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| By Ben Bacque |
Money and Currency 101: What you don’t learn at School!
Money and currency are right now less predictable, more
complex, more chaotic, and paradoxically therefore more needing to be
understood than at any other time in human history. To understand the complex situation we have
now, we need first to go back to basics to understand it all. What is “money”, really, and why do we have
another word for it, “currency”?
Funny money
The funny thing about money is that it is just an idea, the
idea of “the centre of value” for all goods in an economy. Consider a super-simple moneyless market
economy that trades in just 4 goods, labeled A through D, as shown in Figure 1. Here we need just 6 barter-exchange rates to
trade everything, noted by lines between the letters (no-one trades A for A,
etc – duplicates and inverse ratios are unnecessary and not shown). Line A-C might represent how many ducks per
plasma wide-screen TV, B-C how many geese.
We observe that as the number of goods increases, the number of
relationships increases much faster: for 26 goods we need to know 325 different
exchange rates (Figure 2). But by simply
placing a reference point in the middle, let’s call it “money”, we only need
26, as shown in Figure 3. To find the
fair barter exchange ratio between two goods, we just multiply their money-ratios
(“prices”) together. Now, to make it
real, and practical, let’s take one of those goods, G, say, and place it in the
middle. Now we can understand our entire
market with only 25 prices in Gs (Figure 4), plus we have something real we can
trade with and use as physical money, namely the good G. This thing (or things) we place in the middle
we call currency.
The money-idea and the real currency G solves for us another
nasty problem that barter presents. What
if I have ducks, and want a plasma wide-screen TV, but the plasma-screen merchant
is picky, and needs geese but not ducks?
We need something to be money
for us, or trade is simply too complicated.
Using currency, our plasma-merchant can buy his own geese – I don’t need
to find them for him. Money is a very powerful
idea, and currency’s value comes from the simplification it offers.
Complex Situations
But even after money, through currency, has simplified
things, markets and trade still get complex, so let’s delve into complexity and chaos theory to understand
the fate of our fowl. Much as relativity
theory rocked the physics world, and quite literally the real world, complexity
theory is now rocking all scientific disciplines, including economics. The theory points to two key outcomes.
The first is that complex systems obey power-law rules, not
the “normal” Gaussian distribution that we came to know and hate in our
statistics and risk-analysis courses.
The big difference here is that power-law based systems have outcomes
with “fat tails” that give rise to “black swans”: there are bigger chances of
wild outcomes. Further, chaotic
power-law systems exhibit a property known as bifurcation, where the system can
suddenly change its behaviour by moving from one set of steady states (a
“strange attractor” in complexity-speak) violently to another set. The occurrence of these shifts is not
necessarily predictable or time-able, though we get hints.
Secondly, and more interesting yet is the emergent order in
complex chaotic systems. The best way to
understand this in terms of economics is to read “ I,
Pencil”, written in 1958 by Leonard E. Read. (Read "I, Pencil" here.)It also applies to
currencies in some cases. What Mr.
Pencil has to say (and not just about pencils, but all goods, including
currency-goods) is that we can’t know why, exactly, we arrived at pencils as
our solution to writing efficiently, nor can we know how to build a pencil, as
that can only be done by the market-at-large.
The information with which to build the modern pencil emerged inside the
market, not within us, and each of us can only understand a little bit of it,
never all. You can’t write it down, or explain
it. A complex system like a market can
“choose” to make pencils and “learn” how to make them better. It can “decide” to make them differently,
has, and does. It can do the same thing
with currencies. Our ecosystems have
done all this for millennia, and the ecosystem is very good at making trees,
birds, all kinds of things. At the
system level, there are not many differences between ecosystems and markets.
Serious Currency
So we can’t know exactly why, but for some reason, quite
early on and for several thousand years - most of our civilized life in fact -
man’s markets have chosen precious metals as their preferred currency. There are certainly exceptions, for instance
in Canada we have had axe-heads, beaver-pelts, wampum, chopped-up autographed
playing cards(1),
as well as so many competing metal coinages circulating at the same time that we
had our own set of exchange-rates, the Halifax Ratings of 1758. But in terms of all these goods-based
currencies, gold and silver have always been preferred because their attributes
serve the money-function so well.
Currency must be relatively scarce (stuff that is plentiful
has little economic value), durable, divisible, portable, easily authenticated,
and the metals possess all these attributes.
Gold, silver, and copper are also terrifically valuable for their
ductility, malleability, and as the best conductors of heat and electricity,
thus only part of their value is currency-value. Had gold and silver not been rendered
“expensive” because of their extreme utility to the market as currency, rest
assured their use in all sorts of applications would be guaranteed. In fact, it is possible that the market long
ago “understood” this, and selected these metals precisely because of their limited-supply
and ubiquitous potential application. We
can never know, but I don’t consider it coincidental that all our monetary
metals come from the same column in the periodic table of the elements. To my sisters who ask “Why gold?” I could
only reply “Why tree?” They are the same
question. Same answer, too: “because it
works.” (2)
What is currently currency?
Paradoxically, perhaps, that we now have paper currency is
due to the gold-bankers. In the 17th
century British and Dutch merchants grew tired of lugging around bags of coins
(and getting mugged), so a market developed for safe gold-storage, for which transferrable
receipts were issued and these entered circulation in payment for goods. Not long after, that very first clever banker,
who, upon noticing that not everyone showed up for their gold at the same time,
issued just one extra receipt in the form of a loan, created fractional-reserve
gold-backed banking, and it lasted a long time.
The paper receipts morphed into bills and notes, banks came and went
again if they ran the reserve too low, but in general, notes were redeemable on
demand in gold for many, many decades.
In fact, most of the 200-year industrial revolution, an era
of unprecedented innovation, prosperity and financial stability occurred under
a gold-standard monetary regime. But
what benefits innovators, individuals and industry does not necessarily equally
reward bankers and bureaucrats.
So things changed – I would argue for the worse – in the
early 1900s when central banking took the world by storm, and the industrial
revolution was ground to a halt. Until
then, things had been a bit chaotic, it is true, but it does turn out that chaos
is a part of nature. Most money-historians
point to a meeting of bankers and dignitaries at Jekyll Island in 1908 as the
turning point, after which central-banking legislation was enacted in many
countries, in the US in 1913, Canada in 1914.
The theory was that to ensure bank stability – there had
been runs and failures, mind you! – What was needed was a “lender of last
resort” to whom a fractional-reserve gold-backed bank with a sound balance sheet but a
temporary liquidity-crunch could appeal so that the bank’s outright failure
might be averted. Unfortunately, chaotic
systems don’t much like being controlled, and they bite back, as they did in
1929, and through the 1930s, and again now.
International Trade and Currency
Before moving on to the next step in the evolution of our money
– and it truly is evolution, though selection is not quite natural – we need to
talk about trade. In times when only
precious metals were used to settled international trade, there was no need for
currency exchange rates, per se, as one would simply compare weights of pure
metals. But paper currency, redeemable
into gold only locally in a country or region, changes the picture. There are some things that must balance when
currency-regimes trade. The net flow
must be zero. If goods go one way, currency
has to move the other. If a country
tries to create a currency other than gold, and then buy more stuff than it
makes using it, those dollars, say, are going to eventually come home as
foreigners can’t spend them locally, nor convert them to gold. And when they return, the exchange rate
drops. Long term, it is a zero-sum game,
and US dollars have been flowing out for decades now.
Reserves of gold, in the old days, or trading-partner
fiat-currency in our times, are held in reserve by central banks so that goods
entering the country can be paid for, and international accounts settled, so
then further trade can occur. Until the 1930s, this tended to occur
bilaterally, but gradually the Bank of International Settlements, formed in
1930 to deal with Germany’s WW I reparations, assumed the role of the single
overarching global central bank. It
still is (though it is suspiciously absent from media coverage!).
Trade was seriously disrupted by World War II, as were flows
of gold and currency to settle the trade that did occur. The solution presented to this and other
trade and currency problems was the Bretton Woods agreement of 1944 in which it
was decided that the US Dollar would replace gold for the settlement of
international trade. At the time it was
redeemable for gold by foreign central banks, but not US citizens, who lost
that right in 1933 when dollar redemption and private gold ownership were
revoked and the dollar depreciated from $20.67/oz to $35/oz overnight.
This all worked until 1971, when the US, having printed too
many dollars in support of Bretton Woods, and not wanting to ship all their
national gold reserves abroad, suspended all redemption into gold. The French were the last to get gold for
their dollars at the set rate. Support
for the value of the US dollar was maintained thereafter through the artifice
of enforcing oil transactions in US dollars, thus necessitating demand by all
who, say, want to drive or stay warm.
The US dollar still clings to value as a global reserve, but tenuously.
Canada’s money now
I remember as a youth learning about money reading the words
“Pay to the Bearer on Demand” on our Canadian bills, and noticing the words
disappear in 1969, and seeking to understand what that meant. I now understand. Our money-concept currency-placeholder today,
the “dollar” is created solely by act of fiat.
It is simply a promise by all Canadians to each other and to foreigners,
imposed upon us by the government we elect, that we will accept the currency
for our goods and services. Further we
are required to submit our taxes in this currency. We expect others to honour it, but we can no
longer demand of our banks that they produce a fixed amount of real money, i.e.
gold or silver, when presented with bills.
This is a recent development. I
can remember it happening.
Debt-money
Our currency is now created by debt. Our supply of currency is created initially
by the Bank of Canada when it issues currency and buys with it Government of
Canada debt. Only a small fraction,
perhaps 5% of Canada’s money is created this way. The rest is created when we enter into debt
with the banks. When I get a loan, the
bank creates two entries on its balance sheet, an asset – my debt, and a liability
- the demand-deposit balance that lands in my account. And money (strictly, currency) is thus
created as the balance sheet expands.
Amazing, isn’t it? Yet that truly
is how our money supply is now created.
I will leave it as an exercise for the reader to figure out from whence
comes the extra money needed to pay the interest on the money borrowed in a previous
period.
Inflation and deflation: the truth
Inflation of our money supply now occurs when individuals,
corporations, or governments borrow money in Canadian dollars. It contracts when debts are re-paid or worse,
when defaults occur. It is an
interesting comment on the degree to which we have come to blindly accept the
current system that Canadians now almost universally associate inflation and
increasing price levels with an advancing economy. In fact, the opposite is true, all else
equal. As an economy grows it only does
so if it can learn more efficient ways to get things done through
specialization. Specialization only
occurs if it is less costly. Less cost
means lower price. In a stable-currency
economy, there is an inherent downward
pressure on almost all prices. Not just
VCRs get cheaper. The only reason prices
keep going up in dollars now is that we keep incurring more debt. Don’t forget your homework assignment above!
Enough theory. What is going on now? This summary was not intended to scare you silly. Canada fortunately has had some of the best banking (and thus currency)
The, Ahem, Current International Situation
Enough theory. What is going on now? This summary was not intended to scare you silly. Canada fortunately has had some of the best banking (and thus currency)
practices in the world. But the facts are chilling when summarized:
- Fiat currencies and central banking now dominate the globe. This is unique in human history. All previous fiat currencies have failed, most of them spectacularly so;
-
Money supplies (and debt levels everywhere)
are enormous, and under enormous pressure in
both inflationary and deflationary directions;
- Many debtors, including individuals, cities, counties, states are essentially insolvent when the current value of future obligations are considered;
- Governments everywhere are under intense pressure to issue debt and create money to bail out failing financial institutions;
- Insolvencies and default are moving from private failures (Long Term Capital Management, Bear Stearns, Lehman Brother, MF Global off the top of my head) to sovereign failures (Iceland, Ireland, Greece, and onwards)
- In addition to conventional debt, the opaque over-the-counter derivatives market has put orders of magnitude more leverage into the banking system, a very destabilizing influence;
- In the US and internationally, the rule of law in finance is being largely overlooked, some might say it is in tatters;
- TheUS dollar, as shaky as it is, is still the primary tool for international trade settlement;
- The Euro, perhaps created to compete with the US dollar in that role, is either doomed or the governments within it are. One cannot have common monetary and disjoint fiscal policies and trade balances amongst sovereign nations. It can’t work, as there is no way for the complex system to balance itself;
- The Bank of Canada has virtually no gold reserves;
- Canada maintains a strategic reserve called the Exchange Fund Account of primarily US dollars, Euros and Yen to ensure the continuity of trade, with just 0.25% in gold.
Science is now at odds with the possibility that central
banking provides stability. We now know that central
control paradigms on complex systems may have a short-
term stabilizing effect, but that this can only be achieved
at the expense of much greater (though perhaps less
frequent) instability as the system shifts to a different
strange attractor as it rejects the control offered. There
is only a certain amount of certainty in nature, and we
cannot cheat.
A sign that a state-change in our financial system might
be imminent is when things start to get very correlated,
when everything either goes up, or it all goes down, everywhere, at the same time. This was evident before fall
2008, and it is evident again now as the HSBC correlation
index is at an all-time high2. In 2008 what were previously
uncorrelated asset classes - stocks, bonds, commodities,
real estate - all began to move in unison. That is the sign
that the market is changing its mind about its money.
What Can You Do About It Personally?
What one chooses to do about all this depends on
what one expects this now highly unpredictable currency-
system to do. It is not impossible that fiat currencies yet
persist for some time, that voters vote for austerity, gov-
ernments develop fiscal prudence, citizens bear down, pay
off personal debt, pay higher taxes, and accept reduced
government benefits, and we then might have a period
of deleveraging to slowly but very painfully unwind the
world from our current position while maintaining our
faith in fiat. Currency would be the best asset to own in
this slow deflationary scenario. I don’t think it is likely.
It is more probable that the band-aid will be torn off
quickly by the market, and the US dollar and the Euro
will vie for the lead in the battle for the bottom. While
governments and bankers may try to manage a gentle
de-leveraging, in examples from history the market has
been savage. Typically, the attempts to sustain a fiat
status quo involve monetary inflation (and then the
unintended hyperinflation) as the means to “solve” the
debt crisis in the local currency. If one were certain of
the inflationary scenario, debt would be the best thing
to have, provided one also possesses inflation-proof hard
assets, and/or inflation-indexed income, so that one can
meet interest payments.
Short-term predictions are even more difficult in this
system, as crowd behaviour will lead to such paradoxical
effects as rushes to US treasuries as a “safe haven” despite
what seems an obvious inability for the US to do anything
long term but inflate away their global obligations. While
the US remains our largest trading partner and we link
our currencies through the reserve mechanism Canadians
will to some extent get taken along for the US ride.
In my opinion, in a great de-leveraging the most sensible thing to do is to own some of the most real form of money you can, precious metals. Individual miners or
mining funds are an option, to own metal-in-the-ground,
but as insurance against global financial calamity, watch
out for sovereign risks. Countries play gold close to the
chest once trouble hits. If you hold securities “in street
name”, you are dependent on the solvency of your finan-
cial institution. If you believe that the financial system
will persist with derivative assets intact, one could buy
GLD or SLV, but know that these will likely be early
casualties of a state-change. Better yet might be one
of Sprott’s PSLV or PHYS, or CEF, or BMG, or other
Canadian bullion funds.
The best currency-insurance you can get? Physical
metal, in your possession. Premiums for physical metal
over the “spot” or other “paper-metal” prices are only
going up.
The other important thing you could do is to write
our politicians, tell them you now understand how our
monetary system currently works (or not!), that you don’t like it, and that we need to get back to gold or another
market-tested metal to restore financial faith.
And if they ask you “Why gold?” Ask them right back
“Why tree?
1.
Seriously, In 1685, Jacque de Muelles, Intendant of Justice, Police, and
Finance for New France found himself without funds to pay his soldiers. After
exhausting local sources of borrowed currency, he finally cut a deck of cards
in pieces, initialed each piece, and paid his troops with them. These entered
circulation as currency. Card-money was again issued in 1686 and 1690,
circulated freely until 1714, and was finally redeemed and retired in 1717.
From A History of the Canadian Dollar, James Powell, Bank of Canada, 2005. The
full text can be found at: http://www.bankofcanada.ca/publications-research/
books-and-monographs/history-canadian-dollar/
2. https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=2Q
70z09rbF&n=282506.PDF
by Ben Bacque, Canadian MoneySaver contributor
Ben’s interest in economics and investing began in his teens,
trading equities on the TSE in the late 1970s. After receiv-
ing bachelor’s and master’s degrees from the University of
Toronto in Engineering Science and Electrical Engineering,
Ben pursued a career in telecommunications in Ottawa.
Having co-founded Tropic Networks in May 2000, Ben
went on to lead Tropic in product, technology, and R+D
management through the mine-fields of the tech bubble bust
until acquisition by Alcatel-Lucent in May 2007. After
ensuring a successful transition of product, customers, team,
and technology into the ALU fold, Ben has now spent sev-
eral years “on sabbatical”, consulting and pursuing personal
interests, especially in the areas of political economy and
economic history, bringing his systems-theoretic perspective to
bear. Ben currently lives in Ottawa, but is always happiest
when sailing with his family on the Georgian Bay. Ben can
be reached at jbbacque@gmail.com
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