Tuesday, August 11, 2009

The Financial Crisis for Dummies: Money

Money, it took me 37 years to make a bunch of it and it took me 40 to "get it". In fact I am not sure I still completely "get" money. I mean that in the theoretical sense. After researching a bit I came to the conclusion that very few people actually understand money the way it works today. I previously discussed this here.

A definition of money
The first attribute of money is as a medium of exchange to make an economy churn. It is very much the oil in the economic engine. The meeting of neeeds is a rare occurence in a economy, but with the intermediation of money, from good to money to good, you can match disparate peoples, specialization occurs because money exists. Without money there is no economy but a limited barter economy. It also serves as a store of value. "Going to cash" is what everyone does when the markets go down because cash doesn't lose its numerical face value. This leads to the liquidity preference that Keynes talks about. Finally, in a capitalist system a fiat money will be a bearer of interests. Keep that in mind. You can think of the "risk free" interest paid by the US treasuries on money. There are other properties of money that the litterature identifies (fungible, transferable, durable).

Types of money
Anything can serve as a money as long as it has the properties above. Historically gold has played a huge role as a money. As "out there" examples there is this tribe that used to swap shells in the sea as a money. Ownership of the shells meant money. Don't laugh, we do exactly the same, but instead of sea-shells we use electronic records in computers. Any good history of money will give insights that are valuable into the nature of money but here is a short version: from gold to gold certificates. It is bulky to transport gold and prone to be stolen. Why not exchange the certificates of ownership of gold like the tribes exchanged certificates of ownership of seashells? Then the paper became as good as gold (bretton-woods in a sea-shell) then why not just use the paper and do away with the gold? and if the paper is good why not use binary representation of the paper in computers? That is where we are today, completely virtual instances of "fiat" government money existing only in computers and our imaginations, just like shells in the sea.

Debt is money and vice-versa
All money is a debt. When you give a good to someone and they give you a piece of paper in return, what the piece of paper says is that someone in the economy owes you an equivalent value of goods. Period. Reread this until you get it. So you have a piece of paper that can be redeemed at any time, you have a instant debt. Money is a debt on future production of the economy. US bills say that this "legal tender for all debts private and public". It is enforced by law. All money is debt.
Vice-versa when someone emits a debt instrument, they are effectively emitting money. That money is in circulation in the economy, buys stuff. Debt is money.

Assets are physical goods (a house, a car, a company stock, a commodity etc) swapping them for 'cash' is called getting liquid. You need to think about an economy as a collection of goods and a portion of it as a cash mass. Of course the cash asset has no value but the credit it represents. The amount of cash in the system, the oil in the engine, is represented by various measures called M*, M0, M1, M2. Go read wikipedia for a definition of these.

Velocity of money
When people talk about velocity of money they refer to how many times the debt instrument changes hands. How many times do you use the money to buy a good. If money is used once a week as opposed to once a month, we say the velocity is 4x. The same money has been used to make 4 times the amount of goods move. Demand can be represented by the mass of money and its velocity. For example pre the crash, the velocity of money was very high (and the supply as well). Today the supply is extremelly high, but the velocity has crashed, demand is low.

Inflation as a monetary phenomenon
If the amount of fiat money increases we just have more claims on the same economy. The economy didn't grow, you just have more claims, so the numerical price of things increases. Real inflation is a function of velocity (from wikipedia: I=VxM, which I am not sure I buy). But from this standpoint it is trivial to see why most government economists are mistaken when they focus on consumer price inflation as the inflation index. Inflation will manifest itself on houses and stocks. Inflation will manifest itself on assets bubbles.

Money as a economic stimulant
But it is not all bubbles. If you print money and increase the money supply it will have a stimulant effect on the economy. Why? because you emit debt, that debt is invested and creates real economic value. It also creates some asset inflation which is reported as "growth" because the numerical value increases and "inflation adjustment" is just non existent in reality. Think about it, the price of houses was inflated and being adjusted by the price of milk and steel from china which didn't inflate. The result was the biggest myopic mistake from monetary authorities in the history of mankind.

Bubbles and ponzi schemes
Ok, pay attention. When you print money you increase asset prices so you increase monetary returns (housing increases 10% a year) so people want more debt which begets more monetary inflation in a ponzi scheme. This dynamic is non-linear. See this post for an example of a high-ranking official that says "printing money is a way to kick start an economy". This dynamic first observed by Marx in 1870, Fisher in the 30's and Minsky in the 70's is at the root of the instability of money.

A little debt goes a long way, too much debt will kill you
So a little debt is a stimulus. Give me debt at 5% and I will create value at 10% a year so everyone is ahead. The banks got paid for lending me money and I created real economic value and got 5% for it. But when you have too much debt in a capital structure, a slight variation in asset prices will wipe equity out. Remember that equity is usually junior to debt in capital tables. What that means is that if the shit hits the fan and asset prices go down then debt gets paid first and equity gets paid last. But if the leverage (debt to equity) is say 20x then a variation of 5% of asset prices leaves you "underwater". Think about your own mortgage. If you have 10% equity and your house price went under by 20% then you owe more money than you would make if you sold the house. This is what happens on a wide scale with debt-money and leverages approaching 30x. Debt is an asymetric beast.

A ponzi crashes: fractional reserve debt money as a money vampire
So let's look at the flip side. When monetary ponzis crash you end up having a lot of debt in the system that has no real counterparty in the economy. Remember that "real money" begets "debt money" via the money multiplier of the fractional reserve banking system enshrined by the FED. So the first problem is that money that did not exist as savings but was created by the banking system in many cases becomes SENIOR to real money. How disturbing is that? This by the way was the basis for Marx's work in 1870. He wasn't anti entrepreneur, he was anti banks. In a nut-shell, banks print money in the form of debt until equity gets wiped out of existence on slight asset variations. This point is so obvious to me now and so revolting. As a side note, one of the fews that still studies this stuff is Steve Keen from the university of Sydney.

A ponzi crashes: interest bearing debt money as a economic vampire
What goes up must go down, but on the way up, most people will gladly pay the interest to banks. If your house appreciates at 10% you are better off taking a 5% loan. In fact you should leverage to the hilt. So follow me for a bit of non-linear math now. Money grows at a fraction of itself (it is the definition of an exponential). That is the definition of interest. So the mass of money grows as a fraction of itself. While the economy follows and in fact leads then all is good. But if money mass grows ahead of economic mass then what you have is a default (materialized as inflation or straight defaults). Debt that was spurring growth is now choking it by vampiring its cash flows.

Taleb's call: transform debt to equity right now
This is already a long and complicated post, but it must become trivial for you in order to understand Nassim Taleb's current call on how to solve the current debt crisis: transform debt to equity. The problem with debt is that it fixes a payment schedule come hell or high water. It is claims on cash flows that do not care about the context outside of bankruptcy court. But when you have hell then the cash flow payments will choke you. So the way out is to transform interest bearing debt to dividend paying equity. If the economy recovers you will participate in the upside if the economy tanks you don't finish it off. The call is right on. Of course this call is also completely impractical. Debt with interest bearing instruments is the basis of our capitalist system, it is a great service when the economy goes up and a great injustice when it goes down. Sharia compliant investments means zero interest. Is interest evil? Are the muslims onto something? God forbid, but again in a down market debt will kill you.

We don't understand money
In reading the research litterature I realize one thing: the state of the art of money modeling is very poor. I will explain why I think this is so. Most models solve for equilibrium. Take you average economic policy paper (including the stuff by Bernanke) and you will read a lot of fancy math on equilibrium. But here is the thing money is always out of equilibrium it is a dynamic entity. (Steve Keen is one of the few I read that models dynamically). The mathematical tools to study equilibrium are fairly developped if complicated. The mathematical tools to study non-equilibrium barely exist. State of the art is "mathematica" the software program that enables to simulate what is going on. In other words these are tools that only exist for the past 10-20 years. 5000 years of money history hasn't taught us anything. Hopefullly this time 'it is different'.


Andrew Meyer said...

There was an article that came out in June talking about why the Greeks are of such fascination. Part of the reason is that they are one of few cultures that existed prior to the widespread use of money and post-money. For this reason, many of their myths (King Midas and Erysichthon) originated pre-money but were reevaluated post money.

Money has some fascinating, utterly unnatural elements. I think you'd enjoy the article. It offers some different, corrosive portrayals of money.


Marcf said...

Very interesting read, thanks Andrew. The "self-destructive" nature of money was grasped back then. Today of course it is a political class that has no will power and will mortgage the future of our kids so that their precious retirements are untouched... sad really.

Alain said...


I'm discovering your "Financial Crisis for Dummies" posts. I'm impressed! they're technical enough and very comprehensible. Great work!

Regarding Money, I invite to read Roger-Pol Droit ( A comme... argent, in French - sorry ;-) ) and philosophers who wrote about Money and Ethics, such as Emmanuel Levinas.


Marcf said...

Hey Alain,

I have a tough time following philosophical analysis of money in the vein of "money encodes human relations". I was interested to read in your profile that you had both a business and engineering background (essec+telecom). One of my pet peeves is that the french grandes ecoles should be unified in a physical campus where you can attend various courses in the vein of a read US university. Specialization kills perspective and the current mess must be addressed from a variety of perspectives and needs a multi-disciplinary mind to grasp ramifications.

Alain said...

I agree with you, when you say that specialization kills perspective.

regarding physical campus, it's coming, it's coming...for instance, HEC Paris just joined the ParisTech PRES in june : http://bit.ly/OsFxm, and TELECOM ParisTech has announced that they are going to leave Paris and move closer to the other engineering/management schools of ParisTech in the south-east suburb of Paris.

Take care.

BTW : I didn't know that you retired...