Knowing what I don’t know about money

“What you don’t know can’t kill you!” Maybe not, but you’re probably poorer for it. This will be the blog post where I show off my stupidity. (Believe me, this is not a proud moment.)

I have no idea how money works.
I mean, I get the vague concept, and I can use it happily enough – these numbers are basically IOU notes you can trade for food, shelter, and fun stuff; and some of these IOU notes can be pooled by a community for larger-scale ventures like schools, emergency services and shooting foreigners.

It’s just the basic system of applying particular values to things before they can be exchanged I have trouble with. How can anyone decide the comparative worth of farm animals with fabric, refined metals, edible plants, and the work required to construct a building?

I have no idea how it works. I understand how supply and demand can affect values, it’s just how those values are applied in the first place I don’t get. Also, the concepts of credit and interest.

In Niall Ferguson’s The Ascent Of Money, he used an introductory example which I can paraphrase here to show what I Just Don’t Get.

Say someone has 1,000 bits of gold. They lend 100 bits to someone they trust who says they can use those hundred bits to create things of value, and pay it all back in a year’s time. No gold has to change hands – it’s just written down as an IOU note, and the gold-owner can set the pieces aside untouched. This means there’s now 1,100 bits of value in the economic system. And if the friend promises an IOU worth 10 bits of gold to another friend (despite not having any physical chunks of the stuff themselves), then there’s 1,110 bits of value in the system… which is where I’m afraid my brain breaks down.

Only 1,000 bits of gold exist, and 110 bits of value have been conjured up out of nothing, based on trust.

Now, say the person with the gold charges his friend 10 bits of value on top of the repayment, for the inconvenience of being deprived of the use of 100 bits of gold for the past twelve months. Bam! That’s 120 bits of value in the system. And if the friend also charges 10% to their friend, we’re up to 121 bits of this phantom value. And that’s before any work’s gotten started.

AustinPowersCrossEyed

So, we have created 121 extra bits of value based on two people gambling that their friends can pay them back. This is the simplest entry-level example of how economies work, and it leaves me wondering what the hell’s going on. I get as far as saying that the economy is like a religion based on gambling with the perceived value of IOU notes, and then I’m stumped. It’s like building houses on top of clouds. By the time material things of value have been created and sold from the initial loans, the system becomes a blend of real and imaginary things of value. And I’m lost.

Of course, economies are vastly more complex: there are more people in the system; interest rates change, as do the values of things being created or pulled from the ground; the ones with the gold may be more or less willing to lend it out; some people can play the system, gambling to create bubbles of value which may or may not burst. It seems everyone is in debt to someone else. (Is it too complicated to figure out how to cancel out all these debts and start afresh? Apparently it is…)

And yet… I can’t deny that, historically, economies which use interest did better than ones which didn’t. Countries with more sophisticated systems of dealing with credit and debt (such as the Netherlands in the 17th century, or the UK in the 18th and 19th) did better than those which did not, and countries with more sophisticated economies improve faster over time (but there are a host of other factors to account for, such as geography, politics and legal systems which would have an effect). This bizarre, convoluted, mathematical belief system works, somehow.

…but one obvious question to ask is: for whom does it work? Some people do a lot better out of it than others, hoarding IOU notes. And sometimes the bluff is called, which means these elaborate bets (that people can pay back what they owe) fail, with a domino effect buggering up a large chunk of the system.

To go back to the religious analogy, it’s almost as if people suddenly start realising that maybe the priests of the economy have been bullshitting them all along. Unlike religion, however, I don’t see anything to replace the system – still grasping for a science to explain how things really work; nothing like humanism to show how we can get by without it. Instead, we all dutifully go back and trust the priests not to bugger it up again (which, of course, they do).

Maybe what’s needed is something like the Enlightenment, but for money? (Yes, I’m well aware that Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations is a product of the Enlightenment; but do economists have their equivalent to Newton, Maxwell or Einstein’s laws? Can we make successful, repeatable predictions about what the economy will do next? Or is it all guesswork? Is economics a ‘dismal science‘ in more ways than the phrase’s originator intended?)

Religion is still with us after thousands of years of recorded history and while it might have its uses, it can be problematic. I would say the say the same is true about money; neither are going to disappear any time soon. The fantasy of a religion-free, rational, secular future is about as likely as one without money. The socialist utopias of Iain M Banks or Star Trek: The Next Generation will remain just that.

Meanwhile, discussions of debt-based economies continue to trigger The Magic Roundabout theme in my head, and I’m still utterly, utterly lost…

 

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2 responses to “Knowing what I don’t know about money

  1. Wow! There are so many concepts here, including: market clearing prices, fractional reserve banking, money as a value store, fiat currency vs. commodity-backed currency, macro- and micro-economic theory, and more.

    To get an understanding of how different money systems work (or not), it might be worth separating these concepts out from one another. Start with the basic concept of what money is—a method of universal exchange—and then move onto the other areas progressively.

    DK

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