Understanding Money: Part 4 – The Value of Money

Money and Value

As discussed in Understanding Money: Part 1 – Introduction when nations’ currencies were made of precious metals, the actual value of the currency was carried by the currency itself. It had intrinsic (see next section for a discussion on intrinsic value) value. For a gold coin, the measure of its value was the amount of gold in it. The value of gold as a metal is due in a large part to its scarcity and associated cost of production.

If a bushel of wheat were our commodity currency, we could plant more acreage. For gold, it takes an immense amount of money to find and develop new deposits. It takes years to develop a new deposit before the first ounce of gold is poured. So the supply of gold is what economists term as inelastic. It can’t readily be increased to meet demand. Today, the commercial producers that own significant deposits have a production cost of around $1100 per oz. So its minimum price or value is its cost of production.

Have you noticed that very few people have enough money? This is particularly true of sovereigns – monarchs and governments. A key aspect of a sovereign is it’s control of the money supply. A sovereign may control the ownership of all gold production but it cannot control the amount of production to any degree. What is a poor sovereign to do when it wants more short of stealing another sovereign’s gold through warfare? Fiat or paper currency to the rescue.

Historically, sovereigns used various means of debasement to increase their supply of money. They added base metals reducing precious metal content. They “clipped” a little bit off of coins reducing their gold content. They made coins smaller. The people noticed and repriced goods accordingly. The money supply increased but the unit value fell as its intrinsic value was lowered (less precious metal). The sovereign always manged to find a way to debase commodity currency.

Paper currency began as promissory notes that could be redeemed for a quantity of some hard asset with intrinsic value. This became the representational currency mentioned in Understanding Money: Part 1 – Introduction. Sovereigns quickly realized that paper currency had no intrinsic value – it was only a small piece of ink-stained paper. They also found they could control the extrinsic value by arbitrarily determining what and how much of an asset it could be exchanged for. The promise to exchange a note or bill for an amount of some underlying asset could be met as long as there was an appropriate amount of the underlying asset in storage somewhere.

But as in modern banking, not everyone wanted to redeem their bills at once and so the sovereign found it could reduce the actual amount of stored assets and the public would never know. The other side of this coin is it could keep the amount of underlying assets fixed but print more bills.

Again, the sovereign always manged to find a way to debase representational currency. Which brings us up to the modern day and fiat currency that offers a no-nonsense approach to currency debasement.

What Is Intrinsic Value?

We will define the intrinsic value of an object as the value that an object may have independent of its role as money. As an example, consider that your car actually represents different values to different people. To a scrap dealer, your car might be worth $150, its value as scrap metal and plastic. To an auto parts recycler, your car might be worth $500, its value when disassembled and sold in pieces to body shops and repair garages. On the used car market, your car might have a “book” value of $3000 to a car dealer and $4500 when sold to the public.

From the viewpoint of the manufacturer, he had to pay $3200 for components and raw materials plus $2,000 in labour to assemble and finish it. Administration and marketing added another $3000.

The point is that your car is an asset that has value in many markets. At a minimum, it has a production cost or value which includes the raw materials costs, and a destruction value for when it is disposed of.

So what does this mean for money? Coin has as an intrinsic value, the value of the metal it is made from. It also has a cost of fabrication. CNN Money had an article titled: Obama wants cheaper pennies and nickels. For the penny, they state:

The raw material cost of the metals used in a current penny is only about 0.6 cents per coin, according to prices quoted on the London Metal Exchange, and a breakdown of a penny’s composition from the mint. The mint paid 1.1 cents on average for the metal used in a penny in 2011, but that is the cost of ready-to-stamp blanks from the supplier, not raw material traded on commodity markets. … the administrative cost of minting 4.3 billion pennies costs almost a half-cent per coin.

Altogether, it cost 2.4 cents to make a penny in 2011 and about 11.2 cents to make a nickel. The destruction value of a penny, however, is close to its raw material value or about 0.6 cents. So a penny, independent of its monetary value of 1 cent, has an intrinsic (scrap) value of 0.06 cents.

For paper money, the raw materials costs are minimal – a bit of paper and a bit of ink. It’s destruction or scrap value is so small to a paper recycler as to be zero. Hence paper currency has no intrinsic value.

A gold coin on the other hand has an intrinsic value around the spot price of gold, or roughly $1750 based on today’s spot price (2011) if sold as scrap to a refiner.

The Federal Reserve Note

The legal currency of the US is the Federal Reserve Note (FRN). It may be “redeemed in lawful money [the FRN] on demand at the Treasury Department” (see quote below). That is, another FRN of the same value. It has no intrinsic value as a piece of ink-stained paper. Since it can only be exchanged for another FRN equivalent to itself it has no physical extrinsic value either.

What it does have is psychological extrinsic value. That is, the value assigned to a one dollar FRN is one US dollar by general agreement of the population. When a fiat currency loses its psychological extrinsic value, when the populace no longer has confidence in the currency, then we have the condition for hyperinflation of the currency.

If we were to look at the Federal Reserve’s balance sheet, we would see all currency in circulation listed as a liability (see line item “Federal Reserve notes, net of F.R. Bank holdings” in table 8 under liabilities). Here is the official description in Section 16 of the Federal Reserve Act (emphasis is ours):

Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues. They shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank.

The Fed notes that currency constitutes “legal tender” for all purposes. Federal and state courts since then [1933] have repeatedly held that Federal Reserve notes are also ‘lawful money’  Indeed, in Milam v. U.S., 524 F.2d 629 (9th Cir. 1974), the court upheld that Federal Reserve notes are ‘lawful money’ and as such may be used to redeem other FRNs.

So the $100 bill or FRN you have in your hand is actually a debt instrument considered to be an asset to you but a liability to the Fed. Since all debts are paid in US dollars, if you want to close the debt by demanding repayment, you will be given $100 in FRNs as payment in kind by and only by the Treasury Department or a Federal Reserve bank. So the currency you hold has no intrinsic value and its extrinsic value is effectively itself which is … ummm, sorry.

Fiat Currency As a Confidence Game

We know from earlier discussion that the $100 bill originally came from the Fed when they used it to buy an asset from one of the few banks they actually trade with called a primary dealer. Historically, the assets they purchased were US Treasuries, the highest quality of debt on the market. Since the financial crisis began in 2007, they have acquired other forms of debt assets such as mortgage-backed securities (MBS) and the debt of government-sponsored enterprises (GSE) such as Fannie Mae.

Consider what the Fed has done. It has issued debt instruments, US currency or FRNs, payable in an equivalent amount of similar debt instruments or FRNs (economists have a lovely term for this property called fungibility), and to secure the debt they have issued, they have taken in alternative debt instruments, Treasuries and MBSs, which in turn are redeemable in US dollars or FRNs.

So by law, your FRN can be redeemed on demand at the US Treasury or the Fed with an equivalent FRN. Even if it could be redeemed at the Fed using other assets the Fed acquired in issuing the FRNs, such assets would still be debt that itself is redeemable only in FRNs. Even the gold listed on the Fed’s books is in the form of Gold Certificates – debt instruments – rather than gold bars. You can’t make this stuff up!

In short, fiat money is a confidence game in all senses of the term meaning a swindle but also a swindle that the public has confidence in. Its real and only value is extrinsic and lies in the degree that the public has confidence in its three aspects that define its nature as money: a medium of exchange, a unit of account, and a store of value. The first two characteristics are easily served by fiat money. The third characteristic depends entirely on public confidence in it. When a currency loses the confidence of the public, hyperinflation is the result, partly because the sovereign can print more at will as the existing currency loses value (public confidence).

This brings us to the end of our introduction to understanding money. The single key point to take away is that all money represents debt. For those of you who might want to explore the historical aspects of money in depth, we recommend Niall Ferguson’s book The Ascent of Money.

Next

In creating this series, a number of avenues opened up giving us some cause for excitement. We explore these ideas in Understanding Money: Part 5 – It’s All Money.

The Series

 

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