Sometimes I think economics is about finding a host of synonyms for the word "money". Why do you go to work? To make money, of course. But economists prefer to say you earn a wage. Or, if you’re a big shot, a salary.
Businesses sell us things to get money, but economists prefer to say they make sales to generate turnover which, after they’ve paid out a lot of money on wages and rent and many other expenses, leaves them with money called income or profit.
Economists do talk specifically about money, but they define it much more narrowly. Consider this: how would you like to live in a barter economy, where you’re paid with some of whatever it is you’ve helped produce, then have to exchange those things with other people for some of the things they’d help produce?
It would be a hugely cumbersome and time-consuming business. Which is why, a long time ago, someone invented money. We get paid with money, which we use to buy the things we need. Much simpler and easier.
That’s what economists mean by money – a means of paying for things; a "medium of exchange". To an economist, money has little intrinsic value. It’s the things it buys that are valuable.
Economists mainly focus on those valuable things – what’s happening to them and how they work - and ignore the money used to buy and sell them.
It’s true, of course, that economists and the rest of us put dollar values on all those things – prices of the goods and services we buy, the value of the houses and other assets we sell.
Expressing the value of so many and varied things in dollars makes it easier to compare them, add and subtract them. So another part of economists’ definition of money is that it’s used as a "unit of account".
(This, however, exposes a big limitation of economics. There are a lot of important things in life and the economy whose value or cost can’t be reduced to a dollar figure. Things like love, trust, honesty, anxiety and stress. Economists are always forgetting to take account of factors than can’t be measured in dollars.)
Of course, not all the money than comes our way is spent immediately. Some of it we save to spend later – sometimes much later. Which means the third requirement money must fulfil is to be a good "store of value".
But now we’re clear on what money is, the big question is: where does it come from? How is it created?
Well, we know that coins and banknotes come from the government. Notes are printed in Melbourne by the Reserve Bank; coins are made in Canberra by the Royal Australian Mint. The Reserve sells to the banks all the notes and coins they want.
But notes and coins account for less than 4 per cent of all the money in circulation. Most of us hold most of our money on deposit with the banks.
In principle, the Australian dollar is a creation of the Australian government. Like almost every currency these days, it’s a "fiat" currency – meaning it has no intrinsic value: notes are just pieces of paper, and the metal used to make a $2 coin is worth a small fraction of $2. An Australian $50 note is worth $A50 purely because the government says it is.
This also means the government could print – or credit to people’s bank accounts – as many dollars as it wanted to (though not without ramifications).
But here’s the trick: although that is true in principle, in practice money is created by the banks. As Emma Doherty, Ben Jackman and Emily Perry explained in the Reserve Bank’s Bulletin last year, money is created when banks make loans.
The bank either puts the loan money directly into its customer’s deposit account, or pays it into the account of the business selling whatever it is its customer needed the loan to buy. Either way, since money is notes and coins ("currency") plus bank deposits, the amount of money in circulation has just increased.
Amazing, eh? But before you run away with the idea that a bank could create as much money as it wanted to, there are two further points to understand.
First, there are obvious limits on how much money the banks can create. For a start, they’re not giving it way, they’re lending it. They must have a customer wanting to borrow at the interest rate charged, and likely to be able to repay it.
And the banks also need to be in a position to make the loan. They must keep a sufficient share of their assets in liquid form (cash) to be able to meet any withdrawals the new borrower makes from their account, as well as to meet any withdrawals by existing borrowers.
This pretty much means they need to attract more cash deposits to support the loan they just made. The banks’ loans need to be backed up by enough capital, supplied by shareholders, in case borrowers can’t repay their loans or other bank assets fall in value.
All this is necessary to ensure the banks don’t collapse. So these factors imply that creating money comes at a cost to the banks, which limits the extent to which they can increase their loans.
Second, an individual bank can’t create money in this way, only the banking system as a whole can. That’s because the bank that initiates the loan can’t be sure that all the loan money spent comes back to it as deposits. Some of it will, but most may go to other banks.
Next week it’s back to talking about the things we do with money.
