Bad Money
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Gresham's Law, Clipped Coins, & American Finance
An obscure economic theorem called "Gresham's Law" states that:
Bad money drives out good.
What does that mean, and how does it apply to us today?
Gresham's Law is named for Sir Thomas Gresham (1519-1579), an English financier who lived and wrote during the Tudor Dynasty. During Greshams' era, coins were minted from the same metals that backed their value.
A 'good' coin In Tudor England contained the exact amount of precious metal that made it valuable. In other words, (to invent an example here), a $10 gold coin was actually made from exactly $10 worth of gold. A $10 coin made of $10 worth of gold was called 'good money'.
In an effort to enrich themselves, certain unscrupulous types regularly messed with the Tudor coinage. Sometimes they 'clipped' the coins (meaning they shaved off small amounts of gold and stashed it). Sometimes they debased the coins by mixing in cheaper metals, once again allowing them to pocket some gold.
This clipped and debased coinage was called 'bad money'.
Gresham observed that when both bad money and good money are in circulation at the same time, the bad money will always drive the good money out of circulation because people will pocket and hold whatever 'good' money they find and circulate only the bad money.
To use another off-the-wall example, say you are going to the Tudor 7/11 for a Tudor Slurpee and you know you have both a 'bad' coin and a 'good' coin in your pocket. You are going to pay for that Slurpee with the 'bad' coin (if you have any sense at all), and take the 'good' coin home and squirrel it away.
Before long, all the money in circulation will be 'bad', and all the 'good' money will be locked up and out of circulation. Squirreled away. Frozen.
We no longer circulate gold coins (partly for this very reason, and others as well), but today, the United States has managed to kick off a worldwide Gresham's Law scenario anyway. The 'good money' is currently locked up in the hands of an elite few and is not circulating. The bad money', the money that is circulating, is debased currency backed by nothing of real value.
How can this happen in a world where currency is symbolic?
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Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism
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Modern Money
Modern money is no longer backed by gold or precious metal, but rather by the the economic health and global reputation of the nation issuing it.
(For an explanation of the no-longer-used 'gold standard' and a discussion of its historical advantages and disadvantages, click here.)
Money backed by economic activity has a number of advantages over money backed by gold. The biggest advantage of this kind of money (called fiat money) is that more of it can be printed and circulated, thus creating more capital and with it more opportunity for business growth and expansion. By contrast, when money is backed by gold, the amount of money in circulation is limited to the amount of gold in reserve. Less gold, less money.
As long as businesses use fiat money (the kind not backed by gold) as capital to expand and add value to society in the form of real goods or services, the value of the fiat money stays stable. It remains 'good money' (even though it isn't backed by gold) because the economic health of the country printing it is maintained. The value of the money is in the value of the people and their activities: industry, services, manufacturing, and so forth.
Real goods and services = fiat money that has real value.
Fiat money goes 'bad' when more and more fiat money is created but no real value is added to the society printing it. The simple act of printing more money is not what makes the fiat money go bad. What makes fiat money go bad is printing lots more of it but not immediately using that increased money supply to create more goods, more services, more jobs, more buildings, more exploration, etc.: In other words, more real things of real value.
That's what's happening in the world today, especially in the U.S.
How did it happen?
The Dark Side of Modern Money
Clipping coins isn't an effective way to game the system when a society uses fiat money, because the value of the money is symbolic.
In order to cheat with fiat money, what you have to do is create profit without adding value. While you extract profit to no good end, you must at the same time hoard all the real property, goods, and valuable services for yourself and make no improvements whatsoever, risk no expansion, and employ no more workers, (in fact, get rid of them as soon as you can because they eat into your profit).
Can you think of an enterprise that is currently in the business of doing this?
In case you haven't guessed yet, that business is banking.
Banks make money off of debt, and so it is in the interest of every bank to create more debt so they can at the same time create more money (and keep it, to create more debt).
Banks create debt (and make money) through a process called fractional reserve lending. In simple terms, what this means is that a bank only has to keep a fraction of the amount of money on its books in reserve, as liquid money that you could go into the bank and actually withdraw.
So, say you put $10 in a bank. The bank keeps $1 in reserve against your $10 and loans out the other $9 and charges interest on the loan, thus making a little money.
Now here's the tricky part:
The person who borrowed that money can (and usually does) walk across the street to another bank and deposit that $9. That second bank will keep .90 cents and loan out $8.10. A total of $17.10 has just been created out of thin air by the two banks (the first $9 loan plus the second $8.10 loan that is probably already on its way to sit in Bank #3 until it is spent).
As crazy-making as this sounds, it works out so long as the money lent out is spent fairly quickly on real goods or services or anything else that adds value to the economy underlying the whole transaction. Usually that is exactly what happens.
It's also important (if a fiat money system is going to work) for the banks to make responsible decisions about how money is lent and to whom, how much is lent out and to whom, and for limits to be placed on how small the fraction can be that the banks must keep in reserve.
If the banks keep a fraction of a fraction of a penny of each dollar deposited, that's asking for trouble. If the banks take the money to be loaned out and use it go gamble on the stock market, that's another potential huge problem.
If the banks can gamble all the money loaned out on the stock market and do it many times over and over (using the same money) by inventing 'products' out of debt that are then sold and resold on the stock market (leverage, securitization) that can go batshit-bad really, really fast.
Last but not least, since the government controls and prints the money supply in a fiat money system, the government also has to observe some basic economic principles or the whole system goes out of whack.
If the government prints money and creates debt but does not turn around and add value in the form of goods, service, or improvements, the value of the money drops and the society experiences inflation: too much money chasing too few goods.
Governments can do this by waging pointless wars (lots of money printed, no value added), propping up failing businesses (lots of money printed no value added), failing to regulate the banks (gazillions of dollars created out of thin air, no value added), or collapsing the boundaries between retail banking (your local bank that keeps your checking account) and investment banking (Bear Stearns, Lehman Brothers).
So, the dark side of fiat money is debt.
Debt can be used as capital to make the economy stronger (either by government or individuals), or it can be squandered or used to fuel enterprises that suck out profit without adding anything real to keep the money stable.
When both kinds of debt are being circulated--bad debt that fuels imaginary money and good debt that provides capital for actual business expansion, goods, services, and jobs--then we have a Gresham's Law scenario with fiat money.
Bad money drives out good.
That's what has happened today. The bad money has driven out the good money.
Now What?
In 1950, manufacturing comprised 29.3% of the Gross Domestic Product of the United States and financial services comprised 10.9%.
By the beginning of 2005, financial services had doubled to comprise a whopping 20.4% of GDP, while manufacturing had plummeted to only 12%.
These figures are taken from a report compiled in November of 2004 by the Bureau of Economic analysis entitled "Gross Domestic Product by Industry." Today, in mid-2009 with the American auto industry in free fall and unemployment headed into the double digits, these figures are almost certainly much, much more dramatic and unbalanced.
While we were shipping all our industry and good jobs overseas, the U.S. financial services sector was aggressively marketing consumer debt so Americans could keep buying things that other nations were now making. (The infamous 'consumer economy'.)
In 1974, outstanding household debt in the U.S. totaled $680 billion. That's a lot of money, but nothing compared to the thirteen trillion dollars it had morphed into by 2006.
In 1969 domestic debt was 12% of GDP in the U.S.
By 2006 domestic debt was 107% of GDP.
So right now, we have lots and lots or fiat money backed by not much in the way of real goods, real services, real economic growth.
We have bad money.
Now what?
Hey, do you really think I have an answer? Are you serious? I mean, come on! If I did, would I be writing for Hub Pages? Would I be sitting in my living room in Michigan with Ghost Hunter's on the TV in the background wondering if my Adsense revenue will make up for the jobs I'm not scaring up this week over at Elance?
Get real!
But I can tell you what the U.S. is not doing about our bad money right now:
We're not regulating the financial industry.
We're not finding a way to revitalize manufacturing, to keep jobs in the U.S. or to add real value by supporting businesses that produce real products or real services. We're not monitoring the Federal Reserve (which monitors the money supply), or keeping investment banks out of your back pocket. In fact, we're letting investment banks regulate the investment banks.
Yeah, that's a good idea.
In short, the U.S. government is currently not only allowing the bloated, top heavy, out-of-control financial sector to suck profit out of the cadaverous U.S. economy without adding value back in, it's helping the financial sector suck profit out without adding value back in.
I'm no financial genius, but I'm thinking we might start a true recovery by taking that bad money out of circulation. Stand up to the banks. Make them stop hoarding the good money. Make them accountable. Start adding real value, instead of just sucking profit.
That's my personal suggestion.
I don't think for a minute this is going to happen without bloodshed. What I mean is, I expect there will be a further collapse of the U.S. economy, or even a further collapse of the world economy. It will get uglier and uglier. If we press for real reform now, instead of later, maybe we can prevent some of that ugliness. Economics is not rocket science, financiers just try to make it sound like rocket science to keep their hands on the wheel.
We keep hearing about the 'first green shoots' of recovery starting to show. There are no green shoots. You know this, don't you? The media and the government keep going on as if any day now (Bernanke claims by the fourth quarter of this year) people will starting spending again and the 'consumer economy' will be back.
I just want to know one thing:
Start spending what?
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Comments
Hi Mike--Thank you for the kind words about the article. I agree with you though that we are unlikely to be able to effect any change until things get way scary-bad. Sometimes I think that it isn't a moral issue at all, even though it's so easy to frame it that way. What I mean is, there are from time to time these huge tectonic shifts in the way society is organized: the development of agriculture, the industrial revolution, the invention of the automobile. I think sometimes that we may be approaching one of those shifts, and what we are witnessing is a more value-neutral destruction of the old system. I know that sounds kind of 'woo-woo-! LOL! I like to think of it like that though because it makes me feel both less angry and less powerless. Thanks for your thoughts. :)
I've never being to happy about morality as a concept. It is often just one of those emotional tools used to manipulate and control people.
And while social structures change in terms of going from agrarian to industial the structure of humans tends to stay the same with those at the top doing quite nicely and those at the bottom doing quite badly. And I genuinely don't think that structure will ever change overall. It is the natural human social order. All you can do is to try and alter your position as an individual within it. And on that dismal note: I'm gone again.
The rich get richer and the poor get children. :)
Same as it ever was.
Graet hub Pam, and I LOVE that title. Bad money. Yes. I don't think you quite got the FRAUD that is fractional reserve banking however. In your version it almost sounds like the first bank actually has the right to lend out that money as they have it on deposit, when the truth is that out of that initial $10 the bank has the right to lend out $100 thus creating $90 out of thin air (ninety fictional dollars you might say) and charging interest on it, thus debasing the currency even at the moment it is being created, after which that $90 goes into another bank, and then another, and then another, more and more fictional money being lent out on the back of it, all of which acrues interest to the banks. And if this isn't insane, I don't know what is.
I think your response to Mike's comment hits as close to home as we can get to right now. What you call the "tectonic shift". No gradual shift will do it. That's why Obama, for all of his good intentions, is destined to fail. That new set of "values", which has resulted in the total unaccountability of business and government, and its representatives are simply too deeply-embedded to be removed by consensus. So this shift, like the ones you named, will be "bloody" and probably bloody. Our Founding Fathers tried to break from a similar corruption (both social and economic) logically and peacefully, but were left with only the violent means.
In my view, for what it's worth, the essence of the new shift must be collectivity of some kind. (It's interesting to me that the powers-that-be and their opinion makers have made "collective" a dirty word through their preoccupation with "cults".) But even though the natural instinct of all people affected by this criminality is to do what Mike suggests - take care of yourself, that is the wrong way to go, because it leaves us powerless against the institutions that represent the cancer. Both financially and spiritually, our strength lies in coming together. Our separation is what has kept us weak.
I have lived in a collective, and I am now responsible for a large family. So I know the good and bad of people living together beyond blood. It is hard work . . . certainly not a utopia. But our individualism, at least the way we've been brain-washed into practicing it, is our undoing.
Damn, I sound like some sort of communist. But that's not the case. This country is based on collective living. When people first came to this continent, they had to come together to survive. And the colonies were able to defeat the British, against all odds, only because they were able to overcome their differences just enough to support an army. Collective living is a big part of the good side of our history.
Mike is right that most shifts eventually leave power in the hands of more or less the same people that caused the problem. That is what seems to be happening now. My thesis is that the reason that bit of history keeps repeating itself is that society at large never manages to grasp the spiritual and practical principle that two men coming together are greater than the sum of their parts.
Well said, Pam. Your conclusion is right on. I'm pretty sure you're right. But then, we wouldn't want to start scaring people, now, would we. Gag. Great article. Nice follow up (or continuation) to your "What is the Gold Standard".
Again you demonstrate why you are my favorite hubber. Now to the bat-shit bad. You got it right but you must remember the government can only produce more government- no value added at all. Maybe we can get some fiscal conservatives elected in 2010 and stop this slide into socialist chaos.
Hi CJ--Even as I was writing the fractional reserve lending part I thought to myself, "I'm making this sound way nicer than it really is--it's so much worse than this times 10000," but I was going for simplicity. I actually think that a separate hub on the topic alone is worth doing, because I know you're right--it so much more rotten than that. If you're interested, the Kevin Phillips book by the same title is very good. Don't buy it. I'm sure it's at your local library and if not, I'd be glad to lend you my copy if you weren't across the ocean. It's more technical, but the data he presents in that book will just blow your head off. This is so much worse than most people realize. Thanks for your comment.
Steve--In my more hopeful moments I imagine a post-financial apolcalypse society that is more tribal, more local, more cooperative, and kind of a cross between high tech and agrarian. kerryg here at HP has imagined such an eventual outcome too, but like you, I think the path from here to there will not be very pretty.
It really is hard to reach out right now, isn't it? The 'culture wars' are alive and well and seem to cancel out any attempt at populism that isn't empty rhetoric. I think things will have to get worse by several measures before people are willing to come together over these issues. I don't count those foolish 'tea parties' as coming together.
Frieda--Thanks. It's one thing to articulate what's wrong. It's another to do much about it. It's really very frustrating.
RV--That's the problem isn't it? We haven't had a fiscal conservative in EITHER party for over 30 years. The Republicans lost their way--I don't see that party as holding conservative values anymore. And the Democrats, with a few exceptions, have all sold out to finance, oil, and the insurance lobby. So we're left with a government that spends for the rich and ignores what the rest of us want no matter which side gets in.
Actually this is more of a response to Steve Rensch, above.
I wasn't really suggesting that you only think of yourself, but that you think for yourself. A small difference admittedly but an important one. While two people working together can achieve more than an individual that will only happen where those two people both have an objective to achieve that is compatible. Which means they both have to think for themselves and make a decision about what it is they want and how they are willing to achieve it. And the simple fact for me is most people simply aren't willing to do that. They look to "leaders" to supply them with answers on a plate, and that is exactly what those leaders then do. Except the answers they supply are the ones which profit themselves, not the people they claim to want to help.
And it is that intellectual irresponsibility by the masses that allows the same social situations to keep reoccurring. Until they stop being followers and mature enough to view democracy as a partnership of equals and make decisions for themselves they will continue to allow themselves to be ripped off. Those who can see it happening aren't sufficient in number to prevent it, and boy is it frustrating.
They sell themselves in to servitude to a leader and get ripped off, so they dump that leader but then simply elect a new leader to sell themselves in to servitude to and so simply get ripped off again.
Quite why so many people are so terrified of actually thinking and making decisions still evades me, perhaps Pam knows, she's the one with a psychology degree.
Another great hub, Pam - a really good explanation of the processes behind the impenetrable wall that is money. Like you, I hope for the best and fear for the worst. If things go tits-up over there, you have a home in Greece!
Once again, I find myself agreeing with Steve about the strengths of unity, at least on a small scale. The Money Guy uses the phrase 'Agrarian Socialism,' and I like that - this is what we have here!
Hi Mike--No answer to that one, I have no idea why people seem to have an aversion to critical thought, but yes, it is frustrating.
I do think Americans have an anti-intellectual streak that runs very deep, and in recent years has morphed into something like being proud of one's own ignorance, as if ignorance isn't just bliss, it's also virtue.
I also think that looking at political leaders as if they are a cross between celebrities and babysitters doesn't help matters, and then if you factor in the culture wars and the fascination with managing other people's morals instead of dealing with issues one at a time drags us all down even more.
Lack of education matters though, because if you don't value education and you don't feel the need to educate yourself, then the stupid polarized World Federation Wrestling match that passes for political discourse in this country seems reasonable. In many large American cities 70% of the kids who start high school never finish. And we wonder why we can't think.
Hi Sufi--I like that phrase too, "agrarian socialism". I never heard that before now. If things get ugly I'll for sure take you up on that Greece offer! Actually I'd love to go to Greece even if things don't get ugly. But they will get ugly of course. I think 2010 will be way worse than 2009. I hope I'm wrong but I don't think I am.
You don't think this recession will improve this year, Pam?
The Money Guy's phrase - I have that feeling that he was preparing for this a long time ago. I hope that you are wrong, too - it looks like you guys are having a difficult enough time over there. Besides, most of my clients are in the US :(
You are welcome anytime - Greece needs tourists!
It ain't just America, Britain is just as bad. The tabloid press will savage anyone who attempts to open an intelligent discourse on a subject that is possibly detrimental to their wealthy owners. And so most people don't even try as they don't need that much misery in their life.
Although I agree most humans seem to have a fascination with what others are doing, possibly in an attempt to not have to face what they are doing. No doubt that's why there are so many gossip mags and avoiding-reality TV shows. It is easy to make simple decisions about what others should do, or be forced to do, rather than the much more complex issue of making a decison about what you yourself are going to do. The old existentialist angst.
Power to make decisions for others comes with less personal suffering attached than making decisions for yourself that you have to live with, for better or worse.
Hi Cindy--No, I don't seen how it can be better in 2010. First of all, the real estate market has not bottomed out yet. Foreclosures are still increasing, unemployment is rising. Businesses are still going bust because commercial credit (which typically renews on a 5 year basis) is still frozen, so there are all these commercial defaults on the horizon. GM is not out of the woods by any means and could still disappear entirely--there's another 3 million jobs gone (if you count parts suppliers, the service jobs in and around the factories, etc). Credit card defaults are at an all time high and climbing. What economy can they possibly be talking about? Which economy is going to turn around this year? The US economy? I mean, how? I'd be happy to believe it but I don't any reason on earth that it will except that Bernanke says so. Every single person in my family who still has a job has taken a pay cut, a benefits cut, and has been warned of possilble lay off or termination within the coming months. Every single person. I mean, people have to have money to spend money, and most people have to have jobs to have money.
So yes, I do think it will get worse, much worse, before it gets better. Already they are talking about a second stimulus plan here because the first one was inadequate. At some point you have to stop and ask, what are we stimulating exactly? Are we trying to revive "the consumer economy", the one based on debt and imaginary money? Why? I think we should let that economy die and create a healthier one, but that would involve getting tough with the financial industry and that's not happening. It won't happen either. Not soon anyway, not soon enough to prevent a collapse.
Sufi--I guess I'm gonna half to trot on over to TMG and check all that out. (And also start saving for that airline ticket!)
Mike--Yes, what is happening the US now kind of reminds me of what happened when Britain lost its industrial base, but the US is so big, it could drag everyone down.
With all this being said, no one should be surprised with the economical climate we live in today...I think women should run the worlds finances!
Nancy's Niche:
"...I think women should run the worlds finances!"
Man, aren't we in enough trouble. Now excuse me while I go and hide!!
Nancy & Mike--LOL! No comment. :)
I know our governement in the the UK is in deep doo doo, as far as money goes. Interesting but worrying hub
Thanks ethel--I appreciate you reading it.
You so hit the nail square on the head on describing what Obama is doing right now. Borrow, spend, and print money.
We are in rough time if this continues, then on top they are trying to push through this stupid cap and trade, which has the potential to raise the prices on everything, and close down a lot of industries.
This endless, mindless spending has to come to an end.
Keep on Hubbing!
Hi eovery--I really think blaming Obama for it misses the point. This has been coming for years. Democrats and Repulbicans both had a hand in selling us out, and it didn't happen overnight. Thanks for your comment though. :)
There are no such things as Democrats and Republicans there is only the party of money. Great Bat-Shit Hub you have here Pam. I think it is your best yet.
In the Financial services Industry we call what you describe as the multiplier effect. Fancy term for the same thing you said. I saw another comment that put in how the First bank gets its money from thin Air.
I thought that was just a little too simple to leave it alone. The first Bank Does not get its money to lend from thin Air. Nor do the rest of them. They get that money by borrowing it from the Federal Reserve at the infamous Fed interest rate the news is so found of discussing.
The Fed gets that money by selling Debt Obligations on Behalf of the Treasury. That's right the National debt is the thin Air that all of that money comes from. So how much does the Fed Charge the Taxpayer to create all of that debt for us?
A little known provision of the TARP act was a single line changing how much the Fed charges us from 6 percent to 8 percent.
How is that for Bad Money? The Fed is not charged tax on its profit it simply pays that amount too its shareholders. Who are these Shareholders? That is right they are the member banks. So they create money and Debt and make a cool 8 percent off the top from the taxpayer, before they ever start charging interest to us lowly consumers. It is a mathematical impossible to ever get rid of the debt when you always owe more than the money placed in circulation.
There is no reason for a politician to change this system, as they get paid quite nicely to leave it the same. The downfall of all great societies, the moment they realize they can steal from the public coffer.
TMG
mike - I knew where you were coming from, and I'm sorry that my characterization of your point sounds a little curt.
I believe people will only speak out in the way Pam and Mike advocate when their lives are even more crushed than they are now. The question is, when that times comes, and people rise up, what leaders will be waiting for them? The sort of leader we were blessed with during the American Revolution who could turn the win into something really different and enlightened and long lasting? Or the sort of leaders that the French were left with after the French Revolution, which resulted in the preeminence, after just a few years, of the same sort of people who created the original problem? I have not seen those leaders that we need yet.
I'm coming from your Gold standard hub, this is a fantastic follow up and, like I said, I think you're a financial genius :-) I don't know what's the breaking point where value as opposed to debt will begin to be created again, but I agree that financial regulation would be one of the first measures that should be taken to that effect. Actually, not regulation (which already exists to an extent) as much as control. E.g. the regulation on how credit could be given to people and how much of it was present and accounted for here in Spain (for example, you couldn't take a loan on the whole price of a house, just 80% to ensure you could back up that house with value, or you couldn't take a loan for a new car if it put more than X% pressure on your existing debt) but the problem is those rules were set aside and disregarded, simply ignored. Had they been enforced, we'd be in chaos anyway but with a lot less people out in the digs. Oh well, this is a lesson I don't think Mr Greed will learn any time soon... reather depressing.
The u.s. government neither controls or prints the currency. The entire operation is privately run for profit.
The government borrows its money just like everyone else and pays interest on it.
Just as a little side note, no money is ever printed for the purpose of servicing the debt created by interest. The debt is simply allowed to grow indefinitely.
Hi CWB--I'm sorry. I was trying to write a companion piece to the Gold Standard hub--one that explains the kind of money that isn't backed by gold, a fairly technical explanation--and how that kind of money can go 'bad'. I guess what I should have written is, "The Fed is an privately-owned evil cabal of the uber-rich which totally controls our government to its own dark purposes." Apparently that's the only acceptable statement to make about money on the internet these days. Sorry for deviating.
Sorry pg. Just making an observation. Didn't mean to offend.
Absolutely brilliant hub pgrundy. You have explained the concept of bad money really well. I hope US understands the value of regulation. Keep up the good work.
Thanks Jay!
CW--Sorry to snap. Having a less than ideal day here. No worries. ")
thanx for such nice info about bad money
its amazing
i have liked ur hub
u have just given the worthseeing knowledge here in ur hub thats full of applause
i felicitate u
The problem now unlike the 1970's is that now we cannot deliver to the world bad money. That is, the dollar must keep value because we are bound to the Chinese as creditors. We have a boat load of bonds to sell and the government may decide to scare people out of the stock market and into bonds to make the Chinese happy. I wonder if that will happen and discuss it in an update here: http://hubpages.com/hub/Why-Goldman-Sachs-Is-Commi
Mike Craggs says:
4 months ago
At last I have found someone who can explain these things in terms I can understand.
A brilliant post -I liked the gold standard one as well - but I still think all us "little folks" are well and truly screwed (to use a technical expression) and will be for some years to come.
The people who need to do something about it are the ones who are still gaining wealth and power by keeping things as they are. Catch-22.
Eventually even their personal finances may hit the wall, at which point they will look to change things, but all us poor folks are going to take a hammering until they do.