mDuo13

The only basis for good Society is unlimited credit.

Oscar Wilde1

While working in the world of digital finance, I've come to realize that most people aren't really aware of how money truly works. I mean, people have some knowledge of how they use it, but the lack of deeper understanding becomes a real problem when you try to explain how digital money works — no comparison makes sense if you're lost on both sides of the equation. To amend that issue, allow me to share some shocking truths about so-called real money that I've pieced together while investigating the mysteries of digital cryptocurrency.

Let us begin by thinking about loans, borrowing, and credit in the abstract. These get a bad rap, but they can and often do serve a good economic purpose. Sometimes you really just need that money now. Maybe your rent is due but your paycheck is late. Maybe you see a great business opportunity but don't have the funds to pursue it. Maybe you just forgot your wallet before coming to the bar. The solution to all these problems is basically the same: a lender, or credit issuer, fronts the costs for now; the borrower provides the funds later; and they use a crucial little scrap of paper — a contract — that contains written promises of who owes whom in the time between.

When handled responsibly, both parties benefit. Lenders get paid back a little more than the amount they fronted, in exchange for sacrificing their opportunity to use the money for something else, and taking on the risk that the borrower may default. Meanwhile, the borrower gets the benefit of time: money now, when it's needed. In the case of a business, this is especially critical because it breaks the entrepreneur out of a catch-22 where the business can't make money because they don't have any money to invest in making it a successful one. When lending is used irresponsibly, inevitably someone gets screwed, but that scenario, and all the instruments and regulations that have accumulated around it, is another topic entirely.2

Somewhere along the line, an enterprising person invented banking, by realizing that they could combine the services of lending and borrowing, and act basically as a matchmaker3 between those who need money and those who have money to spare and invest. The bank saves everyone the trouble of finding parties on the other side of the equation, and solves the problem of matching up the amounts of money people need to lend or borrow. In exchange, it pockets the spread between rates. This is all well and good, and ordinary. Many businesses, from Visa to Kickstarter, operate on a similar principle. The problem is, the banker needs a large cash hoard of his own in order for depositors to withdraw their money if they need it even before the corresponding loans are repaid.

The real magic happens when you invent fractional reserve banking. Fractional reserve happens when an inventive bank pulls a trick on its depositors. The bank realizes that, if two people deposit $100 each, and the bank lends out $100 of that money, then it can keep the other $100 in reserve to give to either depositor when he comes back wanting to withdraw his money. As long as both depositors don't simultaneously need to pull out more than $100, then no extra vault of money is necessary.

Now, let's count the money in the system. To begin with, we had two depositors with $100 each, for $200 total. Now, we have a borrower who's got $100 that he's going to go spend on whatever he needs now; and we have two depositors who each have a balance of $100 in the bank that they can access at will, for effectively $300. No new dollar bills were printed, but the amount of money in the system increased. You can argue that someone's money isn't real, and technically that's true, but that's missing the point. After all, on paper the borrower still owes $100 (plus interest), but he gets the value of the things he buys immediately. Meanwhile, the two depositors each have the illusion of having $100 in the bank that they can access and use at any time. Interestingly, the depositors and the borrower can even pay each other by telling the banker to adjust their balances, without even withdrawing first: that way, the illusion is maintained. The system works on the trust that everyone will have their money when they need it.

As for what happens when the trust is lost... A classmate of mine once asked where all the money went in the Great Depression. The answer was, most of it never existed in the first place. A bubble — excessive trust — existed in stocks and bonds and bank deposits and other scraps of paper that people believed and trusted to have value. When suddenly people lost that trust, the illusionary money disappeared, leaving everyone poorer. The fractional reserve example we talked about isn't the only case, but it serves as a perfect case study for our lesson: Trust creates money. When people are willing to accept credit — a promise of future money — then the total money in existence increases. When trust is lost, the total amount of money in existence decreases.

Let's take a step back and talk about what "money" means. Money is generally considered an asset, something that's valuable. Some kinds of assets, like cars, land, or Tide laundry detergent, are useful. Other assets, like the Mona Lisa, or John Lennon's autograph, are rare, and carry a mystique that makes them valuable. Some assets, like gold, are a little bit of both: (somewhat) rare, and (somewhat) useful. Paper money is neither. A retired Deutsche Mark bill is no more useful than the paper it's printed on; no one will accept it as payment. The Euro, on the other hand, is quite valuable. Rarity doesn't determine the value of the bills, either: the U.S. $20 bill is much more common than the $10 (Almost nine billion scraps of paper with Jackson's face in circulation compared to less than two billion with Mr. Hamilton's) yet the $20 bill can be readily exchanged for twice as many hamburgers, or twice as many of anything, really.

So why do people accept that putting a different number on the paper makes it worth twice as much? The truth is, even government-issued money — like good old US greenbacks — is just a promise of value written on a piece of paper: literally, a promissory note. If you go back in history, the fledgling US government issued hundreds of millions of Continental dollars. These notes were based on flimsy promises, and the people doubted their value: for a while, it was unclear whether there would even be a U.S. government, post-Revolutionary War, to pay them back. In the end, although the government survived, colonists were right to doubt the Continental currency: with too many bills printed and no way to get rid of them, the Continental dollar decreased in value and was retired. Fortunately, the U.S. learned from its mistakes, and made stronger promises to back the new dollar: it constrained the supply of paper money to match the government's reserves of gold and silver. (It also helped that, after the war, the British laid off of counterfeiting American currency.) The dollar is no longer tied to gold and silver, but the U.S. government is one of the world's most widely-trusted issuers of currency: people trust the U.S. to issue dollars responsibly4; and the Federal Reserve promises to make change for its bills at the stated rates. (That's why the $20 is worth twice as much as the $10.)

Of course, cold, hard cash is not the only form of money. I'm guessing most of you don't get paid in cash, store your life savings in your mattress, and pay your rent with an envelope full of dollar bills. Most money in the world only exists as numbers in a balance sheet. It's not all that different from cash, after all: they're both just written promises of value (modern systems replace the paper with a computer system, but the premise is the same). When you wire money from your bank account to someone else's, do you think they go into a vault, grab $1000, load it in an armored vehicle, and drop it off at the other bank? No! They subtract a number from one balance sheet and add it to another. Of course, the government pays very close attention to banks' accounting so that everything still balances out in the end. (Even though issuing credit effectively creates money, the balance sheet also acts as a promise that the money will be paid back: all illusory money must eventually come to an end.) Ultimately, though, commerce is possible because the people exchanging those scraps of paper have trust in the institutions issuing them. It sounds crazy, but it works.