Help me understand the global monetary system.

May 6, 2004 3:06 PM

Money confuses and scares me. [further within]

Is there a fixed amount of money in the world today, or is it variable? If I find a new gold deposit and sell it for cash, am I creating new money or just spreading the old stuff around? If I put my money in a bank account and they lend it to someone else, isn't that doubling the amount? Do countries have to destroy old banknotes before they can print new ones? What's to stop a nefarious foreign government from printing shedloads of new banknotes and spending it all on Hawk jets before anyone notices? If money in the West used to be based on precious metals, but is now based on securities and services, how did they manage the changeover, given that comparing the two seems entirely based on instantaneous and transitory sentiment?

posted by Pretty_Generic to work & money (26 comments total)

macroeconomics deals with this

basically, money is created through interest. there's a set limit of money in the world, which is always increasing.

banks create money for us in a couple of ways. here's a cache of how banks do it by depositing money in the form of interest into our accounts from their reserves, and howstuffworks lets us know that the fed creates money in three basic ways:

The reserve requirement
The discount rate
Open market operations

click on the howstuffworks link to learn more about those three items.

question 2: look up the "gold standard"

it'll get you results like this. basically, nixon removed us from the gold standard, though it was a long time in coming. in fact, there was even a period of time where it was illegal to own gold.
posted by taumeson at 3:32 PM on May 6, 2004

1) Variable.

2) Spreading old stuff.

3) No.

4) No.

5) Nothing (google for "russian currency devalutaion").

6) They threatened jail-time for anyone using precious metals as currency.
posted by falconred at 3:36 PM on May 6, 2004

"Is there a fixed amount of money in the world today, or is it variable?""

Variable. Money is printed and destroyed around the world by the various agencies in charge of doing so.

"If I find a new gold deposit and sell it for cash, am I creating new money or just spreading the old stuff around?"

You are not creating new money. How could you do that? You didn't print the money. You've made the money that's out there more valuable, however. (The same amount of money now represents more stuff than it did before.)

"If I put my money in a bank account and they lend it to someone else, isn't that doubling the amount?"

If we use physical money as an example, you can see the answer is "no", because that dollar has been given to someone else. If you ask for your dollar, the bank has to come up with one from somewhere. The same with electronic money.

"Do countries have to destroy old banknotes before they can print new ones?"

Certainly not the US or any other modern economy. Someone might do that, though.

"What's to stop a nefarious foreign government from printing shedloads of new banknotes and spending it all on Hawk jets before anyone notices?"

One country's money is worth to another country only what the other country can buy with it. If I print an EB bill, and I offer it to you, you'll ask me, naturally, "what's this worth? If I take this and offer it back to you for something you own, what would you give me?"

"If money in the West used to be based on precious metals, but is now based on securities and services, how did they manage the changeover, given that comparing the two seems entirely based on instantaneous and transitory sentiment?"

I'm not sure what you're asking here. There used to be an amount of gold or whatever actually kept in a vault for every bit of currency created. Then they said, why do that? People thought the money had value because the gold had value. But, wy exactly does the gold have intrinsic value? Answer: because people think it does. And people think the currency has value; and it does, because it could buy other things besides gold.

To understand how this works, and basic economics, imagine that you and someone each made stuff, and bartered with each other for it by exchanging the stuff you've made. Think about how that would work, before I go on.

Then, imagine that you made bread, but I grew wheat. You made new stuff, worth small amounts, all the time while I make big stuff, worth large amounts, only once or twice a year. So, one of us would have to keep tabs for the other, or both. So, now we don't exchange the goods directly, we keep accounts of it recorded somewhere and make sure we're even. Think about that for a while, now.

Then, imagine that there were more of us, all trading things around like this, and we all keep track of stuff, and someone says, "hey, Bill owes me twenty loaves of bread, how many of those loaves would be worth one of your pairs of shoes?" Now we know how much wheat, bread, and shoes are all valued relative to each other. Think about that for a while, now.

Then, imagine that we've done this for a while and someone says, "Hmm, if we can tell that all this stuff has a value related to all the rest of the stuff, then can't I just create some unit of measurement, say, for example, 'loaves of bread', that everything can be valued in?"

Then, some bright guy gets the idea to have a bread warehouse, where he exchanges bread (or bread IUOs) for a "bread warehouse IUO". That's a service he gets bread-loaf units for performing, too. Maybe he starts loaning out bread-loaf units to people at an interest rate, even.

Later, the people have a government of some sort and decide that instead of various bread warehouses making these various bread warehouse IUOs, the government should handle the bread warehouse IOUs. The private ones are still being used, but people switch over to the government one because, well, it's the government and they trust it more.

The bread warehouse IOUs are now a governmental currency. Money. It's all represented by a warehouse full of bread that the government buys for every IOU is issues.

Then, see my answer to your last question. Why bother with keeping a bread warehouse? (Or, yeah, keep the warehouse and keep a bunch of bread hoarded, but why bother to directly connect every IOU to a loaf of bread purchased, when that is implicit anyway, given that people except the government to back up their IOU with something of value.)

For more, do a Google search on basic economics.

Do you mind if I ask your approximate age? I don't mean anything by it, I'm just curious.
posted by Ethereal Bligh at 3:44 PM on May 6, 2004

The amount is variable. The fact that money deposited into one account can be lent out is the multiplier effect, one of the wiggier aspects of money that you'd encounter in Econ 101.

Only a small fraction of the total money in the world exists as specie (that is, coin or paper money). One problem with literally printing money (normally, governments use monetary policy, that is, how much interest the central bank charges to other banks, to affect the money supply, and therefore inflation: lower loan rates means loans are more attractive, therefore more money in circulation, thanks to the multiplier, but this can cause inflation--more money chasing the same amount of goods) to buy military goodies is that General Dynamics would probably get suspicious if you rolled up to their head office with a wheelbarrow full of cash; another is that the markets would notice pretty quickly and devalue the currency, so there's usually not a good reason to do this. In the 20s, Germany was saddled with a huge mark-denominated war debt, and tried to get out by hyperinflating its currency--the value would drop in the course of one day, something we saw more recently with rump Yugoslavia under Milosevic.

Here's a pretty good history of the gold standard. It doesn't seem to mention the Plaza Accord in 1985 (?) which devalued the USD and floated the JPY and was a step along the way towards today's floating currencies. Near as I can tell, a bunch of heads of state got together and said "ok, our currencies are floating now."

If you're interested in this stuff, find a used introductory textbook on macroeconomics.
posted by adamrice at 3:47 PM on May 6, 2004

What's to stop a nefarious foreign government from printing shedloads of new banknotes and spending it all on Hawk jets before anyone notices?

I don't think you could get them delivered in under 24 hours.
posted by yerfatma at 4:01 PM on May 6, 2004

If I put my money in a bank account and they lend it to someone else, isn't that doubling the amount?

Bank lending does indeed increase the money supply. Check out this page from the Fed. Scroll down to Reserve Requirements and Money Creation for an example.
posted by blue mustard at 4:15 PM on May 6, 2004

Blue Mustard and other: I don't think that your answer to the bank lending question will be helpful to someone who "is confused and scared" of money. In very basic, abstract terms, bank lending does not increase the money supply as Pretty Generic understands the term "money supply".
posted by Ethereal Bligh at 4:22 PM on May 6, 2004

I have a dollar. I deposit it at a bank. The bank loans you my dollar¹. You now have a dollar and I still have my dollar. So there are now two dollars in the world available to be spent.

You also have a debt, of course. The argument that your debt cancels out the greenback in your pocket may be arithmetically correct, but it's economically misleading. There are now two dollars in the economy, and the second dollar is available to be spent, re-spent, or deposited back in the bank (where it can be lent out again!). Sure, you will pay your debt at some point. When you do, you will reduce the number of the dollars in the world back to one. But this is just temporary, since the bank will soon afterwards lend my dollar to someone else.

¹ Due to reserve requirements, the bank can't loan the whole dollar, but only a portion of it. But for simplicity, assume it loans the whole dollar.
posted by blue mustard at 4:47 PM on May 6, 2004

No, in these basic terms, there's only one dollar in the economy. The one you gave to the bank.

I'm not disputing the multiplier effect. I'm disputing that in the simple terms you're using, what you say happens actually happening. It's not. And, economically speaking, that's very important when we're talking about the money supply as a tangible entity, in the way that Pretty Generic is asking and you are, unfortunately, incorrectly implying.

"Money supply", as you are thinking of it, is the immediate elasticity of the supply, which does have a multiplier effect.
posted by Ethereal Bligh at 5:04 PM on May 6, 2004

immediate elasticity of the supply, which does have a multiplier effect

Yikes, now I'm scared and confused.

However, I stand by my comments. We have obviously interpreted the original question in different ways.
posted by blue mustard at 5:25 PM on May 6, 2004

Let me try to make this more clear. The sense in which Blue Mustard is correct, is that when you deposit a dollar in the bank, you still think you have that dollar. It's still "yours". But then, so also thinks the person to whom the bank loaned that dollar. That perceived "creation of wealth" actually acts to some degree as an actual creation of wealth. Similarly, that money on deposit is considered by other people to be money that's still "yours". They may be more inclined to lend you money on the assumption that you'll be able to pay it back, and there you again have an increase in perceived wealth.

Note that in actual dollars, the bank loaning that money did not increase the number of actual dollars (physical or electronic) in existence, and that dollar cannot possibly be acting within the economy as anything more than one dollar.

However, when you have a dollar bill in your wallet, it's not doing anything at all. It's a unit of value that's been taking out of the system. It's like something of valuable put into storage that could be of use to someone.

What all this lending does is make it possible for all those actual dollars that exist to be acting each within the economy as closely to a full dollar as possible.

On preview, Blue Mustard: I interpreted the question from the standpoint of someone who doesn't know anything about economics or what money really is. Not as someone who is using economic terminology as it is commonly used, where what terms really mean are not what they necessarily seem to mean, because, as happens in science and math and all other technical fields, they have been slowly redefined over time.
posted by Ethereal Bligh at 5:28 PM on May 6, 2004

Ethereal Bligh: I'm 20. I'm not really scared of money, that was my flawed attempt at humor. I am however terrified of immediate elasticity.

Thanks for your thorough and helpful answers people. So am I right in saying that essentially any government has the right to print as much money as it likes for itself (inevitably devaluing it in the process)?

And one final tricky question: what would happen to the world economy if we all shared a single currency? I assume we'd still have inflation, right?
posted by Pretty_Generic at 5:54 PM on May 6, 2004

what would happen to the world economy if we all shared a single currency? I assume we'd still have inflation, right?

Initially, the world economy would go out of whack. Export/Import competitiveness, purchasing parity, standards..etc. IANAE.

I can't predict if it would stabilise. That depends on politics (as does the current economy).
posted by Gyan at 6:47 PM on May 6, 2004

" So am I right in saying that essentially any government has the right to print as much money as it likes for itself (inevitably devaluing it in the process)?"—Pretty Generic

"Right" is a loaded word. In principle, though, yes, in the same sense that a government has the right to do any damn thing it wants to do. In practice, however, things are more complicated. There might be various international agreements that constrain how a government does these sorts of things.

To answer your second question, there's probably a couple more points to be made (and they relate to the first, as well).

Um, your questions have been both about basic macroeconomics, and touching upon international trade and economics. The latter complicates things.

Let's focus only on what happens within a country with a single currency.

Since the government is the one who backs the currency and issues it, but also is always a major agent in the economy, it might be tempted to just print money and use it to buy things within its own economy and to pay payrolls and whatever. This will sooner or later cause inflation, because there's more money out there representing the same amount of "stuff". A goverment might do this if it's in trouble financially. In doing so, it's basically stealing from all the people that already had money. Maybe it intends to pay it back in some sense. Or hope no one notices. (But you don't need anyone to explicitly notice, because the value of the currency is, in the simplest terms, subject to supply/demand pressures; and making a whole bunch more currency available to the economy makes it worth less because the supply has been expanded.) What more responsible governments do, instead, when they need money, is they explicitly borrow it from the public by way of issuing bonds and the like. Taken alone, this would take money out of circulation and replace it with a loan to the gov. But the gov spends it.

The government can, and does, put more currency into the economy by way of loaning out currency it's issued. In theory, there would be a direct relationship to doing this and printing new money. Government prints some money, and then loans it to someone. This is inflationary, too.

You can imagine that they might print some money, loan it out, issue a bond to represent that money they print, and be paid for the bond by the money they printed. :)

Now, about international trade, currency exchange, and your question.

If you think about how I answered your first question, you'll see that a unit of currency has some value related to actual stuff that's being traded within the economy. That determines by itself what that money is "really" worth.

Imagine a government, or a business in that country, buying something internationally in their own currency. Like I said in my first response, in theory how people will value your currency is related to what they thing it is really worth, and that would be what it's worth in terms of your own country's goods. Right?

And how would they determine that? Well, they would use that currency to buy stuff from your economy. It would all work.

In reality, though, most governments until recently didn't let people buy and sell goods in currencies across borders where the transaction is a part of the economy like any other. Instead, a government might set an artificial exchange rate between their currency and others that they force you to use. (And by controlling how trade happens, they can get away with that.)

Now, they'd only really care if there was some trade going on because otherwise the exchange rate would be irrelevant. And that trade itself will force even the artificial exchange rate to conform somewhat to reality for the reasons that I've already described. But, this way, the government can A) control it; and B) take advantage of any differences between the actual relative value of the currencies and what they set the exchange rate to be.

Okay. Let's turn it around. Again, think about how the trade between countries acts to make the exchange rate reflect real relative values. What if trade is very limited? Then there wouldn't be much pressure for the two currencies to have accurate valuations relative to each other. Now imagine that there were a single currency, but two isolated regions that don't trade much with each other. What happens then? In that case, the only sense in which there's a single currency is the sense in which it's the same currency, but the local value of the currency will differ and there won't be much pressure for it to even out. And where most of the economic activity and wealth for that currency really is, is where the value will be determined. That smaller, isolated economy will have its currency changing in terms of what it can buy locally completely arbitrarily relative to that local economy. You can see why you might not want this to happen.

Of course this happens within national economies...that's why there are regional cost of living differences.

The world economy could support exclusively a single currency to the degree to which it is economically integrated—then that currency would work for everyone, mostly.

But you'd still have inflation just like you have inflation within a national economy for reasons having nothing to do with international trade or currency exchange rates.
posted by Ethereal Bligh at 7:07 PM on May 6, 2004

One last point. Notice how in my little story about the evolution of trade and money, your question about digging up gold and selling it is deflationary. That is, it makes the money that exists worth more, because there's the same amount of currency representing more actual wealth than was there before.

Now, I'd love to get into trade and comparative advantage, but I won't. Let's just say that in your example, because people for some reason like gold, your effort of digging it up actually translated that labor into new wealth that didn't exist before. Trade via comparative advantage creates wealth that didn't exist before, but in a different sense. (You can figure out how by thinking about my farmer and baker example above. What if each of the two people had to grow their own wheat and bake their own bread? Would they be able to? Would they be as good at it as they are when they specialize?)

So, a healthy economy is actually creating wealth all the time. If that's the case, then shouldn't the currency be devaluing all the time? Yes. So why doesn't this happen?

Because governments take advantage of this and they do all the things we've talked about above that are inflationary. That works out well, because the inflationary pressure cancels out the deflationary pressure, and the currency stays relatively stable. (And it's bad for an economy to have a currency changing value very quickly, either direction. If you think about two people in a currency borrowing/lending relationshipwith an interest rate, along with assuming they are being paid a salary in that currency, you'll see how a quckly changing value, up or down, can really screw things up.)
posted by Ethereal Bligh at 7:20 PM on May 6, 2004

That's quality answering.
posted by Pretty_Generic at 7:43 PM on May 6, 2004

...not only that, but my little explanation makes it a bit more clear what's been going on with the current US economy.

Productivity in the last three years has been going way, way up. Productivity is just a measurement of how much wealth is created for a given unit (or time, whatever). Your digging up gold is more productive than, for example, simply digging up dirt. You selling the dirt isn't as deflationary as you selling the gold.

So you can see that an abnormally high productivity increase is essentially deflationary.

On the other hand, because the economy had been contracting a few years ago, the government decided to loan money out at very low rates, which is inflationary.

In fact, the rates are so very low, it's amazing that it hasn't triggered inflation. But the productivity numbers are part of the explanation for why it hasn't. They represent a deflationary pressure that counteracts the inflationary pressure of the low interest rates.

No one really know, however, why in the hell the productivity numbers have gone up so much. And the dramatic productivity rise is also a big part of the reason why the employment situation hasn't gotten better. If employers are getting more and more value from the people they employ, they don't need to hire new people, even if the economy is growing, which it has been.

Also, there are other factors that can cause an economy to start being deflationary, besides weird productivity increases and such, and those have been in play, as well. The only real strong influence the gov has on the economy is spending and controlling the interest rate at which it loans money out. If it's worried about trying to get a declining economy going again, then lowering interest rates is the best way to do it.

The problem here is that there's a bottom limit for interest rates. You'd think it would be zero, but it's actually somewhat higher than zero for some reasons I won't go into.

So, what could happen is that an economy in recession could have a government lowering interest rates to goose it. But it doesn't work. Maybe there's some other deflationary pressures happening.

Meanwhile, falling interest rates, and the fact that they can't go below zero, all conspire to make it less and less in the best interest of lenders to lend out money. That slows economic activity for the reasons mentioned above.

So a real danger is that you have a deflationary situation and no room for the government to lower interest rates. And then you could have a "liquidity trap", which is very bad news. It's a kind of death spiral. It's what happened to Japan.

So, what's happened the last few years is that the Federal Reserve Bank has been trying to make the rates low enough to spur economic activity and inflationary pressures so that the economy would grow (which it has), and employment would grow (which it hasn't). And people love free money. There's been calls to lower the rates to effectively zero, but the Fed has refused to go that far down specifically so that they have some wiggle room to avoid a liquidity trap.

On the other hand, the rates are unbelievably low.

And now the Fed is worried that whatever has been keeping the lid on the economy even though the rates have been low, might blow off if they're not quick enough to start raising rates when it looks like things are picking up more steam. So that's why they're talking about, but have not yet, raised rates.

No one wants the rates to rise because it will make money more expensive to borrow. It's fueled what I think is a housing bubble, and interest rates rising might pop the bubble (which is good in the long term, but bad in the short term).

Okay, I'll shut up now. :)
posted by Ethereal Bligh at 8:19 PM on May 6, 2004

When I wrote:

"So, a healthy economy is actually creating wealth all the time. If that's the case, then shouldn't the currency be devaluing all the time? Yes."

Devaluing was the wrong word. I intended deflating.

Deflation: currency is worth more = things are cheaper

I wrote those comments in a bit of a frenzy, they were not as carefully thought out and carefully written as they should have been. I got kind of caught up in explaining these concepts, which I quite enjoy explaining for some damn reason that probably indicates a mental deficiency.
posted by Ethereal Bligh at 9:11 PM on May 6, 2004

Ethereal Bligh, you have made what would have been a long and boring ax on ecomonics one of the most interesting and informative posts i've read in a long time.

good job!

i'd borrow you a dollar for it, but i still have no idea if that's a good thing or a bad thing.

if ya don't teach, you should consider it.
posted by jeribus at 10:45 PM on May 6, 2004

I live in terror of an actual economist reading my comments. I just re-read them, and, not even being an economist, there's a bunch of things I'd like to rewrite or make more clear because I fear that I've given the wrong impression about them. Not to mention that I could be flat out wrong about some stuff. Sigh. (Particularly, I want to make clear that deflation and inflation are distinct from a expanding or shrinking economy.)

I also kinda want to point out that exchange rates that arise naturally through trade are what I was talking about (aside from pointing out that many exchange rates have been, and some are still, artificial); but that in the same sense that investors trade in shares of companies, people can trade in a currency market. In theory that's good, it decreases "friction", should make for a quicker and more accurate relative valuation of currencies. However, in the same way that speculation can get things out of whack in the securities markets (where company valuations end up being more dependent upon people's psychology about trading the shares rather than what they think the underlying company's economic activity is really worth), it can make things get out of whack in the currencies markets. Most contemporary economists are pretty strong on free trade and trade in general, and you'd think they would be keen on currency markets. An example of this would be Paul Krugman (who, regardless of what you think of his NYT op-eds, is indisputably an economist of the first rank). But, as Krugman has argued, currency markets can have very distorting effects on an affected country's underlying economy that can be very destructive because of speculation. So he, and many others, are lukewarm or even hostile to currency markets for this reason. Or, rather, they think there needs to be controls on the markets to keep the bad things from happening.

But I won't mention that stuff. I'll restrain myself.
posted by Ethereal Bligh at 11:43 PM on May 6, 2004

And one final tricky question: what would happen to the world economy if we all shared a single currency? I assume we'd still have inflation, right?

What would happen:

First, a bunch of currency arbitragers and people who provide currency hedging and futures would be out of a job.

In the bigger picture, it would mean that exchange rates couldn't flex. A universal monetary unit here is worth an UMU there is worth an UMU in Bangkok. But things need to flex, for reasons that EB was going into. So if exchange rates can't, output -- economic activity -- will. You'd expect country-wide economies to go into more frequent boom and bust cycles.

To some extent, this is what happened back when everyone was on a gold or pound-sterling standard -- because you could always go through the medium of gold, exchange rates were essentially fixed, and there were country-wide booms and busts at rapid intervals (at least in the US).

Or consider states within the US -- "exchange rates" are fixed, so output has to flex, so statewide economies tend to be rather more cyclic than the national economy is.

As to inflation, there might or might not be depending on how the currency and economy were managed.
posted by ROU_Xenophobe at 12:20 AM on May 7, 2004

What?! EB is not an economist?! Nice work nevertheless.
posted by Dick Paris at 2:45 AM on May 7, 2004

I have some confusion about the technical details of money - if it's all electronic, where does it actually exist? Is it only in some database in a bank somewhere? Is there an official record of how "many" actual dollars exist, electronically or otherwise? Is this some international agency, or the U.S. government? What would stop a rogue bank or government from, say, wiring someone money but not "deleting" the appropriate amount on their end? I am having trouble envisioning just how money exists..
Also, generic: think carefully about this phrase: "Money has value only because people think it has value".
posted by ac at 5:02 AM on May 7, 2004

There are only estimates of the money supply. In fact, there are different estimates for different things, referred to as M0-M5 (M5 being the broadest definition).

The more you look at it, the slipperier it gets.

What would stop a rogue bank or government from, say, wiring someone money but not "deleting" the appropriate amount on their end?

IANAB, but I can speculate that banks only accept transfers from accredited institutions, and that to maintain accreditation, an institution must open its books to regulators from time to time. Obviously this means you could get away with it for a while, but you'd better have your plane tickets to Argentina in order first.
posted by adamrice at 9:09 AM on May 7, 2004

Ah, so that's why the economy in Argentina is so bad. All those rogue economists hiding out there...
posted by bingo at 10:47 AM on May 7, 2004

in fact, there was even a period of time where it was illegal to own gold.

Is it legal again? Last I heard it was still illegal for Americans to own bullion above x amount...jewelry being an exception in most cases. (But jewelry was always exempted from the rule, I believe because of the sheer volume of other metals involved in making jewelry gold.)

I remember reading about the government using the rights of eminent domain to take gold mines away from individual people as recently as the 1990s.

The last time I tried to buy kuggerands (1995ish), I was told it was illegal for Americans to bring them back into the United States, because we are still forbidden to own bullion coins.

Alan Greenspan, in this article talks about gold, but doesn't mention that it's legal to own.

Hmmm, I guess perhaps digging through the Treasury laws is in order, unless someone has a citation handy about the current state of allowed ownership.
posted by dejah420 at 11:32 AM on May 7, 2004