Money, what is it?

What is money? A funny thing happened on my way to the bank... the bank created money out of thin air. Yes, it's true. In the US, we have a system of finance by which our private banks can create money. It is moderated to some degree by the Federal Reserve, which is itself a creature that is part government part private sector. "Secrets of the Temple," by William Greider, now with the Nation magazine, goes deeply into this subject. I happen to be reading it with two other people at this time.

The way money is created by the private sector is as follows. Lets say a bank has one million dollars. It is supposed to keep a percentage in reserve in case people want to come and get cash, say 10% in reserve. The remaining 90% can be loaned out to individuals and businesses. That 90% is typically put right back into a bank in the system of US banks. This bank can, in turn, loan out 90% of that 90% (81%), holding 10% in reserve. That 81% is stored in another bank, or the same bank that gave the loan, and then 90% of that 81% can be loaned, and so on. This multiplying process effectively creates money where none existed before. It isn't printed by the government.

Surely it's more complex than this, and the percentage of reserves required is something other than 10%, but that's the basic concept. Ultimately, the "money" in circulation is mostly loans, or debt. Now, if that debt is invested to produce goods and services, the debt can be paid back, with a little left over, and the system works. However, if that debt is simply used for consupmption, with nothing to show for it afterwards, and no way to pay back the debt, then we face an unsustainable situation. Eventually, the system fails. Unfortunately, to a great degree, the later is ocurring in the United States.

Obviously, there's more to money than that. There are the various ways of counting money: M1, M2 and M3 are categories of "money," that are increasingly less liquid. That is, less readily available upon demand. Less liquid money might be yours, but it might be locked up in a certificate of deposit that matures in three months, and cannot be spent right now (unless you pay a stiff penalty for early withdrawl in some cases).

Below is a summary of the trends in M1, M2 and M3 over time. Note how the money supply has expanded much more rapidly than the population in the US. Shouldn't we all be richer? Well, the fact is, and I've not shown it here, the wealthy top percentage of Americans ARE wealthier, but the lower tier have actually lost wealth over the past few decades. I'll save that discussion for another time.

US Population:
1950 151 Million
1980 226 Million
2000 281 Million
2005 292 Million

Wealth Distribution (1):
1979 86% of financial wealth held by top 10%

M1: currency and demand deposits held by consumers & businesses;
1950 $130 B
1979 $362 B (range 359 -381B)
2005 $1,365 B approx
11% growth per year between '79 & '05 on average

M1 per capita:
1950 $861k
1979 $1,601k
2005 $4,675k

M2: M1 + small savings accounts, CDs, mutual funds.
1950 $287 B
1979 $1,425 B (range: 1,372 - 1,473)
2005 $6,500 B (range: 6,400 - 6,600)

M3: M1+ M2 + large CDs (100k +), less liquid assets.
1950 $295 B
1979 $1,725 B (range: 1,656 - 1,808)
2005 $9,750 B (range: 9,502 - 10,058)

Velocity: GDP/MX (2) Turn-over of money
1960: 3.5 for M1
1979: 6.8 for M1 ($362 B)
2005: 8.9

The difference between GNP and GDP is a matter of the nationality of the producers and the location of production:

GNP = goods and services produced by US corporations in USA + goods and services produced by US corporations in other countries (our countrymen's production)

GDP = goods and services produced by US corporations in USA + goods and services produced by foreign corporations in the USA (within boarder production)



1. p 39, Greider, "Secrets of the Temple"
2. http://www.economagic.com/em-cgi/data.exe/var/vel-gdp-per-m1