“Money and debt are as opposite in nature as fire and water; money extinguishes debt as water extinguishes fire.” Charles Holt Carroll
One of the questions most often asked by people who want to understand finance is; what is the definition of Money? Not the properties of money, not the uses of money, but the definition of money. When we try to solve a math problem, if our definitions are not clear, then our attempts to solve the problem will fail. If we try to solve financial or ‘monetary’ problems, our attempts will also fail unless we have a clear definition of money to work with.
Definition; Money is “that which extinguishes all debt”
To understand this we need to look at each word closely. Debt is a matter of one person owing something of value to another person. Debt can be created in several ways, but the end result is the same; the debtor owes something to the creditor.
For example, if you borrow a pound of sugar from your neighbor, you now have a debt owing to the neighbor. Once you return the pound of sugar, the debt is extinguished. But the definition says that money extinguishes all debt; while a pound of sugar extinguishes the sugar debt, it will not work very well in extinguishing other debt.
If you work at a job, and are paid for your labors with sugar instead of money, you will not be a happy camper… you would have to carry hundreds of pound of sugar from the pay site, and then try to swap the sugar for things you need. You expect to receive your salary directly in the form of money… you can then use this money to buy what you need. Sugar cannot extinguish all debt. Sugar is not money.
As you work at your job, you build up a credit towards your employer; that is, the employer has a debt owing to you, a debt that grows daily. On payday, the employer hands you money, and the debt is extinguished; if the employer gives you a check, the debt is not extinguished, but rather transferred to the bank the check is drawn on.
If you subsequently cash the check, the debt is extinguished. Otherwise, the bank remains your debtor; that is, it owes you the money that the employer gave you in the form of a check. Your employer no longer owes you anything… the debt has been transferred to the bank. The bank owes you the money.
Another example is a purchase; as you buy an item in a store, debt is created; if you pay cash, the debt is extinguished immediately. If you pay using a credit card, the debt is transferred to the credit card company. Instead of owing money to the store, you owe to the credit card company… the debt has been transferred, not extinguished. Credit does not extinguish debt. Credit is not money.
So, let us test ‘legal tender’ using the definition. Does the current crop of paper ‘money’ or ‘legal tender currency’ meet the definition of money? Does paper money extinguish all debt? The part ‘all’ is clear; if we owe a debt denominate in dollars, and we try to pay this debt with Hungarian Forints, it will not work. Before we can pay a dollar debt, we need to sell our Hungarian Forints for dollars, and then use the dollars to pay the debt. This is like a salary paid in sugar; first sell the sugar for money then use the money as desired.
So paper money is lacking in universality, the ability to extinguish all debt. Now let us see if paper money meets the second, more critical part of the definition; does paper money extinguish debt, or simply transfer it…?
To determine this, we need to take a quick look at the history of paper money, aka ‘bank notes’. The very name ‘notes’ gives us a clue; ‘note’ is another word for debt paper; like a treasury note; notes are IOU’s… promises to pay.
Printed on the face of the original US dollar was a line stating; this note entitles bearer to a fixed quantity (weight) of gold (or silver), the exact amount depending on the face value of the note. In other words, the ‘note’ was redeemable in gold or silver; the note did not have to be sold for money. Unlike a bond or other debt paper, one simply turned it in, to be redeemed in Gold or Silver, at any time. The word ‘redeemable’ implies a guarantee of quantity and timeliness; selling is subject to availability and market price.
Notice what an incredible transformation has occurred, seemingly innocently; if bank notes are used to pay a debt, rather than gold coins, the debt is NOT extinguished; rather the bank note, which is an IOU, is transferred from the payer to the payee. Gold coins extinguish debt, whereas iou’s (bank notes, or Dollar Bills) transfer debt. Like if we repay our sugar debt, not with a pound of sugar, but with an IOU; a promise of sugar on demand.
This is the basis of paper ‘money’; a promise to pay real money to bearer… and yet all seemed fine as long as the issuing bank had enough cash (physical) gold or silver in its vault, or real bills that mature into gold in not more than 91 days in its portfolio, to balance all the notes issued. This is in effect a 100% gold backed currency… the transferred debt could always be extinguished, by taking the debt note (dollar bill) to the bank and redeeming it in gold or silver. Like telling your neighbor its OK, I have the sugar in stock, you can pick it up at any time… in fact, better yet, you can give this IOU to someone else, (transfer the debt) and the new holder of the IOU can ‘redeem’ the sugar.
No ‘run on the bank’ is possible, as there is always enough gold on hand to meet all possible demand; that is, even if every note issued were demanded at once, the bank could comply; by releasing cash gold from the vault, and by rediscounting (exchanging for cash gold) the real bills in the portfolio. As always, the bank’s books were balanced; assets included cash Gold or Silver (specie), and real bills. If your neighbor wants the sugar, you simply hand it to him… or to whoever presents you the IOU…
I suspect you anticipate what comes next; the bank issues (more precisely, lends out at interest) more bank notes (IOU’S) than it can redeem on demand… this is called ‘fractional reserve’. Once the ‘fractional reserve’ idea comes into use, things change… again. You wrote IOU’s for six pounds of sugar, while holding only two pounds. If all the IOU holders show up, you are in trouble…in fact, you are guilty of fraud… making promises that you do not keep is the definition of fraud. The fraud will be revealed if more sugar than you have is demanded… else you can get away with the fraud… for a while.
Remember, these fractionally backed notes remained redeemable. Otherwise people would not have accepted them as money equivalents. This led to the problem; what if more demand for Gold arose than was available? This is called a run on the bank. Or, if you like, the fraud is revealed.
It does not mean that the bank’s books no longer balance; what it means is that the asset side was no longer constrained to cash gold or real bills; it now held government bonds, more debt paper. When people demand Gold, the bonds have to be sold… and the price of the bond would crash if too many came on the market at once. Thus, the question of liquidity arises… as well the question of the quality of the ‘assets.’
In regards to liquidity, the ‘solution’ is the creation of a Central Bank, a lender of ‘last resort’… if any bank is subject to a run, the Central Bank will lend it money as needed to stave off the run… but what if the Central Bank itself does not have enough money on hand to lend to banks subject to runs? What entity bails out the Central Bank? Er… the taxpayer of course!
No one can question the quality of the asset side if it is constrained to cash gold, or real bills; both these are 100% liquid and desirable assets. Government bonds are quite another issue; these bonds depend on the ‘faith and credit’ of the issuing authority. Bonds are items of negative value… of debt. In effect, rather than cash gold backing the notes, the notes are now backed by… more IOU’s, in this case treasury bonds…
Of course, today things have gotten even worse than this. The current USD bank note is no longer redeemable in anything… in other words, it is a promise to pay… what?? Nothing but other bank notes… Furthermore the central bank has only Bonds or Notes (more IOU’s) in its asset column… so debt ‘backs’ debt!
The root of the current ‘financial’ crisis is right here. Negative values (debt) fill both the asset and liability side of the Central Bank’s books… there is nothing of positive value here. Only the ‘full faith and credit’ of the issuing authority adds any perception of value… but this perception is now fading rapidly. Especially as the quantity of bonds, and bank notes, unlike the quantity of Gold, is limited only by the self restraint of the politicians who control the central bank and the treasury. As the Mogambo Guru says, ‘we are Freaking Doomed’.