation is when money losses value over time. This is most felt as an increase in the cost of living. Prices go up and consumers must part with more and more of their money to pay for goods and services.
Why does this happen?
In a nutshell, the more money in circulation, the less valuable it is.
While this concept doesn’t tell the whole story behind inflation, it is a useful starting point for understanding how it works.
Before fiat currencies, central governments would have to mine precious metals in order to create more currency.
Now, they simply issue bonds in exchange for the creation of new money by the central banks.
Our dollar is backed by the US dollar.
During the seventies, the US dollar became the base currency for the other currencies of the global economy. Our dollar is thus pegged against the US dollar.
It is important to follow the movements of the US dollar because these have a flow on effect throughout the world.
The velocity of money.
Simply put, the velocity of money is the rate at which money is being spent. It is the turnover of a nation’s currency, expressed as a ratio of gross national product (GNP) to total money supply.
In other words, the velocity of money refers to how much of the currency is being spent on the creation and consumption of goods and services.
According to Investopedia,
“Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services, as this helps investors gauge how robust the economy is, and is a key input in the determination of an economy’s inflation calculation.”
“Economies that exhibit a higher velocity of money relative to others tend to be further along in the business cycle and should have a higher rate of inflation — all things held constant.”
The fractional reserve banking system.
The US banking system allows for bank deposits to be backed up by only a certain amount of actual cash. The Federal Reserve requires most US banks to keep at least 10 per cent of all deposits available for withdrawal.
For example, say you deposited $10,000 into a savings account. Only $1,000 of this is kept as cash that you can freely access without dipping into the cash of someone else’s deposit. The remaining $9,000 is usually issued out in the form of loans.
Banks are paid interest on these cash reserves as an incentive to stop them lending out too much. On the other hand, banks also earn interest on any cash that they lend out.
Why do this? To expand the economy. The more capital available to be issued as loans, the more consumers can spend. The more they spend, the more others earn and the more we all earn, the more we can spend again. This keeps the economy moving forward and inflation ticking along.
When borrowers can’t repay this credit, however, there can be catastrophic effects on the economy. Banks become squeezed and the savings accounts of countless individuals are at risk.
Our economy is credit-based.
It may be a shock to discover that money has no intrinsic value. But, an even bigger shock is that most of the spending is done without money.
Instead, it’s done with credit.
Credit is basically an agreement between lender and borrower. The lender hands over an agreed amount if the borrower promises to pay it back, with interest, at some point in the future.
According to hedge fund manager Ray Dalio, in his informative video How the Economic Machine Works, the US economy has about $50 Trillion in credit compared with just $3 Trillion in actual money.
Since credit turns into debt as soon as it is issued, credit is seen as a liability for borrowers.
It is also seen as an asset for lenders – an investment that will yield the set amount of interest and increase overall capital upon settlement.
Why understanding credit is important.
According to Dalio,
“Credit is the most important part of the economy and probably the least understood.”
Because the issuance of credit sets into motion a series of mechanical and predictable series of events.
These are the debt cycles that shape our economy, allowing us to foresee when recessions are likely to occur.
In our next post about the money system, we will explore the workings of both the short-term and the long-term debt cycles to show how wealth can quickly turn into nothing at the brink of economic collapse.
Let us know your thoughts below, and don’t forget to subscribe to our newsletter for part 2!