There’s this obsession with physical money in life. I don’t know where it comes from or why it persists, but it does. I guess maybe it’s the sense of security of being able to feel something and hold it in your hands. To many people a gold bar is pure money because you can pick it up, you can feel its density, and you can see how pretty it is. Paper notes or cash are not quite as sexy. But they’re still pretty cool. Even a small child knows that a cash note is cool. Give your kid a $1 bill and their eyes light up. Give an Austrian economist a $1 bill and he’ll flick you off (and then he’ll go buy something without admitting that he loves using paper money). You get the point. Money is ultimately based on trust and being able to feel something tangible gives people a sense of security, I guess.
Anyhow, I don’t fully understand the obsession with money as a physical thing because money in a modern economy is almost never a physical thing. It’s just a number in ledgers. Technology and the evolution of banking is rendering physical money slowly, but surely extinct. For instance, I bank online and I have for almost a decade. I’ve never been inside my bank. I don’t even know where it is. I don’t deposit money in it. I mean, I know there’s a physical address somewhere, but that doesn’t matter much to me. All I know is that there are numbers in a computer system attached to my name and when I want to purchase goods and services I tell my bank to shift numbers from one account to someone else’s account. On rare occasion I go to another bank’s ATM and withdraw physical cash. After all, there are times in life when a stack of 100 $1 bills are necessary….
But where does this cash come from? And how does it relate to the money supply? Our monetary system is designed around what Monetary Realism calls “inside money” (because it comes from inside the private sector). That is, the most common form of money for everyday transactional purposes exists in the form of bank deposits as numbers in a computer. If you have an account at a bank you can withdraw cash for convenience purposes. Cash is what MR refers to as a form of “outside money”. That is, it comes from outside the private sector. Wait, how does that work?
I’ll let the NY Fed explain this part of the process:
“Each of the 12 Federal Reserve Banks keeps an inventory of cash on hand to meet the needs of the depository institutions in its District. Extended custodial inventory sites in several continents promote the use of U.S. currency internationally, improve the collection of information on currency flows, and help local banks meet the public’s demand for U.S. currency. Additions to that supply come directly from the two divisions of the Treasury Department that produce the cash: the Bureau of Engraving and Printing, which prints currency, and the United States Mint, which makes coins. Most of the inventory consists of deposits by banks that had more cash than they needed to serve their customers and deposited the excess at the Fed to help meet their reserve requirements.
When a Federal Reserve Bank receives a cash deposit from a bank, it checks the individual notes to determine whether they are fit for future circulation. About one-third of the notes that the Fed receives are not fit, and the Fed destroys them. As shown in the table below, the life of a note varies according to its denomination. For example, a $1 bill, which gets the greatest use, remains in circulation an average of 21 months; a $100 bill lasts about 7.4 years.”
So you can see where the cash came from. Cash is sold by the US Treasury to the Fed at cost and then distributed to the banking system. It came from “outside” the private sector and exists to facilitate the use of inside money by allowing bank customers to draw upon their accounts. In recent decades, the amount of currency or cash in circulation has actually increased in large part due to the convenience of the ATM. But make no mistake. Cash does not rule the monetary roost. Cash is merely a convenient form of money for purchasing goods and services that facilitates the existence of inside money.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.