The Dallas Federal Reserve Explains Money – A
Good Read For Millennials
It’s important to learn some basic concepts about money & the
monetary system, so let’s begin with what the Dallas Fed has to say about those
topics…This blog was created to
watch for any signs of major monetary system change. But one problem in this
regard is that many people have no idea what we mean when we use the term
monetary system or how major monetary system change might impact their own
daily lives.
One good first step for anyone
wanting to learn more about these issues is to learn some basic concepts about
both money and what a monetary system is. I live in the Dallas, Texas area
and we have one branch of the Federal Reserve Bank system located
here in Dallas. Visitors can take free
tours of the Dallas Fed and it also does produce educational materials on these
basic issues.
Below I have pasted in some
excerpts from this article produced by the Dallas Fed
simply titled “Money”. I selected these
excerpts because they relate to various issues I see discussed all the time in
doing research for blog articles here. It should be noted that the Federal
Reserve is not without its skeptics and critics and some of the statements
pasted in below would be challenged by those critics for sure. But overall,
this paper is a good place to start learning about the basic concepts that lead
to the debates we see about both money and how a monetary system should
function. I encourage readers (especially younger readers who may not have had
much formal exposure to these concepts in school) to read the full paper.
I asked Dr. Judy Shelton to preview the information presented in this article and
she offered this comment about it:
“I hope this
kind of information reaches many young people and causes them to reflect on the
importance of trustworthy money.” — Dr.
Judy Shelton
Dr. Shelton
is the US Executive Director for
the European Bank for Reconstruction and Development and also a Senior Fellow at the Atlas Network.
Further below, I will list
some of the issues and debates that I see arise from the basic concepts
presented in this paper. (note: I added some underlines below for emphasis)
——————————————————————————————————————–
Introduction
Paragraph to “Money”
“Money is so
important that when no official money exists, people often create it. For
example, during World War II, prisoners in prisoner-of-war camps used
cigarettes as money. All other goods were priced in terms of cigarettes, and
prisoners willingly accepted them as payment for any other good. While
cigarettes have value to smokers, once they become money, they gain value in
terms of everything they can be exchanged for, whether a person smokes or not.
People will always find something to serve as money, even with no government to
enforce its legitimacy.
What Is
Money? Money is anything that is widely accepted as a form of payment for
goods and services or repayment of debts.” . . . .
Defining
Money by Its Uses
“How can we
know when something has become money? One way to identify money is by its uses.
Money functions as (1) a medium of exchange, (2) a unit of account and (3) a
store of value. When people accept money as payment for goods and
services, it is not because of the intrinsic value of the money; it is
because they believe it will allow them to purchase the goods and services they
desire, now and in the future.” . . . .
The Characteristics of Money
“Cash
payments account for almost 50 percent of all transactions in the U.S., so
the role of currency in the country’s payment system is very important. Just
imagine if you were designing the nation’s currency from scratch. You already
know that currency must function as a medium of exchange, a unit of account and
a store of value. But what features does your money need? Six characteristics
have been identified: Money must be durable, portable, divisible,
scarce, uniform and acceptable.
There are
more than 107 billion cash transactions in the U.S. per year.” . . .
Types of Money
“We know
that one of the uses of money is as a store of value. But how does money get
its value? Three different types of money are recognized based on their sources
of value: commodity money, representative money and fiat money.”
Commodity Money
“A commodity
is an item that has value in and of itself. This can include anything from cows
and wheat to silver and gold. . . . .
Through
history, the commodity that most commonly has become money is a precious metal. Metals have all the characteristics of money. Metals are
generally durable, lasting a very long time in circulation. When minted into
coins, precious metals become relatively portable. They are divisible by weight
or denomination. They are scarce, requiring time and energy to find and
extract. Precious metals are uniform because their value in trade can be
confirmed using rules regarding purity. Last, by being easily recognizable,
precious metals are acceptable to most people.” . . .
“As a
society’s demand for money increases, the constraints of using a commodity
often become burdensome. To simplify transactions, people stop using the actual
commodity as money, and instead paper becomes the commodity’s
substitute. The new paper money is called representative money.”
Representative Money
“Representative
money does not have value on its own. Its only value lies in the value of the
commodity it represents. It is actually a promise. When a government begins
printing representative money, it is promising that the money is backed by, and
often can be exchanged for, a specific amount of the represented commodity. The
strength of the representative money is based on both the value of the
commodity and the credibility of the promise to redeem it for the
commodity.”
“Early forms
of representative money were often receipts for gold and silver deposited with
local metal smiths. In time, people began to accept the receipts as payment,
rather than returning to claim the commodity. When this happened, the receipts
began to function as money. By accepting the receipt, a person trusted
in the ability to return to the smith and obtain the amount of metal specified
on the receipt.” . . . .
“Eventually
governments officially converted commodity money to representative money in the
form of paper currency. This was essentially a promise that the printed note
could be redeemed for a certain amount of gold or silver coin—called specie.”
Fiat Money
“Fiat money
is money by decree. When it is no longer feasible or desirable to back money
with a commodity, governments can declare an item to be money. This
decree means that the money is an acceptable payment for goods and services and
enforceable for repayment of debts. Fiat currency has no value in and
of itself, as commodity money does, nor does it represent a promise to exchange
for a commodity, as with representative currency. Its value comes
exclusively from the willingness of people to accept it as payment. This
willingness is driven mainly by the belief that when a person wants to spend
that money, it will still have value— that is, the next person will accept it
as well.” . . . .
“Fiat
currency has many advantages over commodity and representative money. Fiat
currency is not constrained by the arbitrary amount of a commodity. Although
this does pose a risk, namely that the money supply can expand without limit,
it has an advantage: The money supply can grow and shrink to meet demand.” . .
. .
“The
disadvantages of fiat currency are largely associated with its management. If a
regulating body makes too much available, inflation—the general rise of prices
in the economy—can occur. If not enough money is available, growth in the
economy can be constrained. Balancing between not enough money in
circulation and too much money in circulation has proven difficult for some
countries. When the growth of the money supply gets out of hand, it can
lead to an economic collapse and the abandonment of the money. If
people cannot count on money to retain its purchasing power, they will refuse
to accept it whenever possible. While the government can enforce the use of
fiat money for the repayment of debt, enforcing its acceptance for other
transactions is often more difficult.”
Federal Reserve Notes and the
World
“The
stability of U.S. currency, coupled with the size of the U.S. economy, has made
Federal Reserve Notes desirable money, not just domestically but worldwide. At
times throughout history, countries have held the notes as reserves and
occasionally circulated them in place of their own currency. This demand is
driven by the perceived safety of the dollar—the belief that it will hold
its value and will remain acceptable for transactions for many years to come.
“
. . . .
“If the Fed
makes money too cheap, meaning interest rates that are too low, more money will
flow into circulation through lending activities, and this generally causes
prices of goods and services purchased with that borrowed money to rise. When
prices rise, we experience inflation—a general rise in prices over time. Low
and predictable inflation, around 2 percent, is actually beneficial to the
economy, but too much inflation, caused by an overabundance of money, will
cause the purchasing power to go down and can damage economic stability.
During the
Great Depression and through World War II, many countries abandoned the
practice of using their gold reserves to back the currency they
circulated—known as the gold standard. After the war ended, a push to
reestablish gold on an international scale led to the hosting of a conference
in the village of Bretton Woods, N.H. At the conference, it was agreed that
countries would commit to a system of fixed exchange rates. The United States
agreed to maintain the price of gold at $35 per ounce and to exchange dollars
for gold. The dollar became the de facto world currency as many
international transactions were quoted in dollars. As long as countries
believed that the United States was both willing and capable of redeeming the
notes for gold at any time, the notes were considered to be equivalent to the
gold they represented. In 1971, President Richard Nixon suspended the
convertibility of notes to gold and ended the gold standard. However, the
end of the Bretton Woods agreement was not the end of the circulation of U.S.
currency abroad.
Billions of
dollars in Federal Reserve Notes are used outside the United States in a number
of ways. Some countries circulate the money as their only form of currency.
Some countries try to preserve the value of their currency by pegging it—that
is, setting the exchange value of their domestic currency—to the dollar, and
many more circulate Federal Reserve Notes unofficially. Countries’ specific
reasons for using Federal Reserve Notes may vary, but the dollar’s use
is generally associated with its effectiveness as a medium of exchange, unit of
account and store of value.”
———————————————————————————————————————–
My added
comments: The information presented
above is intended to spur the reader to read the full paper presented by the Dallas
Fed and to try and highlight some of the basic concepts that
prompt intense debate. The more the reader understands these basic concepts,
the better the reader can evaluate the various points of view you will find
about both money and how a monetary system should function.
It should be
pointed out that some of the conclusions presented in this paper are hotly
contested and debated by critics. Here is one example from one of the excerpted
quotes above:
“Low and
predictable inflation, around 2 percent, is actually beneficial to the economy“
There is
much debate on whether or not targeting a 2% loss in the purchasing power of
the money people use every day to pay for goods and services is “beneficial to
the economy”.
Also, this
paper from the Dallas Fed takes the view that the Federal Reserve has done a
good job overall of meeting its objectives to 1) control inflation and 2)
encourage full employment. Critics of the Fed disagree strongly with that view
as you will quickly find if you do any research on these issues at all. Before
you can evaluate these various points of view to agree or disagree, a basic
understanding of the concepts and issues is needed and that is the goal of this
article.
Over the
years in doing research for this blog, I can list some topics of debate I see
out there that readers should further explore (this blog provides you a lot of
material to help with that here and here).
Here are just a few examples:
1) Should
the US have abandoned the gold standard?
2) Should
the US return to the gold standard?
3) Has the
Fed really protected the purchasing power of the US dollar during its existence
since 1913?
4) Is a gold
standard practical for use in a modern economy?
5) Does Fed
monetary policy protect large banks over the interests of the average person?
6) Has Fed policy done a good job of meeting it’s mandate to
provide a stable value to our money and also promote employment?
7) Can we really just not worry about government debt and create
all the money we need without sparking a loss of confidence in our money?
This list
can go on and on, but hopefully you can see that these basic money issues and
concepts are very important to all of us which is why this blog was
created. The view we take here is that the more people understand these
issues, the better off we will be.
One final
comment:
If you read
through the excerpts above, you can see an interesting history of how our money
has evolved into the monetary system we have today. This is one of the
strengths of this paper by the Dallas Fed in my view.
Please note
how that one thing about money and monetary systems has remained constant over
time. People must trust that the monetary system will protect the
purchasing power of whatever is being used for money over time. You see this
theme repeated over and over again in this paper by the Dallas Fed no matter
whether it is talking about “commodity money”, “representative money”, or “fiat
money”.
The huge
financial crisis which rocked the world in 2008-2009 shook the public trust in
our present system to the core. This is what has led to much of the discussion
and debate we have featured on this blog since that time. People like Jim
Rickards have predicted that due to poor monetary policy decisions and due to
the continued ramping up of debt in our financial system, a day will come when
the present system cannot be sustained. This prediction includes a view that
the US dollar will then lose its global status as the world’s reserve currency
and also endure a sharp and rapid loss of purchasing power. This is why these
issues are so important in our view here. As the Dallas Fed has
stated repeatedly above, people must have trust and confidence in their money.
Without that trust, the system cannot be sustained over time. What
if the public loses trust in our money before we can see and respond to the
loss of confidence?
If and when
the day arrives that too much public trust is lost, it will become vitally
important for people to understand these basic concepts and also the various
proposals on how to fix a broken system and restore public trust.
I especially
hope to encourage younger readers to explore these basic concepts and learn as
much as possible. Understanding both some of these basic concepts about money
and the history of how our money and monetary system has evolved over the last
100 years is huge help in that process and is not widely taught in our formal
education system.