Writing in The Independent on Monday 24th March 2008, Bruce Anderson headed his piece, 'Human beings still don't understand money.' He was writing in response to the current global economic hiatus resulting from the consequences of irresponsible lending in the USA.
This is a thesis I have been hawking around now for some sixteen years, my contention being that money functions as language, but the more general point is that despite its being in existence now for some 3,500 years, we still fail to understand it.
The move from the barter economy to the cash economy was one of the most liberating events in the history of the development of the human race since the much earlier development of language. It was language that permitted the intellectual transactions which made possible the development of human civilisation. Money not only made possible the development of urban civilisation, but also necessitated the development of the political institutions to validate the currency. Whatever its demerits, the Roman empire, as noted by our editor in the last edition, created a political union in which a common currency was accepted and thus facilitated trade within that union.
There can be no doubt that money is of immeasurable importance in the development on human civilisation, but it has its dangers. In the First Epistle of Paul the Apostle to Timothy, we are warned that 'the love of money is the root of all evil'; Greek mythology offers us the story of King Midas. If money were thought to have some kind of magic then Goethe more recently exhorted us to caution with his tale of The Sorcerer's Apprentice, who discovered that he could conjure up a spell but unfortunately did not know how to stop it. We conjured up money but now we can't control it.
Greek tragedy frequently concerns hubris, that overweening pride and insolence, which always precedes a fall from grace. Nowhere in the modern world is hubris so evident as in the realms of international finance.
When Adam Smith first theorised upon economics he devised his concept of 'the dual circulation' (of goods and money), the latter accurately mirroring the former. All that was required was sufficient currency to facilitate all the transactions. Capital was accumulated and invested in expansion; the joint stock company made possible the combination of accumulated capital from many sources, and loans were made from deposits to capitalise new ventures.
The problem with Smith's idealised view of the dual circulation arose because there is no rigid calculus linking the amount of money in circulation to the amount of goods; it is because of this that inflation can occur. In all its forms, money has inherent flaws. Gold was the original currency, both within the early states and internationally. It had certain advantages: it was rare and its supply could be controlled, usually by the king and his ministers; it did not corrode - it is for good reason that chemists refer to it as a 'noble' metal. All currencies have conventional value, that is, they have value only within a convention of beliefs and laws. Even gold is only useful as a currency while all are prepared to accept it. Gold and silver were 'commodity currencies', that is, they were themselves a commodity but one which everyone was prepared to accept. The only problem with gold and silver was that they were inconvenient to carry around and were likely to attract the attention of thieves.
The first paper currency came into existence when goldsmiths issued notes of deposit on gold which they held securely for others. The note of deposit confirmed that the bearer had gold to that value and was thus able to pay, the payment being made by the actual transfer of gold. It was soon realised that the notes of deposit could be used to trade goods, accounts being recorded and only final balances being settled in gold. This was 'contract money', that is, a promissory note to pay the bearer the agreed sum in something valuable. When eventually city states held gold reserves, then fiat currency came into being; from the Latin fiat ('let it be so'), this was currency simply because the government said it was. These were effectively notes of deposit backed by the government.
The next advance came when the goldsmiths who held the gold realised that not all of their depositors would want their gold back at once and so began investing a proportion of the deposited gold in illiquid assets which would pay interest. Thus, rather than charging depositors for holding their gold, the goldsmith was now able to offer interest on deposits, the interest deriving from the investments. Even now though, lending was constrained by the size of the deposits. Providing the ventures to which loans had been made were sound then there was no risk to depositors. However, it was only one small step from here to the next big development.
Since not all depositors would want their gold back at any one time, providing there was enough gold to pay those who did, it was possible to issue more notes, that is, lend out more money, that was actually backed by gold; combine this with the idea of fiat currency and we have a recipe for disaster.
Between 1951 and 1971 the London Clearing Banks were required to maintain a minimum liquidity ratio of about 30 percent of deposits, that is, they could lend out just over three times what they held in deposits. In 1963 this was reduced to 28 percent, of which 8 percent had to be in cash (the cash ratio). In 1971 the liquid assets and cash ratios were abolished; banks were expected (note the word 'expected') to maintain a ratio of 12.5 percent of 'eligible assets'. Finally, in 1981 the reserve ratio was abolished completely.
To put it bluntly, for the last twenty-seven years we have been not only spending money we do not have, but money that doesn't even exist, at least not in the sense that it is premised upon the production of goods.
As if that were not enough, new financial instruments have come into being, ever more contrived. We have moved from barter, the simple exchange of goods, to trade using gold as currency; then, we moved to the use of notes of deposit as currency; and then to fiat currency. Each step has taken us further from a clear connection between goods and money as propounded by Smith. But the next step takes us to another degree of abstraction; these are derivatives.
Some years ago the demand for Morgan cars so outstripped supply that one might have to wait anything up to 12 years from ordering the car to actually receiving it. Thus, it became common for people to order a car and then wait; as the delivery date drew closer the value of the order increased because it could be sold on to someone who was too impatient to wait for a car. Thus, if you had an order for a Morgan due for delivery in the next twelve months, although you had only agreed to pay 20,000 for the car, the order was worth, say, 25,000 or more to someone who was desperate for a Morgan. So a trade emerged in orders for Morgan cars. Note, this is not a trade in cars, only in orders for cars. This is, in effect, a derivative; no real goods change hands, only pieces of paper.
This type of trading has gone on to ever greater degrees of abstraction and dissociation from real goods and is at the root of the present crisis. In Smith's idealised economy, money is backed by goods, but today banks lend money which is 'virtual', , that is, its value is not backed by goods. Furthermore, the banks' loans appear on their balance sheets as 'assets'- until that is, they fail to 'perform'; this is when they are moved to the liabilities column. And if that were not enough, the banks then bundle up these loans into parcels which they sell on to other banks, who repackage them and sell them on to other banks and so on until nobody knows who owes what, nor to whom. Like a juggling act, it looks fine until the juggler drops one of the balls, then the whole act falls apart.
Let me try to create a model of an economy from my garden. I buy some beans and plant them; this is investment. They grow and towards the end of the year I can eat some (this is consumption) or I can leave some on the stem to ripen and use as next years' seed (this is reinvestment). Being a cautious soul I restrict my consumption and keep more seed for sowing next year, and probably some extra for the year after that just in case next years' harvest is poor. The following year I plant the beans I saved to produce that year's crop and because I was prudent, I actually sow more seed that last year, thus producing a bigger crop. In this way I am expanding production. If I carry on this way then each year, barring mishaps, I will produce more and more beans up to the limit of the land available. If sufficiently successful, I could trade my surplus beans for extra land, by which means I could even further expand production. And so it could go on until I became a bean billionaire.
This, in highly simplified form, is at the root of all economic activity. You will notice that money was not mentioned in the above economic model, yet it functions perfectly (assuming everybody is happy to eat beans). It may seem flippant but this is in effect the method used by Piero Sraffa in his 1960 critique of the theories of classical economics in his book, 'The Production of Commodities by Means of Commodities'.
What the banks have been doing increasingly over the decades is planting beans that don't exist and expecting a crop to grow. Like all lies, it has taken a bigger lie to cover it, but eventually the truth emerges. It is for good reason that speculative frenzies are called bubbles - when they finally burst we see that there was never anything of substance there in the first place.
It is not that this problem has arisen over the weekend. Peter Warburton, in his excellent book 'Debt and Delusion'(1999) was issuing dire warnings of the consequences of financial folly, saying that, "... if nothing of a cataclysmic nature has occurred in the global financial system by the end of 2003, then it will truly be a miracle." It was not a miracle that occurred but the creation of ever more Byzantine financial instruments that allowed debt to be finessed and a further four years to elapse. Now, however, the storm has broken and current estimates put the eventual damage at 500 billion (5 x 1011 ).
More recently, Larry Elliott and Dan Atkinson, in their book 'Fantasy IsIsland', a mordant critique of the Blair premiership, revealed that in the six years between January 2000 and December 2006, while mortgage debt and consumer credit had risen respectively by 94 percent and 65 percent, incomes had only risen by 22.4 percent.
Writing in The Observer, Sunday13th April 2008, Will Hutton presents alarming figures for bank lending: between 2004 and 2007 the banks increased their lending by 200 percent; however, in that same period bank capital only increased by 20 percent.
Even in these times of 'turbo-capitalism', as some like to call it, it has taken a long time for the dam to break and it will take a long time to repair the breach. Despite numerous reductions of base-rates by the Bank of England these are not filtering through the retail banking sector, and not surprisingly since they need to rebuild their balance sheets. Already, building societies and banks have withdrawn previously generous mortgage offers; property prices are falling and High Street spending, most of which is underwritten by property values, is falling dramatically. The government has already reduced its estimate of economic growth for the next twelve months to about 1.25 percent, half of its normal trend rate. The British economy has, over the last 60 years, grown at an average rate of 2.25-2.5 percent, and thus a growth rate of 1.25 percent, though growth in nominal terms, is actually a shrinkage, which will result in rising unemployment, further compounding the problem.
How long this current storm will take to blow itself out is open to debate, but as Adam Smith noted, "there is a great deal of ruin in a Nation."
'Debt and Delusion - Central Bank Follies That Threaten Economic Disaster'- Peter Warburton, 1999, publ. Penguin (ISBN 0-14-027752-8)
'Fantasy Island - Waking Up to the Incredible Economic, Political and Social Illusions of the Blair Legacy'- Larry Elliott and Dan Atkinson, 2007, publ. Constable (ISBN 978-1-84529-605-6)
Chris Waller - Permission granted to freely distribute this article for non-commercial purposes if attributed to Chris Waller, unedited and copied in full, including this notice.
This article originally appeared in the June 2008 issue of Economania, newsletter for the British Mensa Special Interest Group on economics, trade and finance.
Members can discuss this and other articles on the economics forum at International Mensa.