Money, Value, and the Fed

“Money, like anything else, derives its value from its scarcity relative to its utility.” -- Modern Money Mechanics, Federal Reserve Bank of Chicago, 1961-1992, p.2

That remarkable proclamation states the doctrinal premise for how our money system works. 

The Fed authors clearly expect that readers will accept the statement’s validity as self-evident: Everyone knows, they seem to be saying, that all valuable things are by definition scarce. They then proceed to describe over the following fifty pages just how the Fed purports to maintain the value of our money by keeping it scarce without diminishing its utility. 

The theory underlying this doctrine of “scarcity-plus-utility-equals value” is disarmingly simple. Everybody knows that when commodities are produced in greater quantity than demanded, their price goes down, and when demand outstrips supply the price goes up. Price, of course, measures market value. So if you want a thing to maintain its value, you don’t flood the market with it. Since money is a traded commodity (it hasn’t always been: see below), the same logic holds for it as for other market items. If you want money to retain its value, you have to keep it scarce. “Modern Money Mechanics” explains how the fractional reserve banking system creates money to meet the growth demands of the economy, but keeps it scarce at the same time.

Does keeping money scarce protect its value?  Should money be treated as a commodity?

But let’s reflect for a moment. Does that same market logic really hold for money itself? In a world where jobs, homes, crucial public services are disappearing catastrophically because “the money’s not there” to maintain them, we have to wonder whether keeping money scarce is the best and only way to protect its value. After all, its prime utility lies in its function as a mediator of exchanges. And if exchanges are crying out to be mediated (jobs waiting to be done, services not provided, mortgages going unpaid, etc.) but no money is available to mediate them, then our monetary system is not fulfilling the “utility” part of its charge. From that perspective it is losing its value, not maintaining it.

We’ve been reading a lot lately about how despite the massive taxpayer-funded bailout program, we’re still suffering from insufficient availability of credit. But the problem here lies not only in the banks’ much-decried unwillingness or inability to grant credit in the current depressed economic climate. It lies deeper: in the basic value-depends-on-scarcity premise that the Fed so self-assuredly proclaims.

Think about that “like anything else” part. How many valuable things can you think of that aren’t scarce, and whose value does not rise if they become scarcer? Well, how about sunlight? Air? Friendship?  Altruism?   Information? Communication? Honesty?  On and on – literally thousands of “things” both concrete and abstract are valuable simply because we need them to support our lives. They may be more abundant or less so depending on circumstances – there’s less sunlight in the winter, for example, and none at night – but their value is not determined by their scarcity.

What, then, sets these intrinsically valuable things apart from those other things whose value evidently does depend on their scarcity, things like gold and diamonds, say?

What sets them apart is that they are not traded commodities. (The abstract concepts in the group can’t even be considered commodities at all.) That is, their value is not expressed in a price. And this price-bound notion of value is clearly what drives the Fed’s policies governing the issuance of money. So the value-equals-scarcity-times-utility formula is really about market price, not value in its more basic sense of “what’s needed and desired”. And since for the Fed money is a commodity like any other, if its price goes up, so does its value, and scarcity is what will drive its price/value upward.

Which all leads to the question: Should our access to money be limited like this by its marketability? When our lack of money is piling misery upon catastrophe, can we afford to continue believing that there’s nothing wrong with that commodity-money system itself? Are we doomed to an eternity of bubbles and crashes, bank manipulations and bailouts, insufficient stimulus packages and unaffordable healthcare? Doomed to societal disintegration?

No, we are not. Not if we can get clear on some basic concepts about the things that are truly valuable to us and how to preserve them.

 The Crash is not an act of God.

Let’s start with the recognition that this devastating crash we’re suffering is not a natural disaster, not an act of God, not inevitable. It results from human beliefs, choices, behaviors. Our monetary system and the behaviors it gives rise to was created by us humans, and we can improve on it. But we can’t improve on it if we don’t understand it.

So here’s a thumbnail primer. 

For starters, money has not always been a tradable commodity. Originally it was just a record of value created, saved, or exchanged. In the middle ages, this record took the convenient form of notches in what were called “tally sticks”. The sticks themselves had zero value beyond their record-keeping function. Over the centuries, many kinds of physical tokens have fulfilled this function of simply representing the value of the goods or services traded: shells, wooden coins, tobacco leaves, carved stones, IOU notes, etc. Only much later did our money itself become an item to be traded on markets. But clearly, the Fed’s definition of money and how it works is based on its marketability – i.e., on a particular understanding of money that was not preordained, not inherent in money’s essence, but entered into by conscious design.

We can change that design if we see a good reason for doing so.

Money as Debt.

Fast forward to the present. As the Fed’s Modern Money Mechanics handbook makes clear, nowadays practically all money is created in the form of bank debt. Banks don’t just lend out money already deposited by account holders; they create it literally by the stroke of a pen, or of a computer key, that enters dollars into the accounts of borrowers. These “fiat” loans (“fiat” is Latin for “let there be!”) are repayable with interest, as everyone knows – but the money for paying this added interest cost is never itself created. Practically all money in circulation is debt principal. This means that our dominant system automatically puts us into competition with each other for the very stuff that we need in order to process our transactions: the money. Of course, not every transaction is itself a loan; but ultimately, every dollar we use in the buying and selling process that undergirds our lives must be repaid to the bank that created it. Those banks are nearly all privately owned. (The Fed is a cartel of privately owned banks). And they charge interest on the loans that create our money. In order for that interest to be paid, someone else’s principal must be captured, and unless those someones can refinance their debt, they will default.

Clearly, such a devil-take-the-hindmost system would collapse if no mechanism existed whereby new money could be made available to pay the interest on the old loans. That’s what started the near-axiomatic “growth imperative” for our national economies. More value must be created to justify the issuance of new loans, whose proceeds can initially be used to pay the interest on the old ones. So the economy must grow; and unless limits on exploitation and production are imposed, it will grow as quickly as the markets will bear. And when economic survival is at stake, the players will pay scant heed to the environmental and social disruptions that the growth imperative imposes.

The implications of this debt-based, growth-compelling monetary issuance system are profound. On the positive side of the ledger, it makes available large amounts of money to finance large capital projects. It’s what made the industrial revolution possible, with its huge investments in raw material extraction mechanisms and production facilities. Our modern economy continues to employ those same techniques. But we’ve reached a point in our relation to the Earth and to each other where the benefits of those positive returns are shrinking fast. (One can also debate just how “positive” they’ve actually been.  After all, they’ve never benefited the majority of the world’s people, let alone our natural habitat.) Even more serious: The system can’t possibly be sustained. Debt piled upon debt, with interest steadily compounding; clever players devising ever more lucrative, quicker ways of extracting value from our dwindling human and natural resources; the “finance” industry itself having amassed something like a 40% share of the money economy – these dynamics have led us into a perfect storm of economic collapse. We’ve seen the beginnings of it in 2008-2010, but certainly not the end.

So that’s the monetary system we’ve inherited. This rudimentary understanding of its essential characteristics will suffice as a basis in our search for how to transform it from a scarcity-producing, unsustainable juggernaut into a productive, balanced, trust-building, sustainable tool that serves rather than diminishes humankind and the natural world.

We’ll look at that next in this series on "Money, Value, and the Fed".