Central banks: money supply and currency debasement

Central banks are the issuers of new money and can control the availability and cost of money in an economy. By influencing the money supply they can accordingly change the value of the money in circulation, directly impacting the savings of citizens. It is specifically the unexpected changes in the supply of money that causes a rebalancing of its value.

This essentially follows the fundamental point made by the quantity theory of money, which states that increases in the money supply result in proportional increases in the prices of goods and services, if everything else remains equal. Of course, in the real world everything does not remain equal, nor does the distribution of new money happen equally, though the underlying idea is very easy to understand: if we increase the amount of money in circulation without any increases in productivity, each piece of money becomes worth a little less. This is also referred to as the debasement of money, and is most often expressed by a decrease in purchasing power. Inflation of the prices of products and services essentially means a loss in purchasing power of existing money, as one dollar might buy you 10% less compared to last year.

From this same theory also follows that decreases in the amount of money in circulation should result in an increase of purchasing power of the existing money that remains; again, all else being equal. Central banks in theory do have methods of removing money from an economy by selling assets that they have on their balance sheet they have previously obtained. With less money in circulation and no change in productivity, each bit of money should become more valuable as fewer pieces of money are chasing the same amount of goods.

What we see throughout the entire history of money, however, is that the ability to create new money is always preferred over the reduction of money. In fact, the power to create new money to finance expenditures that otherwise would not have been possible has always been misused, resulting in the collapse of the money itself. It is easier to solve problems by creating new money than it is to make structural changes, and given that the negative externalities of money creation are generally delayed and opaque, it is pretty much always preferred. In democratic countries, those in charge tend to choose instant gratification over longer term health, as their biggest problems often relate to how people feel right now, not how people feel in 5 to 10 years when they might no longer hold position.

In authoritarian regimes, there need not be too much concern about what people think of the government creating more money but even in developed and democratized nations this power goes relatively unchecked. The negative effects of the creation of new money are not part of common discourse, nor is it a very digestible or interesting topic for most everyday people. Furthermore, it is much easier to understand and support a politician that solves your immediate issue, whether he did so by creating new money or not.

As a quick aside: one of the reasons governments and central banks tend to not be able to reduce the amount of money supply in their economy is because they are built on debt, meaning over time a big part of the value of the economy consists of loaned money. The size of this debt relative to the size of the economy is out of proportion for many nations today, and the only reason this has been able to grow this big is by virtue of the ability to create new money.

Reducing the money supply means money becomes more valuable and loans become more expensive, which means higher interests on those loans (lenders ask for more compensation for lending out their money). Many people, organizations, and nowadays entire nations have loans that have an expiration date but that they will not be able to pay off by then. This means their loan will most often be extended against the now higher interest rate. For many economies these loans form a massive part of the value that is in them but many won't be able to pay those new interests, defaulting on their loans, wiping out trillions of dollars worth of value. That means governments and central banks are somewhat cornered.

Because they have allowed the debt in their economies to rise to absurd proportions by kicking the can down the road by printing more money when problems arose, their only real option is to keep printing more money and inflate away their debt. The idea here being that because loans are denominated in an absolute amount, say $1 million, if everything else becomes more expensive because of inflation, that $1 million is technically worth less than it was before as it can buy you fewer products. This approach seems to be perhaps the only option that is left on the table. If this all sounds very complicated, don't worry. There is a short video coming up later which addresses this but it is just an aside for having some idea of why reducing the money supply is no longer a real viable option for many governments and their economies, such as the United States and the European Union.

Consistent inflation of the prices of goods and services is then also not a natural phenomenon but rather an engineered one. In fact, central banks such as the European Central Bank and the Federal Reserve of the United States have an explicit publicly expressed policy that aims for an inflation rate of goods and services of 2% per year and they believe they can achieve so by means of controlling the price of money, essentially by increasing or reducing the money supply. That means that in a world where central banks of developed countries would have fully sound intentions and oracle-like insight into the future, citizens are guaranteed to see the value of their savings decrease by 50% in 35 years.

Most people in democratized and developed countries will believe free markets are best at setting the price of goods and services but for some reason this belief tends to break down somewhat when it comes to who sets the price of money. This is most likely due to the aforementioned reasons, where the negative externalities of a central party influencing the money supply are delayed and rather obscure, and there is a high level of trust in the authorities of the central banks to act in our best benefit and with perfect foresight.

Creating new money out of nothing does not mean an economy has become more valuable of course, or that it has become more productive all of a sudden. One does not simply create new value by issuing more money. Rather, what it does is it redistributes value from those that hold existing money to those that first received the newly created money. Where this power to create new money comes from, and thus what makes the debasement of money possible in the first place, will be discussed in the next segment.

First, we will look at what negative impact the debasement of money and associated inflation has on billions of people across the world, and their ability to save and work towards building a better life.