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Strictly Monetary Part I: A Primer

In Advice, Financial, Strictly Monetary: A Series on January 24, 2011 at 12:40 PM

The global system of money is going through some drastic changes. It is one of the more complicated economic topics, but it is worth a deeper look as the dynamics of this change will have a tremendous effect on our lives. This is the first piece on the topic of money, covering how the monetary system works. Each piece will build on the knowledge from the previous one.

When the global financial system was on the verge of collapse in 2008, every nation in the world threw money at the problem. The process of discovering toxic loans throughout the system literally destroyed money. Compounding this problem was the fact that credit markets froze, or in other words, banks stopped lending money, for fear of never getting it back. Money is created when banks lend. Because they had stopped lending, there wasn’t enough money in the system to sustain the overall operation of the economy.

[You deposit $100 into your bank account. The bank sets aside a fraction of that money, $10, and puts it in the vault. The remaining $90 is loaned out thereby creating $190 in total from your $100 deposit. By lending to each other as well as businesses and individual customers, a country’s banking sector is largely responsible for the function of creating money. When banks stop lending, the money supply shrinks dramatically.]

Creating money and then injecting it into the economy prevented a complete collapse of the global system. The mistake made during the Great Depression in 1929 was a failure to print money and inject it into the American system, which propelled a severe recession into a devastating worldwide depression.

Printing money was a necessary step in an emergency situation. However, there are potentially severe long term consequences of printing money that are coming to the forefront.

Many signs in America point to the beginnings of an economic recovery. When such confidence is restored, banks naturally increase their lending. But with all that extra money still in the system, at some point there will be too much money in the system. Harvard historian Niall Ferguson attests that the economic problem that has plagued economies for centuries has been inflation – when there is too much money in the economy, it is worth less, decreasing your ability to purchase things.

What do we know about inflation?

Inflation is strictly a monetary phenomenon. The fact that prices rise is a direct result of there being too much money in the economy.

While a recession can be felt immediately because of job losses, inflation creeps, slowly eroding your ability to purchase things.

In China, because they didn’t experience the bad debt losses like the rest of the world, they are feeling the effects of inflation right now. They had plenty of money circulating in their system to begin with, and now they are actively trying to destroy it before their money loses its worth. Their money supply does not rely on free participation of banks and its customers. If China wants to destroy money, they instruct the banks to reduce lending. China is the world’s largest trading partner, and they have full control of their monetary situation.

In America, they are only now seeing the effects of all that money creation. Because prices were so depressed in 2008, the rapid injection of money took a long time to make its way through the system. In a free market economy, it isn’t enough to simply inject money. You have to count on banks to start trusting each other, businesses to start borrowing and consumers to start spending. That is only beginning to happen and money is being created more organically once again.

Canada rests in between the US and China. Inflation will be a problem here before it is a problem in America, because we hadn’t destroyed as much money as them during the crisis. However, the Bank of Canada is actively managing the money supply to ensure inflation is kept in check.

Which brings about the question, how do you protect your savings from inflation? Investing your money is the general advice. In the long run, real estate or the stock market has shown to beat inflation with ease.

There are lower risk alternatives that won’t help you beat inflation, but prevent you from losing to inflation. Investing in GICs or even just high interest savings accounts keeps your money available and provides some protection. Right now inflation isn’t a serious problem in Canada, but as it creeps, you can count on the Bank of Canada to increase the interest rates, making it easier to keep up with inflation.

Buying things today instead of tomorrow protects you against inflation, since those same goods will be more expensive later. Ultimately, those who have their cash sitting idly in a chequing account, earning virtually zero interest, are being nickeled and dimed by inflation, every single day.

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