Money, Currency Wars and the Future

Note: The following post formed the basis of a one hour presentation that I gave to work colleagues that had expressed some interest in the topic of money.

Disclaimer: I am merely an amateur enthusiast, and not an economist nor a financial advisor. Your millage may vary.

Preamble

As a result of the Global Financial Crisis in 2007, I took a much more rigorous look into investing, (hence this blog/presentation), which naturally led to the topics of inflation vs deflation, and the nature of money.  Many questions bugged me, such as: "Why to the RBA target 2-3 percent CPI, and why is that the sweet spot?", and "What does an economy 'running too hot' actually mean?".  I now think that I have a solid enough understanding to be able to answer most of these types of questions.  In this article, I hope to give you some of that understanding, although I don't intend to directly answer those questions!

What is money?

Let's start with a definition of money.  The best definition that I have heard for money is formalized obligation.  Obligations are simply IOUs.

So, where did money come from?  Despite the popular belief that money arose out of the barter system to solve the double coincidence of wants, money, as formalized obligation, simply evolved from less formal obligation, ie, informal obligation.

Informal obligation is the sense in your mind that either you owe somebody something, or they owe you something, as in "Thanks mate - I owe you one".  The formalization increases - but not quite to the point of money yet - once these obligations begin to be tracked over time, as in Brownie Points!

Let's consider brownie points between you and your significant other.  You buy you SO a great birthday present - you gain some brownie points.  You miss the mark with the birthday present and it isn't well received - you lose some brownie points.  Neither you or you SO actually keep track of the points formally, but both of you keep a rough ledger of who owes whom.

In the receiver's head, an IOU pops into existence - eg, "Wow, I had better get her a birthday present just a good as this one", and simultaneously, in the giver's head, a UOI, for want of a better term, pops into existence - eg, "I'm gonna get some tonight".  With some luck, later that night, the IOU/UOI pair might vanish from existence, as the debt is repaid.

Obviously, the lack of formalization can lead to disputes about exactly how much one person owes another.  One form of this is commonly known as not pulling your weight.  When a group decides that someone isn't pulling their weight they can raise this issue, however when the response is "Yes I am", the only way the issue can be resolved is to formalize the tracking of contributions and therefore obligations.

Another issue that can arise from the lack of formalisation of the IOU is the exact terms of the IOU.  Is there an expiry date?  Does the IOU bear interest?  Is the IOU transferable?

Have you ever been in the situation involving three people, where somebody both owed, and was owed, the same amount of money, and that person tried to remove themselves from any further obligations by linking the other two - "Hey, if Adam owes me $20, and I owe Zac $20, can we all just agree that Adam owes Zac $20?", and in the nod of heads, a primitive payment was made.

So, payments, in there simplest form, are simply a mechanism to adjust two obligation ledgers - to extinguish the IOU and the UOI, which are simply the two sides of the same obligation between the giver/receiver, lender/borrower or creditor/debtor.

The process of obligation formalization can be contractualization, tokenization, digitization, or serialization of this mental construct - the IOU/UOI pair.  The formalization into a contract can take various forms, from a Note, Bond, Cash Note or Coin, Casino Chip, or a digital record in database.  Once the obligation is formalized, we have money!

It is often said that money must be a) a unit of account, b) a medium of exchange, c) a store of value, however while this is true for a monetary system, it does not need to be true for a particular form of money.  That is, there is no need that the medium of exchange also be the medium to store value.  In fact, the monetary system will be more stable if these roles are kept separate.

Here are some examples of ye olde money:

Note the text: "We promise to pay the Bearer the Sum of One Pound Sterling" - unquestionably formalized obligation.

In Australia, before 1911 when the Bank Note Act was introduced, it was the private bank notes that circulated as currency.  After the Act was introduced, it was the national currency that circulated.  Importantly, the concept of bank IOUs as distinguished from government IOUs still exists in the world today, but as digital credits, it is much harder to distinguish between them.  Indeed, you probably don't even know that you exchange bank credit for government credit every time you withdrawal cash from the ATM.

The above bank notes are also the simplest form of a derivative.  None of these notes are a One Pound Stirling note.  They are Australian Pty Ltd bank IOUs for British Government IOUs.  Being derivatives, there are inherent risks involved.  Will the bank stay in business?  Will it honor it's promise to pay the bearer?  If the bank does honor it's promise, will the British government honor it's promise to pay "One Pound Stirling"?  One Pound Stirling of what?  That promise was long defaulted on!

Another risk within these bank note derivatives was whether on not the note would be accepted at face value by the market.  Given that the Bank of Paramatta only existed for FOUR years, would you hand over your goods for the face value of these notes?

The Monetary Plane

Here we draw a distinction between the physical plane, consisting of real tangible goods, and the monetary plane, consisting of financial products, including cash.

Using our original definition of money, we can see that everything in the monetary plane is an IOU, or debt based, whereas the physical plane consists of real assets.  We also see that only way we know the worth of things in the monetary plane is by the magnitude of the number associated with it, whereas the items in the physical plane have a real value to the holder of the item.

Because the monetary plane uses nominal values, the unit and hence magnitude of these values are completely arbitrary, and without limit.

Spotting Deflationists From the Front of the Room

Rodney Johnson's recent newsletter article (Spotting Winner's from the front of the room - I can't seem to find a direct link to it) caused my partner to question some of our positions and beliefs.   Let me shoot down his arguments one at a time.

Johnson: I just got back from the Global Currency Expo... The theme of the conference was how to position investments as the dollar crumbles after so much printing and so much debt issuance.  ... the attendees ... listened to ... people talk about how the dollar will collapse. But then they had Harry and me bombard them with facts and statistics as to why it’s not true.

Johnson: You see, most every speaker there was using the typical check list to explain why the dollar is in dire straits. Has the government seemingly gone beyond the pale in terms of issuing debt to pay for profligate spending? Yep. Is the government – or its nefarious extension – printing money ad nauseum during a time of peace? Absolutely. Are there hard assets that can be purchased? Of course. Are there capital controls? None that can’t be overcome. Well there you go. The government’s killing the currency for its own ends and people of means can choose to leave the system. Nothing else to see or talk about here, the death of the dollar is a foregone conclusion… or not. 

Johnson: Those rules, the ones about debt, money printing, ease of capital movement, etc., are certainly important factors in determining the health of a currency. But they are not the only rules. There are others, which can trump – and have trumped – these criteria, and that’s what we pointed out from the stage.  While the U.S. is printing money, it is not showing up in inflation-inducing borrowing. That’s because the largest segment of our population, the boomer generation, is now in their saving phase – not their spending phase.  This is the same reason that extraordinarily low interest rates are not causing a boom in borrowing, and why those same low interest rates are not causing savers to flee deposit accounts. The money they have is meant for another time – retirement. So all of Bernanke’s efforts will fail to spark a meaningful recovery and fail to spark inflation as well.

So, his argument here is that savers can prevent hyperinflation by saving, and that the baby boomers are a large enough saving force to do so.  Unfortunately, saving large amounts of a failing currency may delay the collapse of that currency, but then the savers of the collapsing currency will be the worst affected by the collapsing currency, as their life savings will disappear before their very eyes.


Johnson: Just as important as the domestic situation is the current state of other large currencies. If an investor were to leave the dollar, where would he go? The euro, with its Cypriot bail-in and failing states of Italy, Portugal, Spain, Greece, and Ireland, along with 12% unemployment? Or perhaps to the yen, where the government of Japan has just announced plans to destroy its own currency? Boy, those sound like GREAT choices! 

Well the simple answer is "Gold for saving, Euro for spending".  It's somewhat ironic that a guy claiming to know how the world financial architecture works can write about the collapse of the US dollar and not once even mention gold.  No wonder he cannot see any GREAT alternatives.  Johnson also misses the point that the savings medium does not need to be the same as the transaction medium, nor does he understand the Euro.  The fact that the ECB did not bail out insolvent institutions makes the currency STRONGER than if they had, and proves that they WILL stick to their 2% CPI mandate - ie, price stability in the short to medium term. 

Johnson:  Finally, there is the idea that the U.S. dollar is losing its status as the currency of reserve. This is bantered about a lot, and many smart people point to economic reasons why the U.S. dollar will be knocked off its perch. The typical reasoning circles back to the money printing and the debt, and often includes the prospects for future growth. All of that makes sense, but I’ll add another element – security. In particular, the ability to project power around the globe with bone-crushing force. We have it.  No matter what one’s opinion of the wars in Afghanistan and Iraq, there is no doubt that they have allowed the U.S. military to develop into the most battle-tested and experienced fighting force on the planet. No other military has engaged in such warfare over the last decade

There is only a small degree of validity to this argument, in that the US can prevent a full on frontal assault on its dollar with military might.  Iraq and Libya learned this the hard way.  However the current attack on the US dollar is not a full frontal attack - it is a death by a thousand cuts.  Keep an eye on the news and you will see bilateral currency and oil deals going on all the time.  Keep an eye on the SWIFT data and you will see that the Euro already has more usage than the US dollar.  Also,  once it is obvious that its currency is failing, the US military will be completely useless, after all, how motivated will soldiers be if they start getting paid in monopoly money and they try to buy petrol with monopoly money.  The collapse will be as swift as the Russian one.

Johnson: Along the way, we have developed unparalleled techniques for gathering intelligence (like drones) and surgical strikes (by special forces). What does this have to do with the reserve currency? Think back to how the U.S. dollar got that position in the first place – it was immediately after the Second World War and we were the strongest country to emerge from the conflict. 

Er, no.  The reason the US dollar was adopted as the international reserve was not because the US military was the strongest, it was because the US currency was the strongest, because it was backed by gold and the credibility drawn from the ultra productive US manufacturing industry.  And where is that credibility today?  Hahahahaha!!!  That's where.

Johnson: Those who are counting down the glory days of the U.S. dollar are in for a big surprise… it’s going to get stronger.

The US dollar will collapse, just as all currencies have before it.  In the mean time, it may temporarily get stronger, as investors trade via US dollars to get out of the derivative markets, bonds, etc into gold.