What would an economy be without money? For that matter, how would life work without money? Sure, you could exchange an hour on your job directly for a package of T-bone steaks, a sack of potatoes, and a bottle of wine, but how complicated would that be? Especially when your cube buddy wants the makings for a Caesar salad instead. And what would happen if you needed to go to the doctor, and all you had to pay with was your steak and potatoes?
Yes, money simplifies the economic picture by giving us a standard of exchange. Money is simply a commodity that can be universally exchanged as “legal tender” for all other commodities and services. It is the lifeblood of an economy. Yes, it does make the world go round.
Like any other commodity, there can be too much of it or too little, and its true worth is judged only by the value of other commodities. So like the economy it supports, the value and worth of money can change over time. Those changes become apparent as changes in prices. Furthermore, unlike most other commodities, money can be used as a lever or tool to moderate, manage, or control the economy. Economists and policymakers concern themselves with the worth of money, the cost of money, and the use of money to influence the economy. This chapter covers money and its interaction with the economy.
You probably wouldn’t be reading this book if you weren’t interested in money—or at least, the necessities and pleasures that money buys.
Technically speaking, money is anything that is generally accepted as payment for goods and services and repayment of debts. Usually, it comes in the form of paper or coins, but anything could be used as tender, even bottle caps, if society set an accepted standard for using bottle caps as payment. Money is used primarily as a medium of exchange, but also as a unit of measure of financial activity and as a store of value.
As a medium of exchange, money works because of its universal acceptance. If you try to pay for a cartful of groceries with a goat, it might work, but only if the grocer happens to need or want a goat. Money is designed to work for everybody, no matter what they need or want to purchase. It is much more efficient than direct barter. Although “plastic”—credit and debit cards—has seemingly replaced money, it isn’t really money, only a convenient way to administer the payment; the real money changes hands later on behind the scenes.
As a unit of measure, or “unit of account,” as economists call it, money is a handy means to place a value on things. A tab for $104 worth of groceries is much easier to comprehend than a tab for 2⅔ goats. Likewise, imagine the difficulties measuring GDP, incomes, and so forth without money. Finally, money is divisible into known and like units; if one were trading in diamonds instead, no two diamonds are worth the exact same amount, and would thus complicate the exchange.
The money we see comes in the form of currency—that is, printed paper and minted coinage representing units of generally accepted value. As a store of value, one can convert anything to money, at least for the short term, and store the value there until something else is purchased. Many economists caution against relying on money as a store of value for too long, as the increase in money supply (see #17 Money Supply) over time makes a unit of money worth relatively less. Some question whether current economic policies in the United States, Japan, and other countries will drive the value of money down and threaten its status as a store of value.
The vast majority of money doesn’t exist as $20, $10, $5, and $1 bills, but rather as deposits in banks. Those sums of money—and almost everyone has some—can be created by credit and moved around with a check (the old way) or the click of a mouse or keyboard.
Finally, U.S. money is a type of money known as fiat money, meaning that its value, and that it be accepted as a means of payment, is determined by government order. It is not backed by any hard asset such as gold. Technically, you can only exchange a U.S. dollar with the U.S. government for another dollar. Until the 1960s, that wasn’t true—you could exchange currency for gold or silver, depending on the type of money you held.
It’s always useful to step back and think about what money really is. It isn’t an end in and of itself; it is a unit of exchange. It can be exchanged for something else later on. Understanding what money is and what it’s for can give you a more balanced perspective for managing your finances.
Money is a commodity, just like any other commodity you might purchase with it. The money supply is the amount of money within an economy available for purchasing goods or services. The central banks—in the United States, the Federal Reserve—keep close tabs on the money supply, as the amount of money in circulation can have a big effect on the economy (see #30 Federal Reserve, #29 Central Bank, and #18 Inflation).
Money is created by either printing paper tender or by making it available as credit through lending. When the central bank lowers interest rates, it stimulates the creation of more money through lending. When there is more money in circulation, people have more money and spend more money, stimulating demand for goods and services. That helps businesses and creates a stronger economy, but also threatens inflation, since more money is chasing the same amount of goods and services, making the money worth relatively less.
The Federal Reserve measures several categories of money supply, four of which are more mainstream and likely to be in the news. The M0 figure is so-called base money—currency (bills and coins) and central bank deposits. The M1 figure includes so-called demand deposits, roughly equivalent to amounts in checking accounts—money on hand as a deposit in an institution designed to be used actively to buy and sell goods and services in the short term. The M1 is the most “spendable” money in circulation at a given point in time. The M2 adds money in time deposits like savings accounts and CDs—money that is there but not as likely to be used actively for transactions. And M3 adds large time deposits like repurchase agreements and institutional money market accounts—also long-term in nature, and largely out of consumer hands. Economists tie their horse to M1 in terms of measuring the amount of money really flowing around and through the economy; it is like “working capital” in a business.
Economists watch money supply to forecast inflation and other economic effects. If you see reports of increasing money supply, it can mean good times ahead, but it can also mean inflation. Be suspicious of prolonged money supply increases—the government and particularly the Fed may be sacrificing the future by driving down the value of money in an attempt to realize a short-term gain in business activity and employment.
Inflation is an across-the-board rise in prices of goods and services over a period of time. When inflation is present, the purchasing power of a given unit of money buys fewer goods and services; that is, the “real” value of money is less. The idea of inflation is generally scary, as nobody wants to see the decline in the value of money. But if kept in check, some inflation is actually okay, and may even be beneficial.
Inflation is generally measured by two indexes tracked as “basket of goods” proxies of overall price activity, the Consumer Price Index (CPI) and the Producer Price Index (PPI). The Department of Labor’s Bureau of Labor Statistics publishes both figures, along with a core CPI figure that strips out the “more volatile” food and energy components. Since we all need food and energy, some choose to ignore the “core” figure.
Inflation can be caused by changes in demand, supply, or a combination of the two. Demand-based, or demand-pull, inflation occurs when people have too much money or too much cheap money (that is, easy credit), and it chases a fixed level of goods and services. The antidote is to make money more expensive by raising interest rates or decreasing the amount of money available, both normally well in the control of the central bank, in our case the Federal Reserve. Inflation can also be caused by shortages of a commodity, like oil, where price spikes will eventually trickle into the entire economy. Or they can be a combination of the two, as seen in early 2008 when both a supply shortage and a demand increase driven mostly by China drove energy prices higher with a fairly rapid trickling through the economy.
Depending on the amount and consistency of inflation, it can have positive or negative effects on the economy. Too much inflation discourages saving, as the purchasing power of that saving will deteriorate. High inflation may create shortages as people “stock up” in anticipation of rising prices. It creates fear and uncertainty in the business world, delaying business investment, because no one can predict what raw materials, labor, and other “inputs” will cost in the future.
Modest inflation—in the 2 to 4 percent per-year range—is seen as a good thing. Why? Because it’s better than the opposite: deflation (see #19 Deflation). Moderate and predictable inflation is thought to help avoid recessions and sharper business cycle reversals. Inflation also helps borrowers, for the dollars they will use to pay back debts will be worth less in the future, thus easier to come by, as most debts do not get larger with inflation.
It’s interesting to note that inflation and deflation once occurred in sharp and unpredictable cycles. More recently, central bank intervention has moderated those cycles, and has avoided deflation altogether, at least in the United States, since the Great Depression. The moderate and steady inflation rates enjoyed particularly since the oil shocks of the 1970s have created a favorable business climate. See Figure 3.1 for a long history of inflation rates. (It should be noted that this chart is the same as presented in the first edition and only takes us through 2006, but the 356 years before that remain instructive)
Figure 3.1 U.S. Historical Inflation Rate
Source: Wikipedia
Data Source: John J. McCusker, How Much Is That in Real Money?: A Historical Commodity Price Index for Use as a Deflator of Money Values in the Economy of the United States, American Antiquarian Society, 2001; Consumer Price Index (from 2001 forward)
Inflation can be one of the biggest enemies to your finances and financial plans, particularly if you save money. Those savings will be worth less over time if the rate of inflation exceeds the interest rate your savings earn. Most recently, wage increases have not kept up with inflation, another cause for concern. Hard assets like gold and real estate are thought to hold up better in inflationary times, but obviously real estate is no longer as safe a haven as once thought. These days, people have learned to fight inflation by consuming less or buying less expensive goods and services, but that isn’t a strategy for the long term. Inflation remains a persistent threat to finances for all of us, especially as central banks “fix” economic problems by increasing credit and the money supply. Although inflation hasn’t been a big news headline lately, it’s important to watch inflation closely—particularly in the things you tend buy a lot of, including food, health care, and energy.
If inflation is bad, doesn’t that mean that deflation is a good thing? It sure would seem that a decline in the prices of goods and services would be good; our money would be worth more, and we’d all be able to buy more for our money. What’s wrong with this picture?
Actually, economists hate deflation, which is defined as a sustained, across-the-board decrease in prices, a negative inflation rate. Why? Because, quite simply, if people perceive that prices will go down, they’ll stop spending and wait for those prices to go down further. Businesses will do the same thing. Furthermore, businesses won’t be able to sell their products for as much money in the future, and are using relatively more expensively priced materials and labor they have to buy today to produce them in advance of that sale. So for the business, profits suffer; for everybody, the slowdown caused by people hoarding money anticipating it will become worth more later ends up sapping the economy.
Reduced consumer and business spending can cause a severe business slump; in fact, deflation is typically only observed during the most severe business crises, including the Great Depression and the so-called “lost decade” in Japan that started in the 1990s. In Japan, a large inflationary bubble driven by real estate and irresponsible lending unwound. Prices started to drop and banks stopped lending, starting a downward spiral of decreased consumption and spending that didn’t let up until recently, when the central Bank of Japan took rather drastic measures—that is, printing lots of money—to artificially decrease the value of the yen and rekindle mild inflation.
The good news is that we haven’t really seen deflation lately, although there was a persistent threat of it as a consequence of the Great Recession. Figure 3.1 illustrates the fact that deflation occurred considerably more often in the past.
For most individuals, deflation isn’t that scary, unless it is prolonged and leads to an extended business slump. That, of course, means a more severe contraction of business, and additional job losses. The bigger problem can be the actions of central banks like the Fed, which go so far to avoid deflation, they end up sowing seeds of a stronger inflation. That was the big worry in the wake of the Great Recession. Bottom line: the less you hear about deflation, the better.
As the name implies, stagflation is a painful combination of inflation and economic malaise. Since the “typical” cause of inflation is excessive demand in an overheated economy, the combination is a bit surprising for economic purists. But the occurrence of both together happened in a big way in the late 1970s, when high inflation was accompanied by high unemployment, and it continues to be a threat to the current economy both in the United States and abroad (see #10 Misery Index).
Stagflation generally has two causes. One is a supply shock, as in the oil shocks in the late 1970s, and to a degree, the oil price spike in 2008. Inflation is caused more by supply factors than general demand, and so the traditional means of fighting inflation through monetary policy (reducing money supply, raising interest rates) don’t work—they only serve to slow the economy while not solving the supply shortage. Stagflation can also be caused by excessive regulation, or by other practices that make economies inefficient, combined with inflationary monetary policy. Such has been the case in Europe and Latin America from time to time.
For the U.S. consumer, the sort of stagflation caused by oil shocks or similar shortages creates the most concern. If you see inflation in the economy, particularly energy and food prices, that should not be taken as signs of a robust economy; more likely, the economy will sink as higher prices sap the strength, like a tax, of the economy. If the government tries to deal with these effects by tightening the money supply, look out—especially if you’re in an economically sensitive vocation.
The good news: the sort of stagflation caused by regulation or economic inefficiencies is less likely to happen in the United States than elsewhere. Despite what it may seem like sometimes, the U.S. economy is considered to have one of the easiest and most consistent regulatory climates of any developed country. This is why many economists are concerned when they hear cries for more regulation, and why they became concerned with some of the proposed policy changes that came with the recent economic crisis—they want to preserve the “stable state” the United States offers for capitalist commerce.
An interest rate is the price a borrower pays to borrow money. The key word is price—for whatever reason, possibly owing to the negative references to the borrowing and lending of money in the Bible, the concept that interest is a price paid for the use of something, in this case, money, is poorly understood by most. If you think of interest rates as a price, sometimes too high, sometimes a bargain, you’ll learn to make better decisions when evaluating a borrowing opportunity.
From your point of view, interest rates are a price, or cost, of using money. They are also the price, or benefit received, for letting someone else use your money, as in when you deposit money in a bank or buy a bond. Finally, on a national scale, interest rates are also a vital tool used by governments to control money supply and the availability of credit, and thus to exert some control over the economy.
Interest rates are normally expressed as a percentage of a borrowed balance over the period of one year. Many interest rates are quoted as a nominal, or ongoing, interest rate, with an “annualized percentage rate” quoted in parallel to account for all borrowing costs, including fees, associated with a borrowing transaction, on an annual basis. Federal law requires publication of APRs to allow simple “apples-to-apples” comparisons of the price to borrow money.
The interest rate, or price, for the use of borrowed funds depends on several factors:
There are literally hundreds of different interest rates in the marketplace for different kinds of loans or securities of different term lengths, risk factors, and tax status. For most people, the following are most important:
Interest rates affect all of us directly or indirectly. Directly, they determine how much we pay to borrow money for homes, cars, education, and so forth, and they determine how much income we receive on savings—which has been a big issue for many lately who depend on interest income, especially to fund retirement. Indirectly, interest rates and changes in interest rates can give strong clues to which way the economy is going, and which way policymakers want it to go.
Not too many years ago, news headlines featured any change in the so-called prime rate. Whenever it changed in one direction or the other, it was considered news. Although it has declined in importance, the prime rate is still used as a benchmark or reference interest rate by banks, economists, and others in the business world.
The prime rate, or “prime lending rate,” is, in theory, the interest rate banks charged their best, lowest-risk customers. The loans in question were largely unsecured and short term, so the prime rate was a representation of how much the credit was really worth in the marketplace. These days the prime rate is more likely tied to Treasury security rates or to “average cost of funds” figures published by the government; some interest rates are quoted as a percentage above or below the prime rate.
In the United States, the prime rate has typically run 3 percentage points, or 300 basis points for those of you wishing to sound financially sophisticated, above the target federal funds rate set by the Fed.
Most people don’t care as much about prime rates as they did ten to twenty years ago, although they are still used as a benchmark for change. Today, the Fed funds rate, Treasury bill and bond rates, and mortgage rates are more broadly accepted measures of interest rates and interest rate direction.
Economists and others in the financial community use the yield curve to plot the relationship between yield, or interest rate return, and maturity, or length of time a debt security is held. The most frequently reported yield curve compares the three-month, two-year, five-year, and thirty-year U.S. Treasury debt.
Generally speaking, the longer a debt security is held, the higher the interest rate. That’s because of the greater opportunity costs and the greater risks, including inflation, over the longer time period (see #21 Interest Rates). But depending on economic circumstances and central bank policy, the relationship between yield and maturity can change or even reverse. So economists watch yield curves closely for signs of economic health, and financial professionals watch the curve for signs of preference for different kinds of debt securities, such as mortgage rates or bank lending rates.
The normal yield curve (Figure 3.2) shows rates gradually rising as maturity lengthens. This curve can be steeper if investors see more risk in longer-term securities, typically in inflationary times or times where other risk factors like corporate defaults come to the forefront. The yield curve typically flattens (Figure 3.3) when the Federal Reserve raises short-term interest rates to slow the economy, and can even go to an “inverted” state (Figure 3.4), where short-term yields exceed long-term yields, if the Fed acts strongly to restrict money supply. Economists see an inverted yield curve as a sign of a looming recession if the economy cools, as the Fed apparently desires.
Figure 3.2 Normal Yield Curve
Figure 3.3 Flat Yield Curve
Figure 3.4 Inverted Yield Curve
You can watch the yield curve by observing short- and long-term Treasury security and other rates in the financial section of a newspaper or websites. The U.S. Treasury publishes yield curve data (not a chart, unfortunately) at www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml.
On July 1, 2013, the following rates were posted on this Treasury webpage:
It’s not hard to see that these rates, although ticked up slightly from earlier in the year, are still historically low. It’s also not hard to see that for income-oriented investors, this is a grim story—while if you’re a borrower, this is attractive, although since you’re not the government, you don’t get to borrow at these exact rates. In fact, especially at the “short” (time to maturity) end of the curve, by the time you consider inflation, you’re really paying the government to hold your money for you.
If you’re an active income-dependent investor, you’ll want to watch these numbers carefully, and if you’re a numbers kind of person in general, it’s interesting to watch these figures fluctuate.
Aside from the economic signals it sends, the yield curve also helps you figure out the best “deal” for your money as a depositor or borrower. If the yield curve is relatively flat or inverted, it is best to look for shorter-term CDs or other time deposits; likewise, it’s a better time to look for a longer-term, say a thirty-year, mortgage. If the curve is normal and steep, a thirty-year mortgage will cost significantly more, and you’ll do better if you can stretch your payment into a twenty-, fifteen- or ten-year mortgage. As an investor, you should seek longer-term savings deposits or bonds.
In economics and finance, the “risk premium” is the expected additional return on an investment to compensate for the risk of that type of investment. It is the difference between the actual return rate and a “risk-free” return rate often represented by Treasury securities or some other risk-free standard.
In finance, the risk premium can be the expected rate of return above the risk-free interest rate. When measuring risk, a common-sense approach is to compare the risk-free return on T-bills and the very risky return on other investments. The difference between these two returns can be interpreted as a measure of the excess return on the average risky asset. This excess return is known as the risk premium.
The explanation of risk premiums can get fairly technical, so the best way to describe them is by example. Suppose you’re considering buying a ten-year corporate bond that pays 4 percent. If a ten-year Treasury bond is currently paying 2 percent (see #23 Yield Curve), then you would be receiving a additional 2 percent to cover the risk of the company’s credit quality, or default. Similarly, if you buy a stock expecting a 5 percent or greater return on it, the difference between that return and 2 percent would be your expectation to compensate you for the risk.
Part of the reason the normal yield curve (see #23 Yield Curve) slopes upward as maturity lengthens is to cover the additional risk inherent in longer maturities. That risk can come from default risk, interest rate risk (the risk that interest rates might rise over the holding period), and inflation risk. All three of these types of risk are built into a risk premium. The risk premium also takes into account any collateral pledged on the loan and the “seniority”—that is, the order in which any debt would be paid in a bankruptcy or liquidation.
Unless you’re employed in the world of high finance, you probably won’t encounter the term “risk premium” very often in your work, or even in your investing. It’s best to think about it conceptually. When you make an investment, you should ask yourself: “Does the expected return on this investment compensate me for the risk I’m taking?” If it does, the risk premium is in line with reality, and the investment may make sense. If the risk premium is insufficient—that is, the payoff doesn’t compensate you for the risk compared to a risk-free return—look elsewhere.
“Bonds were up today. The ten-year Treasury was up 23/32 in active trading.”
You hear it on the news. But what does it mean when bond prices go up? Is that a good thing, like hearing about stock prices going up?
The answer is—it depends. Yes, the above news item is usually good news. It’s obviously good news if you already own bonds—your bonds went up in value. But it’s also good news if you’re planning to borrow money, because it means market interest rates are lower.
When a bond price goes up, that means market interest rates have moved lower. Why? Because bonds are sold originally with a fixed coupon, or interest payment. A bond issued and sold at a typical $1,000 face value that yields 4 percent will pay exactly $40 per year in interest, period. It may pay that interest once a year, or in two semiannual payments of $20—that doesn’t really matter.
Even though most bonds are issued in $1,000 increments, they’re quoted as if they sell for $100, a figure known as par. If that bond rises 23/32 (of a dollar), that’s the equivalent of saying the bond price rose 71.9 cents to $100.72. Returning to the $1,000 face-value scenario, if you take the $40 in interest and divide it by $1007.20, you’ll get an implied interest rate of 3.97 percent, down from the 4 percent it was originally sold for.
Here’s the “it depends” part of bond prices and interest rates. Normally, the rise in bond prices and the corresponding fall in interest rates are a good thing. But first, that’s only true if you’re a borrower—if you’re a saver, you prefer higher interest rates. Second, the rise in bond prices can often occur as a “flight to quality”—when other assets such as stocks are perceived as more risky, and investors flock to bonds. This may push interest rates down, but only at the expense of other economic pain.
So if you hear that bond prices rose, that means interest rates—rates you would receive or rates you would pay, say, on a mortgage or car loan—are going down. Conversely, if bond prices fall, that means that interest rates are going up. Especially if you’re in the market for a mortgage, you want to watch the ups and downs of the bond market closely.
Are your dollars as good as gold? That’s the central question to understanding what a gold standard is and how it works.
In the gold standard monetary system, paper currency is pegged and convertible into preset, fixed quantities of gold. The supply of money is specifically tied to gold reserves held by central banks (see #16 Money and #17 Money Supply). The gold standard prevailed during the late 1800s and the first half of the twentieth century, but gradually subsided starting in the Great Depression, and was done away with altogether in 1971, after many years where $35 in paper could be exchanged for an ounce of actual gold. This means that central banks, including the Federal Reserve, effectively have no constraints in terms of expanding and contracting the money supply to affect monetary policy (see #56 Monetary Policy).
The gold standard was designed to protect a nation from abuses of monetary policy, and specifically the risk of hyperinflation from an overexpansion in the money supply. Today, we trust governments and central banks not to get carried away with monetary policy. Since no country actively uses the gold standard, those living in fear of hyperinflation buy the metal outright, and have pushed the price of gold up to a recent high of more than $1,900 an ounce, although it has subsided to the $1,200–$1,400 range recently—still high by historical standards.
Many economists following a traditional, pure capitalist, laissez-faire, government-can-do-more-harm-than-good doctrine favor a return to the gold standard (see #59 Austrian School). Doing so would be difficult and painful now, as the rate of currency growth has far outpaced the rate of gold production from mining. A return to the standard would entail a drastic reduction in the value of the dollar and most other currencies, as there wouldn’t be enough gold to go around to back all of the dollars and other paper currencies in circulation.
The gold standard debate is theoretical for most of us, but serves as a reminder that money is simply a commodity, and if there is too much of it, its value goes down. Many investment advisers recommend holding at least some gold in your portfolio, as the actual metal or as commodity futures or gold mining stocks, to anchor at least a portion of your wealth to a gold standard. That’s up to you—and there are plenty of downsides—but understanding the gold standard can help you think through such an investment.
