How Money Works

Money, despite its usefulness as the medium of economic exchange, is neither a consistent measure of value nor a store of value but a theoretically unlimited capacity to make claims on the use-value of goods and services. This is associated with a universal ‘sponge effect’ that money has on the real economy; it privileges interests of money holders over the property rights of value producers.

Economic value is intrinsically relational; it is a result of a complex web of subjective value judgements and comparisons. Short of a monopoly, no single economic agent prescribes the value of anything, but every agent participates in the process whereby value is approximated as Price. Price can be influenced to a significant degree by marketing techniques, by the level of taxation or subsidy, or simply by irrational expectations, but the final arbiter of the product’s economic value is always the market.

At the periphery of the market stands a seemingly neutral entity, the banking system, which provides the market with a universal measure of value: money. In the present-day capitalist economy, governments have negligible control over the money supply, issuing only about 3 per-cent (M0) of the broad money in circulation (M3), while the remaining 97 per-cent is created by the banks in the form of ‘monetised’ credit. One person’s debt to the bank is another person’s bank account balance. The volume of bank-money created via credit issuance is limited only by the risk of insolvency associated with the increasing ratio of credit, which constitutes an immediate interest-bearing asset for the bank but also an unrealised claim on the bank’s capital, to the bank capital, consisting of cash reserves, central-bank issued digital-currency reserves and other net assets.

Since most money in circulation is held in the form of deposit accounts rather than cash, banks can leverage the public trust that the money OF the bank (credit) is as good as the money IN the bank (currency reserves). The money OF the bank, which constitutes the aggregate of all deposit-account balances, is not logically equivalent to currency but is just a promise of the bank to pay the deposit back on demand, what in most cases amounts to settling electronic transactions for account holders with other account holders. Since some account holders we may transact with are with other banks, at the end of each day banks add up what they owe to one another and clear any outstanding obligations via payment in currency. This clearing process is accomplished with only a fraction of the amount that would be necessary to pay for all the customer transactions with currency.

As a result, despite the fact that mortgage interests rates are at an all-time low (around 5 per cent) “mortgages currently generate a return on capital of 35 to 40 per-cent for banks” (The Age). That’s a net profit after tax of 7-8 times the lending interest rate, what would obviously be impossible if the ‘loans’ were drawn from the currency reserves.  In other words, if the income before expenses and taxes is 5 per-cent on a dollar then profits cannot be 35-40 per-cent on a dollar after expenses and taxes without some creative accounting. Clearly, a radically different measure of value is applied to the same ‘loan’ amount when assessing cost to the bank and cost to the borrower.

We normally think of a measure as a standard, a yardstick, a fixed quantity of something in terms of which everything else that shares certain properties can be quantified. The supposed standard of measure of economic value is not something of definite quantity but is ‘elastic’, able to stretch or contract according to lending activity and changes in the economic output. All money is devalued whenever credit is issued, because credit is used as currency without costing the same amount of currency to issue. In other words, bank-credit involves an imperfect transfer of purchasing power. (Howden 2013, Journal of Prices & Markets) The effect is of course that the measure is biased, allowing for expropriation of value in favour of whoever has the capacity to issue money or money-substitutes. But this is only a secondary effect. More fundamentally, money is not just a bad measure of value but not even a store of value, because the same value cannot be present in two places at the same time - as a valuable product, service or commodity and as a monetary claim on the same:

“Since real-value does not cease to exist in its object-form on account of its monetary re-presentation, the notion of money as the store of value involves a double count of nominally the same identity of value: once at the object-level of goods and services where it remains intrinsically valuable, and once again at the meta-level of monetary re-presentation that purports to store its value.” (Kowalik 2015, Real-World Economics Review)

Money, be it hard currency or credit, is therefore only one thing: a theoretically unlimited capacity to make claims on the use-value of goods and services. In Kowalik 2015 I have shown how this capacity mirrors or re-presents the size of the real economy. Whenever products or services are brought into existence there is an automatic transfer of some percentage of their value to those who hold money, a deflationary sponge effect, with no need for making an explicit transaction. In other words, when the size of the real economy increases so does the purchasing power of money even if the effect is obscured by the inflationary effect of monetary expansion:

“If an inflationary movement and a deflationary one occur at the same time or if an inflation is temporally followed by a deflation in such a way that prices finally are not very much changed, the social consequences of each of the two movements do not cancel each other.” (Mises 1996, Human Action p414)

In principle, all the money in existence can buy all the goods in existence, allowing money issuers to just buy Everything and leave value-producers with valueless tokens. This does not happen only because long-term exploitation is best served by leaving enough economic value in the hands of the productive workforce to keep it motivated to continue creating value and exchanging it for money. The problem is of course not with money itself, which is a valuable and now indispensable technology, but with the lack of measures to preserve equitable ownership of value among value-producers, money holders, and money issuers. As long as this defect remains in place money will work in favour of money holders and money issuers, at the expense of property rights of all value producers. The effect of biased money is bigger and more pervasive than the capitalist system itself. In Kowalik 2015 I discuss a possible solution to this problem.