The US Dollar, How does it Work!
Money as a concept has been around for hundreds of years. Prior to paper or fiat money as we know it nowadays, there were coins made from silver and gold which served as the monetary medium for societies. With the introduction of paper money, banks started to issue bills that are a lot easier to denominate, store, and spend.
Posted by Hicham ALAOUI RIZQ on 02 May, 2023
Money Backed by Gold
There was always a key behind printing and issuing these paper money, Some reserves backed this money. Which means, that the dollar you have in hand, you could theoretically exchanged it to some precious metals. In most cases, this was “Gold”.
This convertibility mechanism of paper money, creates a certain level of confidence among those who held it.
This consensus limited also the potential of the damaging inflation for the economy, because the amount of money issued in the system is naturally limited by the amount of gold that is kept in reserves.
During the great depression, the convertibility from dollar to gold was an oppressing issue for the federal reserve, because simply, it limits the money supply and leads to a deflation which is damaging the economy.
The FDI, afterwards issued an executive order which makes owning gold illegal, and require everyone to convert it into US dollar.
In a short time frame, the Oz of gold jumped from $20 in 1933 to $35 in 1934. Which depreciated the US dollar, therefore, that executive order comes to set a governance price for the gold.
For US governance, the gold standards was not ideal, but at least it kept a certain degree of confidence in the value of money and when applied correctly, it could prevent hyper inflation.
Bretton Woods Agreement
US Dollar at center
In 1944, Most of countries who were adopting the gold standards, signed what we call the Bretton Woods agreement. This agreement states that, all national currencies should have the value in relation to the dollar. This agreement made therefore, the US Dollar, the dominante reserve currency.
Currencies were convertible to dollar therefore to gold at a fix rate of $35 per ounce.
The Bretton Woods agreement had a decent run until 1971, when Richard Nixon, the 37th U.S. President made his pitch to terminate the convertibility of USD into Gold. Nixon set the wheels and motions for the current fiat money system that we know today, A glorified confidence game backed by nothing.
In August 1971, Nixon states that the US government will suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in a amount and conditions that serves the dollar stability and interest.
This suspension turns out to be permanent and it ended up all sort of illusion that dollar or other currencies would have a conversion to gold.
The US Dollar
After the abandonment of the gold standards, the paper money only has value because the people agree among themselves that it has value and the federal reserve said it.
Fractional Reserve Banking
The money you think you have in your bank is not actually there, Surprised? Hold on. I will explain!
The fact is that the banks lend out your money to many of the bank's other customers. And banks have permission to do this because of the fractional reserve system.
Banks have to keep a certain amount of liquidity in relation to the loan they give to customers, this minimum liquidity reserve would meet the often demand of the bank's customers to withdraw money from ATMs or a deposit kept with the bank.
This fancy term in finance would suggest the practice that banks and also brokers use the money of any customer for their own purposes in an exchange for a compensation through lower cost of borrowing.
What the banks hope in this situation is that only a small proportion of their users will actually withdraw their money. Hence, they keep small liquidity in their deposits in this case.
The bank run
Well, You would probably conclude that Rehypothecation is incredibly risky! Yes, it is.
What happens if all depositors come at once and request their money back? Well, then you get what is called, a bank run.
A bank run happens when all people rush to withdraw their money all at once which will result in a liquidity crunch where the bank can not pay back all its depositors.
The bank crunch happens more usually because of rumors that a bank is facing a shortage of funds, which leads to people running to withdraw all their money at once, which is pretty scary.
Not only banks with short liquidity but also those who are in strong positions are susceptible to a bank run. People hear about one bank facing a run, so they rush to their own banks to withdraw their funds.
This panic due to the bank runs, lead to the formation of the FDIC or the Federal Deposit Insurance Corporation, an insurance that covers the loss of balances of less than $250K per depositor, per insured bank for each account ownership category. Those with balances above that average are still at risk of a loss.
The best example of a bank run was in 2008 with Lehman Brothers, where financial institutions started to withdraw their deposits which leads to a massive liquidity crunch. Moreover Euro crisis in Greece and Cyprus in 2010. So much so that the government had to place a limit on the number of people who could withdraw from ATMs, only 60 Euros per a day.
Multiple Effect of Money
Fractional reserve banking places a fundamental role in the multiplication of money. The feds or the equivalent central banks are the ones who determine the reserve ratio for banks. which is the minimum amount of deposits that banks must hold in liquid securities in order to meet their obligations.
This stock of money that is kept in near-term deposits refers to what we call the M1 money supply. It's the money that includes, coins, notes in circulation, and other money equivalents that can be easily converted.
As everyone knows, banks have the right to give loans to their customers, therefore increasing the broad money supply in the monetary system, Here is a concrete example..
For example, if the federal reserve requirement is 5%, The banks have the obligation to hold only 5% of their balance sheet in their reserves.
The other 95% is free to give as a loan, Which means that banks could lend out 20 times the amount of money that is kept in their reserves. This is what we call the money multiplier effect, which means that the money that exists in the economy could be many multiples of the money that actually exists in the banks.
Besides the M1 money supply, You would hear about M2, M3, and MZM (Money Zero Maturity ) money supply.
M0 and M1 are narrow money and they include coins, notes that are in circulation, and other money equivalents that can be easily converted to cash.
M2 includes M1 and short terms time deposits in banks and certain market funds.
M3 includes M2 in addition to long terms deposits.
At last, there is the MZM, or money zero maturity which includes financial assets with zero maturity which are immediately redeemable. The federal reserve bank relies heavily on the MZM data because its velocity is a proven indicator of inflation.
The chart above shows the evolution of the M1, M2 money supply over the past years. The spike within both M1 and M2 happens only during the Covid pandemic, which had a massive impact over the money board money supply. Was it because the feds printed more money? Yes, that's the slight tick over M1 supply, but the M2 spike is related to another factor.
The federal bank have usually three tools at their disposal to impact boarder money supply.
In order for the feds to increase the economy money supply, They have to increase the reserve ratio. vice versa for a contraction of money supply.
The reserve ratio itself ranges from 3% to 10% for number of years, this made sure that banks had reserves that are broadly inlines with their activity, the banks who are viewed riskier, had to hold more reserves therefore, more restricted in their ability to create money.
Here is the end of story for the reserve ratio. Along the global pandemic, in Mars 2020, the feds had to drop the reserve ratio to 0% for all banks. In other words, they eliminate any needs for reserves at all.
The banks are not really required to keep reserves in order to meet withdraw request, they can effectively loan out as much money as they want into the economy therefore inflating the M2 money supply.
Here is a fun fact, almost the 5th of all US money supply in existence was created in 10 months in year 2020.
Jerome Powell: As a central bank we have the ability to create money digitally
Excess money Vs Limited goods
When free money and easy credits are out in the monetary system, It's quite hard to bring them back in without economic damage. That's because flooding the system with an excess of money supply that chases limited goods, would lead to a pretty crazy levels of inflation.
Decentralization hence, blockchain would be the key for a better economy.