Monday, March 03, 2014

MONEY Or: ECON-101 applied to the real world.

Or: ECON-101 applied to the real world.

Measure of value
People talk about money as if it were some kind of stuff, like wood, or apples, or houses, or bicycles. But money is actually information about values. As you learned in ECON-101: money is a measure of value. A given value denominated in a specific currency is a price. The value is (or should be) the same whether it’s specified in dollars or euros or cowrie shells. It’s like specifying a length in metres or in feet or in ells; or temperature in degrees Celsius or degrees Fahrenheit. The length and the temperature are the same regardless of the measuring units used. We expect the value of a thing to be the same whether it’s measured in dollars or euros. That’s why we want to know “How much is that in dollars?” when we buy something in a foreign country.

So money isn’t stuff. It’s a way of measuring the value of stuff. That makes it very useful for trading stuff. Before there was money, people bartered. They offered a certain amount of some stuff, say jars of oil, in exchange for other stuff, say jars of wheat. The concept of money apparently began in the Middle East when people used the seals on the jars as tokens for the jars themselves. The seals were marked to show both the commodity and the owner. They broke the seals in half, and brought half-seals to market to trade for other half-seals. Then they showed up at each other’s warehouses or barns, matched the half-seals to each other, and carried off their purchases.

Eventually, people began to make tokens of value using stuff that couldn’t be used for much else. The reason gold was used is that it doesn’t rust, and that it’s almost useless. Besides money, about the only thing you can use gold for is to make pretty things. Material tokens of value are called cash; and many people still prefer cash over other forms of money because these tokens are definitely made of stuff, so cash confirms the feeling that money is some kind of stuff.

When people began to use metal to make tokens of value, the concept of money as information was almost complete. I say almost, because many people then and now believe these metal tokens have “intrinsic value.” That is, people believe that the value of a piece of gold somehow fixed. This is the reason people want to go back to the gold standard, the assumption being that this will somehow stop shenanigans like price inflation, unbacked credit, “printing money”, and so on. Unfortunately, it doesn’t work that way. And the reason it doesn’t work that way is that money is – wait for it! – information, not stuff. People will give away goods in exchange for tokens of value if, and only if, they believe they can exchange those tokens for goods of the same value as the goods they gave away. Once they stop believing this, we have serious trouble, perhaps even runaway inflation.

Inflation will happen regardless of what the tokens are made of. When the Spanish imported hundreds of tons of gold into Europe from South America, prices measured in gold went up: people had to give more gold for the same value of goods. The reason for this is that the amount of goods had not increased. The amount of wealth, and hence its value, remained the same. There wasn’t more wheat or timber or cloth or real estate just because there was more gold. But people believed that gold was wealth. That mistake cost them a great deal of wealth: Spain almost went bankrupt.

Types of Money
We use many forms of money in our current state of economic sophistication:

a) Cash is metal and paper tokens each of which represents a certain value: a penny, 25 cents, 5 dollars, etc. These tokens were originally fixed weights of “precious metal”. Pretty soon, they became coins of fixed size and weight that represented some value. Then came paper money, which could be “redeemed” for metal coins.

b) Cheques are pieces of paper that represent whatever value we write on them. $24.95, $1200, $75,346, etc. These evolved from “letters of credit”, which a traveller would carry from one place to another. A banker in the traveller’s home country would guarantee that the traveller’s debts in the foreign country would be covered up to the amount on the letter of credit. Related to this are bonds, which are promises to pay a certain amount of money to the person who presents the bond. Letters of credit and bonds can be traded, because they are promises to pay, as can cheques, something the pay-day loan companies exploit. "Currency trading" is actually trading promises to pay.

c) Bank book, bank statement: this represents the value of money you have “on deposit”.

But most of the money we use nowadays is pure information:

d) Digital data stored on a computer storage device on the bank’s servers. These are records of the amount of money in your accounts and investments, the amount of money you owe on your loans, and so on.

e) Digital information moving to computer storage from the card terminal on which the merchant and you press buttons so that you can pay for your purchase. This money is pure information. The only way you know the payment has been made is by another piece of information: the slip of paper on which the transfer of money has been recorded.

Public spending
The use of electronic transfers makes it crystal clear that money is information. It’s not stuff. But thinking of it as some kind of stuff causes confusions that can bring down governments. Or worse.

When major public works are proposed, a lot of people ask, “Where will the money come from?” This misses the point. The real question is, “Is there enough wealth (energy, materials, and human skill) to do what we want to do?” If there is, then “paying” for it is just a matter of recording the value of the resources used. How do you that? By issuing enough money tokens to represent that value. This freaks out some people, who see it as “printing money.” But that’s exactly what private banks do when they lend you the money to buy a car or build a house. They "deposit" a credit in your account, which means that you now have that amount of money to spend. They don’t have anywhere close to the amount of money “on deposit” that they lend out. By law, in Canada they can lend up to 200 times what they have “on deposit”. What happens when they want to lend more than that? The get a loan from another bank, and “deposit” it.

Inflation (again)
If you understand that money is a measure of wealth, then inflation is a weird thing to happen. It’s as if the measure of distance changed because there are too many metre sticks floating around, and we have to make them shorter so we can use them up to measure the distance from here to there. That’s absurd. The distance from here to London is the same no matter how long or short a metre stick is. But that’s what happens when we have inflation. Briefly, inflation happens when there is a mismatch between the actual value of a country’s total wealth and the value of that wealth as measured by money, the measure of the wealth that we have. If the total value of wealth is X, and our money totals 2X, then prices will have to double to maintain an accurate ratio between value and price. This is what happened to Spain in the 15th century. In effect, in a period of inflation money embodies false information about value, and the money system won’t work unless and until people accept the new, lower value of money.

But inflation is not the same as increasing the money supply. Inflation happens when the money supply increases faster than the amount of wealth. It does so for many reasons, one being that people raise prices beyond the value of the goods and services they offer. Another is interest beyond the cost of processing the money data. That means that more money is needed for people to maintain something close to a stable trading system, and banks oblige by issuing even more money, at interest, of course.

The money supply should increase in proportion as we create more wealth. And prices should change as different commodities increase or decrease in value relative to each other. That is, these changes in the value of wealth cannot be measured absolutely, only as ratios. That’s why the price of gold increases. The amount of gold remains about the same,  because new gold mines add very little to the total amount of gold stored in places like Fort Knox. But it must measure more wealth, and the only way to do that is make an ounce of gold measure a larger amount of wealth. So the price of gold is raised.

Prices of commodities do change as their values change. In fact, most consumer goods are cheaper than they were decades ago, but inflation tends to disguise that. We have to measure prices in “constant dollars” to see the price changes. We would have “constant dollars” if the money supply were to change exactly in proportion to the change in wealth.

Prices also change in relation to each other. Sixty years ago, you could have bought about 1,000 loaves of bread for the price of a typical TV set. Now, a typical TV set is worth only about 100 loaves of bread, and it’s a better TV set, too.

We could of course insist on a fixed price for gold, in which case a dollar would measure larger and larger values of wealth. That in turn would require prices to fall. Suppose we now have twice as much wealth as we had before, but the same number of dollars to measure its value. Then what was priced at $1 would now have to priced at 50 cents. That’s called deflation, and for some reason we don’t like it at all.

Supply and demand
Economists tend to talk as if the economy were some kind of natural phenomenon like the weather.  It is of course no such thing, but a human invention. The “law of supply and demand” demonstrates this nicely. It is considered to be a description of how prices behave when particular commodities become more or less abundant. It is actually a description of human psychology. It describes how humans behave when they believe something is scarce or abundant.

When something that we want appears to be in short supply, we will offer more of what we have a lot of in order to get the scarce commodity. This is how it works in a barter economy, and it works exactly the same way in a money economy. Advertisers know that making a product appear to be scarce will enable them to charge more for it. Perceived scarcity explains bubbles. Actual scarcity can cause revolutions and wars.

The easiest demonstration that this “law” is an abstract description of human behaviour is to observe what happens when somebody has nothing to trade for what they want, or else doesn’t want to trade. If they have the power to do so, they just steal what they want; and if the owner of the wealth objects, they beat him up or worse.

Robbery instead of trade illustrates the truth that trade both requires and builds the rule of law, that is, civilisation. You can’t trade with people who’d rather steal from you. And once you start trading, you have to have some rules, or else you or the other party will revert to stealing.

2012-09-04 & 2012-03-03

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