Money is an indirect medium of exchange through which
we purchase goods and services. Money is similar to a battery, the former is a
store of value, and the latter is a store of energy. Before money, we used a
system of direct exchange known as bartering in which people traded goods amongst
each other. An example of this would have been exchanging fish for clothes.
This form of direct exchange was local and limited. How does one determine how
many fish would be needed for clothes and vice versa? Bartering
becomes increasingly difficulty when attempting to exchange higher value goods.
A natural consequence of bartering was credit, an “I owe you”. Therefore, accounting, the need to quantify an “I Owe You” graduated bartering from a social system to a number system. This allowed us to quantify an “I Owe You” through a unit of measure. Once a unit of measure was in place it allowed for the creation of an indirect system of exchange. This indirect system of exchange has taken various forms throughout history. Clay, metals, precious metals, coins, paper notes and now digital currency.
This enabled the storing of value and removed the economic limitations of bartering. It unlocked the incentive to produce goods and services to meet demand. Profits and wealth could be accumulated, stored, and reinvested. Money and commerce would begin to transform society over time by meeting the needs and wants of the people it served.
Money is a social construct. It holds no intrinsic value, but the value given to it by society, governments, and central banks. Intrinsic value is the measure of what an asset is worth. The metal and paper used in the production of coins and paper notes is worthless relative to the value we give them. This perceived value is a belief structure, so long as most of us have faith in the system. As a society, we collectively believe in money’s value, with each transaction reinforcing this belief. The creation, evolution and continued use of money is a byproduct of our collective social and economic cooperation over time. Given money and its value are such powerful tools one might wonder what determines its value and who is in control?
Power is the capacity or ability to direct or influence the behavior of others or the course of events. Money and power go hand in hand throughout history. Money is an instrument of power. With all inventions, and money is no different, it is not long until a person or peoples begin to use it in different ways. It all depends on whose hands the money is in. Today, governments and Central Banks use fiscal and monetary policy to influence economic conditions.
Fiscal policy is a governments ability to increase or reduce spending and taxes. In theory the role of government is to act as a ballast tank to the private sector depending on the prevailing economic conditions of the time. A ballast tank is a compartment within a ship which holds water to provide stability and to ensure the ship does not breach its tipping point. Therefore, government is a counterbalance used to harness the power of the private sector while mitigating systemic risk. If the system is representative of private and public sectors, their potential failure is a risk.
During economic downturns governments should spend more than they collect in taxes (budget deficit) and during economic growth should spend less than they collect in taxes (budget surplus). A government’s ability to spend and borrow is pegged to the back of the taxes paid by its people and businesses. There is an inherent disconnect between the short-term nature of politics (re-election) and the long-term nature of prudent financial management.
Monetary policy is the European Central Banks (ECB) management of the cost and supply of money. The cost of money refers to the interest rate charged to borrow money. The supply of money is the amount of money in circulation and available to lend. How the ECB manages these responsibilities depends on current economic performance. Is the economy growing or declining? The ECB uses the following tools to influence economic variables towards its mission of price stability:
- Increase or decrease the interest rates at which banks can borrow or deposit money. Raising or lowering interest rates increases or decreases the cost of borrowing, the benefit of saving and therefore, the availability of money and its consumption.
- A higher or lower reserve requirement (deposits) for banks results in less or more money being available to lend to people and businesses.
- Increase or decrease the supply of money by buying or selling short term government debt which usually reduces or increases interest rates.
The aim of government and Central Banks is to prioritize economic growth while monitoring and influencing price stability. Price stability is the gradual rise in the cost of goods and services we buy over time, inflation. Fiscal and monetary policy is used to stimulate growth during an economic downturn and constrain excessive growth during an economic upturn. Fiscal and monetary policy is a difficult and delicate balancing act given the variables involved. The ECB controls the supply of money in Europe of which Ireland is a part of. The Irish Central Bank contributes to and supports the ECB in this role.
Government policy prioritizes sustained economic growth as it is seen to improve our collective standard of living over time while keeping unemployment low. A rising tide lifts all boats so to speak. It may not be immediately apparent on a year-to-year basis but decade to decade the improvement in our standard of living is evident. Economic growth is traditionally measured by Gross Domestic Product (GDP). GDP is the total annual productivity of a countries people and businesses.
The aim of government is to target a sustainable level of growth so as not to restrict or overheat the economy. Target economic growth or GDP is usually between 3% to 4% or 1% to 2% above inflation per year over the long term. Our social and economic system is built on sustained economic growth. Without ongoing growth our system is in danger of collapse.
Inflation, the rise in the price of goods and services
over time can be caused when too much money is chasing too few goods. Measuring the
value of a good is primarily determined by supply and demand. When demand
exceeds supply prices usually rise. A higher price encourages an increase in
supply. When supply meets or exceeds demand the price stabilizes or falls.
Rising prices therefore regulate supply and demand. Supply and demand economics
is a model for price discovery. Price is what the open market is willing to pay
at a moment in time. Prices fluctuate as the market ebbs and flows. Therefore,
value is determined by the price paid and the direction of the market
thereafter. The market will reveal good or bad value over time based on the
If the supply of money, the amount of money in circulation, is greater than a countries growth it can lead to monetary inflation which decreases the value of its currency. If the supply of money is less than a countries growth it usually leads to lower levels of monetary inflation or deflation which increases the value of its currency. The supply of money determines the value of the money in our pockets and our ability to afford goods and services. Therein lies the reason for price stability.
Central Banks target an average inflation rate of up to 2% per year over the long term. Why 2%? It is seen to encourage economic growth, high employment & price stability while allowing households and businesses make sound decisions around saving, spending, and borrowing into the future. It incentivizes spending decisions in the short term as they will be more expensive in the long term. Money today is worth more than money in the future because its value is being slowly eroded over time. A thousand euro ten, twenty or thirty years ago was worth more back then, than it does today. As a thousand euro today is worth more than a thousand euro in ten, twenty- or thirty-years’ time. The Central Statistics Office (CSO) measures inflation using the Consumer Price Index (CPI): https://www.youtube.com/watch?v=32aOAu9zmxg
An interest rate is compensation required by lenders for default and inflation risk. Interest rates will vary depending on loan type and length. A credit card for example will charge a high level of interest because it is short term, the risk of default is higher, with no underlying asset to secure the debt against. When we compare this to a mortgage, the interest rate is much lower. This is because the debt is long term, the risk of default is lower with an underlying asset that appreciates long term. Should the borrower default, the bank can repossess the house and sell it to recoup the outstanding loan amount.
Given inflation will gradually erode the value of our money over time, a lender will require an interest rate that incorporates inflation rates over time too. This is to ensure the lender is no worse off financially following repayment in full. For example, if inflation were to average 2% per year it would take a little over 34 years to halve the purchasing power of our money. The same €10,000 basket of everyday goods today will cost us €20,000 in 34 years’ time. The longer the repayment time horizon the more inflation risk increases, mortgages being a prime example. Therefore, an interest rate is the representation of default and inflation risk.
The setting of interest rates by Central Banks seeks to influence the rate of inflation. If inflation is higher than desired, interest rates usually rise to curb rising prices. If interest rates are high, it encourages saving and discourages borrowing. If inflation is lower than desired or we have deflation, interest rates usually fall to curb falling prices. If interest rates are low, it discourages saving and encourages borrowing.
If money is a social construct, debt is too. Debt predates money. Today, personal debt is used to fulfill our needs and wants that we have failed to save for or could not ordinarily afford otherwise. A mortgage being a need and a new car being a want. A key tenet of personal finance is to avoid debt and only borrow if absolutely necessary. This is because it will cost us more time at work to earn the money needed to repay the debt due to the interest charged. Our ability to repay debt is reliant on us earning an income. Like all good and bad things in life, they compound. Debt is detrimental to our wealth building efforts as it acts as a substantial drag on our number one wealth building asset, our income.
Given personal debt is detrimental to building wealth, one might assume government debt would be viewed in the same way. Given the role of government within society there are extenuating circumstances that make government debt a necessary evil. The Great Financial Crisis (GFC) and the Covid-19 pandemic are two recent examples in which government has had to pull the debt lever to keep the show on the road. Government debt is often measured as a percentage of GDP. What it owes, against what its people and businesses produce. A government’s ability to repay debt is pegged to the back of its taxpayers, people and businesses. Therefore, a countries growth is key to maintaining a sustainable level of debt. Ireland is a small open economy and susceptible to significant changes in our economic fortune based on global events outside our control.
While it would be great for government to be pursuing a wealth building strategy for its citizens, national debt has become normalized over time. To become debt free would require significant spending cuts and tax hikes (austerity). It would be insufferable; citizens would not tolerate it and politicians won’t push the self-destruct button. In addition, this would only undo the debt we have built up and get us back to zero. To continue spending less than we produce would have an impact on economic growth, employment, and price stability. This website provides some interesting insights on government debt and how our taxes are spent: https://whereyourmoneygoes.gov.ie/en/
Link to Spotify podcast episode: https://open.spotify.com/episode/39ErMlyVFnN6JelkyYcwg5?si=2138d8207fb146ba
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s2-e9-money-the-nuts-and-bolts/id1539630506?i=1000542278342
For personal financial planning advice email firstname.lastname@example.org or call (01) 539 2670.