Money Creation for Dumbos

We don’t really mean what we say in the heading of this blog posting.  First, we couldn’t use “for Dummies,” because that one was already taken.  Second, our readers aren’t dummies.  Third, our readers aren’t flying elephants, either.  Come to think of it, “Money Creation Made Easy” might have been a better heading, except that money creation isn’t easy.  It is, however, quite simple.

All money is a contract; all contracts are money.

We’ve covered this before in some depth, so to get started we’ll just say that anybody who is competent to enter into a contract can create money, and anyone who has entered into a contract has created money.  That’s because “money” is correctly defined as anything that can be used to settle a debt, “all things transferred in commerce.”

All money is a contract, just as in a sense all contracts are money.  A contract is just an enforceable promise, specifically, “[a] promissory agreement between two or more persons that creates, modifies, or destroys a legal relation.” (“Contract,” Black’s Law Dictionary.)

And what is necessary to “create, modify, or destroy” a “legal relation”?  Well, first you need “equality of status.”  A contract is a “meeting of the minds,” and that can only happen between persons of legally equal status.  That’s why a contract with a minor is not enforceable.  The law presumes that there is no equality of status, and therefore a contract between an adult and a child is voidable at the will of the child . . . with a few caveats, of course.

All market transactions are contracts.

Every transaction in the market is a contract.  Does that mean that a child who goes into Burger Doodle and orders food and eats it doesn’t have to pay, or can demand his or her money back after having eaten?

Of course not.  For one thing, “voidability” only applies to fulfilling a contract, not to a completed transaction.  A child who orders food, pays for it, and eats the food has entered into a contract and fulfilled the terms.  It’s over and done with.  The contract has been completed.

Suppose, however, that a child orders food, pays for it, and, before it is delivered, says, “I changed my mind.  I don’t want it.  Give me my money back.”  Technically, the child can do that.  Also, technically, the store can tell the kid not to come back.  Would or should the store tell the kid to beat it?  If the kid makes a habit of it (or an adult, for that matter), probably yes.  If it’s rare, probably not.

Obviously, people create and destroy money all the time, just not in very good or beneficial ways.  Every time you use a credit card or make a purchase on credit you are creating money, and when you pay your bills at the end of a month, you are fulfilling your end of the bargain and destroying or cancelling money.

Currency — "current money" — is a transferable contract.

What confuses people is that what most people use to cancel the money they have created is money that other people have created.  I pay my credit card bill and cancel that money with other money I received from somebody paying me for something, just as the person paying me got his money to pay me from somebody paying him, and so on.

All money, however, has a beginning, just as it all has an end.  What we’re looking at today is the beginning of money: money creation.

There are, ultimately, only two ways to create money.  One is to produce something and offer it in exchange.  The other is to promise to produce something, and offer that promise in exchange.  How good your money is depends on the trust that other people have that you will deliver what you have produced, or have promised to produce, when people who have received your promise bring it back to you so you can keep your promise.

Excruciatingly rare (three known) U.S. 1861 $10 demand note.

Both kinds of money are embodied in contracts.  When you make a promise to deliver something you have in your possession right now, the promise is called a “mortgage.”  A mortgage is “past savings,” a contract conveying a right or an “interest” in something that you have in your pocket, warehouse, storeroom, barn . . . whatever.

This is why a loan of money based on past savings bears “interest.”  The owner is putting his savings at risk, and deserves to be compensated.  Whether the compensation is justified or is “usury” is a question we won’t address today.

Money based on existing savings is usually in the form of a demand note of some kind, i.e., there is usually a statement to the effect that “The issuer of this note promises to pay to the bearer (or holder in due course) on demand the stipulated consideration described in this contract.”

Historically, most exchange was by means of bills and notes.

When you make a promise to deliver something you do not have in your possession right now, but expect to have in your possession by a certain date or on the occurrence of a specific event, the promise is called a “bill of exchange.”  A bill of exchange is “future savings,” a contract conveying a right in something that you do not have right now, but reasonably expect to have in your possession by the time the bill matures or comes due.

Where mortgage-type notes bear interest, however, bills of exchange are "discounted."  What does that mean?  Suppose someone with the prospect of purchasing capital worth $100,000 that will generate $125,000 in 90 days.  (Keep in mind that this is what we call an "example" and is not intended to be realistic.)  This someone, call him "A", draws up an offer called a bill of exchange, and takes it to the bank.  A tells the bank's loan officer, "I need $100,000."  The loan officer looks over everything and says, "Sure.  We will create a demand deposit for you in the amount of $100,000 if you agree to pay us back $102, 040 in ninety days."  A says, "But I'm only borrowing $100,000!  Why do I have to repay $102,040?"  The loan officer says, "We discounted your note 2%, so we're creating $100,000 worth of new money for you, substituting our good word for yours, thereby providing a service.  Out of the $2,040 you pay us back in addition to the $100,000 principal, we have to meet our expenses, make our profit, and insure against the risk that you won't repay us anything.  So we accept your bill of exchange with a maturity value of $102,040 in exchange for a demand deposit of $100,000 and unrealized revenue of $2,040, the total backed by a promissory note on which you are obligated to pay us $102,040 in 90 days."  A says, "Okay, but what if I pay it off in 45 days?"  The loan officer says, "Sure.  Then you only owe us $101,020, or a 1% discount."

Now, if you look this up in a finance textbook, they will make it easy on you and say that someone wants to borrow $98,000, so he goes through the whole process of getting back $98,000 and paying back $100,000 (why the textbooks use this example has a number of historical reasons that we don't need to go into here, just accept that $100,000 bills of exchange — commercial paper — is the traditional denomination, and 90 days is the traditional period of time), and the bank's revenue is an even $2,000, out of which it must meet all its costs.  The principle is exactly the same, although the principal changes. . . .

Those are the basics of modern money creation.  There is a great deal more about the operation of a just money and credit system, of course, but that’s the basic theory.  Everything else is either an “add on” or a misapplication or misunderstanding of these principles.

#30#