The Dallas Federal Reserve Explains Money - A Good Read for Millennials

This blog was created to watch for any signs of major monetary system change. But one problem in this regard is that many people have no idea what we mean when we use the term monetary system or how major monetary system change might impact their own daily lives.

One good first step for anyone wanting to learn more about these issues is to learn some basic concepts about both money and what a monetary system is. I live in the Dallas, Texas area and we have one branch of the Federal Reserve Bank system located here in Dallas. Visitors can take free tours of the Dallas Fed and it also does produce educational materials on these basic issues. 

Below I have pasted in some excerpts from this article produced by the Dallas Fed simply titled "Money".  I selected these excerpts because they relate to various issues I see discussed all the time in doing research for blog articles here. It should be noted that the Federal Reserve is not without its skeptics and critics and some of the statements pasted in below would be challenged by those critics for sure. But overall, this paper is a good place to start learning about the basic concepts that lead to the debates we see about both money and how a monetary system should function. I encourage readers (especially younger readers who may not have had much formal exposure to these concepts in school) to read the full paper. 

I asked Dr. Judy Shelton to preview the information presented in this article and she offered this comment about it:

"I hope this kind of information reaches many young people and causes them to reflect on the importance of trustworthy money."  -- Dr. Judy Shelton

Dr. Shelton is the US Executive Director for the European Bank for Reconstruction and Development and also a Senior Fellow at the Atlas Network.

Further below, I will list some of the issues and debates that I see arise from the basic concepts presented in this paper. (note: I added some underlines below for emphasis)

--------------------------------------------------------------------------------------------------------------------

Introduction Paragraph to "Money"

"Money is so important that when no official money exists, people often create it. For example, during World War II, prisoners in prisoner-of-war camps used cigarettes as money. All other goods were priced in terms of cigarettes, and prisoners willingly accepted them as payment for any other good. While cigarettes have value to smokers, once they become money, they gain value in terms of everything they can be exchanged for, whether a person smokes or not. People will always find something to serve as money, even with no government to enforce its legitimacy.

What Is Money? Money is anything that is widely accepted as a form of payment for goods and services or repayment of debts."     . . . .

Defining Money by Its Uses

"How can we know when something has become money? One way to identify money is by its uses. Money functions as (1) a medium of exchange, (2) a unit of account and (3) a store of value. When people accept money as payment for goods and services, it is not because of the intrinsic value of the money; it is because they believe it will allow them to purchase the goods and services they desire, now and in the future."  . . . .

The Characteristics of Money

"Cash payments account for almost 50 percent of all transactions in the U.S., so the role of currency in the country’s payment system is very important. Just imagine if you were designing the nation’s currency from scratch. You already know that currency must function as a medium of exchange, a unit of account and a store of value. But what features does your money need? Six characteristics have been identified: Money must be durable, portable, divisible, scarce, uniform and acceptable.

There are more than 107 billion cash transactions in the U.S. per year." . . . 

Types of Money

"We know that one of the uses of money is as a store of value. But how does money get its value? Three different types of money are recognized based on their sources of value: commodity money, representative money and fiat money."

Commodity Money

"A commodity is an item that has value in and of itself. This can include anything from cows and wheat to silver and gold.  . . . . 

Through history, the commodity that most commonly has become money is a precious metal. Metals have all the characteristics of money. Metals are generally durable, lasting a very long time in circulation. When minted into coins, precious metals become relatively portable. They are divisible by weight or denomination. They are scarce, requiring time and energy to find and extract. Precious metals are uniform because their value in trade can be confirmed using rules regarding purity. Last, by being easily recognizable, precious metals are acceptable to most people."  . . . 

"As a society’s demand for money increases, the constraints of using a commodity often become burdensome. To simplify transactions, people stop using the actual commodity as money, and instead paper becomes the commodity’s substitute. The new paper money is called representative money."

Representative Money

"Representative money does not have value on its own. Its only value lies in the value of the commodity it represents. It is actually a promise. When a government begins printing representative money, it is promising that the money is backed by, and often can be exchanged for, a specific amount of the represented commodity. The strength of the representative money is based on both the value of the commodity and the credibility of the promise to redeem it for the commodity."

"Early forms of representative money were often receipts for gold and silver deposited with local metal smiths. In time, people began to accept the receipts as payment, rather than returning to claim the commodity. When this happened, the receipts began to function as money. By accepting the receipt, a person trusted in the ability to return to the smith and obtain the amount of metal specified on the receipt."   . . . .

"Eventually governments officially converted commodity money to representative money in the form of paper currency. This was essentially a promise that the printed note could be redeemed for a certain amount of gold or silver coin—called specie."

Fiat Money

"Fiat money is money by decree. When it is no longer feasible or desirable to back money with a commodity, governments can declare an item to be money. This decree means that the money is an acceptable payment for goods and services and enforceable for repayment of debts. Fiat currency has no value in and of itself, as commodity money does, nor does it represent a promise to exchange for a commodity, as with representative currency. Its value comes exclusively from the willingness of people to accept it as payment. This willingness is driven mainly by the belief that when a person wants to spend that money, it will still have value— that is, the next person will accept it as well."  . . . .

"Fiat currency has many advantages over commodity and representative money. Fiat currency is not constrained by the arbitrary amount of a commodity. Although this does pose a risk, namely that the money supply can expand without limit, it has an advantage: The money supply can grow and shrink to meet demand." . . . .

"The disadvantages of fiat currency are largely associated with its management. If a regulating body makes too much available, inflation—the general rise of prices in the economy—can occur. If not enough money is available, growth in the economy can be constrained. Balancing between not enough money in circulation and too much money in circulation has proven difficult for some countries. When the growth of the money supply gets out of hand, it can lead to an economic collapse and the abandonment of the money. If people cannot count on money to retain its purchasing power, they will refuse to accept it whenever possible. While the government can enforce the use of fiat money for the repayment of debt, enforcing its acceptance for other transactions is often more difficult."

Federal Reserve Notes and the World

"The stability of U.S. currency, coupled with the size of the U.S. economy, has made Federal Reserve Notes desirable money, not just domestically but worldwide. At times throughout history, countries have held the notes as reserves and occasionally circulated them in place of their own currency. This demand is driven by the perceived safety of the dollar—the belief that it will hold its value and will remain acceptable for transactions for many years to come. "

. . . .

"If the Fed makes money too cheap, meaning interest rates that are too low, more money will flow into circulation through lending activities, and this generally causes prices of goods and services purchased with that borrowed money to rise. When prices rise, we experience inflation—a general rise in prices over time. Low and predictable inflation, around 2 percent, is actually beneficial to the economy, but too much inflation, caused by an overabundance of money, will cause the purchasing power to go down and can damage economic stability.

During the Great Depression and through World War II, many countries abandoned the practice of using their gold reserves to back the currency they circulated—known as the gold standard. After the war ended, a push to reestablish gold on an international scale led to the hosting of a conference in the village of Bretton Woods, N.H. At the conference, it was agreed that countries would commit to a system of fixed exchange rates. The United States agreed to maintain the price of gold at $35 per ounce and to exchange dollars for gold. The dollar became the de facto world currency as many international transactions were quoted in dollars. As long as countries believed that the United States was both willing and capable of redeeming the notes for gold at any time, the notes were considered to be equivalent to the gold they represented. In 1971, President Richard Nixon suspended the convertibility of notes to gold and ended the gold standard. However, the end of the Bretton Woods agreement was not the end of the circulation of U.S. currency abroad. 

Billions of dollars in Federal Reserve Notes are used outside the United States in a number of ways. Some countries circulate the money as their only form of currency. Some countries try to preserve the value of their currency by pegging it—that is, setting the exchange value of their domestic currency—to the dollar, and many more circulate Federal Reserve Notes unofficially. Countries’ specific reasons for using Federal Reserve Notes may vary, but the dollar’s use is generally associated with its effectiveness as a medium of exchange, unit of account and store of value."

-----------------------------------------------------------------------------------------------------------------------

My added comments: The information presented above is intended to spur the reader to read the full paper presented by the Dallas Fed and to try and highlight some of the basic concepts that prompt intense debate. The more the reader understands these basic concepts, the better the reader can evaluate the various points of view you will find about both money and how a monetary system should function. 

It should be pointed out that some of the conclusions presented in this paper are hotly contested and debated by critics. Here is one example from one of the excerpted quotes above:

"Low and predictable inflation, around 2 percent, is actually beneficial to the economy"

There is much debate on whether or not targeting a 2% loss in the purchasing power of the money people use every day to pay for goods and services is "beneficial to the economy". 

Also, this paper from the Dallas Fed takes the view that the Federal Reserve has done a good job overall of meeting its objectives to 1) control inflation and 2) encourage full employment. Critics of the Fed disagree strongly with that view as you will quickly find if you do any research on these issues at all. Before you can evaluate these various points of view to agree or disagree, a basic understanding of the concepts and issues is needed and that is the goal of this article. 

Over the years in doing research for this blog, I can list some topics of debate I see out there that readers should further explore (this blog provides you a lot of material to help with that here and here). Here are just a few examples:

1) Should the US have abandoned the gold standard?

2) Should the US return to the gold standard?

3) Has the Fed really protected the purchasing power of the US dollar during its existence since 1913?

4) Is a gold standard practical for use in a modern economy?

5) Does Fed monetary policy protect large banks over the interests of the average person?

6) Has Fed policy done a good job of meeting it's mandate to provide a stable value to our money and also promote employment?

7) Can we really just not worry about government debt and create all the money we need without sparking a loss of confidence in our money?

This list can go on and on, but hopefully you can see that these basic money issues and concepts are very important to all of us which is why this blog was created. The view we take here is that the more people understand these issues, the better off we will be.

One final comment:

If you read through the excerpts above, you can see an interesting history of how our money has evolved into the monetary system we have today. This is one of the strengths of this paper by the Dallas Fed in my view. 

Please note how that one thing about money and monetary systems has remained constant over time. People must trust that the monetary system will protect the purchasing power of whatever is being used for money over time. You see this theme repeated over and over again in this paper by the Dallas Fed no matter whether it is talking about "commodity money", "representative money", or "fiat money".

The huge financial crisis which rocked the world in 2008-2009 shook the public trust in our present system to the core. This is what has led to much of the discussion and debate we have featured on this blog since that time. People like Jim Rickards have predicted that due to poor monetary policy decisions and due to the continued ramping up of debt in our financial system, a day will come when the present system cannot be sustained. This prediction includes a view that the US dollar will then lose its global status as the world's reserve currency and also endure a sharp and rapid loss of purchasing power. This is why these issues are so important in our view here. As the Dallas Fed has stated repeatedly above, people must have trust and confidence in their money. Without that trust, the system cannot be sustained over time. What if the public loses trust in our money before we can see and respond to the loss of confidence?

If and when the day arrives that too much public trust is lost, it will become vitally important for people to understand these basic concepts and also the various proposals on how to fix a broken system and restore public trust. 

I especially hope to encourage younger readers to explore these basic concepts and learn as much as possible. Understanding both some of these basic concepts about money and the history of how our money and monetary system has evolved over the last 100 years is huge help in that process and is not widely taught in our formal education system.
------------------------------------------------------------------------------------------------------------------
Added note: Follow up to this article with some more basics on money will post here on 4-11-19. That one will feature a video that may be of interest to readers new to these topics.

Followup article is now published here.