Money is a funny concept. We regularly trade goods against colorful pieces of paper. But why? What makes money worth anything and how foolproof is it? Let’s take a quick and overly simplified tour through the history of currencies and see why money, after all, is nothing more than a neat idea.
Money’s Golden Times
Why would anyone decide it’d be a good deal to trade a few pieces of paper for anything? Trade has always consisted of two parties looking to profit, so what made money worth anything, to begin with? To answer that one has to go back in time when people pretty much traded on a basic level. Goods against goods and, more importantly, gold against goods.
While there wasn’t a real bank to be found, gold could be brought to a Goldsmith for safekeeping. This soon led to people taking gold from the Goldsmith, trading it against goods, and a high chance that the same gold was brought back to the Goldsmith for safekeeping by its new owner. To avoid unnecessary circulation of gold they came up with an idea. Instead of trading with gold itself, people started trading pieces of paper attesting them the ownership of a certain amount of gold or assets. And that is exactly why money is deemed trade worthy to this day. Not because it is said to be official and valuable, but because it is believed to represent a certain amount of existing assets.
Park Benches in Italy
The idea of having proof of your wealth in the form of paper and coins was nice enough, though the world did not have a unified system for those. Pretty much anyone could invent their own system, thus making trading deals very complicated as traders within the same city had to face several currencies to trade goods for. This forced them to rethink the system and try to establish a unified currency, an idea that would start on a park bench right outside an Italian city. So if you ever asked yourself why a bank’s called a bank, it’s because it began on a “banca”. The more you know.
Though it was a fresh idea to unify trade, banks started to distort the relation of factual assets available in their vault and the money they created very quickly. Even the goldsmiths mentioned earlier started loaning practices that resemble concepts that we today describe as Fractional Reserve Banking.
Printing Money without Printing It
Money was straightforward back in the day. There was gold in the vault and corresponding pieces of paper in the hands of the customers. However, banks were no welfare institutions and needed to generate income themselves, which they did by lending money with interest. Nowadays that practice is known as Fractional Reserve Banking, meaning that only a certain fraction of money a bank works with, has to be existent in their vaults.
Let’s look at an example. Most major banks have to have 10% of their assets in their vaults. So if we were to deposit 1,000 USD in our bank accounts, the bank would use this money to lend out to other people with interest. Instead of lending out the 1,000 USD physically existent in the vault, they will lend out up to 10 times that amount in good faith that we, the provider of the money and the lender, will not require the amounts at the same time and paid out in cash. At this point, the bank has 1,000 USD in the vault and an additional 9,000 USD lent out, which is, at its core, just a number in their books. They successfully created money out of thin air.
Money Risk Management
This concept only works because banks nowadays are mostly doing risk management. It is deemed highly unlikely that we all need high amounts of cash at the same time. If at all, we nowadays pay for goods digitally by plastic cards, which works in favor of this concept as those made up numbers just get moved from one book to the other. The recent recession in 2008, however, has shown us one thing, if we all needed funds desperately, we’d be out of luck. Banks would indeed run out of assets very quickly, ruining the business and losing all that artificial money people thought was safe in a safe.
There are other issues connected to this practice though, one of which is inflation. The more money is printed or generated otherwise, the lesser the worth of the single bank note and thus the higher the prices of goods. We tend to be very angry whenever we notice an increase of prices in the supermarkets, damning greedy corporations when actual inflation is doing its fair share to contribute to price increases. While banks generate money without actually printing it, the government does print new banknotes whenever it deems it necessary. In the U.S., The Fed prints cash and brings it into circulation. This means, mostly, printing and lending money to the government in exchange for bonds based on debts. But why create more and more money if it makes it worth less and goods cost more?
Debts and Inflation
Because a low rate of inflation is desirable for economic growth. If there’s one thing any government loves, it is growth. Regardless of how feasible the eternal idea of seemingly never-ending growth is, governments do welcome a low inflation rate to keep the economy, and us consumers, supplied with money and uncertainty. More money in hand means more of it to spend and invest in businesses. Rising prices also mean you rather spend money now than later out of fear you may have to pay more. In turn that also means that your precious saving will loose value over time, as inflation is an ongoing practice.
Apart from the fact that your money is not in the bank in its full amount, we are juggling with numbers in a way that can be quite dangerous. Money and financials have become a gamble, one that can crash and burn very quickly as the recent recession has shown us. What makes it even more hurtful is the fact, that if you ever had to lend money and couldn’t pay the bank back. You have just made debts on funds that never existed but was made and sold to you with interest. If this wasn’t a bank it’d be called a shady business wouldn’t you think?
Let’s summarize — money is an idea. A good one as long as it resembles something of actual value. Nowadays banks and governments create it out of nothing, and while that sounds bad, it is entirely wanted. They need you to buy things that get more expensive every day with paper bills that are entirely made up. It is a neat idea indeed.
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