Money, Markets, and Trade

“At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly eager to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood.  Indeed the world is ruled by little else.  Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slave of some defunct economist.  Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

John Maynard Keynes (1936)

Er, um, ah, well, yes, indeed, dear defunct Johnny!

If you seek to understand finance and economics (as much as it can be understood!) it is important to first understand money, and the critical role it plays in allowing economic activity to occur as efficiently as possible. We didn’t always have “money”, it actually had to be invented, and it has been invented and re-invented in many forms many times over. Money has been: tulips in Holland; split wooden sticks in England (from whence we get “stocks”  and stock-markets, by the way); seashells in Samoa.  The economist will tell you that anything that serves as a measure of value, a medium for conducting trade, and a store of value is money.  And he’d be right.

The need for money is easily and intuitively captured in the simple economic expression “Pardon me ma’am, do you have change for a goat?” Fortunately for goats, we came up with another way.  Below we examine some of the history and functions of money, and what money *really* is, which you might find surprising.

Barter

In a barter economy, one good or service is exchanged for another, at a rate mutually agreeable to the two parties of the transaction. Simple enough, and every school-kid can understand exchange rates between different types of goods in their own school-kid slice of the economy that deals with baseball or hockey cards, candy, marbles, whatever. There might even be some well-known exchange rates: two jaw-breakers per chocolate bar, or five baseball cards per comic book, and these barter rates are no different in concept than the one-axe-head-per-beaver-pelt exchange rate that kicked off the Canadian economy, so long ago.

It is not any individual exchange rate in a barter economy that matters here, what matters is:
– the sheer number of exchange rates that are required in order to accommodate all possible transactions, which increases as the square of the number of goods and services;
– the difficulty in establishing “fair” exchange rates for goods that have never yet been traded ( the equivalent of “price discovery” in a money economy);
– and the high cost of executing transactions, which always, in a barter economy, necessarily involves the physical exchange of goods, each of which has a “unit size” (fractional goats being hard to find, or at least very messy), and thus one side or other of the transaction will likely be disadvantaged, depending on how many integral numbers of goats one receives for another’s cow. If the “market rate” is 3.5 goats per cow, and I only need one cow, I probably have to pay four goats for it. Or maybe three goats and a gaggle of geese, but then where will I get geese? I am a goat-herder!  You see the problem.

Money and Morality

Money, acting in its role as a measure of value and medium of exchange, greatly simplifies all these various transactions, by being placed in the middle. Once a society establishes something as money (more on that later: in Canada, we have used beaver belts, moose-skins, wheat, playing cards – monetarily inventive we are!) every good or service can be measured in units of that money, and traded for it, greatly simplifying trade, specialization, and the division of labour.  Without these, our modern economies cannot exist, and we cannot provide even the most basic of human necessities at a scale required by our modern populations.  I think doing our best to avoid famine and disease is a good thing, so I like (good) money.

Clearly money is of great social benefit, that is, unless you are a subsistence farmer, or hunter-gatherer, say, and in that case, how are you reading this?  I have met many people who believed in the adage that money is the root of all evil, and listened to one comedian, who, knowing that time is money, and understanding transitive logic, thought that time was in fact the root cause of all evil, but they are all wrong.   Avarice, greed, lack of charity – these are things to be eschewed, but it is not money itself that is at fault.

To understand that money is an innocent victim of our mistaken morality we need to differentiate its role as a store of wealth from the wealth itself. To blame money for our woes is like holding language responsible for the ideas expressed using it.  Once I sell my goats for money, there is no more reason to hate me for possessing lots of money than for possessing lots of goats (there are plenty of better reasons than either).

Money and Faith and Time

The most important and least understood aspect of money is that its value rests entirely in faith, the faith that after exchanging my goats for it, I will at some future point in time be able to exchange that money for something else more valuable to me than goats, of which I have plenty.   Another way to think about money is as a debt – but an anonymous debt, callable in the market at the creditor’s discretion, for whatever good or service he chooses.  All the participants in a money economy implicitly agree to exchange their goods and services for that money.  If I accept money for my stuff, I am also accepting that the debt to me that that money represents will, at some point, by someone, be repaid with other stuff of my choice.

This equivalence of economic faith in the future and the human-perceived value of money means that economics is inherently a very soft science, without any precise universal natural laws as we find in physics, say.  A key reason for this, aside from (simply) the monumental complexity of our current economies, is that the ultimate arbiter of value, the human mind, is capable of some very strange and illogical beliefs.  Make a list of fruits, deny your subject a pencil and paper to keep track, and start asking them whether they prefer pears to apples, oranges to pears, apples to oranges, etc.  It will not take you long to find out that most people’s value logic will break down at a very small number of fruit-comparisons, resulting in preferences like pears over apples, apples over oranges, but oranges over pears.

Value is largely emotional, and not necessarily very logical.  This kind of thing is what drives economists crazy, and is just one of many reasons why the math doesn’t (always) work (well) when economists try to use it to model our economies (ed: Christy has provided some more on this topic in the comments).  Despite the efforts of those who would attempt to harden economics through mathematics, the most common effect of the modern study is to obfuscate as opposed to enlighten, and to hide the simple, common-sense (though imprecise) principles upon which the health of our economies rely.  For money to be effective in an economy, we must have many things, including the rule of law, but most particularly we must have faith that debts will be repaid, at the same value at which they were incurred.  Plus interest, if applicable, and it is, because we have…

Inflation

The store-of-value function of money requires that it be scarce, that it can’t just grow on trees, else the natural reaction of market participants will be to leave home without any goats at all (so far, this probably applies to most of you) pluck some money in the money-tree forest on the way to market, and return home with dinner.  And a new car and a 3D plasma HDTV.  But what would the “market price” for dinner and cars and TVs be?  Whoever had plucked the most money would set the price.  A money-plucking frenzy would occur, more money would constantly be available to all (the brighter and more strategic thinkers amongst you might buy fertilizer!), and prices would rapidly spiral upwards.

This is the effect of monetary inflation, something with which, unfortunately, we are all too familiar.  If I happen to have sold a goat on Friday for 10 money-leaves, and laid in a couple of day’s supplies for just 2 leaves, putting 8 leaves under my mattress over the weekend, I will be shocked when I return to the market on Monday (I don’t read the financial sections on the weekend) with no goats, but with 2 money-leaves (I am also lazy and don’t pluck money on Mondays), expecting to return home again with the same supplies, only to learn that it will now cost me 2,000 leaves.

Being clever, of course, you will say: “Why didn’t you just take some goats with you, silly, because if you had taken goats to market on Monday, they were fetching about 10,000 leaves apiece!”  But you can see the problem if money is not scarce, both for the store-of-value function, and as a means of valuing goods and conducting transactions.  If monetary inflation is extreme, participants have a huge incentive to as rapidly as possible spend their money and convert it to real goods while the money is still worth something, and market participants must constantly be computing new exchange-rates between their particular good or service, and the (rapidly depreciating) value of money.  To the extent that the changes in rates are not all perfectly aligned, someone is getting ripped off.  And the guy who is frugal and saves his money gets hit worst of all.

Just as we must distinguish between money and wealth to think clearly about all this, we must also distinguish between monetary inflation, and the subsequent price increases that follow, the former being cause and the latter, effect.  But in one sense, money is just like any other commodity, and if it is plentiful and freely available, it is “cheap” with respect to all other commodities.  Once any particular commodity (like, say, printed pieces of paper) is selected by society as money, dramatic increases in its supply has nasty effects on economic activity, and we have seen the destructive effects of rapid monetary inflation in many real economies, with tales of wheelbarrows of Reichmarks being wheeled to market to buy dinner, Argentinian workers demanding daily pay, and rushing off to spend their money before it was worth so much less the very next day, and, more recently, Zimbabwean $100 trillion dollar bills:

If it weren’t so tragic, one would have to laugh.

Many (most?) “modern” economists believe that a small amount of inflation is good and appropriate in a money economy, as it assists in retiring sunset industries, and smoothing difficult re-adjustments in value to the human psyche.  This is true of the economists who administer our money, at the Bank of Canada.  The argument goes something like this.  In any money economy there are always profitable industries, those operating on the margin, making just the skinniest of profits, and those operating at a loss.  That latter group needs to cut its labour costs, say, perhaps a Canadian textile manufacturer trying to compete against a foreign manufacturer who draws from a labour pool willing to work for less, or harder for the same amount.  The textile barons will have a much harder time convincing their employees to take a pay cut than to simply accept the same pay next year as this year, and of course all is measured in money.  If that money is inflating by (ie depreciating in value by), say, 2% per year (the longstanding Bank of Canada target, but targeted using price metrics like the CPI as a proxy measurement, a dangerous game), the company gets that same amount in annual labour savings, but without having to negotiate pay cuts with burly Teamsters at the factory gate with “I hate management” tattooed on one bulging bicep, and “Death to scabs” on the other.  But this argument rests solely on the fact that our modern psyche has been conditioned to think that economic growth is both good and necessary, that declining prices and wages are a bad thing, and that price increases are a natural and inevitable consequence of economic growth.  None of these are necessarily the case, though few want or are willing to admit it.

The Beneficial Inflation of Jacques de Muelles

Is it possible that we do in fact need inflation in some cases, that it could be beneficial?  Interestingly, the answer is certainly yes, and Canada’s monetary history provides an excellent example.  You can read all about it here.  After using wampum, beaver pelts, and other specie as money after Champlain’s arrival in 1608, a variety of coinage was adopted of various origins, nationalities, and values (which, by the way created a bit of a currency-conversion nightmare: they didn’t have computers and pocket calculators, information traveled slowly, and folks tried to settle things down by fixing exchange rates, especially in Halifax).  In 1685, unable to pay his soldiers and facing a consequent decline in economic activity, Jacques de Meulles, Intendant of Justice, Police, and Finance in New France came up with an ingenious idea.  His original (translated) words in his letter to his French masters of Sept 24, 1685 bear repeating:

“I have found myself this year in great straits with
regard to the subsistence of the soldiers. You did not
provide for funds, my Lord, until January last. I have,
notwithstanding, kept them in provisions until
September, which makes eight full months. I have
drawn upon my own funds and from those of my
friends, all I have been able to get, but at last finding
them without means to render me further assistance,
and not knowing to what Saint to say my vows,
money being extremely scarce, having distributed
considerable sums on every side for the pay of the
soldiers, it occurred to me to issue, instead of money,
notes on cards, which I have cut in quarters . . .
I have issued an ordinance by which I have obliged
all the inhabitants to receive this money in payments,
and to give it circulation, at the same time pledging
myself, in my own name, to redeem the said notes.”

While de Muelles’ paper currency did in fact enter circulation and allowed trade to resume, providing a great net social good, his masters were not pleased, citing the ease with which counterfeiting might occur, thus depreciating the French currency that the cards represented.  Card-money was in fact a specie-backed currency, backed by the underlying French currency of the time in which the soldiers were payed, as guaranteed by the local head of state.  The Spanish also did not understand the importance of having some flexibility in the supply of money, and the wealth that money in circulation creates.  Though they sat on a vast hoard of plundered gold, the Spanish declined in economic standing in the late age of exploration because they didn’t put it to work, and the Dutch and British and French (who who had since learned, perhaps from de Meulles and others),  did, and they left the Spanish in the dust.  Or sea-foam.  Or something.  How ironic that now, as the “S” of the Euro-PIGS, they have over-rotated in the other direction.

Money is Debt, Debt is Money

The equivalence of debt and money is made clear in the above example.  Every time de Meulles had to pay a soldier with paper instead of gold he was incurring a debt, as he clearly states in his letter, though he fully expected his government to stand behind the debt, which they in fact did, despite their disapproval (though much, much later, Canadian card-money was retired at only half face-value).  At the moment he signed the card, the amount of money in New France increased.  The money supply expanded.  De Meulle thus created the first case of local Canadian monetary inflation (excluding here the beaver-trappers and shiploads of foreign currency, which also increased the local supply), and it was a good thing, since the expansion allowed a renewal of economic activity, prices stabilized, and normal life resumed.  What we seem to have forgotten lately is that one can have too much of even a very good thing.

Money Supply

Inflation, deflation – what we are talking about is the growth and shrinkage of the money supply.  Modern central bankers spend all their time worrying about the following question: “So, exactly how much money does the economy currently (haha) need to run smoothly, to avoid being stifled as de Muelles economy was, while avoiding inducing excessive consumer price increases?”   The former defines a lower bound, and the latter an upper bound on the “right” amount of money.  But, of course, it ain’t that simple.  Firstly we cannot know where these limits are, as they exist only as an abstract concept, and in reality cannot be known by market participants, even by university-educated central bankers, and certainly not with any foresight, only hindsight.  A second problem is that in our modern world we have many different measures of money, different “monetary aggregates” as they say.  In the good old daze, it was easy to know how much money there was: count all the gold coins.  But as we moved away from gold as money, the picture started to get fuzzier.  So let’s zoom in.

Fiat vs Species-backed Money

There is a top-level dichotomy we need to make between fiat and species-backed currency.  We used, in Canada, to have a gold-backed currency, ie gold was the specie for which dollars could be redeemed.  de Muelles’ cards were an example, since the paper was convertible to French gold coins.  The old-timers amongst you might remember seeing the words “Pay to the bearer on demand” on our bills? No longer.  What that meant was that anyone holding a paper bill could take it to the Bank of Canada, and the Bank was obligated to repay the debt in physical gold.  But no longer.  In fact, I am not sure there are any fully gold-backed currencies anymore.  Perhaps the Swiss franc. [ed:need ref check]

The path leading away from gold-backed currencies in the modern global economy (towards the other kind, that is, money created by act of fiat) began in the early twentieth century, and the meeting of bankers at Jekyll Island in 1908 paved the way towards legislation in Canada, the US, and Britain that created our national central banks.  The idea seemed reasonable enough, as the world had seen some nasty bank failures, so the public was eager for “solutions” to the bank-stability problem.  And the large bankers were only too happy to oblige, because they knew that great profits awaited, and they understood Rothchild’s insight (below) into the power that money-supply control had over public policy.

It is too bad the bankers were so much better informed than the politicians of the day (and still!), because our representatives’ ignorance allowed the bankers to hoodwink the public and start the fleecing process, which continues to this day.  The coupling between paper money and gold was systematically decreased through various financial instruments and legislation, until in the early ’70s, despite that its currency had been selected as the reserve currency of the world’s central banks at Bretton Woods in 1944,  the US declared that it would no longer honour its gold debts even to other central banks, and the last “official” flimsy coupling between the world’s currencies and gold was severed.  France had called the Bretton bluff, and after honouring the French central bank, the US shut the wicket.

Banks and Money

One of the more interesting functions that money allows is banking, and in particular fractional reserve banking.  Its story is well charted in Niall Ferguson’s The Ascent of Money (there is a web site with some good history as well, here), and much of human history since the invention of banking has been driven by the bankers.  As Mayer Amsched Rothchild said so eloquently, “Permit me to issue and control the money of the nation and I care not who makes its laws.”

The basic idea of fractional reserve banking started out in Holland and England, where central repositories for gold issued paper certificates so that folks could lighten the loads in their pockets by carrying around and trading paper, knowing that they could always just head down to the repository, the bank, and pick up their gold in exchange.  They had faith in the transferable debt.

Initially, there were always exactly as many certificates in circulation as there were bars in the vault.  But one day, some clever clerk noticed that there was always a lot of gold in the vault.  There never seemed to occur a time at which everyone wanted to withdraw their deposits.   Surely, then, it made sense to lend some of that gold to someone who could make productive use of it, thus earn some interest on it, and thus improve the banks profitability, all simply by writing one more certificate than there was gold in the vault.  Until that instant, the roles of money-lender and banker had been distinct, and in that moment, the world changed forever.

Until the invention of banking, capital would accumulate, but debt-markets continued to operate in much like a barter methodology.  An individual seeking “leverage”, one who wanted to go into debt, would have to find an individual with an excess of capital (ie, wealth beyond their immediate needs), and cut a deal, and the trust and faith that the debt would be repaid would be confined to the two parties of the transaction.

But with fractional reserve banking, that trust and faith that formerly was a private affair between known parties was anonymized and made indirect (is the term “counter-party risk” that we hear so often with respect to the US mortgage meltdown now starting to make sense?).  When I make a deposit to my bank account, I do not know exactly to whom my money will be lent, nor do I know the creditworthiness of the parties entering into debt with the bank, and indirectly, me.   This anonymization process was exploited to the limit (and beyond!)  in the US mortgage-debt tragicomedy, of which, by the way, we have only seen the opening acts.

The “fraction” in the fractional-reserve equation is a measure of the degree of leverage that a bank assumes on my behalf as a depositor.  Suppose a bank runs a 10% fractional reserve ratio.  Suppose 1000 people deposit $1000 each into their accounts.  There is now $1M in the vault.  If we all decide we need our cash, we will all be able to withdraw our money at the same time.  But with a 10% reserve ratio, the bank can lend out up to $900,000 of our money to parties it believes are credit-worthy, because its policy says it need only have 10% in reserve, at-the-ready to satisfy our on-demand withdrawals. Now, suppose those debtors in turn deposit their cash (they will spend some, but the people they buy from have to put it somewhere too).  There is now again $1M in the vault, with an on-demand liability of just $1.9M, so our clever clerk notices that more money could be lent out while still satisfying the 10% reserve requirement, which is now $190,000.  So the bank lends out another (1,000,000-190,000) or $810,000 to parties it trusts.  And so on.  The result is that after a short period of time, the bank’s balance sheet of assets and liabilities will naturally converge to a ten-times multiplier (the inverse of the fractional reserve ratio) of the demand deposits.  The original $1M supply of money has been multiplied up to become a $10M balance sheet, with $10M of assets (the sum of all outstanding loans plus the reserves in the vault) and $10M of liabilities (the sum of all deposits).  The supply of money has been expanded by a factor of ten.  Cumulatively, we all think we have $10M, and we do.  It’s just that we can’t all have it at the same time now.

If you think that this is an oversimplification, and that the situation might be changed by having a multiplicity of banks into which savers and debtors might deposit their funds, or that instead of depositing the cash they get when they incur their debts, they instead spend it on something, you will either have to dig deeper than I can afford in this brief summary, or just take it on my word (trust me!) that it makes no difference.  Money is a lot like water, and it will slosh and seep between people and companies and banks until this equilibrium point (actually, homeostasis) is achieved.  There is good reason why the term “liquidity” is used in economics.

While this might seem like economic black magic, that money can be created from thin air simply by having a fractional reserve ratio in our banking systems, it can be better understood by remembering that money is debt, and the value of the debt is simply our faith in the future repayment.  The debt represents the product of future work,of future material gains.  The amount of money created by this system is exactly a measure of the depth of our reaching into our future  It represents our collective view of how much and how hard we are willing to work tomorrow for stuff we want today.  This is accomplished by taking demand deposits, which are callable on a moment’s notice (as long as it is not a bank holiday) and “moving them out the yield curve” to exchange for longer-term debt, which is used to fund longer-term more strategic investment.  To the extent that a society, in aggregate,  borrows on future prospects, it creates money.  If we withdraw our deposits in favour of money-in-hand, or pay down debt, or worse, if defaults occur, we reduce the supply of money.

One effect of this increase in the supply of money (inflation) is the effect of rising prices, as more dollars compete for the same amount of stuff.  Since we all have more cash (or the equivalent in our minds, ie healthy bank accounts) and our psyches tend to forget about or discount our longer term debt, we are more inclined to be willing to pay more for goods and services.  We feel rich.  There are more liquid dollars chasing the same amount of stuff, so prices rise.  I can’t buy food with a mortgage or a thirty-year bond, but I can with cash.

But what happens when it shrinks?  What does that look like? Well, it has shrunk quite dramatically, and recently.

What Happened in October 2008?

You almost certainly remember feeling confused about what was going on that fall, but viewed monetarily, it all makes sense.  At that time, in an unprecedented way, everything, and very suddenly, lost value, as measured by money.  Asset classes that normally moved in opposition (negatively correlated) suddenly all moved the same way.  We had grown accustomed to a healthy, balanced market, where, say (example only!), if bonds were doing well, stocks were not, and gold didn’t care (ie it was uncorrelated to other asset classes, say).  But at that time all asset classes plummeted: commodities, real estate, stocks, bonds, even precious metals all got hammered.  Look at the charts.   So what happened?  Simple.  The money supply, suddenly, shrank.

Money represents real stuff, that is what we exchange it for.  If there were a world where there were only 100 goats, and $100 of money, a goat would cost a buck.  If the money supply shrank to $50, goats would cheapen to only fifty cents each.  If it grew to $200, I could make a killing (I would think) because goats would double in price.  Unfortunately, everything else (if it existed) would also have rocketed up in concert, so in fact I am no better nor no worse off in either case, as the amount of real stuff didn’t change.

What we saw in Fall ’08 was the effect of the yardstick by which we measure value, ie money, changing in length.  The yardstick got longer.  It took fewer dollar-yardsticks to measure the same amount of stuff.  But how could it happen so suddenly, everywhere, all at once?  Because, as we saw above, ultimately, human faith creates the value of money.  In Fall ’08, the world, the global consciousness, if you will, had a realization that all was not well, and that we had placed too much trust in our collective future.  In fact, to a large extent, “we” did not, but the institutions we have created and charged with managing all this stuff did it for us.  Whether intended or simply an act of negligence on the job, it is largely our governments and our central and commercial banks that have led us down this path.  Despite that we do elect the former, and voluntarily give our money to the latter, and are thus complicit, I am compelled to engage in sarcasm:  Thanks a bunch.

Central Banks

We certainly seem to read about them a lot these days.  So what is their role?  The central bank for a currency is the lender of last resort (or should be: we will discuss the role of government guarantees against central bank failure later) to the commercial banks that deal with the public.  If a commercial bank suffers a “run” where depositors lose faith, and demand their money to put it under their mattresses, and the bank exhausts its reserves in satisfying them, the central bank will step in and lend some cash to the commercial bank so that the commercial bank will not enter into default and be rendered insolvent, effectively screwing anyone who didn’t get there early out of their savings.  Sounds good, but, does it work?  Well, in “normal” circumstances, yes, in fact it happens every night as the commercial banks settle their accounts.  Could a central bank in turn fail?  Unfortunately the answer is yes, and we may now be precipitously close to such events.

In fact, there has never in history been a central bank that was the custodian of the value of a currency that did not go bust, eventually.  Our current central banks haven’t yet (at least, no-one has yet owned up to it, anyway) but it is either a matter of time, or our policies will change soon enough to prevent it.  What causes a central bank to inevitably implode, and the currency to be devalued?  You should know by now, if you have been following the bouncing ball.  Excessive societal debt.  When a society reaches too far into the future, either “knowingly”, in the private sector, or because an electorate has fallen asleep (zzzzzzz, can you hear the snoring of society?) and allows their governments to do so on their behalf , we sow the seeds of our monetary destruction.

Excessive private debt has a way of working itself out, provided the rule of law is still functioning, because folks and companies go bankrupt, and then can’t borrow more because their folly has been smoked out.  If there is a rash of bankruptcies, good private banks tend to tighten their credit, and only lend to the most reliable debtors.  The money, like a liquid, will flow to the “right” places, and away from the “wrong” ones.  But public debt is different, being a much stickier, more viscous substance, as we shall see.

Government Debt

There can be good reasons why some human collective, like a government, might want to enter into debt.  Infrastructure spending is a classic example.  One might be able to make a business case that spending some money now will pay off later, providing a net positive social good from the transactions: “If we build that bridge, now, instead of later, our local economy will boom sooner, and we’ll get a jump on everyone.  The interest on the debt is paltry in comparison. Learn from the Spanish mistake, let’s put our faith in ourselves (ie our money) to work,” we say.

My own little family collective has, in the past, entered into debt.  We wanted to live in our own house, and had a pretty positive view of our financial future, and, in hindsight, I am glad.  We bought our little house, live in it still, and have paid off the debt.  We think it was a net positive social good for our little society, and that is all that matters.

But a planned and planning organization like a government, which is decoupled from the incentives that exist for the private sector does not have the same incentive structure, or at least the decision-making occurs very far removed from being directly exposed to the communal incentives.  This can be illustrated on the buy-side with the following little maxim:

If you buy something for yourself, with your money, you are concerned about both cost and quality, because you are spending your money on you.  Both matter.

If I buy something for you, I am most worried about cost (my money) but less about quality, as it is you that receives the benefit (no offense intended, dear reader).   Similarly vice-verso, if you have a normal human value-system.

Now what are governments in the business of?  A government spends other people’s money on other people.  The direct incentives for cost-effectiveness and quality of service do not exist to guide the system towards optimal decisions.

The same is true on the debt-side of the equation.  Private debtors have great incentive not to get over-extended (at least they did, before “robo-signing” and mortgage defaulters asserting a superior moral position, and thus not feeling in the least guilty about living mortgage-payment-free in their McMansions to our south).  Governments do not.  In fact, governments have great incentive to do exactly the opposite, ie to borrow beyond their means (which, if you have been following, expands the money supply, ie creates monetary inflation).  If you have difficulty with a “government” feeling the effect of an “incentive”, please have a read here, it might clear up how our understandings differ.

Inflation Revisited: The Looping Crack-Pipe Appears

Once we allow an institution to incur liabilities for which we are ultimately responsible (as is the case with our governments, as we have granted them the power of taxation over us) the possibility of default seems remote indeed.  The debt isn’t personal, and it slips past our consciousness, and we don’t consider it much when voting, and our politicians don’t think about it much (or try not to) as they vote in the next year’s budget deficit and the next money bill, and bureaucrats don’t think about it much as they write the next cheque with public money.  I don’t say this to cast blame, it is all quite natural, and human.  But it is true that a consequence of this devolution of authority to indebt is that no-one pays much attention to public debt until very, very late in the game, by which time extracting oneself can be very painful.  Anyone who has suffered a debt-binge and worked their way out of it honestly through diligence, hard work, and austerity knows this.

Now let’s find the crack-pipe.  What makes it addictive?  Start with a zero balance, perhaps because historically our government has been prudent on our behalf, or because we had a constitutional restriction against public debt in place.  I know.  You think that sounds insane, but it has worked very well in the past [reference].  Public debt being “normal” is a fairly recent thing.  At any rate, this is the first year.  Maybe we changed our minds because there was a tyrannical administration somewhere in the world threatening millions of people for whom we felt a right and an obligation to defend.  There might be lots of reasons.  So we run a deficit that year, we think just temporarily.  The government issues bonds, typically with a term in the range of several years, the Bank of Canada buys them, with dollars, and the government spends those dollars on the important stuff that just had to be done that year, instead of waiting for next year’s surplus, or immediately increasing taxes.  The money the government spends increases the level of activity in the economy, whose activity level we measure with a concept called Gross Domestic Product (GDP).

The monetarists’ equation of exchange, GDP=PQ=MV now comes into play.  GDP we – that is, we think we – know.  P is price, Q is quantity, M is the money supply, and V is the “velocity” of money, the number of times that, in aggregate and “on average”, a single dollar gets recycled through different transactions in a single year.  P and Q are giant matrices of the sum of every transaction in the economy for every type of good or service, multiplying the “average price” by the “average quantity”.  And this is how governments get their income, by taxing transactions that contribute to GDP, or taking a slice off of some portion, like say family income.  Again, no blame, this is just how it all works.

I need you to really think now, because we are about to start looping.  We borrowed money this year.  So M is certainly bigger, by definition, because, hey, we incurred debt (unless a rash of debt default occurred to offset our deficit this year, which, for now, we shall, haha, discount).  Q went up for sure, because we spent it on stuff this year.  P probably went up a bit, and we can try to lay the blame on all that new money now flowing around, or we can say, hey, demand suddenly increased, supply takes a while to catch up, whadaya expect?  V might have gone up or down, it really depends on how that M entered the economy (ie which monetary aggregates were affected in what way by our new debt).  It matters not.  What matters is that we observe that GDP is certainly higher, and we will never know exactly how much of what contributed to the increase.  It seems like magic, but the government appears to have made a wise choice, as our economy has grown (and we like growth, right?) and we can’t see any ill affects at all!  Hurrah!  And that year we defeat the evil dictatorship, and though we still have the debt, heck it was worth it.  By gum, it even stimulated growth, look at that increase in GDP!

Next year’s budget vote rolls around. It worked so well last year, we think we were being foolishly conservative in our former austerity, so we vote in another deficit, and add to our debt again.  We have many expert economists who have noticed something, and they are guiding us wisely as follows:  “When we first encumbered ourselves with this honourable debt, it represented but 5% of our annual GDP.  As this chart clearly shows, our 4% increase in GDP this year means this debt has, without any effort, declined in terms of how long our country, and your electorate, I might remind you, Sir, must work to repay it.  This growth has increased our tax base, so we will be making more income in the future, and we’ll easily be able to pay off that debt and more.  But, just to be prudent,” says our wise economist, “we recommend only borrowing a maximum of 3% of GDP this year.”  And this next year is a boom year, say, because instead of our now-larger economy building mainly destructive stuff like guns and bombs, and shipping them overseas never to return, the economy rapidly re-focuses internally on productive stuff Canadians can use to make more stuff and in turn sell that stuff to others, and so on.  The exact sequence by which we enter into a habit of deficit-spending is not the issue.  It’s what the economists tell us once we are there, which we have a hint of above (plus the fact that we are silly enough to listen to them!) that matters.

I literally suffered a chill down my spine when my brother-in-law (the economist) explained all this to me, and that the people in positions of economic power actually think like this.  The entire concept is seductively simple.  Provided the annual percentage increase in public debt – the annual budget deficit divided by the total outstanding debt – (on average, year after year) remains below the percentage increase of GDP (on average), then every year the total debt “seems” smaller, even if we pay off none of it, ever.  Our existing tax rates need not rise, incurring the wrath of our electorate, with the possible disastrous personal consequence of our being booted from office, and we all get a free lift from the increased economic activity.  Jean Colbert, minister of finance to Louis XIV of France said it best, long ago :

“The art of taxation consists in so plucking the goose as to elicit the least amount of hissing”

Since Colbert’s time, that art has been refined to perfection.  Or has it?  Certainly, inflating away one’s debts is convenient, but, unfortunately it is also highly addictive, and like many addictive activities, it is also self-destructive.  If within our definition of “the art of taxation” we include the long-term well-being of our tax base, I am afraid the addicted-to-growth funding model falls flat on its face.  Alternatively, would we consider ourselves “artful” if, after many years of successful silent plucking, it all ends in one big “SQUONK!”?  I really, truly, hope it doesn’t, but let’s look at the longer term effects of constantly increasing debt.

A continuously inflating money supply, even over a fairly long term, may or may not be a good thing.  Provided the terms of our sage economic advisors are met, ie that economic growth continues unabated and is not achieved at the expense of some other large but uncounted social cost, say, the destruction of our environment, for which we will pay later,  (economists call these uncounted costs “externalities” as though they don’t matter, and are not material to their models), it may be right and good that money supply increase along with GDP, else we might wind up in de Muelles’ position before his clever invention.  It should be clear from the monetarist’s equation of exchange that for GDP to increase without a corresponding increase in money supply (ie, debt) it must do so by achieving a higher money velocity.  Each dollar in circulation must move more quickly from one pocket to another, executing taxable transactions on the way, doing more work, for the equation to hold true.  And it does hold true.  Not physics- and F=MA – , or E=mc^2 – style true, but close enough.  These days, electronic financial products and transaction processing has allowed V to increase well above that of de Muelles’ time: he couldn’t do much about V, so he hit the M button, and it worked for him, in that case.

No, it wasn’t de Muelles’ situation that made me shiver that day, it was the understanding of the potential consequences if our economy genuinely “wanted” or “needed” to contract but we were “programmed” for growth.  In de Muelles’ case the economy “wanted” to grow, but couldn’t, because limited M and physically bounded V (a given coin can only be involved in so many transactions in a given day, even if everyone runs from transaction to transaction)  were holding it back.  By expanding the supply of money, de Muelles relaxed an unnatural constraint on the system, so that it could find its equilibrium ( really, the minimum-energy homeostatic orbit in economic state-space, but I get ahead of myself in terminology).

There is a body of economists, folks call them Austrians, who believe that credit cycles drive all.  And I largely buy it.  Folks have looked at societal debt levels over time, and there emerges a remarkably consistent, roughly 60-year pattern of increasing and decreasing debt levels (and, thus, money supply, in a fiat-currency, fractional-reserve-banking system) that spans hundreds of years.  What is this cycle?  Presumably, it is society’s systemic memory time-constant (see “Gravity Always Wins”, here, you just can’t fool Mother Nature, Ok?) .  Once sixty or so years have elapsed, we have pretty much forgotten how stupid we were last time, and we set off on another round of decades of binge-drinking of debt, followed by the inevitable hangover.

The Crack-House to the South

And now, finally, we can take a look at what is happening today, in the United States, and consider what personal and policy-responses we might make as Canadians.

Some monetary and banking highlights from 100 years of US history:

– the notion of the central bank was introduced in 1908 in response to private banking failures, the idea being to create a private bank too-big-to-fail, as a lender of last resort, but backed by the US taxpayer;

– this central bank, the Federal Reserve, allowed, aided and abetted various US administrations to indebt their electorate by buying US Treasuries as their primary security and asset;

– Fannie Mae (and later, Freddie Mac) are formed in the depths of the depression, with all good intention, to assist US citizens in achieving home ownership.  These too are backed by US taxpayers.  Despite an amazing economic revival after the depression, these institutions are not retired, but persist, distorting the debt-market incentive structures;

– the final tie between gold and the US currency is removed in 1971.  Some stability is maintained thereafter by having all oil-related transactions be priced in US dollars (though this last link is also being shredded by new non-USD oil markets in Russia, China, and elsewhere as you read), creating an artificial demand for US dollars – everyone needs oil in the economies we have built, so everyone needs dollars;

– US federal administrations, one after another, do not have the courage to quit smoking the debt-crack.  They are all addicted, and no-one wants to take the popularity-poll hit on their watch.  US debt balloons, of course, along with (of course, as they are the same thing)  the US money supply;

– hugely profitable incentive structures are created for banks to make home loans to those of bad credit risk (remember Freddie and Fannie? “It’s all guaranteed!  What can go wrong?”).  More (private) debt.  More money.  “NINJA” gets coined, describing the new loans: “No Income, No Job or Assets” but there are big kickbacks all the way through the chain, and the incentives to make sure a debtor would repay are all gone.  Dear prudence, where are you when we need you to come out and play?;

– deregulation of the financial sector (up to about 30% of US GDP currently – mainly just paper and electronic debt shuffling its way around) allows all sorts of new species of financial instruments to spring up, which are complex, ill-understood, and implicitly assume in their construction and initial valuation that they do not suffer from any single or systemic risk (I feel the need to add something technical, like that the assumption was of independent eigenvectors in their failure-probability distribution functions, but that would bore you to death, right?).  Bond rating agencies, unaware of or complicit in the deception, rate these AAA.  Little old ladies and small towns in Finland wind up buying the debt of crack-dealers in Chicago.   Seriously, that is how broken it got ( and still is?);

– the Fed, “feeling” that there is ever more demand for money (“Hey, the GDP is growing, see? We’d better print more!”) continues to back the commercial banks in their exploits by lending them even more money, very cheaply;

– as all this debt (and money) is created over the decades, the US dollar depreciates (we are now in about the summer of ’08, ok?) by a factor of one hundred.  What costs a dollar now cost a penny a hundred years ago;

– and then, with the system wound up so incredibly tight, honed to perfection in the slicing and dicing of the unquantifiable risk of counter-party default, all built up from some simple government guarantees against the default of individual homeowners, exploited to the limit by the clever clerks in financial institutions, and leveraged to the hilt through the completely opaque over-the-counter derivatives markets, all it takes is a tiny little shake or shimmy, and the whole thing crashes down in a crisis of confidence, in the Fall of 08.

And then finally, the global consciousness, smarter than any single one or even any small group of us (like a bunch of bankers or economists) said “Enough.  This is no longer credible.  Much of this debt will not be repaid” and that uber-consciousness thought-meme expressed itself in the actions of myriad private companies and individuals, in myriad ways, all to the effect of reducing their debt exposure, de-leveraging, or, in some cases, simply defaulting on their obligations, which has the most powerfully destructive monetary contractive force.

What the Americans are Now Doing: Economic Hari-Kari

Well, (despite my warning them) the US would appear to be embarking on Quantitative Easing #2, or QE2, for short.  Well see this week (of Nov 1 2010 as I write).  It is hard to know if QE1 was a good idea or not, certainly many giant commercial banks would have failed had the Fed and Congress not acted quickly.  That a positive net social benefit accrues we will only know much later.  The only certainty is that many PhDs in Economics will be granted in the analysis.  It might simply have been better to have taken our lumps in 2008.  But here we are.  The real question now is whether it is the QE2 or the Titanic2.  I personally believe there is a very good argument that the recent British announcement of fiscal conservatism and austerity, moving towards debt reduction is the right answer.

What is “quantitative easing”?  Well, it’s pretty new, the economists have basically just invented it.  When we invent a new theory in chemistry or physics, we go to the lab, we make some predictions, we run an experiment, and observe the results.  If the results agree with our hypothesis, we begin to believe we are onto something, and with enough confirmation, we know it is true.  Like F=MA, or E=mc^2.  We call this the scientific method, and it works pretty well as a truth-discovery process.  The trouble with economics as “science” is that the only way an economist can test his theory is to subject us to it.

The theory behind quantitative easing is as follows.  Suppose something dramatic happens to cause a money supply to shrink rapidly, causing bank failures and seriously endangering economic activity.  After bailing out the banks (a central bank is meant to have discretion in this function, and only bail out the most credit-worthy) and attempting to encourage people to spend and buy and borrow by printing money, and the horse does not appear to be drinking, what else can you do?  Oh, Orwell would be proud, “Quantitative Easing” is when the central bank takes the next logical step.  It starts to buy stuff.  “Hey people aren’t buying, so we will step in!”  Overnight interest rates of zero being insufficient to induce commercial bank borrowing (and money supply growth), and negative interest rates being just silly – “Here, take this money, please, I’ll pay you to take it!” –  I suppose it never occurs to these clever economists that perhaps banks are not borrowing and people are neither borrowing nor buying for very, very, good reasons.  No, in their hubris they arrogantly assume the common consumer, the business man, shareholder, whomever, must be wrong.  They can’t really be blamed for this, there has been a hundred years of (incorrect) economic teaching in our universities that makes them believe this.  “We are born ignorant.  It is education that makes us stupid,” said Bertrand Russel.

The effect of “quantitative easing” is to effectively make the federal government, and thus, the taxpayer, owner of any assets procured in the process.  US taxpayers can look forward to owning inefficient car companies, bankrupt banks, and baskets of consumer mortgages that will never be repaid, for which the original title deeds have long been lost, some would claim intentionally in various suspicious but convenient fires at the banks and mortgage agencies, and the more conspiratorial, in Tower 7.  “Quantitative easing?”.  Yes, Orwell would be proud of the term had he invented it himself in his Ministry of Truth.

There might have been a chance for the Americans, maybe there still is, to recover from this mess with some pride, and some value left in their country and economy.  But it will take incredible leadership, and I certainly don’t think President Obama (or “Dude” as comedian Jon Stewart recently referred to him, to his face, on national TV) either understands any of this, nor do I think he has the skills to pull off a reversal of fortune.  I think now we just get to watch it all play out, and try to think how we should react so that we don’t follow them down the drain.

Canada and the ‘States Compared

It is our great good fortune to have run some federal government surpluses from 1997 through 2007, so that at present, our debt-to-GDP ratio is (relatively, given the bachelor-party binge-drinking of debt that the world got into in the last century) low.  We knocked it up a fair bit with our own little round of “easing” post-2008 as we financed Government Motors (those ads in which ex-CEO Ed Whitacre so proudly proclaimed “We paid back the debt!” conveniently ignore our mammoth equity purchases – you own ’em, folks, but Ed didn’t tell you that!) and as “we” made other foolish asset purchases on behalf of taxpayers.  Australia and New Zealand are in fantastic shape after years of fiscal prudence, but we are not so badly off, except that we happen to share a 5500-mile long undefended border with a nation that is about to go bust and be socially stressed so hard that the rule of law might break down, or they might have another revolution, or…  I shudder.

The choices for our American brethren are pretty stark:  outright default to (largely foreign) bondholders; default to US pensioners, social security, medicare, ie the electorate; or, the most likely, least-hissing approach, and time-tested the world over, inflate it away.  The Chinese, being the majority holder of US debt, are quietly converting US bonds into Greek debt, incredibly and foolishly still backed by the EU, using one of the few mechanisms by which they can dump US bonds without completely destabilizing the currency markets.  But do I wonder who will wind up owning what by the end of all that “easing” and as the maze of debt is unwound.  My expectation is that it simply can’t be predicted, by anyone, because the US will soon (think lots of months or a small number of years, folks) enter a hyper-inflationary phase, and since things move so fast in hyperinflation, you really don’t know who gets a chair until the music has finally stopped.

Canada’s Best Policy Choice:  Qualitative Hardening?

Canada has *much* more freedom in how we choose to respond to the upcoming (yes, it has all just begun, this will take decades to work out, folks) crises and economic shocks.  It appears clear that most global currencies will appreciate relative to the US dollar, and we have been seeing this for years and it is  accelerating.  This will affect the competitiveness of our exports to the US, a huge component of our GDP.  The rest of the world, knowing this, will softly couple our currency with the US dollar.  You can see this on currency charts right now, as the Canadian dollar shows greater correlation to the US than does say, the Aussie dollar or Swiss franc.  So we cannot avoid some of the ride down with them.  But to mitigate, we will need to increasingly trade with other partners, simply because America will not be able to afford what we have to sell, and, if we are smart, we will not trust their dollar or their debt.  There will be great political pressure to help soften the US landing.  I feel very, very, sorry for the average American who, with greater than 50% probability, voted for the Dude and thus sealed their own fate.

As an average Canadian, what can you do?  Well, in a world where the universal reserve currency is no longer serving its monetary function as a store of value, find something that is.  Right now, the market seems to be telling us that gold and silver are returning as the time-tested, scarce commodity that best serves as a monetary store of value.  Another trustable currency may soon emerge from the G-this and G-that and the G-whiz kids, but it will not be a fiat currency, as the world, by then, will have (correctly!) lost faith in printed paper as an asset class.  As a policy initiative, then, it would likely make sense to increase the Bank of Canada reserves of precious metals, so that the world will perceive (correctly!) that Canadian money can be trusted in all three of its functions, and that we are a safe trading partner.  That this makes things more difficult for American trade just means we need to get on with trade diversification more quickly.

I struggle with what to do about the foreign sale of our resources, and all the recent media noise about Potash Corp shows that people care, and it matters.  In a “normal” global market, where truth, transparency and the rule of law were at work, I would not be concerned about resource sales.  But right now?  In fact I am quite a believer in free trade, and that only trade can lead to economic prosperity and the help prosperity can bring to the impoverished and destitute.  More than anything, I believe Canada’s most important role, and the one that will (tautologically, in my view of economics) bring us the greatest future prosperity is that of truth-seeker and truth-teller.

Make our money tell the truth by having it represent something real, like gold, mined from the Canadian Shield, at a reasonable fractional reserve ratio, perhaps 1, a ratio enabled by computers and software that can do the dividing for us.  This needs more thought.  We must stop running government deficits and debasing our currency, the disastrous long-term consequences of which we now see laid before us next door like the entrails of a once-great Republic that so lost its way it committed democratically-sponsored economic Hari-Kari .

And Canada and Canadians must, above all, preserve and foster the free Internet.  For it, more than any technology or organism ever invented or evolved, seeks truth.  And finds it.  Thank you for reading this, on the Internet.

PS: Gulp. Listen to the Canadian economists (not all economists and bankers are evil!) interviewed on October 30 2010 here.

Eric Sprott gets it, and got it long ago. He has many enemies in high places who would prefer you remain deceived.  Please support him.