• Bruce

How money works

Inflation and deflation are a pain in the butt for most people to understand. Finance is made out to be complex. Therefore, understanding the dollars you earn becomes complex, and as a result, you end up working harder and longer to earn them. What if you could understand finance better simply by understanding how money is created and destroyed? Well you can. I learned not so long ago how dollars are created. I only just learned how dollars die. Thinking about the birth and death of dollars similar to the way we explain the birthrate for humans is brilliance. Travis K on Twitter came up with this philosophy. The world is convinced that we’re going to experience inflation or even hyper-inflation because of all the money governments are printing. Travis thinks something different is going to happen. I am going to share his wisdom combined with what I’ve learned from working in finance for most of my career.

A dollar is born when a loan is made. When a bank issues a loan they take collateral. Collateral in simple terms means “something pledged as security for repayment of a loan, to be forfeited in the event the loan isn’t repaid.” A bank can issues dollars for people to borrow based on how much collateral they hold. A bank can’t lend infinite dollars. Thanks to the concept of fractional reserves, they can lend ten dollars for every dollar they hold. (The ratio varies for each bank.) Customer deposits create loans. Loans create money. So if a bank has one dollar then they can lend ten dollars to a customer off that single dollar. This is how money is created out of thin air. A loan births new dollars into the system, says Travis. Banks lending a lot → more total dollars and inflation.

The reverse is how dollars die. A dollar can die too. “Dollars die when debts are paid back,” says Travis. This is the part that surprised me: Money printing only increases the collateral the banks have to lend against according to Travis. Money printing gives birth to potential dollars that can be put into circulation and used by you and me.

This is the simple reframe to understand about money creation. I freaking love the simplicity of this concept. Ready? Here we go. What affects how many dollars are created are these two things: 1) Banks’ appetite for lending. 2) Bank customers’ appetite for borrowing. Dollars can’t be created and put into circulation without these two things occurring. And what drives banks to lend and customers to borrow money? Their psychology. How we feel about the economy has a huge part to do with how slow or fast the recovery will be. Human psychology massively affects inflation.

Nothing matters if the banks feel “weird about lending.” It sounds strange, but what if banks right now feel weird about lending? Well, they do. They’re not writing as many loans. They’re taking less risks. They’re battening down the hatches for what they view as an impending economic storm. The Federal Reserve can create money and give it to the banks who will use it as collateral, but it doesn’t matter if the money isn’t put to productive use.

The inflation we’re seeing could be a mirage. Travis argues that we are seeing some inflation and that’s because “corporates panic-borrowed out of fear.” This fear helped give birth to more dollars.

A lot of dollars are about to die. So if loans being repaid kills dollars, then a lot of dollars are about to die. Many countries, including Australia (where I live), have allowed people to put their mortgage payments on pause. This pause on paying back debt is about to end. Once the pause ends, dollars have to be repaid. And this will change whether we see inflation or deflation.

Dollars may stop multiplying for a while. Travis says the “dollar birthrate will decline.” Why? People are feeling a lot of uncertainty. When fear is a driver amongst consumers, they stop borrowing or desire to borrow a lot less. It’s a natural progression because even if you still have your job, chances are you’ve see someone lose their job. When people are losing their jobs around you it affects your psychology — and therefore, your desire to spend money, save money, and borrow money. When there is more demand for products and services, prices go up and so does inflation. When there is less demand for products and services, prices go down to create more demand again. The collective financial psychology has economic consequences and helps drive inflationary vs. deflationary behavior.

What Does This All Mean for You? How this affects you is that Travis believes something different is happening. As the stock market hits record highs and asset prices keep going up, people are running to get rid of dollars because they fear inflation will eat away at the value of their hard-earned dollars. But if debts are going to be repaid then the dollar birthrate, according to Travis, is going to decline. This means asset prices could go down and people will wish they held on to their dollars so they could buy more with them as prices come down and discounts become available.

The argument between inflation vs. deflation continues. I haven’t made up my mind yet about exactly what is going to happen. But staying informed and looking at both scenarios becomes key in this uncertain recessionary environment. Opportunities will appear for those who take the time to understand what is happening and invest their money accordingly. You could rush to the Robinhood trading apps of the world and treat finance like the casino, investing blindly based on hype and Twitter influencers. (Unfortunately, that usually means the house wins and they take all your money.) Or why couldn’t you do well by educating yourself in simple terms about what is happening in finance? Nobody has all the answers in the world of finance but there are clues everywhere that can tell you what could happen if you overlay history and use it as a compass. Understand how dollars are created and how dollars die so you can take advantage of the biggest wealth transfer in history. Buying back time with your money is a huge advantage in life.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.

Article by Tim Denning.