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Why is Money so Important? How is it Created, Allocated and Destroyed?

March 24, 2014

The Origin of Money

As most people recognise, ‘money’ alone determines what gets done and what gets made - directly, as we spend our own money, or indirectly, as we try to influence how others spend theirs.  It also determines who gets what share of our output - based on income.

 

As such, it is the single most important factor in the 'economy'... so it may be surprising that its creation, allocation and destruction does not figure in most economic models!

 

To really understand money, we need to go back to its origins, to see how and why it was first created and allocated, and also destroyed.

 

On one account, ‘new money’ was created by the King issuing ‘tokens’ to his soldiers and household for ‘services rendered’. These ‘tokens’ did not have to be ‘funded’. They were simply created (out of sticks, clay, shells, stones, metal, etc.).

 

His subjects relied on the King’s capacity to honour the promise attached to the tokens: “that the money issued, could be redeemed for value” (namely, goods from the King's store)[1].

 

It is this promise that turned the ‘tokens’ into ‘money’.

 

When the tokens were redeemed for goods from the store, they were re-deposited in the Kings strongbox.  At this point, the tokens ceased to be money, as the 'promise to pay' was extinguished upon redemption.

 

The tokens again became 'money' only as when re-issued to signify the King's promise to pay for new work done by his soldiers and household.

 

Creation of Money in the Modern Economy

Today, it is very different. Quantitative Easing aside, the king (or government) does not create our new money.

 

Now, most ‘new money’ is created as ‘debt’… mostly by banks as they lend[2].

 

And, instead of the King, we now rely on the whole of society to make good on the promise to give fair value (in goods and services) in return for the tokens (Coins, Notes and eMoney).

 

Which raises the question:

 

What if, in addition to lending new money into existence, we could again create new money ‘out of thin air’ (like the King) to recognise new work done?

 

In this case, the payee would have no obligation to repay the money, just as the king’s soldiers and household did not have to repay the money (as it was created to recognise the value they had contributed).

 

But what work, and who would decide who gets how much?

 

Clearly, we don’t want the government just printing money for its own use. By forcing governments to raise taxes (or borrow and repay the money with interest out of future taxes), we impose some limits on ‘pork barrelling’.

 

Nor do we want the government just dolling it out to a section of the population… no matter how ‘deserving’. We all know where that leads: to fraud and corruption, and a sense of ‘entitlement’ that destroys the incentive to work.

 

If we are to create ‘new money’ for a section of the community…it needs to be for ‘new work’ that is valuable, and not yet monetised.

 

So, what is ‘valuable’ that is not yet ‘monetised’?

 

This question is answered in the next section: The Knowledge Economy

 

[1] This is illustrative only. The history of money is not so straightforward. Wikipedia http://en.wikipedia.org/wiki/History_of_money

[2] As Sir Mervyn King (ex- Governor of the Bank of England) explained in 2012: “When banks extend loans to their customers, they create money by crediting their customers’ accounts” Bank of England p3. http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech613.pdf

[3] Bank of England: Money Creation in the Modern Economy http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf

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