Harley Hahn's
Internet Insecurity

Chapter 12...

Understanding Money (Really!)

What is Money?

The main theme of this book is that the Internet, as important as it is, does not stand on its own. The Internet is a part of life, and to use it well, you need to understand the other parts of life, including your own nature.

We live in a society that is, to a large extent, cashless: we spend most of our money using checks, credit cards, debit cards, automatic payment services, and other abstract tools. The Internet is more extreme. On the Net, everything is cashless, and all transactions are abstract.

However, Internet commerce does not operate in an isolated environment. Money is money, and when you buy and sell over the Net, you do so within the confines of our everyday monetary system. For example, even though it may be fast and easy to use your credit card on the Net, if you don't pay your bill on time, something unpleasant will happen to you and it will happen off the Net.

In the long run, you will be better prepared to look out for your own interests if you have a sense of perspective, an understanding of why our monetary system is the way it is and what it means to you. So, in this chapter, I am going to talk about money: What is it? Where did it come from? How has it evolved? I will explain the basic ideas that underlie our modern economic system and show you why they are important to your life. In Chapter 13, we will cover the specific topics you need to understand in order to buy and sell on the Internet.

So, what is money?

It sounds like a simple question, but like a lot of simple questions, this one gets more and more slippery as you try to pin down the answer.

One way to understand money is to ask how people would exchange goods and services without it. Before the invention of money, buying and selling was carried out by bartering, that is, by trading one good or one service for another. Although bartering is simple, it has two important disadvantages compared to using money. First, it is inflexible; second, it does not provide a great deal of incentive for people to increase their productivity. Consider this example.

Farmer Brown lives in a town with no formal monetary system. Every year, he plants corn in the spring and harvests it in the late summer. At harvest time, he trades his corn for whatever goods and services he can find in his immediate neighborhood.

Over the years, Farmer Brown has found that there is no point growing more corn than he can use to trade at harvest time. Although many people may want his corn, only a few of them have something he wants at the time the corn is available, and if he waits too long the corn will spoil. If he grows and harvests extra corn, he'll just end up throwing it away. Later, during the winter, when Farmer Brown has nothing to trade, it is hard for him to get the supplies he needs to support himself and his family.

Farmer Green also grows corn, but he lives in an area in which gold coins are used as money. Instead of trading his corn for goods and services, Farmer Green sells it for money. Although most of his money comes in at harvest time, he is able to save some of it to use during the winter when he has nothing to trade.

As you can see, Farmer Green's situation is better than Farmer Brown's because Farmer Green is able to store his wealth for as long as he wants and spend it throughout the year as he sees fit. What is less obvious is that money gives Farmer Green another, much more important, advantage over Farmer Brown.

Farmer Brown's market is limited, because he can only sell corn to those people who, at harvest time, happen to have something to trade with him. As a result, Farmer Brown has no motivation to produce more than the minimum amount of corn. In fact, any effort he puts towards growing extra corn or making his business more productive is just a waste of time.

Farmer Green, on the other hand, can sell to anyone with money and, hence, has a much larger market. As a result, he has a reason to grow as much corn as the market will bear. Moreover, if he can find a way to grow extra corn, he is motivated to develop new markets. Thus, Farmer Green is rewarded for making his farm as efficient and as large as possible. As a result, he spends time developing new ways to grow, harvest, store and distribute corn. He can also use his money to buy better equipment, which allows him to farm a larger area in the same amount of time.

If Farmer Green is at all ambitious, he may — with hard work, good planning, and some luck — be able to build an enduring business that will employ other people and create wealth for him and his family. Moreover, his business will encourage the development of other businesses, such as those selling farm equipment.

Because Farmer Green can sell his corn for money, he will support the building of a railway line to help him distribute his products over a larger area. Once the railway goes in, it will not only expand Farmer Green's market, it will bring new goods to all the people who live in the area. Over time, the people in Farmer Green's town will become wealthier than the people in Farmer Brown's town. As a result, they will pay more taxes, which will allow the town to build roads, schools and hospitals.

Obviously, this is a simple example, and I don't want to pretend that economics is as simple as:

Farmer + Corn + Money = Automatic Prosperity

What I want to show you is that the idea of money, which we all take for granted, is crucial to our lives because it greases the wheels of economic activity. It is true, as Farmer Brown shows us, that it is possible to buy and sell without money ("I'll give you twenty baskets of corn for a cow"). However, as Farmer Green shows us, the only way to carry on large-scale commerce is to base it on a well-developed monetary system.

There are two reasons why money is so important to Farmer Green. First, buying and selling with gold coins is a lot more convenient than trading food for animals.

Second, money offers Farmer Green a great deal of flexibility. If he were to trade his corn for, say, cows, he would be limited as to what he could do with the cows. He could milk them, eat them, or use their hides to make leather, but not much else.

Gold coins, on the other hand, are valuable because they represent an abstract idea. When Farmer Green sells his corn for gold coins, he has a lot of choices because other people will accept the same coins as payment when he wants to buy something.

Aside from convenience and flexibility, the coins that Farmer Green receives have another quality that makes them suitable for buying and selling: they are fungible. FUNGIBLE means that an item is interchangeable with an equivalent item. Money is fungible because it is the amount that is important, not the specific coins or bills.

If Farmer Green, for example, sells a certain amount of corn for ten $5 gold coins, he doesn't really care which ten coins he receives: for practical purposes, all $5 coins are the same (as long as they are not counterfeit). However, if Farmer Green were to sell the corn for ten cows, it would make a big difference which cows he receives. (A large, healthy cow is a lot more valuable than a small, poorly nourished cow.) Thus, gold coins are fungible; cows are not.

We are now ready to define money:

MONEY is an abstract, fungible medium of exchange, used for the buying and selling of goods and services.

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The Idea of Money

For thousands of years, people have been using money of some type. The earliest money consisted of commodities, such as foods and animals. Over the years, many different types of commodities have been used as money: cacao beans (the Aztecs), almonds (in parts of India), barley (Babylonia and Assyria,) rice (Southeast Asia), butter (Norway), salt (China), oxen (Greece), sheep (the Hittites), buffalo (Borneo), cattle (Europe and India), and even human slaves (Ireland and equatorial Africa). In modern times, cigarettes and liquor were used as money in Germany following the Second World War.

At one time or another, just about every useful commodity that could be cultivated, bred, harvested or mined has been used as money. Although some of the commodity-based systems grew to be quite complex, they were, basically, glorified barter systems that were too limited to support a sophisticated economy. The biggest problem with commodities, especially animals, is that they are difficult to transport, count, store, and manipulate (as you know if you have ever walked into a convenience store late at night and tried to get change for a cow).

Some cultures developed monetary systems based on small, natural objects, such as shells, stones or animal teeth, which had little or no intrinsic value. Such objects were able to support a more sophisticated monetary system than one based solely on commodities. There are two reasons for this.

First, these types of small objects are more enduring than commodities such as rice, salt and cattle. Shells, stones and teeth don't spoil, disintegrate or die. Moreover, they are convenient to use and easy to carry from place to place.

Second, as a medium of exchange, shells, stones and teeth are more flexible, because they have little or no value in their own right. People who use these types of objects as money can assign the value in the way that best serves their needs. For example, it might be decided that blue shells are worth five times as much as yellow shells.

Although small natural objects are more practical and abstract than commodities, they do have some inherent problems. First, there is the matter of supply. If an economic system is to work well, the amount of money that circulates must be just right, not too much and not too little. If there are too many shells in one area, for instance, the people who live there will not consider the shells as having much value and will not accept them as money. If, in another area, shells are rare, there may not be enough of them to support all the buying and selling the people in the area need to do.

Another problem with natural objects is that they are not all the same, and this keeps them from being fungible. For example, one particular blue shell may be large and beautiful, while another one may be small, chipped and unattractive. In such a case, people will be reluctant to accept both shells as having equal value.

To solve these problems, it is necessary to make money out of materials that are relatively rare and of uniform quality. Traditionally, the materials that have been the most prized as a medium of exchange have been pieces of metal or coins made of metal. Throughout history, a variety of metals have been used as money, depending on what was available in a particular area, for example, iron (Europe and northern Africa), copper (Egypt), bronze (southern Europe), lead (Burma), and tin (Malay Peninsula).

One of the reasons metal works well as money is that it will hold its value over time. For example, rice will disappear when you eat it, and if you don't eat it, it will spoil. Cows and sheep will die eventually no matter what you do.

Metal, on the other hand, is permanent. Moreover, you can convert metal from one form to another at any time without having it lose its value. For example, a plain piece of metal can be formed into a tool or a piece of jewelry. Later, that same metal can be melted again and formed into something else and still hold its value.

Historically, the most important way in which metal was exchanged was in the form of coins. Once a group of people were able to create coins, their money became not only practical, but fungible, which allowed their economic system to grow more rapidly. For example, if you arrange to sell a cow to someone for 100 coins, there is no reason for you to care which particular coins you get. As long as they are all the same weight and purity, one coin is as good as another.

Of all the metals, gold is the one that human beings have prized the most, even though it has relatively few practical uses. One reason is that gold is more enduring than other metals. For example, over time, iron will rust, copper will turn green, and silver will tarnish. Pure gold, however, will remain unchanged for years and years. Another reason for gold's persistent value is that it is more attractive and more malleable than other metals. Thus, for centuries, gold has been the metal of choice for making jewelry and other decorations.

To a lesser extent, silver has some of these same properties and, in many parts of the world, is more abundant than gold. As a result, a great many cultures came to use gold or silver coins, or both, as a universal currency. Once such coins became widely available, they offered a medium of exchange that was convenient, permanent and fungible. Because, in historical times, gold and silver had few practical uses, coins made of these metals were sufficiently adaptable to represent wealth in whatever way a particular economic system needed at the time. A gold coin, for example, could be worth one cow, two cows or forty cows. An actual cow, on the other hand, is always a cow and nothing more.

As a general rule, the more abstract the medium of exchange, the more flexible it is and the better it lends itself to an increase in commerce and productivity. In this sense, we can consider the history of money to have taken places in two stages. First, money evolved slowly from bulky commodities into small, practical, convenient gold and silver coins. From there, it developed into intangible instruments of commerce that are based entirely on faith.

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Who Invented Money?

The history of money is the story of an evolution from barter to coins, bills, and, finally, completely intangible units of exchange. The driving force behind these changes was the need for enough money to support increased production and prosperity. If the economy of a particular region were to grow consistently, it would require increasingly more money as time goes by. Moreover, the more intangible the form of money, the more the money supply could be controlled. In a few moments, I'll show you why this is so important. First, though, let's consider how money evolved from pieces of gold and silver into our modern currency.

The first coins were minted between 640 and 630 BC in the Kingdom of Lydia, a region in west-central Asia Minor on the Aegean Sea, lying within modern-day Turkey. The Lydian kings created small pieces of metal with a standardized size and weight. These pieces of metal were then stamped with an emblem that verified their worth.

At first, the Lydians made their coins from a substance called electrum, a natural mixture of silver and gold. Later, during the reign of Croesus (560-546 BC), the Lydians began to mint coins out of pure gold and silver, a tradition that was followed for centuries.

The invention of coins greatly expanded the potential for buying and selling within Lydia. For the first time, even an illiterate person could buy and sell with confidence. Instead of having to weigh pieces of gold or silver and evaluate their purity, all a person had to be able to do was count coins. In this way, the Lydian coins sparked a commercial revolution. Lydian merchants started to trade a large variety of products, and the Lydian ruling class became very rich.

As a result, the Lydians were responsible for some of the most important social innovations in history. For example, in the late 7th century BC, the Lydians created the first retail market, in which merchants, often from remote areas, would gather in a central location to sell their goods to the general population.

Another social innovation had to do with dowries. In Lydian society, a woman could not marry until someone paid a dowry (something of value) to the prospective groom. Normally, the dowry was paid by the woman's father or male relatives, which gave them the power to choose the husband. Once coins were introduced, some Lydian women were able to save enough money to pay their own dowries, which gave them more freedom in choosing a husband.

Another important innovation was the first brothel, in which sexual services were offered to the many merchants who were attending the market, buying and selling. Before long, Lydia boasted a number of brothels, and it is said that many unmarried Lydian women would choose to work in a brothel in order to accumulate enough money to secure the type of marriage they desired.

Along with increased commerce and the development of brothels, the Lydian monetary system also encouraged a great deal of gambling. As a result, Lydia is also credited with the invention of dice.

In 547-546 BC, Lydia engaged in a bloody war against Persia. Although the Lydians lost, their mercantile system began to be adopted by more and more towns. Eventually, as the benefits of a stable form of money came to be appreciated, the Lydian system spread to the cities of Greece.

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Everywhere money was adopted, it showed itself to be a strong force, making enormous changes in the prevailing culture. For the first time in history, people began to build towns and cities designed around marketplaces rather than palaces or temples. Money was important because it allowed people to organize their activities in ways that would otherwise have been impossible. A money-based culture was able to grow stronger and become more robust more quickly than a society held together by force or by ties of kinship. Even today, money has an enormous effect on our social organization. On the Internet, for example, much of what you are able to do and much of what you see is controlled by the invisible force of money.

In ancient Greece, the influence of money was profound. In the 6th century BC, the culture of the Greeks was as yet unformed, while their neighbors, the Phoenicians and the Persians, had sophisticated social systems. These systems, however, were not monetary. Once the Greeks adopted the Lydian system of commerce, they were able to surpass their neighbors and break through the invisible wall that had limited other cultures. As a result, Greece become a powerful trading nation that grew to dominate the entire Mediterranean area, and the Greeks developed a highly accomplished culture that eventually changed the world.

It takes more than coins to create a successful economy. There must also be leaders who understand how to guide the economy.

Of course, it takes more than coins to create a successful economy. There must also be leaders who understand how to guide the economy. It took, literally, centuries for people to learn enough about money and how it works to act with wisdom and skill. In the meantime, one country after another fell prey to the most common of the money-induced evils: greed and mismanagement. One of the most important examples is the Roman Empire.

During the time of the Roman Republic (509-27 BC), Rome had its ups and downs militarily, but for the most part, it thrived economically. The Romans had adopted the use of money, which they implemented over an immense area, and it was during this time that most of Rome's commercial growth took place.

In 27 BC, the Roman Empire was founded, the first empire to be organized around the use of money. Over the next five centuries (until 476 AD), Rome was ruled by a long succession of emperors.

The early emperors had a clear respect for the value of commerce and markets, and they appreciated how important the monetary system was to their being able to retain power. As a result, they were able to maintain the success of the Republic and even improve upon it somewhat. During the reign of the emperor Marcus Aurelius (161-180 AD), the Roman Empire reached its economic zenith and, for the first time in history, most of the Mediterranean region and many of the surrounding lands were united under a single political and monetary system.

However, the Roman Empire, as powerful as it was, had a fatal flaw. All power was centralized in Rome and, unlike Athens (the center of Greece), Rome produced very little of value. Moreover, unlike Sardis (the capital of Lydia), Rome was not a major center for trade and commerce. The wealth of Rome was imported, mostly from lands that were conquered by the Roman army.

As a general rule, Roman emperors spent what they had: they did not save and they did not use a budget. Moreover, the later emperors mismanaged the empire's finances by spending more and more money on the army and on a bloated bureaucracy. Over time, it became clear that the empire's wealth could not be sustained by conquests and pillaging. It was then that the emperors, in looking around for a cure, hit upon a plan of action, one that would provide a temporary fix, but would ultimately destroy the very integrity of the monetary system: they debased the currency.

What they did was to reduce the silver content of the coins, which allowed them to manufacture more coins with the same amount of silver. Unfortunately, this type of behavior was not unique to the Roman emperors. Over the next two millennia, it was repeated many times, always with disastrous results.

In the case of Rome, their unit of money was the denarius. Early on, the emperor Nero (who ruled from 54-68 AD) reduced the silver content of a denarius from 100 percent to 90 percent. Over the years, the silver content was reduced again and again by one emperor after another, until, by the reign of Gallienus (260-268), the denarius contained virtually no silver at all. The same amount of silver that, at the time of the founding of the empire, was used to create a single denarius, was now used to create 150 denarii.

The end result was as you might expect. As the silver content of the Roman coins went down, so did their value, leading to INFLATION, a condition in which the prices of goods and services increase significantly for an extended period of time. In the 2nd century AD, for example, a certain amount of wheat cost half a denarius. A hundred years later, the same amount of wheat cost 100 denarii.

The emperors needed more money, not less, but the debasement of the Roman currency had effectively reduced their purchasing power. Their solution was to raise taxes, which they did repeatedly. The uncontrollable inflation and unconscionable taxation combined to destroy the Roman economy leading, eventually, to the deterioration and ultimate downfall of the empire.

This scenario, the debasing of the monetary system by a king or a government leading to inflation and misery, is only one way in which a monetary system can be destroyed. As I mentioned earlier, a growing economy needs just the right amount of money, not too much and not too little. If a country were to find itself with too much money, the same type of thing would happen: inflation would set in, the ruling class would get greedy, the bureaucracy would grow, and the system would collapse. This is exactly what happened to Spain in the 16th century.

In 1492, Columbus made his first voyage to the New World. Over the next 300 years, the Spanish, and later the Portuguese, established colonies in Mexico and South America from which they shipped enormous quantities of gold and silver to their mother countries. Much of the gold and silver was stolen from the native peoples; the rest of it was extracted from mines using mostly native labor.

The Spanish established mints in Mexico and Peru to make coins and, over time, the number of gold and silver coins that made their way to Europe was so large that it created tremendous inflation and inspired enormous greed. By the 16th century, the country of Spain had became so impoverished that it went bankrupt twice (in 1557 and again in 1597). The influx of gold and silver coins also affected Spain's trading partners causing significant inflation in other countries. For example, by the end of the 17th century, prices in England were three times what they were before Columbus sailed to the New World.

However, the increase in currency did have some positive effects. Commerce increased as the regional economies of Western Europe began to grow together, bringing merchants and bankers into a single financial system. As the new coins became ubiquitous, the lives of common people were affected profoundly. For the first time, everyone in Western Europe, not just the ruling class, was able to participate in the economy, and many new types of goods and services became available to anyone with money. Before long, the new economy gave rise to a middle class, most of whom were merchants.

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Paper Money

The earliest records of paper money date to China during the T'ang dynasty (618-906 AD), a golden age of Chinese culture. For hundreds of years, there was no paper money outside of China. Indeed, when the Venetian traveler Marco Polo traveled to Asia (from 1271-1295), he was astonished at the power of the Mongol emperor Kublai Khan, who was able to compel his subjects to use money made of paper.

The Chinese emperors, however, did not use money to expand the economy in a way that benefited the general population. Rather, they confiscated all the gold and silver and then forced their citizens to use paper money. They did so for two reasons. First, they wanted all the gold and silver for themselves. Second, by eliminating the need to transport large amounts of coins from one place to another, the emperors were able to simplify the administration of the largest empire in the history of the world. Collecting taxes, for example, became a lot easier once everyone used paper money.

In the West, paper was not even invented until 1150 (in Spain), and the debut of paper money had to wait until the German printer Johann Gutenberg invented the first printing press with moveable type around 1436. Once money could be printed, it proved to have important advantages over coins: it was cheaper to produce and a lot more convenient.

Sweden, for example, had very little silver or gold from which they could make coins. The Swedes did, however, have a great deal of copper so, in the 1640s, they began to make copper money. Because copper is less valuable than silver and gold, these "coins" were actually large metal plates that weighed about 4 pounds each. In 1644, the government wanted to produce more valuable coins, so they minted copper plates that were worth ten times as much and weighed over 43 pounds apiece.

Clearly, this system was unworkable, and in 1661, the Stockholm Bank became the first European bank to issue paper bank notes. The bank notes were accepted readily, because a single note could take the place of 500 pounds of copper. Merchants liked the new system because it meant that they did not have to move stacks of heavy copper plates from one place to another.

A little reflection will show you that paper money also has a significant disadvantage compared to coins. Because paper money is so cheap to produce — compared to what it is worth — there is a constant temptation for the people with the keys to the mint to print as much money as they possibly can. When that happens, the money quickly loses its value, inflation strikes like the hot kiss at the end of a wet fist, and the entire system collapses. The first particularly egregious example was in France, and involved a Scotsman who came to be known as the Duke of Arkansas. Here is the story.

By the early 18th century, the idea of paper money was generally accepted in Europe, and various banks and governments had already issued their own money. None, however, had been successful. In 1715, a young King Louis XV became ruler of France. At the time, France was virtually bankrupt, and because Louis was still a minor, the monarchy was controlled by a regent named the Duke of Orléans.

In an attempt to solve the country's financial problems, the Duke, in 1716, arranged for the monarchy to start its own bank under the direction of John Law, a Scotsman of ill repute. The Duke was particularly attracted to Law's promise that the bank would be able to issue as much paper money as it wanted.

At first, Law only issued money that was backed by the gold reserves of the bank. The money was accepted, the new bank was a success, and Law was given the title of the Duke of Arkansas. Within a short time, however, the two dukes began to print more and more money, and before long, the bank had issued more than twice the amount of money that it had in real gold.

Meanwhile, in 1717, Law helped found a company to exploit the riches of Louisiana (which was, at the time, a French colony in the New World). Using his influence at the bank, Law created a pyramid scheme to attract investors to the new company. The bank would print money to loan to investors who would use it to buy shares in the company. The company would then use the money from the new investors to pay out huge, bogus dividends to existing shareholders. Before long, the pyramid collapsed, leaving a long trail of worthless money and impoverished investors.

The phenomenon of printed money becoming worthless has happened many times. To me, the most interesting example occurred during the American Revolution. The printing of money was an experiment that was not only a terrible failure, but a spectacular success.

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The First Successful Paper Money

Of all the early American intellectuals, the most revered is Benjamin Franklin (1706-1790). In his lifetime, Franklin was a highly accomplished writer, inventor, statesman, politician and scientist, a man who was widely admired for his wit and for his commonsense philosophy. Among his many other accomplishments, he is also remembered as the father of paper money.

In 1729, Franklin wrote an essay entitled "A Modest Enquiry into the Nature and Necessity of a Paper Currency". At the time, the principal money used in the American colonies was the Spanish silver dollar. After Franklin's essay appeared, several colonies tried to follow his plan by printing their own paper money. The British Parliament, however, considered this to be a usurpation of their powers and, in 1751 and 1764, outlawed the use of paper money in the American colonies.

In 1774, the colonists convened the First Continental Congress (federal legislature) and presented the British King, George III, with a long list of grievances. Fighting broke out, marking the beginning of the American Revolution and, in 1775, the Second Continental Congress established an army and appointed George Washington as its commander. On July 4, 1776, the Congress formally declared its independence from Great Britain by adopting the Declaration of Independence.

To finance the new army, the Congress put Franklin's ideas into practice by issuing paper bills of credit that were (supposedly) backed by gold and silver, and by passing a law that forced people to accept the new currency. As the war progressed, the need for money increased and, in 1777, the Congress issued $13 million of Treasury notes, which became known as "continentals" (because the words "Continental Currency" were printed on the notes).

At first, the value of the continental was set to be the same as the Spanish silver dollar. However, the value of the new money soon fell to two for a dollar. Then, as the Congress issued more and more money to pay for the war, the value of the continental slid further and further. It was not until 1780 that Congress finally stopped the printing press although, by then, the states were issuing their own money. By this time, the Congress had issued $241 million worth of paper money and their value had decreased to 40 continentals per silver dollar. By 1781, the value had fallen even further, to 75 per silver dollar.

This experience, unfortunately, was not unique. Once the idea of paper money caught on around the world, governments would often print money for an important cause: to fight a war, to pay for social programs, and so on. At first, everything would seem to work fine. In fact, by injecting new money into the economy, a government would be able to increase production. Eventually, however, the government would print too much money. The money would then decrease in value, which would create inflation, resulting in a significant loss in purchasing power for the general population.

This is exactly what happened in the United States. After the revolution (which ended in 1783), many people were left with continentals that had become virtually worthless. After an extended debate, the U.S. government decided to redeem all the continentals by trading them for government bonds, but at the rate of only $1 worth of bonds for $100 in continentals.

This experience did not sit well in America. The general population was so displeased with paper money that they returned to using coins almost exclusively, and very little paper money was issued for almost a hundred years. Indeed, the U.S. Constitution (written in 1787) specifically dictates that no state shall "make any Thing but gold and silver Coin a Tender in Payment of Debts." It was not until the 1860s, that the U.S. government once again issued paper money, this time to pay for the Civil War.

In Europe, however, the United States' experiment was looked upon as a great success. It was, after all, the first time a government had been able to finance a war simply by printing money. The door to the mint was now open, and before long, the governments of many other countries started to print their own money.

And thus began our modern monetary system.

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Inflation and Hyperinflation

To appreciate how the Internet is important to the world economy of the 21st century, it is necessary to understand the major economic forces of the 20th century. One of the most significant forces was the threat of inflation.

Throughout this chapter, I have discussed examples of inflation, a condition in which the prices of goods and services increase significantly for an extended period of time. In the 20th century, there were a number of occurrences of extreme inflation, called HYPERINFLATION, in which prices skyrocketed beyond all reason. Before I can explain how this can happen, I need to spend a moment discussing the advantages — and disadvantages — of paper money.

The original purpose of paper money was to provide a convenient way to represent more tangible forms of money. For example, a paper note could be printed to represent a specific amount of gold or silver. Merchants would accept the note because they knew that, whenever they wished, they could present the note to the issuing agency — a bank or a government — and exchange it for the actual gold or silver.

Since paper money was a lot more convenient than coins, few people actually traded paper for gold. However, because people believed they could make the trade, they had faith in paper money, and it was this faith that made the whole system work.

From time to time, governments or banks would print more money than they had real gold. This, as we discussed earlier in the chapter, would cause inflation, which would create economic instability. However, inflation alone is not enough to make an economic system fail. An economic system does not fail until the people lose faith in the currency. In the 20th century, this happened many times, always with disastrous results. The most interesting example occurred after the Russian Revolution when the new government deliberately sabotaged their own currency.

In February of 1917, the regime of Tsar Nicholas II was overthrown and, nine months later, in November 1917, the Bolsheviks, led by Vladimir Lenin, seized power. The Bolsheviks (who, in 1918, changed their name to the Communist Party) promoted an idealistic philosophy in which all property, including the means of production, should be owned and administered by the state for the good of the people.

Some of the newly powerful Communists dreamed of building a society without money. The plan called for money to be replaced by a rationing system based on coupons that would be allotted by the state. To destroy the current monetary system, the Communists printed as much money (rubles) as everyone wanted. Within a short time, the monetary system was effectively destroyed by hyperinflation: paper money had lost so much value that it took 10,000 new rubles to buy something that, before the revolution, cost only one Tsarist ruble. Within a few years, however, it became obvious, even to the Communists, that the country could not function without money and, in 1921, the government was forced to introduce a new currency.

The most extreme case of the collapse of a currency occurred in Germany after World War I. The war had lasted from 1914 to 1918. Germany and her allies had lost the war, and the other European countries, particularly Great Britain and France, pressed for extreme retribution. The details were specified by the Treaty of Versailles, which was negotiated in 1919 by the United States, Great Britain, France and Italy. The treaty sharply reduced Germany's power and gave some of her land to other countries. It also established the League of Nations, the forerunner of the United Nations.

Most important, the treaty placed the blame for World War I on the Germans, and ordered them to pay the cost of the war. Although the U.S. objected, the other countries, in April 1921, presented Germany with a huge bill of 132 billion German marks. This was equal to about $33 billion U.S. dollars (about $329 billion in today's dollars). Although most of the blame for World War I did lie with Germany, their economy had been devastated by the war, and the terms of the treaty made it difficult for them to sell goods for a fair price on the open market.

The German government did begin to make payments to other countries. However, the Germans were not able to meet even their own domestic obligations, so in order to come up with the money, the government began to print large amounts of paper money without any tangible backing. The result was a severe debasing of the German currency. Within several months, prices in Germany started to rise. As the government printed more and more money, prices rose without bound, and the government found itself needing to issue paper money faster than it could print it.

How bad was the situation? In November 1919, just after the war, one U.S. dollar cost about 4 German marks. By July 1922, a dollar cost 500 marks. By January 1923, the cost had risen to 18,000 marks. At the height of the German inflation, in November 1923 — four years after the war — a German mark was worth so little that it cost 4,200,000,000,000 (4.2 trillion) marks to buy a single U.S. dollar. In other words, in November 1923, one U.S. penny was worth 42 billion German marks.

The hyperinflation finally ended on November 29, 1923, when the German government created a new currency in which each new mark was worth a trillion old marks. One U.S. dollar was now worth 4.2 new marks. To keep the currency stable, the government based the new money on land values. In 1924, the U.S. loaned Germany $200 million so it could return to the gold standard, which further stabilized the new German money.

However, by 1924, the damage had been done. Extreme inflation had placed a great financial burden on the Germans, especially on the working class and the middle class. This burden, combined with a general resentment over the harshness of the Treaty of Versailles, created great suffering within Germany. This suffering, in turn, fostered long-standing discontent and an atmosphere of political extremism, leading to the conditions that allowed Adolf Hitler to come to power in the early 1930s. In 1935, Hitler unilaterally nullified virtually all of the Treaty of Versailles.

The German experience with hyperinflation was extreme, but it was by no means unique. The 20th century saw a number of countries succumb to this deadly economic malady, among them Bolivia in 1985, Argentina in 1989, Peru in 1990, Brazil in 1993, Ukraine in 1993, and Kosovo in 1994.

Such occurrences are serious because they affect more than one particular country. Not only is an entire region destabilized, but the economy of the world as a whole can be affected. For example, at the height of the hyperinflation in Bolivia, Bolivian merchants and consumers were able to achieve a certain amount of stability by establishing a large black market economy using U.S. paper money. In order to make the system work, however, the Bolivians required an ever-expanding supply of American cash. The principal way in which they accumulated this cash was to export coca paste, which was used to make cocaine for the U.S. market. Once the drugs were sold on the streets of America, the cash was shipped back to Bolivia where it was used to support the underground economy.

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The Real Lesson of History

For most of history, the world has been an embattled and chaotic place in which a huge amount of human effort has been devoted to war and the problems caused by war. Traditionally, many people have considered the causes of war to be aggression, politics, greed and hatred. In order to bring peace to the world, the thinking goes, we must learn to control these primal urges.

However, aggression, politics, greed and hatred are inevitable expressions of human nature. What the lessons of history have really shown us is that the best way to ensure world peace is to create a stable economy in which people, countries, and regions are economically dependent on one another.

For example, the harsh economic conditions in Germany that followed World War I were one of the principal causes of World War II. After World War II, however, the winning countries did not demand reparations from Germany. Instead, they spent a huge amount of money and effort rebuilding the Western European economy and stabilizing its currencies. The U.S., for example, spent over $12 billion ($85 billion in today's dollars) from 1948 to 1951 as part of the Marshall Plan in which an enormous amount of food, manufactured goods, and raw materials were sent to Europe, much of it to Germany.

This might seem like a lot of money for a country to spend rebuilding other countries after a war (especially when you consider that the United States was one of the winners of the war). However, the Marshall Plan — named after U.S. Secretary of State George Marshall — was one of the best investments the country ever made. As a result of this program, Europe was able to recover from the most devastating war in history and — over the next fifty years — create a unified economic system (the European Union) that assures peace in Europe for the foreseeable future. Although the effort cost the U.S. $12 billion at the time, we need only compare this to the cost of World War II, $360 billion, (over $4 trillion in today's dollars) to see that the Marshall Plan was a bargain.

Although the 20th century was marked by the worst wars in history, it was also a period of enormous transition, a time in which the global economy was born, creating a world in which major conflicts are unthinkable. The lessons of the 20th century show us that global peace is not achieved when people around the world decide to act peaceably. Global peace is achieved when people around the world perceive themselves as being economically dependent on one another.

The Internet plays an important role in the new economy by connecting companies, governments and individuals around the world. In an economic sense, these connections do more than simply facilitate commerce. They change the very experience of buying and selling in such a way as to increase the interdependence of the various parts of the global economy. As such, the Net acts as a powerful catalyst of world peace.

Although the Net is still rather new to mankind, the seeds of the new global economy were planted a long time ago, in 1933, when U.S. President Franklin Roosevelt was searching for a way to stimulate the American economy during the depths of the Great Depression.

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How Roosevelt and Nixon Ended
the Gold Standard

The DEPRESSION, or more formally, the GREAT DEPRESSION, was a long period of economic hardship that lasted from late 1929 to 1937. The downturn in the economy actually started in August of 1929. However, most people were not aware of what was happening until the stock market began to collapse on October 24, 1929 (referred to as "Black Thursday"). Within a short time, the economy of the United States deteriorated significantly and the Depression had begun in earnest.

In 1932, Franklin Roosevelt was elected President of the United States after promising to take forceful steps to improve the economic situation. By the time Roosevelt took office in March of 1933, conditions all over the country were appalling. Industrial production was down 56 percent from 1929 and over 13,000,000 people, a third of the work force, was out of work. To make matters worse, farmers all over the country were going broke. (At the time, the U.S. was mostly an agrarian nation.)

One of the biggest problems Roosevelt faced was that a large number of people had lost confidence in paper money and were going to their banks to exchange their money for gold. This so-called "run on the banks" had happened several times since the 1929 stock market collapse, and it was happening again at the time Roosevelt took office. If a bank could not meet the demands of its depositors, it would have to close down. In 1929, there were 24,633 banks. By 1933, only 15,015 were still in business, a decrease of 31 percent.

A run on the banks was devastating for other reasons as well. Not only did it deplete the gold reserves, but it removed large amounts of cash from circulation at the very time that the economy needed it most in order to recover. (As I will explain later in the chapter, an economy cannot grow unless it has an adequate money supply.) The decrease in the money supply from 1929-1933 was one of the reasons the Depression was so severe and lasted so long.

In 1933, much of the world, including the U.S. and many European countries, was on the GOLD STANDARD, which meant that paper money could be exchanged for gold. For example, you could, at the time, go to a bank and trade a dollar bill for a dollar's worth of gold. In other countries, you could either trade your currency for gold or, at the very least, trade for U.S. dollars, which could then be converted to gold.

In normal times, few people would actually make such a trade: it was enough to know that it was possible. However, these were not normal times. By 1933, the U.S. was in big trouble and people all over the country were trading in their dollars for gold.

Roosevelt had to stop this, and to do so, he decided to change the system so that the U.S. government would hold and control all the gold in the country. In other words, he began to nationalize gold.

Roosevelt nationalized gold for two reasons. First, he wanted to stop the run on the banks. Second, he was planning a number of expensive social and economic programs and he needed money to finance them. Controlling the gold supply would give him more control over the money supply.

In 1933, with the cooperation of the U.S. Congress, Roosevelt made it illegal for Americans to possess gold coins or bullion. He then took away the right of Americans to be able to exchange paper money for gold. Finally, he confiscated all the privately held gold in the country by forcing people to trade it to the government for paper money at the rate of $20.67/ounce.

Within a year, the U.S. government owned most of the gold in the country. Then, on January 31, 1934, Roosevelt used the authority given to him by Congress to unilaterally raise the price of gold to $35/ounce. Overnight, an ounce of gold that used to be worth $20.67 was now worth $35. Making this price change allowed Roosevelt to pull a fast one, a monetary scheme that, even by today's standards, was totally awesome. Here is how it worked.

In 1933, the government was able to print $20.67 in paper money for each ounce of gold that it held. In 1934, the same ounce of gold could be used to support $35 in paper money, a difference of $14.33. In this way, the value of the gold held by the government increased by about $3 billion, which meant that Roosevelt was able to create $3 billion in brand new money out of nothing. He could then use the $3 billion to help fund his new programs. In doing so, Roosevelt put a huge amount of new money into circulation, which helped the economy to recover.

However, he did so at a cost. First of all, Roosevelt effectively devalued U.S. paper money (with respect to gold) by 41 percent. Second, distancing the U.S. from the gold standard, he initiated a process that was potentially dangerous. If the U.S. ever went off the gold standard completely, and the government did not have the discipline to keep from creating too much new money, there would be trouble.

Four decades later, in 1971, the remaining U.S. ties to the gold standard were finally severed, by Richard Nixon, in an attempt to solve a serious cash flow crisis. The previous president, Lyndon Johnson, had escalated the Vietnam War at the same time as he initiated expensive social programs (the so-called War on Poverty). In 1969, Nixon inherited these obligations, which he extended on his own.

Both presidents had had trouble getting enough money, because neither they nor Congress were willing to raise taxes to support an increasingly unpopular war. To get the money they needed, Johnson and Nixon borrowed, and then spent, billions of dollars. In the process, they infused a huge amount of money into the economy, which led to serious inflation. It also led to a balance of trade problem, in which the U.S. was importing far more than it was exporting. As a result, more and more U.S. dollars came to be held outside the country.

To keep foreign countries from trading in their surplus dollars for gold, Nixon, in 1971, unilaterally decreed that, from now on, the U.S. would not exchange dollars for gold for anyone. For all practical purposes, the United States was off the gold standard. In 1978, Congress passed a law making it official. Other countries had passed similar laws, and by the end of the 1970s, no major currency was redeemable in gold.

But if a dollar was not redeemable by gold, why should it be worth anything? And if the dollar was no longer tied to gold, who would decide when and how to create new money?

The answers to these questions will surprise you, and they will go a long way towards explaining how our modern monetary system works, and why the Internet is so important to the world economy.

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Business Cycles: Why Someone Needs
to Be In Charge

In a minute, we'll talk about our modern monetary system and I'll answer the questions I posed at the end of the last section: "How can money that is not redeemable have value?" and "Who creates new money?" Before I do, however, I'd like to lay the groundwork for our discussion by posing a more basic question: "Is anyone in charge?"

It is the nature of the economy that it is always changing. Over a long period of time, economic changes come in cycles in which a period of expansion is followed by a period of contraction. During an expansion, production, income, employment and trade all increase, causing the economy to grow. Life gets better and better. During a contraction, life becomes more difficult. Production, income, employment and trade go down and the economy shrinks.

Such cycles are long, taking many months or even years, and the duration of the expansions and contractions varies considerably. In economic terms, a single up-and-down fluctuation — one expansion followed by a contraction — is called a BUSINESS CYCLE. All countries and economic regions go through such cycles. For instance, in the last 150 years, the United States economy has gone through 31 business cycles.

During the period of contraction, the decline in general economic activity causes widespread problems. When this happens, we say that the economy is in a RECESSION. Thus, the U.S. has had 31 recessions in the last 150 years.

As a general rule, a recession lasts from 6 to 12 months, although this is not always the case. The most severe recession took place from August 1929 to March 1933, a total of 43 months. This recession was so extreme that it created the Depression, a long period of economic suffering. The Depression started in November 1929, with the collapse of the U.S. stock market and grew to affect most of the world, including Europe and Canada. Although the actual recession ended in 1933, it took a long time for the world economy to recover. In fact, the Depression itself did not really end until the late 1930s, when massive government spending (to prepare for World War II) infused a huge amount of money into the global economy.

Because business cycles are part of the system, it is natural to wonder if there is anything we can do to avoid the recessions. If this is not possible, can we at least do something to make the recessions as short and mild as possible?

One solution, of course, is to have a war (after all, World War II did end the Depression). Unfortunately, wars only boost the economy temporarily. Although all the government spending does invigorate the economy, most of the money is spent on activities that are fundamentally destructive (such as building weapons) rather than constructive (such as building houses and schools). In virtually all cases, the government will borrow large amounts of money to pay for the war. When the war ends, so does the temporary spending, at which time the huge debt brings about a general economic contraction that invariably leads to a severe recession.

So, although wars can end a recession, in the long run, they have always proven to be devastating to a country's economy. The larger the war, the more economic suffering it ultimately brings.

Clearly we need a better way to invigorate a depressed economy and smooth out business cycles. In today's world, we do have a better solution, one that is based on three ideals:

  • Controlling the money supply wisely.
  • Creating a truly global economy.
  • Keeping the world peaceful.

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Who Controls the Money Supply?

As you can see by now, both people and countries have a need for economic stability. But economic stability does not mean that financial conditions should stay the same for a long period of time. Indeed, as we discussed in the previous section, the economy has a life of its own, moving through business cycles in which periods of expansion are followed inevitably by periods of contraction.

Since change is inevitable, working towards economic stability means doing the best we can to moderate the business cycles. Our goal is to make the expansions as manageable and predictable as possible (thereby avoiding inflation), and to make the contractions as short and mild as possible (thereby avoiding recessions).

I have mentioned that, in the last 150 years, the United States has gone through 31 business cycles, many of which have had devastating periods of inflation and recession. Although there are no perfect solutions, it is possible to manage the economy somewhat. For example, the last period of economic expansion started in March of 1991. As I write this (in May of 2001), the economy is still doing well. In fact, it is, by far, the longest period of economic expansion in modern history.

It is an interesting characteristic of a healthy economy that it cannot stay the same for very long.

What is it that helps keep an economy healthy and stable? There are a number of important factors, and I will summarize them for you at the end of the chapter. (At the time, you will see that one such factor is the Internet.) For now, I want to discuss the element that is most under our control: the size of the money supply.

The health of an economy is very much dependent upon its money supply. Virtually every transaction requires money and, without enough money, the rate of commerce will slow down. Moreover, in order for the economy to grow, individuals, companies and governments must be able to borrow money as they need it. If there is not enough money, interest rates will go up, borrowing money will become more expensive, and the economy will slow down.

It is an interesting characteristic of a healthy economy that it cannot stay the same for very long: the level of productivity must either grow or shrink. Since we prefer that the economy grow, we must make sure that it always has enough new money. If the economy does not get enough new money, it will, over time, begin to contract.

Imagine the economy is a pot of water boiling on the stove. To keep the pot boiling, you constantly have to be adding just the right amount of heat. If you add too little heat, the water cools down and stops boiling. If you add too much heat, the boiling gets out of control.

In the same way, if the economy doesn't get enough new money when it needs it, economic activity will slow down to the point where it will cause a recession. Conversely, if too much new money is put into the economy for too long, it will cause prices and wages to spiral up and up, which will cause inflation.

The basic idea behind modern economic management is for someone to control the money supply in such a way that the economy gets the right amount of new money at the right time. For example, during recessions, the money supply should be increased to speed the recovery. During times of inflation, the money supply should be decreased to hold down prices and wages. Indeed, it may even be possible to avoid recessions and inflation by manipulating the money supply preemptively.

In most countries, an organization called a CENTRAL BANK is in charge of controlling that country's money supply. All industrialized countries have a central bank and, in Europe, the European Union has a central bank of its own to control the Euro and the European-wide money supply. In the United States, the central bank is called the FEDERAL RESERVE, often referred to as the FED.

The Federal Reserve was created by the U.S. Congress in 1913 in an attempt to avoid the booms and busts that had caused such severe problems in the 19th century. The Fed is a hybrid organization, part public and part private, that was set up specifically so as to avoid being subject to short-term political pressures.

The Fed is based in Washington, D.C. and is run by a Board of Governors consisting of seven people who are appointed by the President and confirmed by the Senate. Under the supervision of the Board of Governors are 12 regional Federal Reserve Banks that oversee various parts of the banking system. Although the Board of Governors is a public agency, the Federal Reserve Banks are actually private organizations, although in many ways, they function as public agencies.

From among the seven Governors, the President appoints one to be Chairman, to run the board and to act as chief executive of the Fed. As you will see in a moment, the Fed is an extremely important organization. As a result, the Chairman of the Fed is the second most powerful person in the United States, after the President himself, and one of the most important people in the world.

The U.S. Federal Reserve provides four main services. First, it acts as the money manager for the United States, regulating the money supply as necessary. (We'll talk about the details in the next section.) Second, the Fed acts as the official bank of the federal government. Third, the Fed regulates the U.S. banking system. Finally, the Fed serves as a sort of super-bank, providing special services to all the other banks in the country.

In the context of our discussion, the Federal Reserve is important because it is charged with the task of keeping the financial system as healthy as possible. To do so, the Fed manipulates the money supply in a way that (it hopes) will avoid inflation and recessions, and will encourage the economy to grow in as stable a manner as possible.

In this way, the Fed and other central banks around the world have enormous influence over the lives of people everywhere, much more than most people realize. For example, if the Fed thinks the U.S. is in danger of excessive inflation, it may reduce the money supply in order to cool down the economy. This, however, will increase unemployment, which, in turn, will affect people's marriages, their self-esteem, and their financial well-being, not to mention their ability to buy a house, send their kids to college, and save for retirement.

In a very real sense, the Federal Reserve has huge power over the U.S. economy and, indirectly, over people's lives. And yet, very few people understand what the Fed is and how it works. To show you one aspect of the system, I am going to describe to you how money is created and how the Fed manipulates the U.S. money supply. This is something that I want you to understand because, later in the chapter, I am going to explain how the Internet also affects the supply of money, and you will see how everything is related.

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How Most Money is Created

Most money does not exist in tangible form. In fact, less than 10 percent of U.S. money is in the form of bills or coins. Over 90 percent exists only as electronic data stored in a computer. Think about your own money, for example. Although you probably have some cash, most of your money exists in bank accounts or brokerage accounts, and your wealth is actually stored as data in various computer systems.

There are two ways in which new money can be created. First, it can be printed as bills or manufactured as coins. More frequently, however, money is created just by changing the data stored in a computer. For instance, if your bank were to credit your checking account with, say, a million dollars, all that would happen is that they would make a new entry in their computer. As soon as they made this entry, you would have a million dollars to your name. No new bills or coins would need to be created.

Although it is unlikely that your bank is going to credit your account with a million dollars out of the goodness of their heart, the scenario I have described is similar to the way in which most of the money in the economy is actually created.

When you put money in the bank, the bank does not keep all of your money in a vault (or even in a computer). They loan most of it out to other people. That is how banks make a profit: they accept a deposit from one person, and then loan the money to another person. The profit comes from loaning the money out at a higher rate of interest than what they pay for it. For example, a bank might pay you 4% interest on your savings account, but loan the same money out to another customer at 12% interest.

The Federal Reserve, which regulates banking, does not let banks loan out all of their deposits. By law, banks must retain a certain amount of money on reserve, called the RESERVE RATE. In most cases, the reserve rate is 10%. In other words, banks are allowed to loan out 90% of the money that they accept for deposit. Here is an example to show how it works.

Let's say you deposit $10,000 into your bank account. The bank keeps $1,000 (10%) on reserve, and loans $9,000 (90%), to someone else. That person then uses the $9,000 to buy something, and the money ends up being deposited in another bank.

Once the $9,000 is deposited, the second bank keeps $900 (10%) on reserve and loans $8,100 (90%) to another person. At this point, there is $19,000 loaned and $1,900 held on reserve, so the total money free to circulate in the economy has jumped from the original $10,000 to $17,100 ($19,000 - $1,900).

Of course, we don't have to stop there. The $8,100 that was loaned out by the second bank will find its way to a third bank, whereupon 90% of the $8,100 will be loaned to someone else. This same process will be repeated, again and again, generating more money each time. If you know how to do the math, you will see that, in theory, a deposit of $10,000 can turn into $90,000 (a total of $100,000 in loans and $10,000 held back on reserve).

This is the way in which most of the money in our economy is created. It comes into being because the banks loan out most of the money they take in, and most of that money is loaned out again and again.

The reason the system works is that people have enough faith in the banks to leave their money on deposit. If a large number of people lost faith in the banks, they might demand that the banks return all the money they have deposited (a run on the banks). If this were to happen, it would force the banks to try to recall as many of their loans as they could. In such a situation, two things would happen.

First, every time a loan was recalled successfully, the system would work in reverse and the amount of money in circulation would shrink. If this were to happen on a large scale, the decrease in the money supply would slow down the economy and create a serious recession.

Second, many banks would not be able to recall all their loans fast enough (after all, most loans have repayment schedules that cannot be speeded up). If a bank ran out of money, it would have to close and, once one bank closes, it scares people who have money in other banks.

If a run on the banks got out of hand, it could close down many of the banks and paralyze the economy. This is exactly what happened during the Depression. As I discussed earlier, in 1929, there were 24,633 banks in the U.S. By 1933, only 15,015 were still in business (a decrease of 31 percent).

The reason this does not happen is that the Federal Reserve never lets things get out of hand. For example, if a bank is ever faced with extraordinary withdrawals, it could always borrow money to meet its obligations. If, for some reason, a bank were not able to borrow enough money, the Fed would step in and loan the bank whatever is necessary to satisfy the depositors. In this way, the Fed acts as the lender of last resort.

Even more important, the Fed is charged with the job of regulating U.S. banks. By making sure that the banks are run correctly, the Fed inspires continuing faith in the system.

During the 1929-1933 recession, the Fed was much younger and was not nearly as effective as it is now. In retrospect, economists now believe that if the Fed had done a better job maintaining an adequate money supply during the first crucial years, the Depression would have been significantly shorter and a lot milder.

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How the Fed Creates and Destroys Money: Part I

Every day, in order to fine tune the United States' money supply, the Federal Reserve creates or destroys several billion dollars.

As we discussed earlier in the chapter, the Fed does this in order to maintain the money supply at the level they think is best for the economy. What I am sure you are wondering is, how do they do it? How does someone create several billion dollars? For that matter, how does someone destroy a billion dollars?

Banks have a variety of different holdings. Aside from cash, they also hold bonds and other financial instruments. It is the bonds that are important here, so let's talk about them for a minute.

A BOND is a debt issued by a company, government or government agency in order to borrow money for a specific amount of time. To obtain the money, borrowers make two promises. First, they promise to make regular interest payments. Second, they promise to pay back the original sum of money after the specified amount of time has passed. In other words, a bond is a type of IOU.

Here is a typical example to show you how it works. Let's say the XYZ Company wants to borrow $1,000,000 for 10 years, and they are willing to pay 5% interest a year, with payments every 6 months (which is typical). It will be difficult for them to find one person or one company willing to loan them the entire $1,000,000, so, instead, they will sell 40 bonds for $25,000 apiece.

Let's take a moment to figure out the interest. The XYZ Company has promised to pay 5% a year. For a $25,000 bond, this means $1,250 a year. ($1,250 = 5% of $25,000.) Since the payments must be made every 6 months, the XYZ Company will need to make regular payments of $625 (half of $1,250).

You decide to buy one of these bonds, so you give the XYZ Company $25,000. In return, they agree to pay you $625 in interest every 6 months for 10 years. At the end of the 10 years, the XYZ Company will pay you back the $25,000. From the company's point of view, the bond is a way for them to borrow money at a fixed cost for a specific amount of time. From your point of view, the bond is an investment that provides you with predictable income for 10 years.

Who buys bonds? People, companies and governments that want a guaranteed rate of return on their investments. For example, many retired people buy bonds and live off the interest. Many governments buy bonds in order to earn income from their surplus funds.

Who sells bonds? Any organization that wants to borrow money for a specific amount of time. For example, a city might issue bonds in order to pay for a new high school.

No doubt, you have heard that the U.S. government borrows a huge amount of money. They do so by having the U.S. Treasury issue various types of bonds. To borrow money for a short amount of time (one year or less), the Treasury issues what are called TREASURY BILLS. To borrow money for a medium length of time (between 1 and 10 years), they issue TREASURY NOTES. To borrow money for a long period of time (over 10 years), they issue TREASURY BONDS. (For our purposes, we can consider them more or less the same, so I'll refer to all of them as Treasury bonds.)

In case you are wondering how much money the U.S. Government owes, as of the day I am writing this (May 24, 2001) the federal debt is more than $5.6 trillion, to be precise, $5,660,965,921,275.71. (What I want to know is, what's the 71 cents for?)

So what does this have to do with banks and the Fed? In the previous section, I explained how new money is created when banks loan out money that has been deposited with them. The loaned money is deposited in another bank, where it is loaned out again, creating even more new money. The money that a bank has in cash can be loaned out, but the money it has in bonds just stays where it is. Since bond money does not get loaned out, it does not circulate and create more and more money.

Thus, it is possible for the Fed to control the size of the money supply by controlling how much money the banks keep in cash (which is loanable) compared to how much money they keep in bonds (which is not loanable). To increase the money supply, the Fed moves some of the banks' money from bonds into cash. To decrease the money supply, the Fed moves some of the banks' money from cash to bonds. The details are complex, so we won't deal with them here. Basically, each day, the Fed buys or sells several billion dollars worth of U.S. Treasury bonds from financial companies who act as dealers.

Let's say that, on a certain day, the Fed buys $4 billion dollars worth of Treasury bonds from a particular dealer. To do so, the Fed takes possession of the bonds (electronically) and puts $4 billion in the dealer's bank account. The dealer's bank now has $4 billion more to loan out, which, in the way I have described above, creates a lot of new money. Thus, by buying bonds, the Fed has increased the money supply of the country.

Now, let's say that, a month later, the Fed wants to decrease the money supply, so they sell $4 billion worth of bonds to a particular dealer. To do so, they credit the dealer with possession of the bonds and take $4 billion out of the dealer's bank account. The dealer's bank now has $4 billion less to loan out, which decreases the money supply.

At this point, you are probably wondering, where does the Fed get all the money to buy and sell such large quantities of Treasury bonds? The answer is — and this is the coolest part of all — they don't really have the money; they just make it up.

Do you remember in the previous section, when I observed that, if your bank were to credit your account with a million dollars, you would, all of a sudden, have an extra million dollars to spend? One reason why your bank doesn't do this is that banks can't just go around giving people money out of nothing. If your bank wants to credit your account with some money, that money has to come from somewhere.

The Fed is a different type of bank. They are allowed to credit accounts without having to come up with real money. Thus, when the Fed puts a $4 billion credit in the bank account of a bond dealer, the money doesn't have to come from anywhere. The mere fact that the Fed puts it in a bank account is enough to create the money. Similarly, when the Fed takes $4 billion out of a bank account, the money doesn't go anywhere. It just ceases to exist.

Does this mean that, if the Federal Reserve wanted to, it could credit your bank account with a million dollars without causing a bookkeeping problem? Absolutely. The trick, of course, is to get them to want to do so. If you'd like to try, their phone number is (202) 452-3000. (Ask for Mr. Greenspan.)

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How the Fed Creates and Destroys Money: Part II

The main way in which the Fed manipulates the money supply is by buying and selling bonds, as I have described in the previous section. However, for completeness, I would like to mention that there are two other ways in which the Fed can raise or lower the money supply.

First, as I explained, the percentage of money that a bank must keep in reserve is dictated by the reserve rate. For instance, if the reserve rate is 10%, a bank must reserve 10% of its deposits. This is money that cannot be loaned out.

One way the Fed can change the money supply is by raising or lowering the reserve rate. For example, if the Fed were to lower the reserve rate, banks would be able to loan out more of their deposits, which would increase the money supply. Modifying the reserve rate, however, is a big deal, and the Fed rarely does it.

The other way in which the Fed can affect the money supply has to do with the actual cash that is on reserve. The Fed is itself a bank and, by law, all the money that the regular banks hold in reserve must be deposited at the Fed itself. For example, let's say that, on a particular day, a bank is required to have $100 million on reserve. That $100 million dollars is kept in an account at the Fed in the name of that bank. From day to day, as the amount of money held by banks changes, the amount that each bank must keep on deposit at the Fed changes as well.

On a particular day, a bank may find that it does not have quite enough money on deposit to the Fed to meet its reserve obligation. Similarly, another bank may find that it has a surplus. When this happens, the second bank may loan money to the first bank. Most of the time, such loans are made for only a single day.

Now, as it happens, even though the Fed requires banks to keep all their reserve money in the Fed's bank, the Fed does not pay interest on that money. However, a bank that loans money overnight to another bank is allowed to charge interest. Thus, banks with a reserve surplus are always happy to lend money to banks with a reserve deficit.

The rate at which banks may lend each other reserve money is set by the Fed and is called the FEDERAL FUNDS RATE. From time to time, you may hear that the Fed is raising or lowering the "interest rates". What they are really doing is changing the federal funds rate.

Although this rate applies only to very specific, short-term, bank-to-bank loans, it tends to affect other interest rates in the economy. For this reason, people make a big fuss when the Fed changes the rate. However, in reality, the federal funds rate has less effect on the money supply than the buying and selling of bonds, something which the Fed does every day.

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Money Desensitization

Our world is filled with people and companies who spend a great deal of time and effort in the pursuit of your money. This is especially true on the Net, where merchants ruthlessly exploit the fact that there are no concrete cues to remind you that you are spending real money. Many Web sites, for example, are set up to encourage you to use your credit card to buy impulsively. Companies purposely design such sites to entice you, by any means they can, to spend, spend, spend.

Such experiences, of course are not unique to the Net. They abound in our culture. Modern marketing techniques are designed to take advantage of the fact that, the more abstract the transaction, the less you will realize the true impact it is going to have on your life.

For example, have ever you been to a casino? If so, you will have seen how carefully the environment is designed to encourage you to suspend your critical judgment. There are no windows, no clocks or no reminders of the world outside (the one in which you must work and pay your bills). Instead of allowing you to bet with real money, casinos encourage you to use clay chips that feel like play money. Moreover, to ensure that you don't think too much about what you are doing, the casino provides a host of distractions such as noise, colored lights, costumed hostesses, and free alcohol (not to mention ATMs, check cashing, and access to liberal credit card advances).

Casinos are purposely designed to desensitize you to the fact that the liabilities and debts you incur must ultimately be satisfied in real money — money that may represent many hours of hard work and effort on your part.

To be realistic, when you walk into a casino you are fair game. After all, it is a gambling hall, devoted to taking as much money as possible from people who think they can get something for nothing. No one entering a casino should have any illusions about the purpose of the facility.

However, monetary desensitization is ubiquitous in our culture. Because our monetary system is so abstract and so complex, many people have real trouble understanding the nuances. In particular, unless you are paying strict attention, it can be difficult to appreciate the true extent of your personal liabilities and debts.

For example, a gas station will advertise their gas at, say, 199.9 cents/gallon, rather than 200 cents/gallon. A television commercial will advertise an exercise machine for "four easy payments of $29.95 and a small shipping and handling charge of $9.95", rather than $129.75. When the numbers get bigger, the desensitization efforts get more extreme. Consider this example.

In the United States, many college students must take out student loans in order to pay their expenses. Indeed, it is not unusual for a student to borrow $10,000/year. This means that, by the time he graduates, the student will owe $40,000. By the time he has paid it all back, including interest, that $40,000 will have grown to almost $56,000 (assuming a 10-year loan at 7% interest, which would require 120 monthly payments of $464).

Although this is a huge sum of money for a kid just out of high school, the financial aid system is designed to desensitize students to the magnitude of the liability they are about to incur. Once the loan is arranged, all a student has to do is sign some papers. In many cases, the student doesn't even see a check. The money is sent to the school, which applies it directly to his account. The whole process is so transparent that the student has no real feeling for what he is doing — until he graduates and has to start making payments.

Consider an alternate scenario. A college student is arranging for his first student loan. Instead of making the whole thing into a painless procedure, the loan officer takes the student into a room in which there are boxes filled with $20 bills.

"Do you see those boxes and all that money?" says the loan officer. "I want you to count the money, out loud, one bill at a time, until you get to $40,000. That's 2,000 bills."

Let's say the student counts two bills a second, so it takes him 16 minutes and 40 seconds to finish. When the student is finished counting, the loan officer tells him, "Take a careful look at the pile of 2,000 $20 bills you have just counted. That is what you are thinking of borrowing over the next four years."

"Now," continues the loan officer, "I want you to count out 665 more $20 bills." The student does so, which takes him another 5 minutes and 32 seconds.

"That," the loan officer tells the student, "is all the extra money you are agreeing to pay in interest: $13,300. Remember, you are going to have to pay all this money, whether or not you even finish school or get a good job. Once you borrow it, you have a legal obligation. Now, I am going to leave you alone for a few minutes, and I want you to think about how many hours you are going to have to work to earn enough money to pay back your loans."

This is a story, of course, that will never happen. However, I want you to remember it each time you buy something on the Internet. Before you type your credit card number, imagine yourself counting out the money in real bills — and don't forget to include the interest and the shipping and handling.

I have a friend whose landlord insists that she pay him in cash. Believe me, she has a real feeling for how much she pays because, each month, she must get the cash, count it, put it in an envelope, and give it to the landlord in person.

In our society, though, paying cash for anything but small purchases is unusual. Most of the time, we use checks, credit cards, debit cards or automatic payment services. Sometimes we don't even see the transaction. Like the student in our story, we can incur a liability and all that happens is a sum of money is transferred electronically from one computer to another.

If you want something to think about, imagine you are buying a $200,000 house. You pay 20% for a down payment and borrow the rest by taking out a 30-year mortgage at 7.5% interest. Let's say the bank were to force you to count all the money, in $20 bills, before you signed the documents.

It would take you 1 hour, 6 minutes and 40 seconds to count all the money you are borrowing ($160,000). It would then take you an extra 1 hour, 41 minutes and 8 seconds to count all the interest you will end up paying before the mortgage is finally paid off ($242,748).

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Money and You

Ever since the King of Lydia held the very first coin in his hands, there has always been someone nearby who was willing to take that coin by fair means or foul. Today's economic system is so complex that it is beyond the understanding of any one person, and yet all of us must somehow learn to master enough of the system to protect our own interests.

Such thinking does not come easily. Money is a totally artificial construct, one that is uniquely human, with no analog anywhere in the animal kingdom. As such, using money is not a natural activity. If you want to understand the monetary system and learn how to use it to your advantage, you must do so deliberately, and you must study, think and practice. If you have a flair for numbers and computation, you will have a definite advantage. If you find arithmetic and abstract reasoning difficult, you are going to have a hard time. Sorry, but that's a fact.

Still, you and I are never going to be called upon to run the U.S. Federal Reserve System, and we don't need to master the arcane minutiae of professional economists. If we are going to protect ourselves, all we really need to understand are the basic principles: What is money? How does it work? and What does it mean to us?

In this chapter, I have traced the development of money over the centuries, from barter to commodities to coins to paper money, culminating in our modern system in which virtually all money is stored as intangible computer data.

Money is an idea, one that is based on faith. If I offer to buy something from you for a hundred dollars, you would not agree to the sale unless you had faith that the hundred dollars has value and that it would keep that value.

To say that money is based on faith is not an appeal to the supernatural, for the monetary system does not demand blind faith. The way we use money today is the end product of the activities of a great many intelligent people, and the system has been improved by centuries of trial and error. Moreover, in the last twenty-five years, the tools we use to deal with money have been significantly enhanced to meet the demands of a fast-moving, computerized society. Even though our monetary system may not be perfect, it does work well, and it is administered as wisely and fairly as possible.

If you are going to use the Internet for buying and selling, it is important that you learn to deal with money as a complete abstraction, one that does not correspond to anything tangible, such as gold, silver or even paper. On the Net, money can move quickly and silently without leaving a trace... until you get your credit card bill or your brokerage statement. If you aren't firmly grounded in the realities of our modern monetary system, you are going to be at the mercy of the economic forces that swirl around you like invisible demons, manipulating you and desensitizing you in order to take as much of your wealth as they can.

If you don't understand your own motivations, you are going to get into trouble.

As a general rule, the world is a complicated place, and if you don't understand your own motivations, you are going to get into trouble. This is especially true when it comes to money, on or off the Net. You need to understand, not only how the system works, but how you relate to it and what money means to you personally.

At the beginning of this chapter, I described money as a medium of exchange. In this sense, the function of money is to separate the act of buying from the act of selling. You buy something from another person and the money you give him acts as storage, maintaining its value until he decides to buy something.

Because money can store value, it can be saved and accumulated, bringing wealth and luxury to its owner. But money has another, much more important characteristic. In large amounts, money confers power. The larger the amount of money, the more the power. This has always been the case, and it is the main reason why men have always fought over money, and always will fight over money.

In our society, we need money for many reasons: to satisfy our everyday needs, such as food, clothing, shelter and health care; to care for our children; to educate ourselves and our families; to plan for our retirement; to pay our taxes; and so on. When you stop to consider all the important things that money can provide — not to mention wealth, luxury and power — it is no surprise that our feelings regarding money are extremely personal.

Money interacts with the primal, unconscious forces that lay deep within us all. When we are young, money has little meaning in our lives, but as we grow older, money comes to represent security, comfort, power and hope, all of which we need to maintain our mental health in an uncertain and, often, hostile world. Our relationship with money is crucial to how we view the world, and it behooves us to examine and understand our motivations.

Money can bring security, for example, but only to a limited degree. A real feeling of security must come from deep inside. Some people, perhaps because of their upbringing, never develop an innate feeling that they belong in the world and that everything is working out just fine. As a result, such people are always worried. Watch them and you will see that, in an attempt to make their world secure, they will put in a great deal of time and effort into accumulating far more money than they actually need.

Similarly, money can bring comfort but, again, only to a limited degree. People who, deep down inside, feel unloved, will spend a lifetime fruitlessly looking for a feeling of comfort. For many of these people, money will take the place of love, and they will force their spouses, their friends, and their relatives to prove their love, over and over, by spending money and giving gifts.

Another reason people lust after money is the power it can bring. For people who thrive on power — and there are many of them — accumulating money is an effective way to increase the control they have over their surroundings and over other people. This is why you will see many rich, powerful people — especially men — spend a lifetime pursuing more and more money. Such people are really pursuing power, and power is addictive.

Finally, many people use money in a different way: to create the illusion of hope. For example, they will surround themselves with distractions and possessions, as if the money they spend can make up for the emptiness they feel when they contemplate their lives. In this way, money can act as a diversion, but it will only work temporarily. Eventually, life has a way of catching up to us all.

Life is not always easy. No matter what we do, there will be pain, disappointment, fear and worry. Eventually, everyone dies, and there is nothing you or anyone else can do about it. This is the human condition, and the biggest challenge we face in life is how to come to terms with our mortality, our weaknesses, and our vulnerabilities.

As you use the Net, you will find that it is a great place to buy and sell. However, it is a sophisticated environment, one that is difficult to master. Money on the Net is completely intangible and transactions are transparent, with no physical context whatsoever.

It is important to remember that, deep inside, we all have weaknesses. No one is completely well adjusted, and, at times, everyone uses money for security, comfort, power and hope. This is normal.

If you take the time to examine your needs and your motivations clearly and honestly, you will be able to protect yourself from the forces that only care about your money. Knowing yourself has always been the best way to ensure that no one can take advantage of your weaknesses, your transitory feelings, and your vulnerabilities.

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Money and the Net

In thinking about the Internet and money, it is important to remember that the Net is not an isolated environment. When you buy and sell on the Net, you are participating in the general economy. Too many people have made the mistake of thinking that the Internet is a world unto itself and that, somehow, the regular rules of commerce do not apply.

In the late 1990s, there was a boom in Internet-related stocks, particularly in new enterprises that were set up specifically to do business on the Net, the so-called DOT-COMS. (The name comes from the way in which Internet addresses are pronounced. For example, harley.com is pronounced "Harley-dot-com".)

Within a relatively short period of time, the price of Internet stocks increased enormously, and there seemed to be no end in sight. People would buy stock at a highly inflated price and, a short time later, be able to sell the stock to someone else at an even higher price. Many dot-com companies would issue stock for the first time and, within days, watch the price soar, even though the companies weren't making a profit. In fact, virtually all of the dot-coms were losing money.

Traditionally, the value of a stock is tied to the company's earning potential. If people feel that a company's profits are going to go up, they will bid up the price of the stock. Conversely, if people feel that a company's profits are going to go down, they will sell their shares and the stock price will fall. In the late 1990s, Internet stocks were different. In spite of the fact that very few dot-coms were profitable, their stocks kept going up and up with no end in sight.

This phenomenon is not new, especially to veteran watchers of the stock market. From time to time, a particular type of stock becomes fashionable and prices rise unrealistically as investors follow the trend and jump in blindly in search of easy money. When this happens, the herd mentality creates a bubble. However, the bubble is based solely on speculation and, eventually, it bursts.

It happened in the late 1960s, when the so-called "conglomerates" were, for a time, the darlings of Wall Street. A few years later, in the early 1970s, another bubble formed and burst, based on a group of well-known stocks called the "nifty fifty". And now, in the late 1990s, it was happening again with Internet stocks.

The Internet bubble grew for several reasons. First, there was greed, always an important factor in the stock market. Second, there was a fundamental misunderstanding of Internet technology and how it affects business. (I discussed this topic in Chapter 1.) Finally, there was the widely accepted belief that the Internet had changed the rules of the game. People talked about the "New Economy", one in which the dot-coms would be able to create massive amounts of wealth in ways that traditional companies could not. This idea, of course, was wrong. Any company, even a dot-com, must show a profit to be considered valuable, and, in the long run, the price of a company's stock will come to reflect the company's profitability: no exceptions.

Eventually, of course, the party was over. At the beginning of 2001, the once high-flying Internet stocks began to plunge sharply and, within a few months the bubble burst, resulting in billions of dollars of losses.

Interesting enough, the Internet does have a profound effect on the economy. However, it is not the magic force that would create a New Economy, the one the speculators loved to fantasize about. Rather, the Internet affects the economy in a way that is more subtle but much more enduring.

In order to explain what I mean, I need to digress for a moment to talk about a strange sounding idea, the "velocity" of money.

Let's say you have a dollar bill in your hand. Suppose you go to the grocery store and use that dollar to buy something. What happens to the actual dollar? The store will give it out in change to someone else, who will use it to buy something from a different store. That store will then give the same dollar to another person who will go to a third store, and so on. Over time, the same dollar bill can be used over and over and over.

The same is true for any type of money, even money that is stored electronically in a computer. Over time, all money — coin, paper or electronic — is used and reused.

From our discussion earlier in the chapter, you know that the size of the money supply is crucial to the economy of that country, because money greases the wheels of commerce. If there is not enough money, commerce will slow down. If this happens for too long, there may be a recession. If there is too much money, prices will rise, which may cause inflation. This is why central banks, such as the U.S. Federal Reserve, work so hard to manipulate the money supply on a day-to-day basis.

Thus, if the economy is to be healthy, it needs just the right amount of money. However, when you consider what the right amount should be, you must remember that most of the money in circulation will be reused a number of times. For example, let's say that, in a particular year, the U.S. economy has $9 trillion worth of transactions. However, during that year, on the average, each dollar is used 9 times. This means that the actual amount of money that is needed is really only $1 trillion.

In order to talk about this idea, economists use the term VELOCITY OF MONEY to represent the average number of times a single dollar will be used in the course of a year. In our example, the velocity of money has a value of 9. (In practice, no one knows the actual velocity of money. It's really just an idea used by economists.)

There are two important ways in which the Internet affects buying and selling. First, the Net helps companies and individuals expand their markets. Because of the Net, people are buying and selling more than they would otherwise. Second, the Net makes it easier and faster for the buyer to pay the seller. In these ways, the Net serves to increase the velocity of money, which has the effect of increasing the financial well-being of our society.

Here is why.

In a general sense, the health of the economy is directly related to the amount of business transacted. The more production, buying and selling, the healthier the economy, and the happier we all are as a society.

Economists estimate the amount of business transacted in a particular country by asking the question, "How much money is spent on goods and services in that country over the course of a year?" We call this value the Gross Domestic Product or GDP of that country. Here are several examples showing the 2000 GDP expressed in U.S. dollars for four parts of the world:

United States: $10,227,000,000,000 (about $10.2 trillion)
European Union: $9,887,000,000,000 (about $9.9 trillion)
United Kingdom: $1,657,000,000,000 (about $1.7 trillion)
Canada: $703,910,000,000 (about $704 billion)

Economists talk a lot about the GDP because it is the most comprehensive measure of how much a country produces in a year. One of the aims of both politicians and central bankers is to raise the GDP of their country as much as possible without causing inflation. In fact, it is an article of faith among politicians that:

High GDP + Low Inflation = Reelection

and among central bankers that:

High GDP + Low Inflation = They can relax for the weekend

One way in which the GDP can be understood is by looking at how much money changes hands during the course of a year. By definition, this value is equal to the total amount of money in the economy multiplied by the average number of times each dollar is used in a year. In other words:

Money spent =
    (Total number of dollars) x
    (Average number of times a dollar is used in 1 year)

To express this idea more simply, we can use M to represent the money supply and V to represent the velocity of money:

Money spent = M x V

If we assume that the GDP is equal to the total money spent in a year (a fair enough assumption for our purposes), we get:

GDP = M x V

Since the GDP is related to our economic happiness as a society, we can write:

Economic Happiness = M x V   (as long as inflation is low)

Thus, by increasing the velocity of money, the Internet raises the level of economic happiness of our society as a whole. Or, in plain English, the Internet allows us to be more productive without having to raise the money supply, which would increase the risk of inflation.

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The Internet Factor

Money is enormously important to us, as individuals and as a society. When the economy is healthy and stable, we are happy. When the economy is depressed, we all have problems.

In this chapter, we have talked a lot about money and its history. We have also discussed what money means to us personally, and how it is affected by the Internet. To conclude the discussion, I am going to tie everything together by summarizing the factors that have the most important, long-term effects on our economy and our financial well-being. As you look at these lists, notice that the good factors (peace, global trade, democracy, and so on), are all enhanced by the Internet, and the bad factors, (war, economic isolation, and so on) are mitigated by the Internet.

The Internet does not exist in isolation. It has a continuing and ever-increasing influence on our lives and, as such it is an integral part of our world.

Factors that Encourage a Stable, Healthy Economy:

  • Peace
  • Global Trade
  • Democracy
  • Freedom of information
  • Central Banking
  • Politicians who think in the long term
  • Sophisticated computer technology
  • The Internet

Factors that Work Against a Stable, Healthy Economy

  • War
  • Economic Isolation
  • Totalitarian Regimes
  • Corruption
  • Cultural Isolation
  • Politicians who respond to short-term pressures

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