Making sense of money: Part 1

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Money ranks as one of the most confusing—and consequential—topics in economics. And there’s a revolution afoot.

One lesson I learned as a college professor is that the best way to understand a challenging concept is to teach it to someone else. Bear with me as I learn on your dime. This week, I’m going to stick to the basics of the financial system.

Money is principally a means of exchange. I agree to mow your lawn and you agree to give me $20. I accept the $20 because I can use it to pay my streaming bill, buy dinner at a restaurant (in person, no less!) or get V-Bucks tradeable on Fortnite. We accept dollars in exchange because someone else will accept them in return. Full stop. Dollars aren’t backed by gold (and haven’t been since 1933 or maybe 1974, depending on context). Here’s what the U.S. Treasury says: “Federal Reserve notes … have no value for themselves, but for what they will buy.”

Greenbacks—physical cash—are only a small share of the total supply of money, however. Does your employer pay you with an envelope of cash? Mine doesn’t (and if yours does, there’s probably a reason you don’t want to admit!). Most of us don’t even get paid by check anymore. We’re notified that a sum denominated in dollars has been transferred from our employer’s bank account to ours. It is a bookkeeping transaction. No physical dollars moved from one location to another.

Nor do the banks have cash in the vault equal to the sum of deposits. Sure, the banks have some cash on hand for when we stop at an ATM and make a withdrawal. But most of our account balance is nothing but a bookkeeping entry. If all of us withdrew our balances at the same time, the banks wouldn’t have enough cash to pay it all out.

The banks hold a fraction of deposits as a backstop for their lending. When the bank makes a loan, it creates new purchasing power: It “creates money.” The share of a bank’s lending that must be backed by reserves is determined by the Federal Reserve, but the actual money creation happens at the bank. While the idea of the Fed “printing money” is evocative, that’s not how it happens.

The Fed has other tools to control how much money is created by banks and it employs these tools to manage the economy. As purchasing power promotes expansion, it encourages money creation when the economy lags and tightens up when there are “too many dollars chasing too few goods”—the classic definition of inflation.

We care a lot about the Fed’s efforts to maintain the value of the dollar. When you pay me $20 for mowing your lawn, I expect that it will still have roughly the same value-in-exchange next week when I want to trade my Andrew Jackson for lunch.

In addition to being a medium of exchange, money is a “store of value.” Currencies with higher-than-average inflation are losing value faster than others. Inflation in Argentina has hovered around 50 percent in recent months. If you are paid in Argentine pesos, you immediately look to swap them for something that is a better store of value—dollars, euro, yuan, chickens—pretty much anything else.

The revolution won’t be televised

The core of the monetary system today has existed in its current form since the end of World War II. But change is coming, with the potential to disrupt not just money-center titans like Citigroup and regional institutions such as M&T Bank but also community banks like Canandaigua National Bank and Financial Institutions.

■ Banks’ dominance of financial transactions has perpetuated a system that is relatively slow and expensive. The financial technology or “fintech” industry is poised to overthrow it. China’s AliPay and WeChat Pay now process 90 percent of mobile financial transactions at a fraction of the cost of America’s banks. In 2019, AliPay had a billion users and handled $16 trillion in payments.

■ In the U.S., publicly traded PayPal’s market capitalization doubled in the last year to $360 billion. Square’s market cap is $119 billion, with Stripe reportedly valued at $95 billion.

■ The Central Bank of the Bahamas became the first central bank to issue its own digital currency, the Sand Dollar. China’s digital renminbi may be close behind. And the Fed?

■ And then there’s crypto! Bitcoin has spawned an industry of mock currencies. It has proven to have a unique niche as a medium of exchange as it can be even harder trace than cash. Might crypto displace the dollar as a new store of value? Only if you don’t prize stability.

What does all this mean for banks? Will the Federal Reserve lose what power it holds over the economy? Will the global economy cut its ties to the U.S. dollar? We’ll explore these issues in coming weeks.

Kent Gardner is Rochester Beacon opinion editor.

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