Money mainly serves two purpose. It serves as
- a medium of exchange, and
- a storage of wealth for one’s past labor.
Understanding what money is, especially the paper money in modern days, is extremely important for preserving one’s own wealth. If you don’t know how paper money is created or destroyed, you can save money all your life without knowing what exactly you are saving. And you may not know how your saving can be “stolen” without your permission, or without any decrease in the saving account balance. Paper money is an electronic record, without much real asset to back it up, except a “full faith in the (US) government”, or faith of “in God we trust”. Modern monetary system is all about paper money, inflation, and federal reserve system.
Inflation is the debasement of paper money. Increase in money supply inevitably always leads to inflation, or a higher price of goods & services. Inflation erodes the purchasing power of your money. Therefore, it’s important to keep your money in assets that can track inflation. Every economic cycle has different assets that get inflated. Usually it’s hard to know what kind of assets will get inflated. Therefore, you should keep your assets diversified according to the distribution of the GDP of the (global) economy, or you can use stock index mutual funds or ETFs to approximate the distribution. However, on a few occasions, it may be obvious that certain class of assets should be avoided or increasingly allocated. Under such time, you may want to shift your asset allocation to take advantage of such advanced recognition.
How is money created or destroyed? The process of money creation is mainly controlled by Federal Reserve System or the central bank of a particular country. Through a fractional reserve system and purchase or sale of government debt securities (such as treasury bills), the central bank can create and increase money in circulation many folds. For example, when US federal reserve operates in the open market, and buys US treasury bonds, it is like the left hand (US government) has issued some IOUs into the system, and the right hand (federal reserve) buys it right back by phantom money that didn’t exist before. What is the end result of such operation? The executive branch of the US government gets to spend all the money proceeds from the IOU bond, while the federal reserve simply enters in its electronic record that US government owes federal reserve such and such amount from this IOU that is just issued. In effect, US government dilutes the value of all the existing US dollars by spending the money that didn’t exist before, and take resources away from other US dollar holders.
The same thing is true with all the money in the “lock box” of the US social security funds. It’s definitely an empty lock box with lines of electronic records. The left hand, executive branch of the government, print an IOU, gives it to the right hand (social security agency) which then places the IOU in the lock box as if it is worth anything. Yes, the treasury bonds are a stable investment unlike stocks, and earns some stable interests. But when the two parties of the IOU (I owe you), are the left and right hands of the SAME person (US government), what good is that IOM (I owe myself)? You can’t possibly tell me with a straight face, that right after you spend all the social security taxes that are collected every year, you have also invested those social security surplus in a very good stable investment of IOM, right?
I won’t elaborate further, but instead, I want to point you to a few excellent articles on what money is. They contain much more details than what I can present here:
- Nature of the Money from Jim Puplava, detailed with historical references.
- Five Things that You Need to Know About the Dollar from Minyanville. Short and pithy article.
- My own article on Inflation.
