Saturday, May 7, 2011

Money - What is it?

If you ask someone how much money they have, they'll likely give you a figure in dollars, euros, pesos, real, yen, yuan or whatever currency they are familiar with. Currencies are used to measure a person's economic wealth, but if one steps back and considers the intrinsic value of the currency, one must conclude that there is little to no intrinsic value. For example, when you go to the bank and your account balance is reported to you, it exists only in a computer accounting system, which of course, isn't any more valuable than a Pac-Man high score. If you decide to withdraw cash, now your worth is associated with a piece of "paper" that is 25% linen and 75% cotton. Alternatively, you could withdraw coins which would posses intrinsic value, though generally much less than the face value (except for nickels, see coinflation.com). 

The point is quite simple: 
Currency today (fiat currency) has little to no intrinsic value. It only has general value as long as you can confidently pass it on to the next person is exchange for goods or services. The ability to function in this way demands a limited and predictable supply. 
So why is the concept of money such an important topic? To fully appreciate the question, one must reflect on what money represents, or at least, what it’s supposed to represent. Let’s start with an example. Say I was a farmer and I grew oranges, while my neighbor grew apples. At the end of the growing season I might want some apples. Being that my neighbor has an apple orchard, I might talk to him about trading some of my oranges for his apples. In effect, my ‘money’ is denominated in oranges, whereas his are in apples. Assuming each of our harvests were equally fruitful we may arrange a 1-to-1 swap—one orange buys me one apple. Each unit of fruit represents the work that was put into planting, tending, and harvesting each of our orchards. You can think of this as the blood, sweat, and tears, or simply energy, or of course, work (W = F*d, for the physicists). The point being, that we are trading a portion of our own work for a portion of their work. This is a very simple concept, yet the dollar bill in your pocket is backed by nothing more than the paper it is printed on. It costs less than 10 cents to produce a $1 bill or a $100 bill, yet the work required to produce 1 apple is much less than 100 apples. Similarly, panning for 1 gram of gold may take half a day, but 100 grams will require 50 days of work. In essence, the 100 grams of gold harnesses the amount of work expended to obtain it. It’s like a little energy packet—potential energy. If you need to hire someone to tend your orchard for a day, you could pay them 2 grams of gold because that is how much work is stored in it (of course we are assuming tending an orchard for a day and panning for gold are roughly equivalent endeavors). This is a critical concept, which must be understood. Essentially, what you receive for your efforts should reflect the work that was put into it. This is analogous to conservation of energy, a physical law that accounts for energy in and out of a system. The analogy even works when debt is included, assuming the borrowed money is from genuine savings. This is the natural process for both the economic and physical world. Unfortunately the natural order has been corrupted by fiat currency and our dear politicians who know what’s best.

The U.S. government completely abolished the gold standard in 1971 and has since embarked on a grand experiment, attempting to defy the natural process. By spending recklessly, printing money to finance it and invoking inflation, the government has added dollars that aren't associated with any productive work. You can’t heat your home without real energy and you can’t produce wealth without real production. So how is this reconciled in the economic world? Inflation. In the middle of winter, a home without heat (electrical work) will equilibrate to a cooler temperature. In the world of economics, a currency’s purchasing power will decrease, which is what we are seeing today. 

In light of recent economic events, the government has thrown truckloads of dollars at toxic assets in conjunction with printing and borrowing to ‘stimulate’ the economy. Now some may argue that money is being destroyed as fast as it is being created, or that it is sitting in banks doing nothing thus inflation will be kept in check. This ignores the fact that work-less money is being pumped into the system, while even more is being used to prop up toxic investments that should’ve never occurred in the first place! This is a double malinvestment whammy! Destruction of capital and production capacity at its finest. I don’t want to argue deflation or inflation, but simply point out that currency and its relation to work has be skewed to unprecedented levels. Make no mistake, equilibrium will be achieved, and I can assure you that it will  result in lost purchasing power and a reduction in the standard of living. 

To tie it all together, the fact that we have a currency that is backed by nothing has allowed the government to spend recklessly, which has put our currency and lively-hood in dire straits. To be honest, there is no easy way out of this predicament, but those who see the signs would be well advised to get their house in order and brace themselves for what is inevitable. A life’s savings backed by IOUs is nothing more than a heap of paper that will be blown away in the coming storm. It is advisable to anchor your wealth in gold and silver, which possess intrinsic value, are a sound asset, and have retained their purchasing power for thousands of years.

Again, understanding the difference between currency and money is paramount. Mike Maloney tends to grasp this idea very well and has provided a wealth of information on the topic. One of his websites has some good articles and can be found at wealthcycles.com. There are several free articles that will further your understanding and hopefully transform your idea of saving from how many dollars you have to how many ounces you have. 

No comments:

Post a Comment