Long ago Moses visited Pharaoh and told him God’s command: Let my people go! The Pharaoh disobeyed. So through Moses God brought ten plagues upon Egypt. Even though Pharaoh’s magicians, Jannes and Jambres, could not undo what God had done, they “duplicated” the first plagues God brought upon Egypt, and for some strange reason, Pharaoh took comfort in that.
What is magic, that thing magicians do? More often than not “magic” is just sleight of hand. The magician just fools us into believing he is doing something he is not actually doing. Sometimes, however, even the magician does not know what he doing.
That thing we call the economy is one of the most mysterious things in the world. That is, even though we depend upon it for our food, clothing, and shelter, none of us know exactly how it works. Therefore, when what is going on in the economy concerns us, we consult “experts,” economic magicians, to find out what we should do.
Economic magicians? Does that seem excessively derisive? Then consider these two stories.
- Negative Rates Around the World: How One Danish Couple Gets Paid Interest on Their Mortgage (www.wsj.com)
- Negative Interest Rates (www.bloombergview.com)
Will negative interest rates come to the United States? Probably. Sadly, what economists recommend these days often does not make much sense. Our economy is becoming too contrived, like a house of cards. The problem? Well, let’s begin that discussion by considering a magic trick we call fiat money.
What is ‘Fiat Money’
Fiat money is currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for “it shall be”. (from here (www.investopedia.com))
Because it is not backed by anything, fiat money has no intrinsic or innate value. That is not to say financial analysts do not have formulas to calculate the intrinsic value of fiat money. Nevertheless, fiat money has no utility of its own.
The value that we get from goods and services is innately apparent from the simple, most basic acts of living. We need food to survive, so food has value. The value for tradeable goods and services is predicated on utility and relative scarcity.
For financial assets, and money is the world’s first financial derivative, there is no direct utility. It does not satisfy any basic demand of survival or continued existence. Therefore, any value attached to financial products does not come from utility. It comes from faith. (from here)
What does Jeffrey Snider, the author of the above, mean by “faith.”
Value itself is nothing more than the outward expression of individual faith. The traditional value of money is really just an outgrowth of its historical reputation, earned through so many actions and consequences. Money may seem to add a level of objectivity into the discussion of value, but that is only because of a more universal “faith” in the transactional price discovery process it allows. (from here)
So why do we believe our money has value? There is actually a little more to it than merely believing fiat money is “real” money. Remember that our government uses its power to define fiat money as legal tender, that is, the government says we can legally use fiat money to pay off our creditors. That includes the government itself. Don’t we pay our biggest bill, our taxes, with fiat money?
Thus, using its power, the government prints money and creates a demand for it. So it is that even though fiat money has no actual value of its own, the value of fiat money still follows the law of supply and demand.
- Supply equates to scarcity. How much labor or how many goods and services are required to obtain a certain amount of money?
- The demand for fiat money depends upon the bills we must pay. What is the amount of money we need to pay off our creditors?
Therefore, to make its fiat money serve as an appropriate means of exchange, our government must regulate both the supply of and the demand for its fiat money. That’s what we will talk about in the next post.
Note: that I don’t claim to have a huge amount of economic expertise. I am sharing my observations in the hope of promoting a discussion. Hence corrections and comments are welcome. If you want your comments to include what you think of the economic proposals of the presidential candidates, that is okay with me.