Tuesday, May 28, 2013

The Accounting System #10: The Federal Reserve and Accounting Money

previous: Checking and Credit Cards as Virtualization

Before going on to the use of computer devices, in particular smartphones, to de-coin and virtualize the economy, it would be good to consider the accounting system from the point of view of the government and the Federal Reserve System.

As pointed out in Chapter 1, the economy of the 19th century changed so fast that the arts of banking and governance were inadequate to prevent a series of cyclical booms and depressions, cumulating in the Great Depression that kicked off at the end of 1929. The accounting system of the time was thought to be adequate to the task, but it was unable to give clear indications of coming financial disasters. In fact, the system and its interpretation by humans contributed to the boom-bust cycle. Nevertheless, The Accounting System can be said to have been born out of ordinary accounting and other developments that came in quick succession after 1929.

At the beginning of 1929 a number of past problems were considered solved by economists, politicians, business executives, capitalists, and even ordinary people.

Paper money had solved a lot of problems. It had become standardized. Banks could no longer issue circulating bank notes; only the U.S. Treasury could issue paper money. This was something of a revolution. While counterfeiting existed, for the most part American paper money was self-proving. Unlike a paper check, you did not have to worry if there was money in a deposit account to back it. The government backed it. Compared to coin it was much lighter and much more portable. You still needed coin in 1929 only because a one-dollar bill bought so much. With a briefcase full of $100 bills you could buy a mansion or a boat load of bootleg whiskey.

Critics of paper currency were suspicious of substituting paper and ink, which were almost valueless, for metal coins they thought had intrinsic value. They pointed to past trouble with governments printing so much money that it lost much of its value, including during the Revolutionary War. The hyper-inflation in Germany in the 1920s, which resulted from massive money printing not backed by economic activity, was also a fair caution.

But the U.S. did not print too much money. The asset inflation (high prices for stocks and real estate) of the 1920s resulted from money (not cash, but accounting money) being focused on those assets. People bought stocks and real estate because they thought they would keep going up. They spent money to make more money.

What is accounting money? Recall our late Middle Ages Italian city-state banker, and in 1929 the first thing you should note is that only a few things had changed. Reserves were now set by law, and were spread over the Federal Reserve System. But each bank had very little cash in its vaults compared to the amount of money it carried on its accounting books. The depositors' money was simply some numbers kept on a ledger, and the creditors' debt in money was kept on a ledger. In normal times that was fine. The creditors had used the loans they took to buy things of value, like houses and business assets (and, unfortunately, stocks they had bought at inflated prices).  As they paid them back, accounting entries were made that gave the bank more money, which would then be available to pay out to depositors, to take as profit, and to cover the normal costs of running a bank.

This is a key point that most people don't get. Already, by 1929, almost all money, the count of what people held to be of material value, was in the accounting system. It was not paper money; it was ledger entries on paper. The Crash and Depression did not happen because there was too much or too little paper money or gold. It happened because of a combination of human folly (buying overpriced stocks, followed by panic) and the nature of the accounting system.

Next: #11, The Great Unraveling of 1930

[The Accounting System, Your Fate is in the Cloud, is a work in progress by William P. Meyers, ©2013]

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