I recently began writing down some thoughts on Cryptocurrencies. The more I thought about them, the more I realised the I need to preface that discussion with a refresher on the global monetary system. So today we will explore our current monetary system and that will give us a basis from which to ponder what advantages (or disadvantages) Crypto may offer. (Aside from that, simply understanding what money is all about is incredibly valuable.)
What is money?
What is money? It’s one of my favourite topics. Its part finance, part sociology, part psychology, part history. We use it every day. For many of us, life is principally a quest to get more of it. But have you ever really thought about what money is?
Humans are a highly intelligent and highly social species of animal. Through human evolution we have developed ways of interacting and exchanging what each of us has to offer society in terms of goods and services. The true origins of money are lost in history. Whatever the beginnings, money has evolved alongside humans into the highly evolved, formal and institutionalised thing that forms a cornerstone of modern human life.
How do we “define” money? This can be a rather controversial question largely because it depends on what you consider to be “money”. Ultimately, “money” as we use every day is a social construct that serves primarily as a medium of exchange. It’s a medium by which we gain access to the things we need and desire.
Throughout history, “money” has taken the form of many things. Shells, precious metals, pieces of paper. Today, money is largely electronic records – most payments we make are done by transferring money electronically – automatic direct debits from our bank account, credit cards at the supermarket, “paypal” transactions for those shoes purchased from the USA over the internet. Its all incredibly easy and convenient.
The evolution of “money” alongside technology has resulted in these highly efficient methods of exchanging money for goods or services and improved our quality of life in the process. But what this also highlights is that modern money has no “intrinsic value.” This doesn’t sit well with a lot of people – there’s a lot of people that feel more comfortable possessing something that they perceive to have greater intrinsic value. For example, gold. So they go and exchange most of their numbers on screens into gold bars that they stack under the bed, all the while saying things like “fools…your system of waving plastic cards at electronic terminals to acquire goods and services will soon come crashing down and its us visionaries with our hard assets that will rule the world…”
So given that money has no value, what gives money value? Why do we toil away at work in order to accrue numbers on computer screens?
What gives money “value?”
Lets start with a quick detour into history – bear with me, this is interesting and very relevant… July 1944. World War II is still raging but the leaders of the allied nations are focused on getting the rebuilding process underway. There was a high level of agreement among nations that the economic problems stemming from the first world war were a key contributor to the second. With that in mind, delegates from all 44 allied nations (including Australia) met in Bretton Woods, New Hampshire USA with the goal of setting up a system of rules, institutions and procedures to regulate the international monetary system.
The USA basically dictated the final agreement given that their European allies were devastated by the war and needed US assistance to rebuild.
The final agreement was basically a system of fixed exchange rates. Each country would fix their currency to the “reserve currency” (the US dollar) and intervene in the forex markets in order to preserve the peg. If needed, the newly-created “International Monetary Fund” could assist in bridging imbalances of payments.
To bolster confidence in the system, the US dollar would be backed by gold at the rate of $35 per ounce. Foreign governments and central banks were able to exchange dollars for gold at this set rate.
At the time, the US already possessed 2/3 of the world’s gold reserves. The European allies that were involved in the war were heavily indebted and an outcome of the agreement resulted in large amounts of gold being transferred to the USA. The USA had all the productive capacity and a lot of the gold. This cemented the value of the US dollar in global markets and resulted in a lot of international transactions being denominated in US dollars.
The program had mixed success. The USA loved it because it had all the reserves and all the productive capacity. But the productive capacity was a big problem. They were the world’s factory and thus ran huge trade surpluses with the world. This resulted in even further capital inflows. The rest of the world was suffering from huge dollar shortages and it was necessary to reverse these flows – the US needed to get money flowing out of the country.
Reducing its trade surplus would be one way. But Europe needed US goods as it hadn’t yet built up the productive capacity to make enough of their own. And for the USA, European goods weren’t very appealing imports given that the US was at the forefront of technological innovation. If not via trade, the US would need to shift money to Europe via foreign investment. The end result was the Marshall Plan – the European Recovery Program that would provide large-scale financial aid for rebuilding Europe.
Fast-forward 15 years and by the end of the 1950’s the US was no longer the global powerhouse it was when Bretton Woods was formulated. Europe and Japan had rebuilt and the USA was now running a trade deficit. Within the context of the system, this deficit was good as it helped keep the system liquid and fuel economic growth. But it was inevitable that in time the constant deficits would erode confidence in the dollar as reserve currency. The system, including the gold peg at $35/ounce was defended through the 1960’s. However, by the end of the ‘60’s the trade deficits combined with spending on the Vietnam War had resulted in the system becoming untenable. The dollar shortage of the 1940’s had turned into a dollar glut, the US dollar was meaningfully overvalued and the Yen and European currencies (German Deutsche Mark) undervalued within the Bretton Woods system and the US was seeing accelerating gold outflows under the convertibility commitment.
Then, in 1971 President Nixon “closed the gold window” – US dollars could no longer be converted to gold.
The closure of the gold window was a fundamental change in the global monetary system. Under Bretton Woods, currencies were tied together via fixed exchange rates against the US dollar, which was convertible to gold. Closure of the gold window meant that currencies were no longer backed by gold – they were backed by….nothing…
The “Nixon Shock” as its now often called, is a huge deal in the evolution of the monetary system. It ushered in the current system of floating “fiat” currencies.
So if “money” isn’t backed by anything tangible, what gives money its value?
There’s number of theories on this. I’ll resist going off on other tangents about Venezuela’s recent economic collapse and other interesting historical perspectives and get to the point…
Modern Fiat Currency: A Ticket to the Game
In the realm of economics, modern fiat currency can be likened to a “ticket to the game.” Just as a ticket grants access to a sports event or concert, fiat currency facilitates participation in the economic game of buying and selling goods and services.
Money, fundamentally a social construct serving as a medium of exchange, is indispensable for engaging with an economy. Consider the scenario of desiring to reside in a specific country, such as Australia. The motivation stems from the promise of a certain standard of living—a recognition of one’s skills by potential employers and the appeal of the available goods and services like healthcare, food, and infrastructure. In this context, the Australian dollar derives its value from the demand for it as the medium of exchange within the economy, reflecting the nation’s offerings.
Contrastingly, envision contemplating a move to Venezuela. Here, the consideration isn’t primarily about the country’s currency or governance but revolves around the potential access to goods and services. Unfortunately, the current state of the Venezuelan economy diminishes its attractiveness due to a lack of substantial offerings. The devaluation of fiat currencies, often seen in hyperinflation scenarios, isn’t solely attributed to “money printing” but rather to a drastic decline in productive capacity.
While governments dictate the national “legal tender” and mandate tax payments in the designated currency, this alone doesn’t confer value upon the currency. Instead, the genuine worth of fiat currency stems from the private sector’s endeavors—its productive capacity, innovation, and ability to enhance living standards.
The role of the government remains crucial in fostering an environment conducive to economic prosperity. This entails establishing frameworks that facilitate private sector growth, safeguarding property rights, and investing tax revenues wisely in infrastructure projects that bolster productivity and elevate living standards. Thus, the symbiotic relationship between the public and private sectors underpins the true value of fiat currency within a modern economy.
Where Does Money Come From?
Have you ever pondered the origins of money? It’s a question that often slips under the radar. So, where does money actually come from?
In the modern world, the majority of money exists as electronic records—mere numbers displayed on screens. These digital representations of wealth are housed and managed by banks.
Understanding the pivotal role of banks in the contemporary fiat currency system is paramount to grasping the inner workings of the monetary system and the genesis of money itself.
Essentially, the banking system functions as an expansive payment processing network. Consider your everyday transactions: when you swipe your card at a paywave terminal to settle a lunch bill, your bank facilitates the transfer of funds from your account to the seller’s. If the seller banks with a different institution, the transaction entails your bank coordinating with the seller’s bank through the interbank system.
However, in modern fiat currency systems, banks don’t merely shuffle money around—they are the creators of money.
Contrary to common belief, the government’s role in money creation is limited to the physical printing of notes and minting of coins. In countries like Australia, the USA, and the UK, the money supply is predominantly managed by private banks, which generate money in the form of debt, often termed as “credit.” These banks operate under government licenses and regulatory oversight. Thus, while it may seem unsettling, the government maintains control over the money supply through its regulation of banks.
This delegation of money creation to the private sector has evolved to prevent a scenario where the government holds a monopoly on money creation, leaving the private sector vulnerable to government influence. Such a scenario would be far from ideal, as governments aren’t renowned for efficiency or productivity. By entrusting money creation to the private sector, the system benefits from the dynamism and innovation inherent in private enterprise.
Banks compete with one another to provide credit. When they extend a loan to a worthy borrower, the transaction results in four accounting entries:
The bank’s assets increase by the value of the loan
The bank’s liabilities increase by the value of the loan (being the money deposited into the customer’s account for them to access).
The customer’s assets increase by the value if the loan (the deposit into their account).
The customer’s liabilities increase by the value of the loan (i.e. the loan).
By making the loan the bank has created new money. Importantly, they haven’t created new net assets as there are equal and opposite liabilities – loans therefore don’t make someone wealthier in terms of assets, but they do create new money.
There’s this historical view that banks lend from reserves. “Fractional Reserve Banking” is this idea that banks keep a certain percentage of deposits in reserve and lend out the rest. The amount of loans they can make is dictated by their minimum “reserve requirement.” The lower the reserve requirement, the more the banks can (and will) lend. Do you know what Australia’s minimum reserve requirement is? Zero. There’s no reserve requirement.
Banks are never “reserve constrained.” They are “capital constrained” – they are required to ensure that they have sufficient capital on-hand relative to their loan book. “Capital” is essentially their money – equity capital they have raised from investors plus retained profits are the purest forms of capital.
It’s important to understand that a lot of these conventional theories about money come from an era of “gold standards.” This is why Nixon closing the gold window is so significant. Due to the restraints imposed on the system via a gold standard, the system needed to operate differently. It would be silly to say that all economics theories created before 1971 are outdated and incorrect, but there are some that are.
Of course, leaving money creation solely to the private sector has the potential for disastrous consequences. And indeed we have seen some highly unstable periods. What has evolved is a complex public/private system.
In Australia we have one key entity that works alongside the private banks in maintaining the monetary system: The Reserve Bank of Australia (RBA) was established in 1960 as our central bank (taking over from the Commonwealth Bank). The bank is responsible for several key tasks including setting official interest rates and creating “hard currency” via its subsidiary “Note Printing Australia.”
But in the context of this discussion, the most important role the RBA plans within the banking system is its role in the interbank market.
In essence, the RBA oversees the payments system – this system where banks process all these electronic payments we create each day, including the creation of new credit. They have the capacity to step in and provide liquidity to banks if necessary – the “lender of last resort.” This is an unappreciated and incredibly important role.
The US central bank – the Federal Reserve – copped a lot of criticism about certain steps it took in the 2008 global Financial Crisis with respect to fulfilling its role of “lender of last resort.” Certainly, some actions did seemed to cross the line of its authority from monetary policy into fiscal policy. But on the whole, it performed its key duties admirably. Why do I say this? Because although we saw a staggering number of little banks go bust, we didn’t see widespread bank runs and depositors losing vast sums of deposits. This happened in the period leading up to the Fed’s creation in 1913 and was one of the key reasons for its creation.
The flexibility for the central bank to step in and provide liquidity is incredibly important for the stability of the economy and banking sector. Similarly, it needs to be understood that the banks have a dramatic influence on the money supply as they go about their lending activities and this credit creation/destruction process is important for the welfare of the economy.
These factors are a feature of the modern monetary system. When evaluating any possible alternatives, we need to understand this.
Once again – the design of the modern monetary system allows for the monetary supply to expand and contract as needed without being constrained by, say, the amount of gold in the vault.
Global Trade and exchange Rates
In this world of floating fiat currencies, what happens when we buy something from overseas? Let’s say we buy something from the UK. Will the seller be happy for us to send them AUD? No – they want GBP. So one way or another, through the global payments settlement system our bank will arrange for AUD to be taken from our account, converted into GBP and then deposited into the seller’s UK account.
What if this happened on a massive scale? What if for whatever reason demand for UK goods was massive? Demand for GBP then becomes massive – the banks, on our behalf via they payment settlement system seek to convert AUD into GBP (“sell” AUD/”buy” GBP). If the scale is large enough what happens? The GBP rises against the AUD. If it rises enough then what happens? Those goods start to look way less attractive in AUD terms!
In this system of floating fiat exchange rates we have around the world, the currency acts as somewhat of a “release valve.” If capital flows become too one-sided, one will go up and the other down.
This is an incredibly valuable feature of the modern global monetary system. Without this, if certain particular areas of the world are able to produce goods or services cheaper and better than elsewhere, if pushed to the extreme they become the monopoly provider of goods and services to the world. In time, this will have major social and financial implications around the world.
Trump’s push for tariffs are controversial (and we won’t go off on that tangent today). But I sense that they have broad support from a lot of Americans. In a simple sense they stem from the above issue – other nations have been consistently producing goods and services at a lower cost than the USA can and that has had an impact on the US economy.
Conclusions:
I could go on forever with this discussion. The main reason is that money and the monetary system is such an important factor in so many other financial issues. That’s why having a sound understanding of the monetary system is so valuable. I’ve covered off the key aspects that will be relevant to a discussion about possible alternative monetary arrangements incorporating Cryptocurrencies so I’ll wrap things up.
In summary, the modern monetary system used by most of the leading developed economies isn’t perfect. But it has evolved alongside humans and technology to meet our needs with respect to the efficient sharing of goods and services.
The key area where it is most obviously not “perfect” is in the government oversight of the commercial banks in their role as money creators. The Global Financial Crisis highlighted this – if you had to whittle the event down to just one “cause,” it would be that the government’s oversight of the banks was insufficient. As profit-seeking private companies “greed” took over – lending standards went out the window. The regulator should have been there providing greater oversight.
Reminiscing on this, when I see some of what’s coming out of this banking Royal Commission, I get an eerie sense of deja-vu. Some key points:
Most of the conventional theories about money – where it comes from, the “rules” surrounding it – are from bygone eras of “gold standards.”
In the modern world of floating fiat currencies, governments dictate what the nation’s legal tender is, but they have limited control over its value.
Money extracts its value from the productive capacity of the economy – the private sector. The more productive/innovative, the greater the demand for that currency is likely to be.
Governments assist in assuring “value” by regulating the private sector and helping it to thrive – upholding intellectual property rights, providing quality infrastructure that assists in productivity and improves standards of living.
The principal money creation function is separated from the government and outsourced to commercial banks that create money in the form of credit by competing against one another to make loans to worthy borrowers.
Banks also maintain the payment processing system – basically enabling the global economy to function efficiently and effectively.
Banks are aided in their role of processing payments by government agencies that provide oversight and can step in and provide liquidity if the system ever looks to be breaking down.
The ability for banks (including the central bank) to increase and decrease the money supply is very important for the stability of the economy.
Extrapolated globally, the payment processing system consists largely of floating fiat currencies that change in value relative to one another based on demand – this provides important stabilisation attributes.
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Money: A Ticket to the Game
Money
I recently began writing down some thoughts on Cryptocurrencies. The more I thought about them, the more I realised the I need to preface that discussion with a refresher on the global monetary system. So today we will explore our current monetary system and that will give us a basis from which to ponder what advantages (or disadvantages) Crypto may offer. (Aside from that, simply understanding what money is all about is incredibly valuable.)
What is money?
What is money? It’s one of my favourite topics. Its part finance, part sociology, part psychology, part history. We use it every day. For many of us, life is principally a quest to get more of it. But have you ever really thought about what money is?
Humans are a highly intelligent and highly social species of animal. Through human evolution we have developed ways of interacting and exchanging what each of us has to offer society in terms of goods and services. The true origins of money are lost in history. Whatever the beginnings, money has evolved alongside humans into the highly evolved, formal and institutionalised thing that forms a cornerstone of modern human life.
How do we “define” money? This can be a rather controversial question largely because it depends on what you consider to be “money”. Ultimately, “money” as we use every day is a social construct that serves primarily as a medium of exchange. It’s a medium by which we gain access to the things we need and desire.
Throughout history, “money” has taken the form of many things. Shells, precious metals, pieces of paper.
Today, money is largely electronic records – most payments we make are done by transferring money
electronically – automatic direct debits from our bank account, credit cards at the supermarket, “paypal”
transactions for those shoes purchased from the USA over the internet. Its all incredibly easy and convenient.
The evolution of “money” alongside technology has resulted in these highly efficient methods of exchanging money for goods or services and improved our quality of life in the process.
But what this also highlights is that modern money has no “intrinsic value.” This doesn’t sit well with a lot of people – there’s a lot of people that feel more comfortable possessing something that they perceive to have greater intrinsic value. For example, gold. So they go and exchange most of their numbers on screens into gold bars that they stack under the bed, all the while saying things like “fools…your system of waving plastic cards at electronic terminals to acquire goods and services will soon come crashing down and its us visionaries with our hard assets that will rule the world…”
So given that money has no value, what gives money value? Why do we toil away at work in order to accrue numbers on computer screens?
What gives money “value?”
Lets start with a quick detour into history – bear with me, this is interesting and very relevant… July 1944.
World War II is still raging but the leaders of the allied nations are focused on getting the rebuilding process underway. There was a high level of agreement among nations that the economic problems stemming from the first world war were a key contributor to the second. With that in mind, delegates from all 44 allied nations (including Australia) met in Bretton Woods, New Hampshire USA with the goal of setting up a system of rules, institutions and procedures to regulate the international monetary system.
The USA basically dictated the final agreement given that their European allies were devastated by the war and needed US assistance to rebuild.
The final agreement was basically a system of fixed exchange rates. Each country would fix their currency to the “reserve currency” (the US dollar) and intervene in the forex markets in order to preserve the peg. If needed, the newly-created “International Monetary Fund” could assist in bridging imbalances of payments.
To bolster confidence in the system, the US dollar would be backed by gold at the rate of $35 per ounce. Foreign governments and central banks were able to exchange dollars for gold at this set rate.
At the time, the US already possessed 2/3 of the world’s gold reserves. The European allies that were involved in the war were heavily indebted and an outcome of the agreement resulted in large amounts of gold being transferred to the USA. The USA had all the productive capacity and a lot of the gold. This cemented the value of the US dollar in global markets and resulted in a lot of international transactions being denominated in US dollars.
The program had mixed success. The USA loved it because it had all the reserves and all the productive
capacity. But the productive capacity was a big problem. They were the world’s factory and thus ran huge trade surpluses with the world. This resulted in even further capital inflows. The rest of the world was suffering from huge dollar shortages and it was necessary to reverse these flows – the US needed to get money flowing out of the country.
Reducing its trade surplus would be one way. But Europe needed US goods as it hadn’t yet built up the
productive capacity to make enough of their own. And for the USA, European goods weren’t very appealing imports given that the US was at the forefront of technological innovation. If not via trade, the US would need to shift money to Europe via foreign investment. The end result was the Marshall Plan – the European Recovery Program that would provide large-scale financial aid for rebuilding Europe.
Fast-forward 15 years and by the end of the 1950’s the US was no longer the global powerhouse it was when Bretton Woods was formulated. Europe and Japan had rebuilt and the USA was now running a trade deficit. Within the context of the system, this deficit was good as it helped keep the system liquid and fuel economic growth. But it was inevitable that in time the constant deficits would erode confidence in the dollar as reserve currency. The system, including the gold peg at $35/ounce was defended through the 1960’s. However, by the end of the ‘60’s the trade deficits combined with spending on the Vietnam War had resulted in the system becoming untenable. The dollar shortage of the 1940’s had turned into a dollar glut, the US dollar was meaningfully overvalued and the Yen and European currencies (German Deutsche Mark) undervalued within the Bretton Woods system and the US was seeing accelerating gold outflows under the convertibility commitment.
Then, in 1971 President Nixon “closed the gold window” – US dollars could no longer be converted to gold.
The closure of the gold window was a fundamental change in the global monetary system. Under Bretton
Woods, currencies were tied together via fixed exchange rates against the US dollar, which was convertible to gold. Closure of the gold window meant that currencies were no longer backed by gold – they were backed by….nothing…
The “Nixon Shock” as its now often called, is a huge deal in the evolution of the monetary system. It ushered in the current system of floating “fiat” currencies.
So if “money” isn’t backed by anything tangible, what gives money its value?
There’s number of theories on this. I’ll resist going off on other tangents about Venezuela’s recent economic collapse and other interesting historical perspectives and get to the point…
Modern Fiat Currency: A Ticket to the Game
In the realm of economics, modern fiat currency can be likened to a “ticket to the game.” Just as a ticket grants access to a sports event or concert, fiat currency facilitates participation in the economic game of buying and selling goods and services.
Money, fundamentally a social construct serving as a medium of exchange, is indispensable for engaging with an economy. Consider the scenario of desiring to reside in a specific country, such as Australia. The motivation stems from the promise of a certain standard of living—a recognition of one’s skills by potential employers and the appeal of the available goods and services like healthcare, food, and infrastructure. In this context, the Australian dollar derives its value from the demand for it as the medium of exchange within the economy, reflecting the nation’s offerings.
Contrastingly, envision contemplating a move to Venezuela. Here, the consideration isn’t primarily about the country’s currency or governance but revolves around the potential access to goods and services. Unfortunately, the current state of the Venezuelan economy diminishes its attractiveness due to a lack of substantial offerings. The devaluation of fiat currencies, often seen in hyperinflation scenarios, isn’t solely attributed to “money printing” but rather to a drastic decline in productive capacity.
While governments dictate the national “legal tender” and mandate tax payments in the designated currency, this alone doesn’t confer value upon the currency. Instead, the genuine worth of fiat currency stems from the private sector’s endeavors—its productive capacity, innovation, and ability to enhance living standards.
The role of the government remains crucial in fostering an environment conducive to economic prosperity. This entails establishing frameworks that facilitate private sector growth, safeguarding property rights, and investing tax revenues wisely in infrastructure projects that bolster productivity and elevate living standards. Thus, the symbiotic relationship between the public and private sectors underpins the true value of fiat currency within a modern economy.
Where Does Money Come From?
Have you ever pondered the origins of money? It’s a question that often slips under the radar. So, where does money actually come from?
In the modern world, the majority of money exists as electronic records—mere numbers displayed on screens. These digital representations of wealth are housed and managed by banks.
Understanding the pivotal role of banks in the contemporary fiat currency system is paramount to grasping the inner workings of the monetary system and the genesis of money itself.
Essentially, the banking system functions as an expansive payment processing network. Consider your everyday transactions: when you swipe your card at a paywave terminal to settle a lunch bill, your bank facilitates the transfer of funds from your account to the seller’s. If the seller banks with a different institution, the transaction entails your bank coordinating with the seller’s bank through the interbank system.
However, in modern fiat currency systems, banks don’t merely shuffle money around—they are the creators of money.
Contrary to common belief, the government’s role in money creation is limited to the physical printing of notes and minting of coins. In countries like Australia, the USA, and the UK, the money supply is predominantly managed by private banks, which generate money in the form of debt, often termed as “credit.” These banks operate under government licenses and regulatory oversight. Thus, while it may seem unsettling, the government maintains control over the money supply through its regulation of banks.
This delegation of money creation to the private sector has evolved to prevent a scenario where the government holds a monopoly on money creation, leaving the private sector vulnerable to government influence. Such a scenario would be far from ideal, as governments aren’t renowned for efficiency or productivity. By entrusting money creation to the private sector, the system benefits from the dynamism and innovation inherent in private enterprise.
Banks compete with one another to provide credit. When they extend a loan to a worthy borrower, the
transaction results in four accounting entries:
customer’s account for them to access).
By making the loan the bank has created new money. Importantly, they haven’t created new net assets as there are equal and opposite liabilities – loans therefore don’t make someone wealthier in terms of assets, but they do create new money.
There’s this historical view that banks lend from reserves. “Fractional Reserve Banking” is this idea that banks keep a certain percentage of deposits in reserve and lend out the rest. The amount of loans they can make is dictated by their minimum “reserve requirement.” The lower the reserve requirement, the more the banks can (and will) lend. Do you know what Australia’s minimum reserve requirement is? Zero. There’s no reserve requirement.
Banks are never “reserve constrained.” They are “capital constrained” – they are required to ensure that they have sufficient capital on-hand relative to their loan book. “Capital” is essentially their money – equity capital they have raised from investors plus retained profits are the purest forms of capital.
It’s important to understand that a lot of these conventional theories about money come from an era of “gold standards.” This is why Nixon closing the gold window is so significant. Due to the restraints imposed on the system via a gold standard, the system needed to operate differently. It would be silly to say that all economics theories created before 1971 are outdated and incorrect, but there are some that are.
Of course, leaving money creation solely to the private sector has the potential for disastrous consequences. And indeed we have seen some highly unstable periods. What has evolved is a complex public/private system.
In Australia we have one key entity that works alongside the private banks in maintaining the monetary system: The Reserve Bank of Australia (RBA) was established in 1960 as our central bank (taking over from the Commonwealth Bank). The bank is responsible for several key tasks including setting official interest rates and creating “hard currency” via its subsidiary “Note Printing Australia.”
But in the context of this discussion, the most important role the RBA plans within the banking system is its role in the interbank market.
In essence, the RBA oversees the payments system – this system where banks process all these electronic payments we create each day, including the creation of new credit. They have the capacity to step in and provide liquidity to banks if necessary – the “lender of last resort.” This is an unappreciated and incredibly important role.
The US central bank – the Federal Reserve – copped a lot of criticism about certain steps it took in the 2008 global Financial Crisis with respect to fulfilling its role of “lender of last resort.” Certainly, some actions did seemed to cross the line of its authority from monetary policy into fiscal policy. But on the whole, it performed its key duties admirably. Why do I say this? Because although we saw a staggering number of little banks go bust, we didn’t see widespread bank runs and depositors losing vast sums of deposits. This happened in the period leading up to the Fed’s creation in 1913 and was one of the key reasons for its creation.
The flexibility for the central bank to step in and provide liquidity is incredibly important for the stability of the economy and banking sector. Similarly, it needs to be understood that the banks have a dramatic influence on the money supply as they go about their lending activities and this credit creation/destruction process is important for the welfare of the economy.
These factors are a feature of the modern monetary system. When evaluating any possible alternatives, we need to understand this.
Once again – the design of the modern monetary system allows for the monetary supply to expand and contract as needed without being constrained by, say, the amount of gold in the vault.
Global Trade and exchange Rates
In this world of floating fiat currencies, what happens when we buy something from overseas? Let’s say we buy something from the UK. Will the seller be happy for us to send them AUD? No – they want GBP. So one way or another, through the global payments settlement system our bank will arrange for AUD to be taken from our account, converted into GBP and then deposited into the seller’s UK account.
What if this happened on a massive scale? What if for whatever reason demand for UK goods was massive? Demand for GBP then becomes massive – the banks, on our behalf via they payment settlement system seek to convert AUD into GBP (“sell” AUD/”buy” GBP). If the scale is large enough what happens? The GBP rises against the AUD. If it rises enough then what happens? Those goods start to look way less attractive in AUD terms!
In this system of floating fiat exchange rates we have around the world, the currency acts as somewhat of a “release valve.” If capital flows become too one-sided, one will go up and the other down.
This is an incredibly valuable feature of the modern global monetary system. Without this, if certain particular areas of the world are able to produce goods or services cheaper and better than elsewhere, if pushed to the extreme they become the monopoly provider of goods and services to the world. In time, this will have major social and financial implications around the world.
Trump’s push for tariffs are controversial (and we won’t go off on that tangent today). But I sense that they have broad support from a lot of Americans. In a simple sense they stem from the above issue – other nations have been consistently producing goods and services at a lower cost than the USA can and that has had an impact on the US economy.
Conclusions:
I could go on forever with this discussion. The main reason is that money and the monetary system is such an important factor in so many other financial issues. That’s why having a sound understanding of the monetary system is so valuable. I’ve covered off the key aspects that will be relevant to a discussion about possible alternative monetary arrangements incorporating Cryptocurrencies so I’ll wrap things up.
In summary, the modern monetary system used by most of the leading developed economies isn’t perfect. But it has evolved alongside humans and technology to meet our needs with respect to the efficient sharing of goods and services.
The key area where it is most obviously not “perfect” is in the government oversight of the commercial banks in their role as money creators. The Global Financial Crisis highlighted this – if you had to whittle the event down to just one “cause,” it would be that the government’s oversight of the banks was insufficient. As profit-seeking private companies “greed” took over – lending standards went out the window. The regulator should have been there providing greater oversight.
Reminiscing on this, when I see some of what’s coming out of this banking Royal Commission, I get an eerie sense of deja-vu.
Some key points:
are from bygone eras of “gold standards.”
is, but they have limited control over its value.
more productive/innovative, the greater the demand for that currency is likely to be.
upholding intellectual property rights, providing quality infrastructure that assists in productivity and
improves standards of living.
commercial banks that create money in the form of credit by competing against one another to
make loans to worthy borrowers.
function efficiently and effectively.
oversight and can step in and provide liquidity if the system ever looks to be breaking down.
very important for the stability of the economy.
that change in value relative to one another based on demand – this provides important
stabilisation attributes.
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