Understanding money

and the fiat financial system

Dr. Peter Schmidt

FINC 489 Seminar in Finance: Intro to Bitcoin
 Getting oriented …
• Economics is always about
exchanging one good or service for another
... the beginnings
 Getting oriented …
• Economics is always about
exchanging one good or service for another

• Economies prosper with …

– Specialization and division of labor
– Capital accumulation productivity increases

• But division of labor requires trade!

No coincidence of wants
You have … … but your hairdresser doesn’t like apples
 Value mismatch
You offer … You want …
 Time mismatch
You have to trade … You want …

April August
 How trade nevertheless?
• “Keep a tab open”
– You deliver your good or service now to a customer …
– … and get your delivery in return in the future

• But “open tabs” don’t scale:

– Trading in a small village (<150)
– vs. trading globally (billions)
Problem: How to lower the risk for the initial supplier?
 Solution for scaling trade …
• Use a universally valued placeholder instead
– Placeholder = “pawn”
– Placeholder bridges the divide between the two ends
– Replaces the “open tab” idea:
• Now you no longer even need to know
who your trading partner is!
 Placeholders or tokens …

North America: Wampum shells

 Placeholders or tokens …

Glass beads (West Africa)

 Placeholders or tokens …

Marten (kuna) fur pelts

 Placeholders or tokens …

Gold, element #79, “Au”

Or something like this …

Why was this paper valuable?

 The “job” of money
• Money secures a future claim on goods or services
in return for an initial delivery made

 Money is an open claim

 Money is a risk-minimizing technology
 Why is money valuable?
• Because someone has worked for it …
… and because someone else will work for it,
because money is universally exchangeable

• Possible side effect of placeholders: utility value …

– … but such utility (“intrinsic”) value is irrelevant
for the money function
– We can tell that some tokens work as money,
despite having no (or low) utility value
What makes
good money?

These are some

basic monetary
properties

How are some monies

tracking along these
properties?
Why do monies fall out of use?

1. Better technologies appear

Why do monies fall out of use?
2. Those in charge destroy the system

1.000.000.000.000.000 marks
one hundred trillion marks
 Easy come, easy go
• Most currencies are short lived
– Some decades, on average:
• German mark 1949-2001, then Euro since 2002
• Croatian kuna 1991-2022, then Euro since 2023

• Few currencies (by name!) last for centuries …

– English pound (middle ages)
– US dollar (1792)
– Swiss franc (1798)
… but their underlying nature has changed dramatically
 Recent phases of
Western monetary systems …
• 1700s-1944 Gold Standard Systems
• 1944-1971 Bretton Woods System
• Gold standard “light”
 Recent phases …
• 1700s-1944 Gold Standard Systems
• 1944-1971 Bretton Woods System

• Since 1971 Petrodollar System

 Money in practice
I’m Joe

• Works for his employer “on credit” until May 31

• Employer pays wage of 200 marks on June 1
 They are even … Joe’s claim lives on in the money

• Joe can redeem his 200 marks claim for

boots, groceries, cigarettes, beer …

• If spent = Joe’s claim expires (lives on with next)

 Money in practice

Good money …
• is an intermediary step that
“decouples” sequential exchanges
• provides assurance and eliminates risk
• no money  no exchange  no prosperity
 Digging deeper …
• Joe has not a “fixed claim forever” on
boots, groceries, cigarettes and beer …

• … but Joe’s 200 marks stand for a fractional claim

to all goods in the economy
1
• … let’s say on of all goods available
100.000.000
 Digging deeper …
1
• 200 marks represent a claim on of all goods
100.000.000
• Then there must be 20 billion

200 ∙ 100.000.000 = 𝟐𝟎. 𝟎𝟎𝟎. 𝟎𝟎𝟎. 𝟎𝟎𝟎

marks circulating …
• … and Joe’s claim represents
200 1
= = 0,0000𝟎𝟎𝟎𝟏
20.000.000.000 100.000.000
of “the economy”
“The government cares for you”

Issues a spending program for a crisis

1. Government issues debt
2. Central bank buys this debt for cash
3. Government hands out cash
 More money is created & circulated!
 Exploring the effect …
• Joe’s claim, if circulating money up +50%?
• His 200 marks now represent only
200 1
= = 0,0000𝟎𝟎𝟎𝟎𝟔𝟕
𝟑𝟎. 000.000.000 𝟏𝟓𝟎. 000.000
30 billion

of “the economy” (of all output)

 Increasing the quantity of money

Joe’s claim as a fraction of the economy:

• Before: 0,0000000100 Joe’s claim
• After: 0,0000000067 drops by 33%

If he understood this,
would he still be smiling?
 What happened … ?
 Enlarging the money quantity
cheated Joe out of 33%
of his purchasing power
 Effectively, 67 marks of his 200 marks
were stolen by central bank money “printing”
 Creating money
• Collect more wampum shells
• Make more glass beads
• Hunt more marten & tan the pelts
• Dig for more gold
• … but money that is a piece of paper
or an accounting entry in a computer?
 Caveat: Strongly simplified
• … skipping many intricacies of bank balance sheets
and money creation
 CB

Creating money … Banks

Businesses,
Central bank (= issuer)
Individuals
A L
Currency in circulation
1st layer
“something valuable” Reserve balances

Commercial bank
A L
2nd layer Vault cash Customer deposit
Central bank reserves
Loan to customer

Business (or private individual)

A L
3rd layer Cash in bank Loan from bank
Cash on hand
 Limits?

Fed
A L
Currency in circulation
Base money
“Something valuable”
Reserve balances M0

How
much?
 Limits?

Fed
A L
Currency in circulation
Gold – how much
do you have? Reserve balances
 Limits?

Fed
A L
Currency in circulation
1971 ?
Reserve balances
 Limits?

Fed
A L
Currency in circulation
post-1971
Reserve balances

… as much as
you want!
 This is simplified
What we’re neglecting:
• All money creation in the commercial banking
system through fractional reserve banking:

Whatever base money is created in the Fed

will be multiplied through commercial bank lending
2022 ≈ 31 trillion
2024 ≈ 34 trillion
 US national debt
• To reach the first 1 trillion
– 1776-1982 ≈ 200 years
• Most recent 1 trillion (from 33 to 34 trn)
– A few weeks
Big-numbers (2021) …
Short scale
numbers

Long scale
numbers
 a thousand
Short scale: Every new term above 1 million is 103 times bigger than the previous

1 2 3

a million

Long scale: Every new term above 1 million is 106 times bigger than the previous

1 2

3
 What is a trillion?
Or just wait … (1$ = 1 second)

US EU time (seconds)
106 million million 1.000.000 11,6 days
109 billion milliard 1.000.000.000 11.574 days
or 31,7 years
1012 trillion billion 1.000.000.000.000 31.709 years
 Another Visualization
• Check out the dollar bills visualisation in this article:
https://www.visualcapitalist.com/cp/us-debt-31-4-
trillion-owed-in-2023/
 The word “Inflation”
Original meaning:
• Inflation = increase of money supply
(not the increase of the price level)

Inaccurate, but common use today:

• “Inflation” = increase of all prices
• Better: say Price hike, price increase, price inflation
• Problem: hides cause behind effect
 Precise words matter!
• Obfuscating the terminology
will obfuscate the cause
• Everyone is against “inflation” (as in rising prices)
• “Greedy” businesses raise prices  the “bad guys”!
• But the cause is the expansion of money supply

• “Fighting inflation” without addressing

the root cause inevitably fails
 What’s a price?
• Most fundamental element of coordination
in a free market economy!

• Individual prices all the time

– … because supply of goods changes
– … because demand of goods changes

versus
• Price hikes of all goods
– “the price level rises”
 Causes of price level hikes
• Quantity theory of money
 Causes of price level hikes
• Quantity theory of money
– Generally true, but not in tight lockstep:
• Decline in $ purchase value started long ago
• Even since 2009: Long QE phases without price level hikes
• Current price hike? …
– … by Quantitative Easing: Laid the ground
– … by Covid stimuli  Triggered the avalanche
 Where does the new money go?
• Step 1: Asset price hikes
– Real estate
– Stocks
– Commodities

• Step 2: Production price hikes – ahead of CPI

• Step 3: Consumer price hikes
– CPI (“the inflation rate”):
Heavily manipulated statistic to hide inflation
… by weighing, substitution, hedonistic indexing
– Currently aggravated by supply chain disruptions
 Inflation leads to
monetization of “everything”
• As money becomes increasingly dysfunctional,
“everything” becomes money:
– Family homes
– Stocks
– Art The “Bubble of
– Commodities Everything”

“Everything” monetizes to store value,

because the broken money cannot
Since 2008
Financial Crisis
Fund manager survey 2024
Housing: List prices
 … the importance
of the unit of account

https://x.com/Cole_Walmsley/status/1753886384635437320?s=20
https://x.com/LoveIsBitcoin21/stat
us/1753547375329595903
 Effects of inflation
• Inflation is functionally a tax (Joe: -33%),
depriving you of the fruits of your labor …
– … while you don’t realize what’s going on
– … hold money & yet can’t buy much any more
– … your purchasing power has accrued to s.o. else in a
windfall (= they did not have produce anything to obtain
this purchasing power) Venetian glass beads,
paper money forgers,
debased coins
– Simultaneously: Increases concentration of wealth
 aka the Cantillon effect,
after Richard Cantillon, ca. 1730
 Cantillon Effect
• Inflation allows for the use of debt
as a lever for a massive, invisible
transfer of wealth bottom-up:
– Have collateral  borrow & buy more assets
– Watch asset value grow
– Pay back with devalued currency
• Inflation is a tax on the asset-poor
in favor of the asset-rich
– Bottom-up: also from young to old
Inflation allows the excessive use of
debt leverage for a massive, invisible
transfer of wealth bottom-up
 Inflation is destructive
• Inflation …
– manipulates all prices and
– makes them useless for decision making

• Inflation …
– manipulates interest rates as the price for borrowing
 causes massive misallocation of capital
 Effects of inflation
• Erases the value of dollars …
– Positive dollars (= savings) slowly disappear
– Negative dollars (= debt) also disappear

Side effect: Steady redistribution of wealth

Whoever holds (positive) dollars, loses wealth
Winning strategy: Use debt to invest in appreciating assets,
debt dissolves slowly over time while assets gain
 Effects of inflation
• Inflation erases debt and Other:
1. Austerity (spend less)
is a tax on cash balances 2. Tax (earn more), so
3. Borrow & inflate

T. Humphrey, Keynes on Inflation, who is quoting from

J. M. Keynes’ book “A Tract on Monetary Reform” (1923)
 Effects of inflation
Debauch = corrupt, ruin, spoil, subvert

F. W. Fetter, Lenin, Keynes and Inflation, quoting from

J. M. Keynes’ book “The Economic Consequences of the Peace” (1919)
 Wanna build some wealth?
• Save money! Used to mean:
– forgo current consumption
– transfer your purchasing power into the future
– get (modestly) compensated for your low time preference
• Under broken money, saving is no longer possible;
you are forced into investing
– Take risk by investing in stocks, bonds, real estate
to hunt an uncertain return
– Requires time to educate oneself, follow markets, make
and revise choices
 Yesterday on TV

CBS 60 Minutes, Jan 4, 2024 https://x.com/BitcoinNewsCom/status/1754300664388165865

 Why the gov’t needs inflation
• Post-1971 discovery: “Solve” problems by throwing
money at them (and get reelected)
– But: Gov’t debt balloons
• More money  “kick the can down the road”
– Enormous debt load easier to service
– Create more money to lower cost of borrowing
– At high interest, debt service becomes unaffordable …
… unless they create yet more money
• Hence the govt’s absurd definition of “price stability”
at an increase (!) of the price level by 2% p.a.
 Listen to why “2%” …
• Fed chairman Powell turning around in circles trying to explain the now
globally accepted 2% inflation goal at a congressional hearing at the
Senate Banking Committee 2023 https://youtu.be/Nh96JQklpKM?t=256

• Go find out: Did Powell

answer the question?

• Read about the curious

origin of the “2% target” at
https://mises.org/power-
market/origins-2-percent-
inflation-target
Start at 4:15
“Why 2%?”

https://www.youtube.com/watch?v=Nh96JQklpKM&t=256s
$34 trn isn‘t all ...
 No better elsewhere

https://x.com/zerohedge/status/1753592287311900987?s=20
 Interest rate
• Interest rate = price of borrowing money
• Fed as “money administrator” sets the price it pays
for deposits – Federal funds rate
– Signpost for interests in the whole economy
• Interest rate is a tool of the Fed’s monetary policy
– Crisis, insecurity, “too little” lending  Fed lowers
– “too much money” = price inflation  Fed raises
Zombie firms
 From 0% to 5,25%
in 1.5 years

Covid
Yearly interest payments
on national debt
have surpassed $1 trillion,
more than defense spending
 The “blue” must
Debt to GDP be paid back from
the “red”

Debt is now bigger than GDP

Projection
 Consequences of Inflation
• Inflation is not just an arithmetic inconvenience
– “my expenses have grown 10%”
– “my income has grown 10%”  no big deal

• Inflation is a massive redistribution of wealth

– Poor to rich
– Young to old
• Inflation comes at massive cost to market efficiency
• Paired with low interest rates, it causes massive
misallocation of capital (“zombie economy”)
Shouldn’t we already know better?
For to everyone who has, more will be given,
and he will have abundance,
but from him who does not have,
even what he has will be taken away.
– Matthew 25:29 KJV
Fiat money goes to zero
 Roman Empire From 27 BC to AD 395

https://money.visualcapitalist.com/currency-and-the-collapse-of-the-roman-empire/
1983 = 100
Germany, Weimar Republic
 Nothing can be done
• … except (theoretically) to stop spending & printing
• But then economic collapse would follow, as …
– debt & asset valuations collapse,
– recession ensues,
– unemployment explodes
• But with continued printing, collapse
will be ever likely, too …
1971
 I am
Jerome Powell,
Fed chairman
Fighting inflation = Increasing inflation
Inflation “Reduction” Act 2022
• Ca. $730 billion additional spending
to “alleviate” effects of inflation …
• …
– financed by excessive new debt and new money,
– which in turn will cause much more inflation
 “Fighting” inflation = Increasing inflation

• Subsidies for gasoline, heat, electricity, nat gas,

or “stimulus checks” to pay for them
– initially reduce energy prices
– consumption of energy increases b/o lower prices
– must be financed with more money printing
– prices will push even higher
Fighting Inflation
Friedrich Hayek in 1984
 Twitter tips
• Two interesting accounts to follow
– https://x.com/rajatsonifnance/status/1754122947512381
775
– https://x.com/danieleripoll/status/1753956673084080448