The Money Machine

Not being an economist, I really do not understand money. Having read a lot of articles written by economists, I wonder if even they really understand money. Money is important; money makes the world go around. Money is simple, so simple that even uneducated people manage to handle it. Money is complex, so complex that big governments, replete with oodles of experts are baffled by its implications.

Money is the basis of much of human activity. Whether we work or play, produce or consume, laugh or cry, live or die, pray or flirt it almost always involves money. It is said, no one can have too much money. Otherwise, how can one explain, why Mr. Bill Gates, with an estimated worth of $40 billion, goes to work everyday to earn more money? (The interest on $40 billion is over $10 million a day!).

What is money? Is it just the currency we carry around in our pockets? Is it just numbers in the memory of computers belonging to banks? Is it something real, or is it completely imaginary? Probably a little of each, yet not much of anything.

Who creates money? Most of us mistakenly believe the governments create money, because they have the self-granted right to print it. While governments do print currency, currency is not money. Money is something much more basic, much more fundamental, and much more elusive than currency. Money gets created, seemingly out of thin air, by economic activity of human beings.

Suppose Joe wants to go into business selling bananas at the street corner. First he has to borrow some money to buy some bananas. Joe buys bananas from the wholesale market and sets up his stand. The people who buy from Joe pays him more than what he paid for the bananas, but the buyers are quite happy. It saves the banana eater the time and expense of having to go all the way to the wholesale market to buy one banana. Joe is happy as he makes a profit. While the banana eaters enjoy their bananas, Joe can return some of his borrowed money and use some of his profit to support himself and the rest to buy more bananas the next day.

Joe becomes a cog in the great economic machine. Since he buys bananas at wholesale, the wholesale merchants make money from Joe. The farmer who grows the bananas gets money from the merchants. Joe’s customers have a delicious snack when they feel hungry. As Joe’s business flourishes, his income becomes steady and he expands into oranges, grapes and lemons. He even employs a helper. Joe’s helper now has money to spend to support his needs. Other producers of goods and services benefit as Joe and his helper spends their money on food, clothing, entertainment, housing, gadgets and pets. Suddenly, more baffling things start happening.

Joe even saves some money. Suppose Joe has $100 saved. Joe could keep this money safely under his mattress, or he could put it into the bank. Suppose Joe puts the money in the bank. The bank cheerfully accepts his money and then lends it out to Mary, who wants to buy a TV. With the bank loan, Mary purchases the TV, enriching the TV shop. The TV shop pays a salesman out of the money Mary spends. The salesman spends the money on new shoes. The shoe store person puts the money in his bank account. The bank suddenly has $200 deposited and loans out the extra $100. That money makes a few trips around the block and lands up again at the bank, to be deposited and loaned again.

The $100 deposited by Joe can circulate and be redeposit unlimited number of times, causing the bank to amass a huge amount of deposits (balanced by a huge amount of loans). Yet, if we look at it from a wealth point of view, Joe thinks he has $100, the shoe store has $100 and other depositors have $100 each, causing a massive amount of wealth to be created from a paltry $100 deposited by Joe. This baffling situation may look like a fallacy of arithmetic, but it is not. The circulation of currency creates wealth, and wealth is money. The government printed the original $100 as currency notes. These notes while circulating created deposits and deposits created wealth.

But what does the bank get for facilitating the money multiplying scam? A simple yet obnoxiously powerful concept, deeply intertwined with the concept of money is the notion of “interest”. To entice Joe to put his money in the bank and not under his mattress, the bank gives Joe interest on his money. Not only does the bank keep Joe’s money safely and keeps track of it, but it pays Joe too. Of course, to make a profit the bank charges a higher interest on the loans it makes to the borrowers.

The interest on loans makes borrowers think twice about holding on to borrowed funds. They try to work harder to earn the money to repay and as they repay the bank loans out to other people. It keeps up a constant churning of cash and credit, pushing people to work harder and faster to create more deposits for the bank. Strangely in this economic game, everyone seems to make money and we do not know where it comes from.

Interest is not just an incentive to deposit money in banks. It plays a very intricate, entrenched part in the matter of money. Money always bears interest. Hence money keeps increasing in amount. The increase in the amount of money over time may or may not increase its value. As the money increases in amount and its total value remains the same, then we say the money is actually decreasing in value (per unit of currency) and this leads to a simplistic definition of inflation.

Inflation is a dirty word in the world of money. It erodes value, discourages savings, creates hardship and generally gums up the works. Yet the opposite of inflation, deflation is even worse. Deflation causes money to gain value, and discourages spending. When people do not spend money, other people do not earn money. Economic activity grinds to a halt and everyone turns poor. So inflation is actually a good thing. It is a catalyst for growth. How much inflation is good and how much is bad is a point of great debate.

Economists say that inflation is caused by a lack of balance in the “Money Supply”. The money supply is a baffling yet calculatedly number, it is the sum of all the money in circulation in the economy. Governments have found they can use several seemingly inane tricks to control money supply—or rather influence money supply. Yet the governments do not quite know what the money supply should be, so in effect it is crapshoot and more often than not, grave mistakes are made. The money supply is supposed to go up as the economic activity increases, if it goes up faster, there is inflation, if it goes up slower there is recession or even depression.

Money supply is controlled by the government setting overnight interest rates (in the US that is called the Fed Funds Rate) and ensuring banks withhold some part of the deposits instead of loaning them out. If a bank loans out all the money it gets, then it may cause an almost infinite increase in money supply. Keeping a reserve fund slows the growth of money supply and brings some sanity in this insane racket. In simpler terms, often the government does not quite have a clue, and the economic pawn, the common person, gets the shaft.

Money supply, deposits and currency are just once facet of money. Money or its close cousin wealth covers property, stocks, bonds and precious metals. In addition there are esoteric instruments such as options, futures, indices and so on.

As if all this is not complicated enough, on top of the mess is the real messy stuff called taxes. The idea of tax is simple, to ensure the government can run the country in a smooth controlled fashion it needs money, and it should collect this money from the economic activity in the country. So a deceptively easy yardstick of economic activity is “income”, and the government taxes income.

But what is income? If you think defining money is hard, defining income is harder. If I borrow $10 from you and then forget to pay it back, is it income? If I buy a broken TV for $1, fix it up and sell it for $10, is it income? If a company sells $100 of goods and services, but decides to buy a $1000 building too, did it really lose money?

Suppose I want to be in the cow business. I first sell two cows that I do not own at full price, and then use the proceeds as a down payment on a bulk purchase of 10 cows at a discount. Since I really do not want the cows hanging out in my house, I sell the milking rights for the cows to a milk packager and the futures on cows to a butcher, with the cows retained in Mexico for a handling fee. I use the proceeds to buy options on 20 cows and I sell thousands of shares in my cow investing company. Soon, my balance sheet shows ownership of 30 cows and options on 40 more. Using my stock-equity leverage, I can buy milk in France and sell it in New York. Since I cannot transport the milk, I buy milk in New York from the farmer at a discount who was hurt by my French milk deal and lost his buyer. Similarly I find consumers in France to buy the milk I purchased earlier, at a much higher price because it created a milk shortage. Eventually using more innovative accounting I show a net loss due to my debt-equity swaps and high options overheads, while I never get close to any cows or milk. Which part of what was taxable income?

Partha Dasgupta is on the faculty of the Computer Science and Engineering Department at Arizona State University in Tempe. His specializations are in the areas of Operating Systems, Cryptography and Networking. His homepage is at http://cactus.eas.asu.edu/partha