This is the first post of what I hope will become a series of posts on my blog to discover what money is and how it works. We take money for granted as something that can be exchanged for goods and services, but it is in fact a complicated instrument who’s real value and supply is always changing.
I’ve wanted to write some blog posts like this for a while, but with all the financial turmoil that has hit the world recently, and the mind boggling amounts of money that is being used to prop up the banking industry I think now is particularly good time.
European leaders announced today that they would be bailing out their banks to the tune of nearly £1.5 trillion…. so the theme for my first post is:
Rather than raise taxes or borrow, why don’t governments just print money to fund their spending?
Central banks can literally create or destroy money. They do this every day in order to manipulate the money supply in the economy in an attempt to steer inflation to within a target range. The only problem with creating new money, is that the more they create, the less each unit becomes worth. If they create too much of it, and give it away too cheaply, then it’s purchasing power diminishes and people lose confidence. This can ultimately lead to hyperinflation and the destruction of the currency.
It happened to Germany after World War I, when the government attempted to print money to balance their budget. This lead to hyperinflation peaking at 3,250,000 % per month (prices double every two days). The currency became so worthless that people would need a wheel barrow full to buy a loaf of bread, and would use it as an alternative to firewood to fuel their stoves.
John Maynard Keynes described the situation in his book, The Economic Consequences of the Peace:
“The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance.”
So when a government needs more money, rather than create new money and risk hyper-inflation it will borrow the money through the issuance of government bonds. This by itself doesn’t increase the total money supply.