How does money work? “You don’t talk about money, you have money.” It’s a widespread saying that many hold on to. Today we are breaking with these conventions and talking about them: What is money actually? Where does it come from and how does it work?
Why doesn’t a state just print tons of money when it’s broke? The word inflation should be familiar to everyone, but what exactly does it mean? Even though we deal with the topic of money in one way or another every day in the finance sector, it is not clear to everyone what is actually behind it – and let me say this much: it is a whole lot.
Where does our money come from?
How does Money work? To understand that, we need to know where it comes from. Money outside the office is also an everyday thing: you go to the cash register in the shop, open your wallet and pay either in cash, with a card or, in the meantime, with your mobile phone. Of course, that wasn’t always the case. So let’s make a leap about 9,000 years into the past, when people traded goods for each other – for example, animal skins for firewood. Even then, however, the exchange was not simply 1:1. The exchange ratio was based on the value of the goods as early as 7,000 BC. For particularly rare or difficult to obtain and therefore valuable objects, one could exchange many other things. For a handful of rare and hard to imitate cowrie shells 4,000 years ago in Saudi Arabia, for example, you could buy a whole cow. The problem here: “a handful” is a very vague indication of quantity. So you needed a “currency” that you could better define.
Birth of the banknotes
This is where the Lydians came into play: they were a tribe of people who lived about 3,000 years ago in the west of Asia Minor. They took precious metals such as silver and poured small coins from them. These coins had a certain weight and thus a fixed value. To make them easier to recognize, they were minted with the seal of the Lydian king Croesus. This “currency” spread very quickly. Fun fact on the side: The Romans also adapted the idea and minted their coins in the temple of the goddess Moneta.
Someone who traded a lot now had the “problem” of having to carry too many coins around with him. This was the birth of the promissory notes. Instead of 10 coins there was only one promissory note for 10 coins. With these so-called notes you could exchange your money at a bank. The first banknote is said to have been issued in Sweden in 1661. This concept also spread rapidly, especially among merchants, and paper money increasingly replaced coinage. Another fun fact: On today’s 5 pound note of the British it still says: “I promise to pay the bearer on demand the sum of five pounds”. However, this sentence is only written on the banknote by tradition. The exchange obligation no longer exists, and for good reason.
Other sources write that in Spain the first paper money was issued in 1483. And in China there was paper money already before 1000 in the early Song Dynasty. But it was abolished in 1402, because paper money is only a promise of the issuing bank or the state. And at that time paper money was issued without this promise being kept by the rulers. Which then led to strong inflation.
And gold, for example – unlike a piece of paper printed with a number – cannot be multiplied at will (just as the bitcoin was invested) and therefore has an intrinsic value.
Gold Standard
In the middle of the 19th century, gold established itself in most countries as the equivalent of banknotes and coins. As a rule, banknotes could only be issued if their nominal value was 100% covered by gold or government bonds.
In order to finance the First World War, the decision to suspend the obligation to redeem banknotes with the intention of restoring the economic balance after the war through reparation payments was deliberately taken. This meant that more money could be printed than the equivalent in gold. The result: the money is suddenly much less valuable. At this point, the memories of history lessons and the photos of people with wheelbarrows full of money certainly come up in many people’s minds. Because that’s exactly the result. The German money supply grew many times over during the war years. The years after the First World War were marked by hyperinflation, reparations and wildly fluctuating exchange rates. The original plan to restore economic equilibrium through reparation payments did not work, however, because after the unexpected defeat these payments now had to be made instead of being collected.
With the currency reform on 15 November 1923 a new monetary order came into force, which abruptly ended inflation. With the issuance of new means of payment, this stabilization of the currency was achieved, with the amount of issued means of payment linked to the determination of the gold standard.
With the onset of the global economic crisis in 1929, the gold standard again ran into difficulties. On 19 September 1931, the suspension of the gold convertibility of the pound sterling symbolized the collapse of the international gold standard. The subsequent departure of the USA from the gold standard also triggered a chain reaction. In fact, a system of flexible exchange rates emerged until representatives of 44 nations met at the Bretton Woods Conference on 1 July 1944. All participating countries agreed fixed exchange rates against the US dollar and the US Federal Reserve in return undertook to exchange dollars for gold at a fixed rate for central banks of all participating countries. The International Monetary Fund (IMF) was created to ensure the functioning of the system. The global currency chaos was dissolving rapidly. It came to the economic miracle of the 1950s and 1960s.
The end of the Bretton Woods system
The Bretton Woods system suffered from design flaws from the outset, which became increasingly apparent over time. At the end of the 1960s, the USA recorded economic growth, but also rising inflation and rising current account deficits. The system began to falter. In May 1971, the German government decided to release the DM exchange rate. The dollar collapsed in the following weeks. In August of the same year, the then US President Richard Nixon stopped the nominal gold bond of the dollar. In 1973, the Bretton Woods system was officially suspended. After the termination of the Bretton Woods Agreement, exchange rates were liberalized in most countries.
Consequences for the global monetary system
After the failure of the Bretton Woods system, there were strong international exchange rate fluctuations. As a result, the countries of the European Community merged to form the European Monetary System (EMS), which limited exchange rate fluctuations between member countries. Today’s world monetary order is a mixture of a system with fixed and flexible exchange rates. There is a freely moving exchange rate system between the countries of the EMS and non-member countries such as Japan and the USA. The EMS ended with the introduction of the euro. The EMS II introduced the Exchange Rate Mechanism II (ERM II) as a successor arrangement for the EU countries that are not yet members of the Monetary Union.
Credit money creation – what is it?
When someone takes out a loan from a bank, whether private or public, the commercial bank borrows money from the central bank. These commercial bank liabilities are redefined as borrowers’ credit balances. This means that loans granted by banks are credited to the borrower’s account. This “credit balance” can be deposited with the central bank as collateral for new loans. The money provided is not matched by any real values. New money is thus created with each loan. Experts therefore speak of the creation of credit money. There are hardly any limits imposed on the banks here. However, the Bundesbank tries to control the money supply indirectly. One instrument for this is the minimum reserve already described.
Book money is Virtual Money
Book money is also called cheque money or commercial bank money and refers to virtual money that the customers of banks can dispose of at any time in the case of sight deposits. Time deposits are excluded. Book money is a means of payment that can be used in banking by transferring funds from current account to current account by means of bookings. This also includes, for example, checks and transfers. In economics it is usually compared to cash.
Book money can arise either from cash being deposited or transferred into a bank account, or from credit being granted by credit institutions, which in turn creates credit money.
Crypto Currencies
Crypto currencies are digital means of payment that are based on cryptographic tools such as a blockchain. Find out more about blockchain on Google. In 2009, Bitcoin, the first crypto currency, was publicly traded. The accounts for this currency are called “wallets”, are anonymous and encrypted. Further advantages of the crypto money are the fast transactions as well as the low costs. Crypto currencies are not recorded centrally, but are managed on millions of computers of many users. The processes can be viewed by everyone, but they are anonymous. This is exactly where criticism often comes in, because in this way illegal goods can be purchased anonymously. Security is also not completely guaranteed. In August 2016, anonymous hackers stole Bitcoins worth around 58 million euros. At times, the Bitcoin rate fell by 20 percent. Nevertheless, crypto currencies are booming and enjoying great popularity.
In the course of the trade conflicts between the USA and China, many people rely on Bitcoin as an alternative to the “classical means of payment”. Between the beginning of April and the end of May 2019, digital money increased by 75 percent. From 01 September, for example, the regulation that companies are allowed to pay their employees in crypto currencies also came into force in New Zealand. Bitcoin and Co. seem to be on the advance. Nevertheless in my opinion crypto currencies are to be enjoyed with caution.
We hope we could answer the question: How does Money work and that your decisions will be wiser and smarter with your money!
Want to know more? Have a look at How to get out of the trap of the 9 to 5 scam?
If you want to know more about the History of Money, have a look at the History of Money on Wikipedia