Saturday 10 January 2015

Show me the real money: Three monetary myths that need busting

CENTRAL BANK?

This article originally appeared in the December edition of Penguin's ThinkSmarter Newsletter.


Money pervades our everyday economic interactions. But, despite its importance, it is also pervasively misunderstood. Here are three common monetary myths – frequently perpetuated by economists – that need challenging.

Myth 1: Money emerges from barter

Economists often tell a tale about how old communities first used barter to exchange goods and services. Bartering throws up tricky situations. Take as an example a farmer trying to exchange a cow for bread from a baker, a clumsy and difficult negotiation. Thus, according the old economists like Adam Smith, money was supposedly 'invented' as a way to get around that inefficiency and confusion.

This narrative is ahistorical and inaccurate. Anthropologists have long had a much more convincing account: in small communities without money, exchange does not take place through on-the-spot barter. Rather it takes place through reciprocity, the process whereby I give you something now, and then you return the favour over time. In essence, communities develop elaborate systems of score-keeping – informal ‘mutual credit’ systems are created, and if I don’t eventually honour my obligations under that system, I will be shunned from the community.

It is these ‘I owe you one’ systems that are behind the origins of money. Money is an abstracted form of such credit, taken out of the interpersonal context of a small community, and formalised and legalised within a political system.


Myth 2: Money is a commodity, and a store of value

Money is commonly defined as a store of value, a means of exchange, and a unit of account. But if we break it down, we see that money alone does not store value – whatever form that money takes.

Compare a £5 note, £5 worth of coins, and an internet banking screen saying you have £5 in your account. The same concept of £5 can be expressed in paper, metal or electronic form. There is nothing about the physical state of the money that carries the value. Instead, the value is held in the collective agreement of a community to honour what the money stands for.

There have been many cases where that agreement breaks down, for example, in Zimbabwe. In 2008 there was ‘hyperinflation’, a phenomenon where people lose belief in the money. As that belief disappeared, so too did the value of the money, and Zimbabwe was forced to abandon their national currency. The money itself is not the store of value. The community that agrees to uphold money is the store of value.

Nevertheless, people still cling to the notion that money is a ‘thing’ that has an independent existence that we can identify, like oil or rocks. This is the commodity illusion of credit money. Money is in fact a socially constructed, and politically backed, claim on goods and services. While it may have a physical manifestation, it could also exist purely as an accounting entry.

Imagine doing 5 hours of work for a community, and in return getting given a credit for 5 hours, which is simply written down on a central list that everyone can see, saying ‘We acknowledge you did 5 hours of work, and now you can claim back 5 hours from the rest of the community’.

Now imagine tearing that entry for 5 hour credits off the central list, and shaping it into a rectangle piece of paper – like a voucher – that you can pass around to people. That’s pretty much what paper money is right?


Myth 3: Modern money is created by central banks

THE REAL MONEY PRINTERS
If you ask many people who creates the money we use, most people say that it's down to the central bank. In reality, the central bank creates only a small percentage of the money we use. The majority is created by commercial banks, via a process called fractional reserve banking, in which they issue IOUs against central bank money. Nowadays these IOUs are electronic, and we use them every time we use internet banking or a debit card.

This means that if you bank with HSBC, your money actually takes the form of HSBC electronic IOUs which exist nowhere else but in HSBC’s IT system. That’s what you use when you pay with a card in a shop. This act of ‘moving’ your digital money is really just one bank telling another bank to change a data entry in their IT system. The central bank exists to back up trust in the system, and attempts to influence the private issuance of electronic money by commercial banks, but it doesn’t control the money supply itself.


Some further reading

If these topics interest you, you might want to take a look at my piece Breaching the monetary Matrix: Five exercises to help you understand money, and my essay Riches Beyond Belief. You might also consider taking a look at David Graeber's Debt: The First 5000 Years, Felix Martin's Money: The Unauthorised Biography, and Nigel Dodd's The Social Life of Money.


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4 comments:

  1. One of the core and central problems of perceiving and understanding money for what it is, rather than what it seems to be, is our tendency (and it is a necessary tendency) to abstract the world.

    Our social lives and interactions are governed by an abstract world, sometimes a little separate and sometimes many abstractions separate from the reality of a situation.

    Yet we pretend the abstract mirrors reality... when really, it mirrors ourselves and each other.

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  2. I have a question unrelated to the topic of this post. I am new to this blog so I don't know much about it yet. I see that the Dogecoin donation is above Bitcoin donation. Undoubtedly, Bitcoin is the most popular cryptocurrency now, but why is it in the middle instead of it being at the top? Is it because you are more enthusiastic about Dogecoin? Is it just a blunder? Or does putting it in the middle have some other significance?

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  3. I still believe money is a 'thing' just like oil or a rock(on the basis of the illustration that you have provided. Otherwise, I agree). I may not be right but as far as your post states:

    "There have been many cases where that agreement breaks down, for example, in Zimbabwe. In 2008 there was ‘hyperinflation’, a phenomenon where people lose belief in the money. As that belief disappeared, so too did the value of the money, and Zimbabwe was forced to abandon their national currency. The money itself is not the store of value. The community that agrees to uphold money is the store of value.

    Nevertheless, people still cling to the notion that money is a ‘thing’ that has an independent existence that we can identify, like oil or rocks. "

    Your illustration, the Zimbabwe hyperinflation incident, only illustrates how the value of money decreases. So if I had 10 ZMD before the hyperinflation, I would still have 10 ZMD after the hyperinflation. The value of money itself maybe decreasing but the 'thing' 10 ZMD is still there. This can be compared to value of oil. The amount of oil I have will remain constant with time, although its relative value in relation to everything else will fluctuate. I hope it makes sense.

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  4. "The majority is created by commercial banks, via a process called fractional reserve banking, in which they issue IOUs against central bank money."

    You need to be more careful. The bank IOUs are made redeemable for central bank money, but they are backed by much more than that (e.g., the mortgages and other loans that they issue).

    Otherwise, no monetary economist is going to argue in favor of these "myths." It is all well known.

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