Wednesday, February 17, 2010

On money

One thing I consistently see from right wing "economists" and gold bugs is a fundamental misunderstanding of the nature of money. So let's go back to first principles, okay?

In the beginning, there was no such thing as money. You raised corn. Your neighbor raised peas. Both of you are creating actual real wealth -- you are creating corn, and your neighbor is creating peas. When harvest time came, you agreed to give him a certain amount of corn in exchange for a certain amount of peas. Thus both of you ended up with both peas and corn and had a better diet than if each of you relied solely upon your own production for all of your worldly wealth.

That's what's known as a barter economy -- where you trade some of your economic output explicitly for someone else's economic output. In a barter economy it is impossible to confuse wealth with a token of exchange, because both are the same -- the actual real wealth that adds to your life (i.e., peas you can eat). Unfortunately a barter economy suffers the same problem as Communism: The intermediaries problem. A typical personal computer has about 500 discrete components in it. Each of these components itself requires a huge number of inputs in order to create it. Figure there's about 50,000 inputs to the typical computer sold today. Arranging a system of 50,000 barters to get the components of a single computer all set up together would be practically impossible. This is the intermediaries problem, where, once an economy evolves sophisticated-enough technology, barter breaks down as a method of making sure that what you require for your production is available when you need it. In the rare instances where a barter economy has occurred in modern civilizations, such as rural America during the Great Depression or Russia in the immediate aftermath of the Soviet Union, the result has been basically the cessation of the vast majority of economic activity until the economy is moved back to being a capitalist economy: an economy based on a common token of exchange (call it "money") that can be used to intermediate this complex series of swaps needed to get the inputs for the computer you want to build.

Ah yes, money. By now you should have figured it out from what I said above, but I'll lay it out plain and clear for you:

  1. Money is a TOKEN OF EXCHANGE. Its sole value is what you can buy with it. If you can't buy beans with it, it's not money.
  2. Money is not wealth. What you BUY with money is wealth. Bill Gates probably has less than $200,000 in actual cash in his bank accounts at any given time. His actual billions of dollars in wealth are what he bought with the huge cash flow he got from Microsoft -- the U.S. Treasury bonds, the businesses he bought, the land he owns, and so forth.
  3. When money ceases to function as a token of exchange -- if, say, paper money gets sent through a shredder or converted to mattress stuffing, or metal coins get buried in your garden -- for all practical purposes it ceases to be money as far as the economy is concerned, and instead turns into just lumps of metals with only scrap or dental filling value or fancy toilet paper.
  4. Money is not a store of value. What confuses the gold bugs and conservative "economists" is the notion that money is a store of value. It's not. It's what you *buy* with money that has value. Money itself has no actual intrinsic value except as mattress stuffing, toilet paper, or dental fillings. Money's one and only function is as a token of exchange. Attempts to use money as a store of value are inherently doomed to failure, because the value of money changes as the supply of money circulating in the economy and the supply of goods and services in an economy change.
The last is the biggest most major point. Bill Gates isn't rich because he has rooms of his mansion filled with $100 bills or tons of gold bullion. Bill Gates is rich because of what he owns that was bought with those $100 bills -- the businesses and bonds, the land and the mansions, all of which can be exchanged for money and thence for different assets as Bill requires for his upkeep or investment maximization purposes. Regardless of what happens to the value of money as the supply and demand for money changes, Bill will remain rich as long as the companies he owns (or whose bonds he owns) are healthy enough that he can sell their stocks or get paid off as bonds mature if he needs some actual cash to serve as a token of exchange.

In short: As I've repeatedly pointed out, you can't eat gold. It's what you can buy with gold -- or any other money -- that is what gives it value. And right now you can't buy anything with gold, I can't go into a supermarket and exchange gold for food, gold is just another asset, no different from owning farmland or a chain of restaurants. And it's an asset that has had decidedly bad returns on average over the past thirty years...

One last thought: Money is the fundamental requirement for capitalism. You can have a free market economy without money -- indeed, the first markets were barter-based markets. But you can't have capitalism without, err, capital. And at this point I'll stop, because talking further about the nature of capitalism and how it works as a theoretical system (I say "theoretical" since, like Communism, it is impossible for it to work as an actual practical system and in fact it never has done so) is a subject for another post.

-- Badtux the Money Penguin


  1. Gold is special and unique in that it's return is mediocre to bad, or even worse, in almost every economic environment.

    The one circumstance where it does well is hyperinflation. We won't be seeing that any time soon.


  2. Even in an environment of hyperinflation, other assets do better than gold. The problem with hyperinflation is that it causes money to churn so fast that it gets used on non-productive things just to get rid of it, not that it causes a fundamental shift in the economics of investing. If you have a bunch of rental houses and your economy enters hyperinflation, you end up with a ton of cash, no debt, and rental houses that have appreciated at the inflation rate (at least).

    The worst thing about gold is that because there is so little gold produced every year, and so much of that production goes into electronics production and dental fixtures, it's easy to drive the price of gold up and down with pump-and-dump market-timing schemes in order to fleece the sheep. When less than 100 tons per year of gold are produced in excess of its consumption, it is child's play for anybody with a few hundred million to spare to run a pump-and-dump on it. A variation on pumping and dumping actual gold is actual pump-and-dump of penny stocks in gold mining companies. Pretty much any stock you're offered in a gold mining company right now is a scam offering as part of a pump-and-dump scheme, because the economics of gold mining have not changed since the late 90's (the last time we saw one of these pump and dump schemes) and the result for investors today will be no different.

    Yet you still see people ascribing magical qualities to gold that it simply does not have. It is ridiculous, and when you point out that they are using magical thinking and have no, well, facts to back up what they're saying, they get upset and accuse you of being part of some conspiracy of Jew bankers or some such nonsense like that. It's gotten to the point where I ask them to provide some actual economics data to show that the gold standard has ever worked for a modern economy, and then once they fall into the standard conspiracy theory nonsense, just start deleting their comments. The only conspiracies in our economy are greed and stupidity -- both of which, alas, are in ample proportions, and all that are necessary to describe why we're in our current economic woes.

    - Badtux the Golden Penguin

  3. I had much the same conversation with my mother over the weekend. Money (and gold) is only worth something because people agree it is.

  4. I have to disagree with you on one point. Money is a store of value. Money in the bank is wealth.

    The exchange of money for something tangible sets up an equality based on real or perceived (it doesn't matter which) value.

    Money = Thing
    Thing = Value
    Money = Value

    Attempts to use money as a store of value are inherently doomed to failure, because the value of money changes as the supply of money circulating in the economy and the supply of goods and services in an economy change.

    But, no. This same objection could be applied to any store of
    value. You're just describing specific market risk. The value of corn relative to peas can shift depending on weather conditions and selective vermin attacks. Or the whims of speculators. This happens every day.

    Opening the doors of Ft. Knox would reduce the market value of gold in an instant. The relative quantity determination of any store of value is subject to general and specific kinds of volatility. And it's value at any point in time is denominated in dollars or shekels or yen (oh my!)

    Besides, if buried gold weren't a store of value, why have there been so many pirate movies?

    JzB the my King 2B Silversonic is a store of value trombonist

  5. Jazz, "money in the bank" is indeed a store of value, but only because it is an asset -- a loan you made to the bank, essentially, for which the bank agrees to pay you a given amount of interest while they loan it out at a greater amount of interest and make money from the spread. It does not exist as actual cash in the bank. As Jimmy Stewart explains. It is a low-return asset because it is essentially a way of aggregating loan risks as vs. you lending directly to people, and you're getting lower returns in exchange for greater safety, but it is, in the end, no different from buying a U.S. Treasury bond or any other debt instrument. The bank owes you a debt -- the money in your "bank account" -- and that debt on their books, not money itself, is the store of value. That is why bank deposits are LIABILITIES of banks.

    Cash itself, however, is *not* a good store of value, because the value of a given token of exchange depends upon a) the supply of tokens of exchange currently in circulation, and b) the supply of goods and services in an economy. b/a is essentially what a given token of exchange is worth at any given time, and both b and a are varying so you can't absolutely predict what their value is going to be at any given time. Indeed, even if you have a fixed money supply you cannot predict (a), because it is only money that is "in flight" that counts -- money that is currently sitting idle basically does not exist as far as the economy is concerned, it is only money currently in the process of being exchanged for goods and services which determines what a given token of exchange is worth. Thus the money velocity equations, which use higher math (Calculus) to estimate how much of the money supply is currently in flight, given the velocity of money and the total amount of money in the economy.

    So what does this mean? Well, basically it means that if we used gold as a currency, we'd have the same problem -- money itself would *still* not serve adequately as a store of value due to its fluctuating value over time. Only real assets, not attempts to hoard tokens of exchange, have value. You can't eat gold, and cash stuffed under mattresses will eventually deflate to nothingness, but a house.... ah, a house. That is a real asset. A business... ah yes. THAT is a real asset too, investing in a business. That's where your bank loans are going -- to create real assets. And that's why money in the bank is an actual store of value -- because it's backed by the value bought with the cash you deposited -- while cash under your mattress is stupidity.

    - Badtux the Asset Penguin

  6. Well, I never said money was a GOOD store of value. Though good enough to get me from the Credit Union to the grocery store.
    However, at certain times - like during recessions and deflation - it is.

    Anyway, speaking of mattresses, I was pondering this as I went to take a nap today (have a cold - the nap was GREAT.) Corn and peas aren't very good stores of value, either. They're a bit like cake. Can't eat them and have them, too. So a consumable isn't a very good store of value.

    And seriously - I just got the County assessment in the mail today, and the value of my property is down almost 20% in a year. It was down last year, too. Not a good store of value, these days.

    Gold? Never mind - we've kicked that around until hell won't have it. Oil? Not the last three years, or so. Morgan Stanley has tankers full sitting in port, costing them outrageous storage fees.

    And forget collectibles, they're inflation hedges.

    Businesses - how much was Enron worth in 2002? How much is Chrysler worth today? The market value of businesses was so low in the mid 30's that the dividend return of the very best blue chip companies was over 10%.

    I just put a fair chink into bonds. They are dollar denominated, pay interest, and worth face value at expiration. Looks like the best deflation hedge, as long as the issuers don't go bankrupt.

    Are we screwed, or what?!?

  7. Corn and peas can be traded to other people for other goods that you need. The fact that they can be eaten is what gives them value.

    Your house's worth is the exact same this year as it was last year, assuming you've properly maintained it. It still provides just as much shelter this year as it provided last year. It still has just as much space this year as it had last year. If you sold it, you could buy just as much house with the proceeds as if you'd sold it last year. The fact that all of this involves less intermediary tokens ("dollars") this year than it involved last year doesn't change the worth of your house, if it was a good house last year, it's still a good house today.

    In short, you are confusing the value of the house with the number of tokens you can trade it for. But the house's value is not tokens. Your house's value is how well it keeps you dry, warm, safe, and sheltered. That has not changed between last year and this year, even if the number of scraps of toilet paper with pictures of dead people has changed.

    Which brings up another problem with capitalist economies -- the fact that free market capitalism does an imperfect job of modeling value. That is, over the long term the number of tokens used to purchase something of value such as a home remains relatively constant compared to other things in the economy. In the short term, however, it varies between being less, and more than, the value of the home, as the feedback mechanisms of free market capitalism attempt to adjust relative values in order to properly allocate resources. To some extent this is inevitable because models of chaotic systems invariably fluctuate around a mean rather than ever absolutely converging to a straight line, but the rules of the game need to be set so that these fluctuations are not as wild as they've recently been... when value vs. cost goes completely out of whack, capitalism simply ceases to function properly because it can no longer figure out the value of anything and thereby properly allocate resources.

    - Badtux the Mathematical Value Penguin

  8. That's a thoughtful response, and I'd like to reply in kind. Can't now, since I've got to run and will be gone until late in the evening.

    Suffice it to say for now that the value of my house has not just gone down over the last year relative to green pieces of paper, but also to how many bushels of corn or peas, and how many shares of company stock I could trade it for.

    Someday, this will reverse.


  9. Wow, you guys are really into analog stuff. I've invested all the salary I didn't have to spend immediately in bits in computers. These bits multiply just like yeast, or so the statements I get claim. I used to get paper with numbers on it, but I've decided that's a waste, and now I get my bits straight via email.

    Hopefully, someday, when I need to actually exchange the bits for something, some naive individual will need my bits (I often lie awake at night worrying that the bankers will figure out that they're just bits, and can be both created and destroyed by changing the magnetic patterns on some disks somewhere).

    I enjoy these economic discussions, although I don't understand them.

  10. I don't think I'm confusing anything; though by using the word "value" in different senses, we might be confusing each other.

    You are talking abut the value of my house in terms of its utility, which I agree hasn't changed. But since this is an economic discussion, that's a bit of a red herring.

    And the only way I could buy just as much house with the proceeds of selling it would be to purchase another right here in SE MI, or someplace else equally distressed. As they say in the real estate Biz, location, location, location. Property values for plots and structures of equivalent utility vary: over time and across distance.

    There are a couple of bottom line messages here. One is that there is no perfect store of value. Money is subject to inflation, property is illiquid, gold is too value-dense and difficult to convert without high fees, peas are subject to spoilage or being eaten by rats.

    The other related point is that the value of any asset, relative to other assets, changes over time.

    And money, in its function as a medium of exchange, is the common denominator.

    Item 6 here
    might be paraphrased: A time to buy and a time to sell.

    I'll add that money is a fair store of value, under most circumstance and time frames up to intermediate, a poor store in proportion to the rate of inflation, and a great store under deflation. Which is where we are now.

    jxb the value trombonist

  11. When you get into application programming - you are creating a model of something real. For example, I worked as a programmer for a lumber company - they bought raw logs (sometimes real estate for the value of the logs) converted the logs into lumber which they sold. People were paid for the manufacturing, the *value* of the timber changed and was measured through stages of the process.

    Everything I did on the computer was a model of reality. And that's what money does - it is a dynamic and imperfect model.

    What's real and what's fake? Take away the computer model of Coastal Lumber Company and all the logs and lumber still exist. Wood is real and my programs were all phony pictures of reality.

    Same with money - Take away all the cash and coin with pictures of dead presidents. Corn and peas are real - as is your house. That's real value - the coin is a convenient way of abstracting it.


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