From Commodity Money to Representative Money to Fiat Money

Posted by PITHOCRATES - April 8th, 2014

History 101

(Originally published November 8th, 2011)

The Drawbacks to Using Pigs as Money Include they’re not Portable, Divisible, Durable or Uniform

They say we use every part of the pig but the oink.  So pigs are pretty valuable animals.  And we have used them as money.  Because they’re valuable.  People were willing to accept a pig in trade for something of value of theirs.  Because they knew they could always trade that pig to someone else later.  Because we use every part of the pig but the oink.  Which makes them pretty valuable.

Of course, there are drawbacks to using pigs as money.  For one they’re not that portable.  They’re not that easy to take to the market.  And they’re big.  Hold a lot of value.  So what do you do when something is worth more than one pig but not quite worth two?  Well, pigs aren’t readily divisible.  Unless you slaughter them.  But then you’d have to hurry up and trade the parts before they spoil because they’re not going to stay fresh long.  For pig parts aren’t very durable.

Suppose you have two pigs.  And someone has something you want and they will trade two pigs for it.  But there’s only one problem.  One pig is big and healthy.  The other is old and sickly.  And half the weight of the healthy one.  This trader was willing to take two pigs in trade.  But clearly the two pigs you have are unequal in value.  They’re not uniform.  And not quite what this trader had in mind when he said he’d take two pigs in trade.

Our Paper Currency Evolved from the Certificates we Carried for our Gold and Silver we Kept Locked Up

Rats are more uniform.  They’re more portable.  And they’re smaller.  It would be easier to price things in units of rats rather than pigs.  They would solve all the problems of using pigs as money.  Except one.  Rats are germ-infested parasites that no one wants.  And they breed like rabbits.  You never have only one rat.  Man has spent most of history trying to get rid of these vile disease carriers.  So no one would trade anything of value for rats.  Because these little plague generators were overrunning cities everywhere.  So rats were many things.  But one thing they weren’t was scarce.

Eventually we settled on a commodity that addresses all the shortcomings of pigs and rats.  As well as other commodities.  Gold and silver.  These precious metals were portable.  Durable.  They didn’t spoil and held their value for a long time.  You could make coins in different denominations.  So they were easily divisible.  Unlike a pig.  They were uniform.  Unlike pigs.  Finally, you had to dig gold and silver out of the ground.  After digging a lot of holes trying to find gold and silver deposits.  Which made it costly to bring new gold and silver to market.  Keeping gold and silver scarce.  And valuable.  Unlike rats.

But gold and silver were heavy metals.  Carrying large amounts was exhausting.  And dangerous.  A chest of gold and silver was tempting to thieves.  As you couldn’t hide it easily.  Soon we left our gold and silver locked up somewhere.  And carried certificates instead that were exchangeable for that gold and silver.  And these became our paper currency.

Governments Everywhere left the Gold Standard in the 20th Century so they could Print Fiat Money

The use of certificates like this is typically what people mean by gold standard.  Money in circulation represents the value of the underlying gold or silver.  And can be exchanged for that gold or silver.  Which meant that governments couldn’t just print money.  Like they do today.  Because the value was in the gold and silver.  Not the paper that represented the gold and silver.  And the only way to create money was to dig it out of the ground, process it and bring it to market.  Which is a lot harder to do than printing paper money.  So governments everywhere left the gold standard in the 20th century in favor of fiat money.  So they could print money.  Create it out of nothing.  And spend it.  With no restraints of responsible governing whatsoever.

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A Weakening Dollar is giving Boeing a Trade Advantage over Airbus

Posted by PITHOCRATES - June 23rd, 2013

Week in Review

Before you can buy from a foreign country you have to exchange your currency fist.  For example, if you’re in China and want to buy some aircraft from Boeing or Airbus, you have to exchange you currency first.  Exchange Chinese yuan for U.S. dollars.  Or exchange Chinese yuan for euros.

Now if both Boeing and Airbus have a plane that meets all of their needs leaving price as the only consideration, they have two things to consider.  Price, obviously.  And the current exchange rate.  For if the U.S. dollar is weaker compared to the euro they will get more dollars than euros when exchanging their currency.  Giving the Americans a trade advantage.  Because if the dollar is weaker than the euro the Chinese yuan will buy more from Boeing than it will from Airbus.  A situation that actually exists now.  And it concerns Airbus (see Airbus CEO Concerned Over Euro/USD Exchange Rate Affecting Exports by David Pearson posted 6/20/2013 on 4-traders).

Airbus Chief Executive Fabrice Bregier Thursday said he remains concerned about the strength of the euro against the U.S. dollar which could limit the European plane-maker’s export-reliant growth despite strong demand for passenger jets particularly from Asia.

The CEO has previously expressed concern that the euro’s rise against the dollar could force the company to seek extra cost cuts or savings.

The aircraft market is a world market.  An aircraft manufacturer’s export sales will be greater than their domestic sales.  So a weak currency benefits them.  Which is why governments like to weaken their currencies.  Especially if they depend on robust export sales.  But the down side to that is that a weaker currency will raise prices everywhere else.  So, yes, exports will grow.  But people will lose purchasing power.  As their money won’t buy as much as it once did.

Because the Chinese yuan will buy more from Boeing than it will from Airbus they have to somehow lower the price of their planes to offset that advantage Boeing has. Which means they will have to find costs they can cut.  Find savings elsewhere.  Or watch Boeing sell more planes.

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Currencies, Exchange Rates and the Gold Standard

Posted by PITHOCRATES - June 17th, 2013

Economics 101

Money is a Temporary Storage of Value that has no Intrinsic Value

Giant container ships ply the world’s oceans bringing us a lot of neat stuff.  Big televisions.  Smartphones.  Laptop computers.  Tablet computers.  The hardware for our cable and satellite TVs.  Toasters.  Toaster ovens.  Mixers and blenders.  And everything else we have in our homes and in our lives.  Things that make our lives better.  And make it more enjoyable.  These things have value.  We give them value.  Some have more value to one than another.  But these are things that have value to us.  And because they have value to us they have value to the people that made them.  Who used their human capital to create things that other people wanted.  And would trade for them.

When we first started trading we bartered with others.  Trading things for other things.  But as the economy grew more complex it took a lot of time to find someone who had what you wanted AND you had what they wanted.  So we developed money.  A temporary storage of value.  So we could trade the valuable things we created for money.  That money held the value of what we created temporarily while we looked for something that we wanted.  Then we exchanged the money we got earlier for something someone had.  It was just like trading our thing for someone else’s thing.  Only instead of spending weeks, months even years meeting hundreds of thousands of people trying to find that perfect match we only needed to meet two people.  One that exchanges money for the thing we have that they want.  And another who has what we want that they will exchange for our money.  Then that person would do the same with the money they got from us.  As did everyone else who brought things to market.  And those who came to market with money to buy what others brought.

Money is a temporary storage of value.  Money itself doesn’t have any intrinsic value.  Consider that container ship full of those wonderful items.  Now, which would you rather have as permanent fixtures in your house?  Those wonderful things?  Or boxes of money that just sit in your house?  You’d want the wonderful things.  And if you had a box of money you would exchange it (i.e., go out shopping) for those wonderful things.  Because boxes of money aren’t any fun.  It’s what you can exchange that money for that can be a lot of fun.

Devaluing your Currency boosts Exports by making those Goods less Expensive to the Outside World

So there is a lot of value on one of those container ships.  Let’s take all of that value out of the ship and place it on a balancing scale.  Figuratively, of course.  Now the owner of that stuff wants to trade it for other stuff.  But how much value does this stuff really have?  Well, let’s assume the owner is willing to exchange it all for one metric ton of gold.  Because gold is pretty valuable, too.  People will trade other things for gold.  So if we put 1 metric ton of gold on the other side of the balancing scale (figuratively, of course) the scale will balance.  Because to the owner all of that stuff and one metric ton has the same value.  Of course moving a metric ton of gold is not easy.  And it’s very risky.  So, instead of gold what else can we put on that scale?  Well, we can move dollars electronically via computer networks.  That would be a lot easier than moving gold.  So let’s put dollars on the other side of that scale.  Figuratively, of course.  How many will we need?  Well, today gold is worth approximately $1,380/troy ounce.  So after some dimensional analysis we can convert that metric ton into 32,150 troy ounces.  And at $1,380/troy ounce that metric ton of gold comes to approximately $44.4 million.  So that container ship full of wonderful stuff will balance on a scale with $44.4 million on the other side.  Or 1 metric ton of gold.  In the eyes of the owner they all have the same value.

Moving money electronically is the easiest and quickest manner of exchanging money for ships full of goods.  These ships go to many countries.  And not all of them use American dollars.  But we can calculate what amounts of foreign currency will balance the value of that ship.  Or one metric ton of gold.  By using foreign exchange rates.  Which tell us the value of one currency in another currency.  Something that comes in pretty handy.  For when, say, an American manufacturer sells their goods they want American dollars.  Not British pounds.  Danish kroner.  Or Russian rubles.  For American manufacturers are in the United States of America.  They buy their materials in American dollars.  They pay their employees in American dollars.  Who pay their bills in American dollars.  Go shopping with American dollars.  Etc.  For everyday American transactions the British pound, for example, would be un-useable.  What these American manufacturers want, then, are American dollars.  So before a foreigner can buy these American exports they must first exchange their foreign currencies for American dollars.  We can get an idea of this by considering that container ship full of valuable stuff.  By showing what it would cost other nations.  The following table shows a sampling of foreign exchange rates and the exchanged foreign currency for that $44.4 million.

foreign currencies and exchange rates

If we take the US dollars and the Exchanged Currency for each row and place them on either side of a balancing scale the scale will balance.  Figuratively, of course.  Meaning these currencies have the same value.  And we can exchange either side of that scale for that container ship full of valuable stuff.  Or for that metric ton of gold.  Why are there such large differences in some of these exchange rates?  Primarily because of a nation’s monetary policy.  Many nations manipulate their currency for various reasons.  Some nations give their people a lot of government benefits they pay for by printing money.  Which devalues their currency.  Some nations purposely devalue their currency to boost their export sector.  As the more currency you get in exchange for your currency the more of these exports you can buy.  Most of China’s great economic growth came from their export sector.  Which they helped along by devaluing their currency.  This boosted exports by making those goods less expensive to the outside world.  But the weakened yuan made domestic goods more expensive.  Because it took more of them to buy the same things they once did.  Raising the cost of living for the ordinary Chinese.

The Gold Standard made Free Trade Fair Trade

Some economists, Keynesians, approve of printing a lot of money to lower interest rates.  And for the government to spend.  They think this will increase economic activity.  Well, keeping interest rates artificially low will encourage more people to buy homes.  But because they are devaluing the currency to keep those interest rates artificially low housing prices rise.  Because when you devalue your currency you cause price inflation.  But it’s just not house prices that rise.  Prices throughout the economy rise.  The greater the inflation rate (i.e., the rate at which you increase the money supply) the higher prices rise.  And the less your money will buy.  While the currencies at the top of this table will have exchange rates that don’t vary much those at the bottom of the table may.  Especially countries that like to print money.  Like Argentina.  Where the inflation is so bad at times that Argentineans try to exchange their currency for foreign currencies that hold their value longer.  Or try to spend their Argentine pesos as quickly as possible.  Buying things that will hold their value longer than the Argentine peso.

Because printing fiat money is easy a lot of nations print it.  A lot of it.  People living in these countries are stuck with a rapidly depreciating currency.  But international traders aren’t.  If a country prints so much money that their exchange rate changes every few minutes international traders aren’t going to want their currency.  Because a country can’t do much with a foreign currency other than buy exports with it from that country.  A sum of highly depreciated foreign currency won’t buy as much this hour as it did last hour.  Which forces an international trader to quickly spend this money before it loses too much of its value.  (Some nations will basically barter.  They will exchange their exports for another country’s exports based on the current exchange rate.  So that they don’t hold onto the devalued foreign currency at all.)  But if the currency is just too volatile they may demand another currency instead.  Like the British pound, the euro or the American dollar.  Because these stronger currencies will hold their value longer.  So they’ll buy this hour what they bought last hour.  Or yesterday.  Or last week.  There is less risk holding on to these stronger currencies because Britain, the European Central Bank and the United States aren’t printing as much of their money as these nations with highly devalued currencies are printing of theirs.

This is the advantage of gold.  Countries can’t print gold.  It takes an enormous expense to bring new gold to the world’s gold supply.  It’s not easy.  So the value of the gold is very stable.  While some nations may devalue their currencies they can’t devalue gold.  A nation printing too much money may suffer from hyperinflation.  Reducing their exchange rate close to zero.  And when you divide by a number approaching zero the resulting amount of currency required for the exchange approaches infinity.  Weimar Germany suffered hyperinflation.  It was so bad that it took so much money to buy firewood that it was easier and less expensive to burn the currency instead.  This is the danger of a government having the ability to print money at will.  But if that same country can come up with a metric ton of gold that person with the container ship full of wonderful stuff would gladly trade it for that gold.  Even though that person will not trade it for that country’s currency.  This was the basis of the gold standard in international trade.  When nations backed their currencies with gold.  And kept them exchangeable for gold.  Forcing nations to maintain stable currencies.  By maintaining an official exchange rate between their currency and gold.  If that nation devalued its currency the market exchange rate will start to move away from the official exchange rate.  For example, say the official rate was $40/troy ounce.  But because they printed so much of their currency they devalued it to where it took $80 to buy a troy ounce on the open market.  So a nation could take $80 dollars of that devalued currency and exchange it for 2 troy ounces of gold from that nation.  The official exchange rate forcing the nation to give away 2 troy ounces of gold for $80 when the real market exchange rate would only have given them 1 troy ounce.  So devaluing your currency would cause gold to flow out of your country.  And the only way to stop it would be to decrease the size of your money supply.  Undoing the previous inflation.  To bring the market exchange rate back to the official exchange rate.  Which is why the gold standard worked so well for international trade.  Nations could not manipulate their currency to get a trade advantage over another nation.  Making free trade fair trade.  Something few say today.  Thanks to currency manipulators like China.

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Market Forces and Health Care

Posted by PITHOCRATES - March 4th, 2013

Economics 101

Keynesians try to reduce Human Behavior down to Complex and Confusing Math

We hear a lot about introducing market forces into health care.  But what does that mean?  What exactly are market forces?  Are they like magnetic forces?  Electric forces?  Hydraulic forces?  No.  Market forces are not forces that conform to the laws of science.  Rather, they belong in the realm of the social sciences.  That are less science.  And more opinion.  Where there are a lot of theories.  And politicians massage the data to fit their theory.  As Mark Twain said, facts don’t lie but liars figure.  And politicians figure.  A lot.

So there are no hard rules when it comes to the social sciences.  Just a lot of theorizing.  And a lot of drawing conclusions.  Based on the data.  And how some massage the data.  Something to keep in mind whenever anyone discusses economic numbers.  For the accepted school of economics most politicians adhere to is the Keynesian school.  The dirty little whore of economics.  For there is a whole lot of massaging going on with Keynesians.  With the data.  Not each other.  Politicians love Keynesian economics because this school of economic thought calls for governments to tax, borrow, print and spend.  Empowering government.  Making government grow.  And become more intrusive in our personal lives.  All things politicians love.  Which is why they massage the economic data.  They have to.  Because this school of economic thought doesn’t work.

Keynesians make economics very complex.  Open a text book and you will find a lot of graphs and formulas.  Where they try to reduce human behavior down to math.  Very complex and confusing math.  And you can’t do that.  Humans have free will.  They make decisions based on any number of things.  One influencing factor more or less could change the way they decide.  And there’s no way we can quantify all the variables in our lives.  Therefore, there’s no way to reduce human decision-making down to math.  Which is what drives market forces.  Our decision-making process.  That point in time that triggers the free exchange of money for goods and/or services.

When it comes to the All-You-Can-Eat Buffet Customers think more in Terms of Quantity than Quality

Consider an all-you-can-eat buffet.  And how it changes your decision-making process.  But first let’s look at some typical behavior at a normal restaurant.  Where you may spend $15 for a 4-course meal and drink.  Soup, salad, entrée and dessert.  Which you enjoy with a friend.  You have pleasant conversation as you enjoy each of your 4 courses.  Taking your time.  Enjoying each course.  Slowly getting full.  And satisfied.  The portion sizes are just right.  Leaving just enough room for dessert.  You’re full.  But not too full.  Comfortable.  You’re able to go for an after-dinner walk.  Even take in a movie.

Now let’s consider the all-you-can-eat buffet.  Where you may pay $20 for unlimited access to the buffet.  You’re paying more than for a sit-down service.  Why?  Because you plan to eat more.  You will maximize the value you get for your $20.  Which means you’ll probably skip the soup and salad.  And start loading your plate with the expensive entrées.  You’ll probably go back once or twice.  Making sure you get a taste of everything.  And a lot of anything that is expensive.  Again, to maximize your value.  In fact you maximize so much that you become uncomfortably full.  Too full to sit through a movie without nodding off.  And too full for a walk.  All you want to do is go home and nap.

The restaurant sees this from a slightly different perspective.  The all-you-can-eat buffet is simple to serve.  You mass produce food to load up the buffet so it’s ready at the beginning of the buffet hours.  You replace the items people eat most.  While the less popular items sit longer in the buffet.  Becoming less fresh.  Also, the buffet is a good way to get rid of things approaching their ‘serve by’ dates.  Saving the freshest food for the made-to-order sit-down service.  And putting the older food in the buffet.  Because when it comes to the buffet you know customers are thinking more in terms of quantity than quality.  The food is good in the buffet.  But not as good as the food for the sit-down clientele.

If you Pay Cash at the Pharmacy you are more likely to Ask for the Less Expensive Generic Drugs

These are market forces.  People have come together to make voluntary exchanges.  The quantity of food available makes some people opt for the more expensive all-you-can-eat buffet.  Others may opt for the less expensive but higher quality made-to-order sit down service.  For the person who places the greatest value on eating mass quantities of food will choose the buffet.  The person who places the greatest value on the dining experience (quality of food, made-to-order, conversation, after-dinner walk or movie, etc.) will choose the sit-down service.  If more people are choosing the buffet the owner may extend the buffet hours.  If fewer people are choosing the buffet and leave a lot a food to throw away the owner may end the buffet service.  These are market forces.  Buyer and sellers coming together in the marketplace.  Seeing what each has to offer.  If they come to a mutual agreement they make an economic exchange.  The buyer willingly exchanges his or her money for goods and/or services.  The seller willingly accepts an amount of money in exchange for his or her goods and/or services.

The private economy works because it is buyers and sellers meeting and making exchanges they both freely agree to.  This is the key of market forces.  It’s what makes people with money go to the marketplace.  And it’s what makes people bring goods and/or services to the marketplace.  Because they will seek each other out and make these exchanges.  After which both buyer and seller will come away with something they value more.  This is what is missing in health care.  Buyer and sellers aren’t meeting to make exchanges.  In fact, the buyer and seller do not even meet.  Patients never ask for any prices.  Because they aren’t paying for anything.  Their insurer is.  And the medical provider will always provide the most expensive treatment billing guidelines will allow.  For that’s who they must please.  The people paying them.  Not the patient.  And they have to charge as much as they can to cover all the things they won’t get paid for.  People they treat without insurance who can’t pay.  And for the billings the insurers deny.

So this changes the decision making process.  For everyone.  Introducing a third party into the equation removes market forces.  If you pay cash at the pharmacy you are more likely to ask for the less expensive generic drugs.  If you get free prescription coverage you will ask for the most expensive name-brand medicine they have.  For when you’re not paying price is no object.  But when you are paying price is a very important object.  Because when it’s our money getting value for our money is very important.  So we’ll ask if the name-brand has any more value than the generic.  For who would spend more for something that doesn’t give you any more value than something you can get for less?

When it comes to medical tests and procedures patients aren’t going to ask for more than they absolutely need.  And doctors aren’t going to prescribe any more than a patient needs.  Because they aren’t billing a faceless bureaucrat.  They’re billing someone they have a close and personal relationship with.  And they sure aren’t going to try and bill someone they have a close and personal relationship with for someone else’s unpaid bill.  Not if they want to keep them as a patient.  Because a doctor-patient relationship is a long-term relationship.  A doctor could lose a lot of business by mistreating a patient to make an extra buck.  These are market forces.  Which makes the private sector work so well.  And why their absence makes the health care system not work so well.  Transforming our health care from a moderately priced, high quality, custom, sit-down service to a higher priced, mass-produced, lower quality, all-you-can-eat buffet.

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A Weak Currency may Boost Exports but it will Raise all Prices Businesses and Consumers Pay

Posted by PITHOCRATES - February 24th, 2013

Week in Review

China created a booming economy thanks to a healthy export market.  In part because of their cheap labor.  An in part by keeping their currency weak.  For when you buy goods from China you first have to exchange your currency for theirs.  If your currency is stronger than theirs is you will get a lot more of theirs in exchange for yours.  Allowing you to buy a lot more Chinese goods with your stronger currency.  This is why China likes to have a weak currency.  And takes actions to keep it artificially weak.  Something her trading partners don’t like.  For their weaker currency tends to make the net flow of goods in international trade with China flowing from China to everyone else.  Thus giving China a healthy export market.  At the expense of everyone else’s export market.

But China is a developing economy.  Things change when you become an advanced economy.  Because you don’t have impoverished masses filling your factories manufacturing goods for export.  You have a thriving middle class.  With a high standard of living.  With good jobs giving them disposable income.  And few of them work in the export economy.  So despite all the talk about unfair trade practices of China most people in an advanced economy don’t worry that much about trade deficits.  For they’re buying a lot of imported goods.  From smartphones to coffee beans.  And a weak currency makes these items more expensive.

So there are two sides to the value of your currency.  If you have impoverished masses filling factories to build export goods a weak currency is good.  It lets the state sell more of those export goods.  In an export-dominated economy.  And provides a lot of low-paid factory jobs.  If you have a thriving middle class a strong currency is good.  For it lets the people buy a lot of stuff.  Creating a lot of better paying non-factory jobs.  In a non-export-dominated economy.  Basically the difference between free market capitalism.  And mercantilism (see Is the World on the Brink of a Currency War? by Michael Sivy posted 2/21/2013 on Time).

Currency wars – and trade wars generally – have their origins in a 17th and 18th century economic theory known as mercantilism. The idea was that a country’s wealth comes from selling more than it buys. A colonial empire could achieve this positive balance of trade by acquiring cheap raw materials from its colonies and then ensuring that it exported more finished goods than it imported. This was usually accomplished with tariffs that made imports very expensive.

Such an approach couldn’t work in the modern world. Countries don’t get cheap raw materials from colonies anymore. They have to buy them – especially oil – on the open market. So while currency devaluation makes exports cheaper for foreign buyers, it also makes essential imports more expensive. For Europe in particular, which imports so much of its energy, devaluation isn’t necessarily a plus…

The Federal Reserve’s quantitative easing – buying bonds to swell the money supply – is aimed principally at stimulating domestic demand. European advocates of a cheaper euro currency, meanwhile, are hoping to make national debt easier to finance, not trying to pump up exports. In fact, the continent’s greatest exporter, Germany, is the country least amenable to currency devaluation…

So forget all the talk of a currency war. What’s going on has nothing to do with trade and everything to do with debt and growth and inflation. If the global economy is in danger of reliving the past, it will not be a repeat of the 1930s. Rather, it will be a repeat of the 1970s, when the Federal Reserve expanded the money supply to offset the economic slowdown caused by the oil crisis – and ended up encouraging double-digit inflation.

The double-digit inflation of the Seventies really devalued the currency.  Raised prices.  Greatly limiting the amount of stuff people could buy.  Even though printing money then didn’t work these nations believe it will work now.  Because it will make their exports cheaper for foreigners to buy.  Despite making everything more expensive inside their own country.

But there is another reason they love to print money.  It lets them spend more.  And it makes old debt easier to pay off.  We call it monetizing the debt.  For example, if a nation has a GDP of $1 million and a debt of $500,000 that debt is huge.  It’s 50% of GDP.  But if we turn on the printing presses and devalue the currency to one tenth of its original value that GDP is now $10 million ($1 million divided by 1/10).  Making that outstanding debt only 5% of GDP.  And a whole lot easier to repay.  But what is one person’s debt is another person’s retirement savings.  So not only does inflation increase prices it destroys our retirement savings.  And all this just so we can boost the small sliver of our economy we call exports.

If this is so bad on so many levels why do governments print money then?  For one simple reason.  To get people to vote for them.  Because all the people see is the free stuff the politicians are giving them.  The damage it causes comes later.  And they can always blame that on Republicans.  Who refuse to raise tax rates on rich people to make them pay their fair share.

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Money, Gold Standard, Banknotes, Bills of Exchange, Checks, Credit and Debit Cards, ATMs and Online Banking

Posted by PITHOCRATES - January 4th, 2012

Technology 101

People storing their Gold in the Goldsmith’s Safe was a Precursor to the Gold Standard

Money is a temporary storage of wealth.  It improved on the barter system.  Instead of having to find people to trade our wealth-creating talents for the wealth-creating talents of other people we just stored the wealth we created in money.  If you built a plow and wanted a sack of wheat you didn’t have to find someone who had a sack of wheat who wanted a plow.  You could just go to the city market and sell your plow for money.  And use your money to buy the wheat.

Money took many forms.  Animals.  Grain.  Tobacco.  Alcohol.  And other commodities.  All of which had drawbacks.  Grain can become cumbersome to carry to market.  And it can be difficult making change with animals.  The precious metals gold and silver solved these problems.  Easier to carry.  Easy to exchange for goods.  You just weighed out whatever amount needed.  Durable.  Not easy to get so it would hold its value.  It was uniform.  Gold was gold.  Silver was silver.  Not so with animals.  They can be big or small.  Old or young.  One breed or another.  Making the value of animals non-uniform.  On top of not being very divisible in making change.

So gold and silver became the money of choice.  As it gained universality it became even more valuable.  And a bit dangerous to carry around on you.  Or leave at your home in your sock drawer.  Because other people wanted it, too.  And not the kind looking to trade with you.  The kind of people who just want to take your gold.  Se we needed a safe place to store it.  And few places were safer than a safe.  And who had a safe?  Goldsmiths.  So people took their gold to the local goldsmith.  Who placed their gold into his safe.  And the goldsmith gave the person a note stating the value of gold stored in his safe.  A precursor to the gold standard.

Merchant Banks Specialized in International Trade and Foreign Currency Exchange

And the banknote was born.  A promise to exchange that note for the amount of gold or silver specified on the note.  These notes were much easier to carry around than the heavier metal itself.  So the metal stayed in the safe and people started using the notes for currency instead.

And there were other notes that held value.  Such as a bill of exchange.  Popular with international trade.  Because ships rarely travel empty.  Which means at each port they are unloading one cargo (the import) and loading one new cargo (the export).   The people who do this importing and exporting are merchants.  They buy and sell.  That is, they pay money for one cargo and then collect money for another.  A good portion of these payments and collections equal each other.  So instead of paying money for one import cargo only to get most of that money back on a subsequent export cargo, they used bills of exchange.  And the merchants added the sum of payments and the sum of collections for each account (import/export company).  And carry any amount remaining owed or due on a ledger.  Or the company owning would send money to the company with the outstanding balance due to clear the difference.   Merchant banks carried out these transactions.  Who specialized in international trade and foreign currency exchange and acted as a clearing house for these bills of exchange.  The bill of exchange was a very valuable temporary storage of value.  And sometimes used as money.  One could even take it to a bank and exchange it for money for a small discount fee.

Buying and selling without exchanging money turned out to be very convenient.  And it spread.  Instead of taking cash to a utility we could mail a check.  Instead of mailing cash to a mail order company we could mail a check.  And we do.  We write checks from our bank.  That others deposit into other banks.  We write a lot of checks.  The volume is so great that massive computerized clearing houses process these checks.  Where computers read the magnetic ink on these checks and post payments and receipts to the individual bank accounts.  Where most payments and receipts cancel each other out.  Much like those bills of exchange at the merchant banks.

The Economy took off because of Banking and International Trade

As technology advanced we found other ways to pay without using money.  Credit cards were very popular.  Until people realize they have to pay the bank back.  Which led to debit cards.  Which is like writing a check at the point of purchase.  The merchant processes your debit card and your bank transfers money from your bank account to the merchant’s account.  Very convenient.  And no growing credit card balances.  Just declining bank balances.  Then came the Internet.  Which has taken the cashless economy to new heights.  And for those who still need cash while out and about you can always visit a convenient ATM.  One swipe of your debit card and the machine gives you cash.  And the ATM’s bank networks with your bank to transfer money from your bank account to theirs.  Automated by computers operating 24/7.  Spending money has never been more convenient.

Today most of our money is just numbers on some ledger.  Inside some computer.  Many of our employers even pay us electronically.  From our ‘pay check’ to the economic activity we engage in there is a whirlwind of banking activity behind the scenes.  As the banking community settles these accounts.  They do it quickly.  And efficiently.  Allowing ever greater economic activity.  And mobility.  Wherever you are you can log into some computer network (credit/debit card, ATM or Internet) to access your money and engage in economic activity.

People may not like banks.  But one thing for sure.  None of this would be possible without banks.  The economy took off because of banking.  Starting with those great Italian city-states of the 14th century.  And their international trade.  Their great merchant bankers leading the way.  Giving the world modern finance.  A modern economy.  And the way to a higher standard of living.

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Free Trade

Posted by PITHOCRATES - November 28th, 2011

Economics 101

When People can Buy and Sell as they Please without Outside Interference we call it Free Trade

Agriculture advances gave us food surpluses.  Food surpluses gave us a division of labor.  The division of labor gave us trade.  Money made that trade more efficient.  Religion and the Rule of Law allowed great gatherings of people to live and work together in urban settings.  Thus unleashing human capital.  And creating a great diversity in economic output.  Because all these people with spare time could create new things.  That other people discovered.  And wanted.

The Rule of Law gave us property rights.  And it’s because of property rights that people take chances.  Then.  And now.  To create things.  Invest their labor and capital.  Because they own what they create.  And are free to trade these products of their own labor and capital.  Freely.  With whom they want to.  At the value of exchange they agree to.  Encouraging others to do the same.  So they, too, can enjoy the products of their own labor and capital.

When people can buy and sell as they please without outside interference we call it free trade.  Outside interference can include many things.  But mostly it means government interfering with market forces.  Such as taxing things differently.  Placing tariffs or quotas on imported goods.  Subsidies to certain domestic manufacturers.  Etc.  All things that complicate the exchange of goods and services.  Because you have to consider all of these other things in addition to the goods and services you wish to exchange.  Complicating the economic exchange.  Making it more costly.  Less free.  And simply less of it.

The Overregulation of a Free Market Creates a Black Market

The less free and more complicated trade gets something happens.  The overregulation of a free market creates a secondary market.  A black market.  Where economic exchanges occur free from government interference.   The black market then becomes the free market alternative to the overregulated ‘government’ market.

The former Soviet Union is a good example.  Government bureaucrats completely controlled the market.  They set the prices.  And allocated the resources.  Poorly, I might add.  And the result?  Stores full of items no one wanted to buy.  Long lines at stores selling the basic necessities of life (such as soap and toilet paper).  Where people waited to buy their allotted quota because there was so little available to sell.  And a thriving black market where you could buy the latest in Western fashion and electronics.  Which proved very handy in bribing government bureaucrats.  Because even they wanted what the Westerners traded freely.

Another good example are cigarettes.  Stores across certain state lines do very well selling cigarettes.  For these stores can sell cigarettes at steep discounts compared to those on the other side of the border.  Why?  Cigarette taxes.  And some cities and states really pile them on.  Making some people spend more money on gas as well as risking trouble with the law to get these more affordable cigarettes.  Often buying them in bulk.  And then smuggling them back home.

An Overly Regulated Market alters our Economic Decision Making, Resulting in Less Economic Activity

A free market lets us come together freely to buy and sell what we choose.  An overly regulated market alters our economic decision making.  Due to higher prices.  And regulatory costs.  A minimal amount may not affect our purchasing decisions.  Whereas an excessive amount pushes some outside the law.  Into the black market.  Back to a free market.  Which is what we all want.  To freely buy and sell what we choose.

The net effect on the economy?  The less free the market is the less economic activity there is.  Either due to higher prices.  Or higher regulatory costs.  Both of which leave us with less to spend on other economic exchanges.  And less motivation to commit labor and capital to create new things to trade.

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From Commodity Money to Representative Money to Fiat Money

Posted by PITHOCRATES - November 8th, 2011

History 101

The Drawbacks to Using Pigs as Money Include they’re not Portable, Divisible, Durable or Uniform

They say we use every part of the pig but the oink.  So pigs are pretty valuable animals.  And we have used them as money.  Because they’re valuable.  People were willing to accept a pig in trade for something of value of theirs.  Because they knew they could always trade that pig to someone else later.  Because we use every part of the pig but the oink.  Which makes them pretty valuable.

Of course, there are drawbacks to using pigs as money.  For one they’re not that portable.  They’re not that easy to take to the market.  And they’re big.  Hold a lot of value.  So what do you do when something is worth more than one pig but not quite worth two?  Well, pigs aren’t readily divisible.  Unless you slaughter them.  But then you’d have to hurry up and trade the parts before they spoil because they’re not going to stay fresh long.  For pig parts aren’t very durable.

Suppose you have two pigs.  And someone has something you want and they will trade two pigs for it.  But there’s only one problem.  One pig is big and healthy.  The other is old and sickly.  And half the weight of the healthy one.  This trader was willing to take two pigs in trade.  But clearly the two pigs you have are unequal in value.  They’re not uniform.  And not quite what this trader had in mind when he said he’d take two pigs in trade.

Our Paper Currency Evolved from the Certificates we Carried for our Gold and Silver we Kept Locked Up

Rats are more uniform.  They’re more portable.  And they’re smaller.  It would be easier to price things in units of rats rather than pigs.  They would solve all the problems of using pigs as money.  Except one.  Rats are germ-infested parasites that no one wants.  And they breed like rabbits.  You never have only one rat.  Man has spent most of history trying to get rid of these vile disease carriers.  So no one would trade anything of value for rats.  Because these little plague generators were overrunning cities everywhere.  So rats were many things.  But one thing they weren’t was scarce.

Eventually we settled on a commodity that addresses all the shortcomings of pigs and rats.  As well as other commodities.  Gold and silver.  These precious metals were portable.  Durable.  They didn’t spoil and held their value for a long time.  You could make coins in different denominations.  So they were easily divisible.  Unlike a pig.  They were uniform.  Unlike pigs.  Finally, you had to dig gold and silver out of the ground.  After digging a lot of holes trying to find gold and silver deposits.  Which made it costly to bring new gold and silver to market.  Keeping gold and silver scarce.  And valuable.  Unlike rats.

But gold and silver were heavy metals.  Carrying large amounts was exhausting.  And dangerous.  A chest of gold and silver was tempting to thieves.  As you couldn’t hide it easily.  Soon we left our gold and silver locked up somewhere.  And carried certificates instead that were exchangeable for that gold and silver.  And these became our paper currency.

Governments Everywhere left the Gold Standard in the 20th Century so they could Print Fiat Money

The use of certificates like this is typically what people mean by gold standard.  Money in circulation represents the value of the underlying gold or silver.  And can be exchanged for that gold or silver.  Which meant that governments couldn’t just print money.  Like they do today.  Because the value was in the gold and silver.  Not the paper that represented the gold and silver.  And the only way to create money was to dig it out of the ground, process it and bring it to market.  Which is a lot harder to do than printing paper money.  So governments everywhere left the gold standard in the 20th century in favor of fiat money.  So they could print money.  Create it out of nothing.  And spend it.  With no restraints of responsible governing whatsoever.

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