Explaining How Money Works to a Five-Year-Old

One reddit user was confused about the current financial crisis and posed the following question:

Where is all the money? I hear nothing but bad news about financial crisis all over the world, and it seems that there is a shortage of cash – like it is some sort of natural resource.

People haven’t stopped buying stuff. They still need food, clothing, medicine, shelter. Taxes are still collected. Fines are still levied.

So where is all the money? I mean, labor has been produced to make things and wages paid to the laborers. The things are purchased by other laborers, who were paid for producing goods or services, etc. It’s a closed loop, right?

And he wanted it explained as though he were a five-year-old. So in steps user otherwiseyep who offers the following detailed explanation. It’s excellent and well-worth the read:

All actual “money” is debt. All of it, including monetary gold, etc. (Don’t argue with me yet, I’ll get to that.)

Imagine a pretend world with no money, some kind of primitive villiage or something. Now let’s invent paper money. You can’t just print a bunch of paper that says people have to give you stuff, because nobody would honor it. But you could print IOUs. Let’s walk through this…

  • Let’s say you’re an apple-farmer and I’m a hunter. You want some meat but haven’t harvested your crops yet. You say to me, “hey, go hunt me some meat and I’ll give you 1/10th of my apple harvest in the fall”. Fair enough, I give you meat, you owe me apples. There’s probably a lot of this kind of stuff going on, in addition to normal barter. In time, standard “prices” start to emerge: a deer haunch is worth a bushel of apples, or whatever.
  • Now, let’s say a week later, I realize that my kid needs a new pair of shoes more than I need a bushel of apples. I come back to you and say, “Hey remember that bushel of apples you owe me? Could you write a marker, redeemable for one bushel of apples, that I can give to the shoemaker in trade for a pair of shoes?” You say okay, and we have invented a transferable note, something a lot like money.
  • In time, our little villiage starts to figure out that a note redeemable for a bushel of apples can be swapped for all kinds of things. The fisherman who doesn’t even like apples will accept apple-certificates in trade for fish, because he knows he can trade them to boat-builder who loves apples. In time, you can even start to hire farm-workers without giving them anything except a note promising a cut of the future harvest.

Now, you are issuing debt: a promise to provide apples. The “money” is a transferable IOU– your workers get a promise to provide value equal to a day of farm-work, or whatever, and it’s transferrable, so they can use it to buy whatever they want. The worker gets fish from the fisherman, not in exchange for doing any work or giving him anything he can use, but in exchange for an IOU that the fisherman can redeem anywhere.

So far so good. But there are a couple of forks in the road here, on the way to a realistic monetary system, that we’ll address separately:

  • What happens if your apple orchard is destroyed in a wildfire? Suddenly all the notes that everyone has been trading are basically wiped out. It didn’t “go” anywhere, it’s just gone, it doesn’t exist. Real value was genuinely destroyed. There is no thermodynamic law of the conservation of monetary value– just as you and I created it by creating transferable debt, it can also be genuinely destroyed. (We’ll get back to this in a minute, it gets interesting).
  • The second issue is that, in all probability, the whole town is not just trading apple-certificates. I could also issue promises to catch deer, the fisherman could issue promises of fish, and so on. This could get pretty messy, especially if you got the notion to issue more apple-certificates than you can grow: you could buy all kinds of stuff with self-issued debt that you could never repay, and the town wouldn’t find out until harvest-time comes. Once again, value has been “destroyed” people worked and made stuff and gave you stuff in exchange for something that doesn’t exist, and will never exist. All that stuff they made is gone, you consumed it, and there is nothing to show for it.

The above two concerns are likely to become manifest in our village sooner or later, and probably sooner. This leads to the question of credit, which is, at its most basic, a measure of credibility. Every time you issue an apple-certificate, you are borrowing, with a promise to repay from future apple-harvests.

After the first couple of town scandals, people will start taking a closer look at the credibility of the issuer. Let’s say the town potato-farmer comes up with a scheme where his potato-certificates are actually issued by some credible third-party, say the town priest or whatever, who starts every growing season with a book of numbered certificates equal to the typical crop-yield and no more, and keeps half of the certificate on file, issuing the other half. Now there is an audit trail and a very credible system that is likely to earn the potato-grower a lot of credit, compared to other farmers in town. That means that the potato-grower can probably issue more notes at a better exchange rate than some murkier system. Similarly, the town drunk probably won’t get much value for his certificates promising a ship of gold.

Now we have something like a credit market emerging, and the potato-farmer is issuing something closer to what we might call a modern “bond”…

  • So some time goes by and people start catching onto this system of credit-worthiness, and farmers and fishermen and so on start to realize that they can get better value for their IOUs by demonstrating credibility. People with shakier reputations or dubious prospects may not be able to “issue money”, or might only be able to do so at very high “interest”. E.g., a new farmer with no track-record might have to promise me twice as many potatoes in exchange for a deer haunch, due to the risk that I might never see any potatoes at all.
  • This obviously gets very messy fast, as different apple- and potato-certificates have different values depending on whether they were issued by Bob or Jane, and everyone has to keep track of and evaluate whose future apples are worth what.
  • Some enterprising person, maybe the merchant who runs the trading-post, comes up with the idea to just issue one note for all the farms in town. He calls a meeting with all the farmers, and proposes to have the town priest keep a book of certificates and so on, and the farmers will get notes just like everyone else in exchange for the crops they contribute to the pool, and the merchant will keep a cut of the crops with which to hire some accountants and farm-surveyors to estimate the total crop yields across town and so on.
  • Everyone agrees (or at least, enough farmers agree to kind of force the other ones to get on-board if they want to participate meaningfully in the town economy), and we now have something like a central bank issuing something like fiat currency: that is, currency whose value is “decided” by some central authority, as opposed to the kind of straight-up exchange certificates that can be traded for an actual apple from the issuer, for example.
  • Now we have something that looks a lot like a modern monetary system. The town can set up audit committees or whatever, but the idea is that there is some central authority basically tasked with issuing money, and regulating the supply of that money according to the estimated size of ongoing and future economic activity (future crop yields).
  • If they issue too much money, we get inflation, where more apple-certificates are issued than apples grown, and each apple-note ends up being worth only three-quarters of an apple come harvest-time. If they issue too little currency, economic activity is needlessly restricted: the farmers are not able to hire enough workers to maximize crop yields and so on, the hunter starts hunting less because his deer meat is going bad since nobody has money to buy it, and so on.

At this point, you may be asking, “Why the hell go through all this complexity just to trade apples for deer and shoes? Isn’t this more trouble than it’s worth?”

The answer is because this is a vastly more efficient system than pure barter. I, as a hunter, no longer need to trade a physical deer haunch for a bushel of apples to carry over to the shoemaker in order to get shoes. You, as an apple-farmer, can hire workers before the crop is harvested, and therefore can grow more, and your workers can eat year-round instead of just getting a huge pile of apples at harvest-time to try and trade for for whatever they will need for the rest of the year.

So back to money…

The thing to remember is that all throughout, from the initial trade to this central-banking system, all of this money is debt. It is IOUs, except instead of being an IOU that says “Kancho_Ninja will give one bushel of apples to the bearer of this bond in October”, it says “Anyone in town will give you anything worth one bushel of apples in trade.”

The money is not an actual thing that you can eat or wear or build a house with, it’s an IOU that is redeemable anywhere, for anything, from anyone. It is a promise to pay equivalent value at some time in the future, except the holder of the money can call on anybody at all to fulfill that promise– they don’t have to go back to the original promiser.

This is where it starts getting interesting, and where we can start to answer your question…

(for the sake of simplicity, let’s stop calling these notes “apple certificates”, and pretend that the village has decided to call them “Loddars”).

  • So now you’re still growing apples, but instead of trading them for deer-haunches and shoes, you trade them for Loddars. So far, so good.
  • Once again, you want some meat, except harvest time hasn’t come yet so you don’t have any Loddars to buy meat with. You call me up (cellphones have been invented in this newly-efficient economy), “Hey otherwiseyep, any chance you could kill me a deer and I’ll give you ten Loddars for it at harvest-time?”
  • I say, “Jeez, I’d love to, but I really need all the cash I can get for every deer right now: my kid is out-growing shoes like crazy. Tell you what: if you can write me a promise to pay twelve Loddars in October, I can give that to the shoe-maker.” You groan about the “interest rate” but agree.

Did a lightbulb just go off? You and I have once again created Money. Twelve loddars now exist in the town economy that have not been printed by the central bank. Counting all the money trading hands in the village, there are now (a) all the loddars that have ever been printed, plus (b) twelve more that you have promised to produce.

This is important to understand: I just spent money on shoes, which you spent on deer meat, that has never been printed. It’s obviously not any of the banknotes that have already been issued, but it’s definitely real money, because I traded it for new shoes, and you traded it for a dead deer.

  • Once you and I and others start to catch on that this is possible, that we can spend money that we don’t have and that hasn’t even been printed yet, it is entirely possible for a situation to arise where the total amount of money changing hand in the village vastly exceeds the number of loddars that have actually been printed. And this can happen without fraud or inflation or anything like that, and can be perfectly legitimate.
  • Now, what happens if another wildfire hits your orchard? Those twelve loddars are destroyed, they are gone, the shoe-maker is twelve loddars poorer, without spending it and without anyone else getting twelve loddars richer.

The money that bought your deer and my shoes has simply vanished from the economy, as though it never existed, despite the fact that it bought stuff with genuine economic utility and value.

The above pretend history of the pretend village is not how modern money actually came to be. In reality, things are much less sequential and happen much more contemporaneously without the “eureka!” moments. The above was a parable to illustrate how money works to a 5-year-old, not an actual history of how money emerged.

Until fairly recent times, paper money was not really very useful or practical for most purposes, especially if you wanted to spend money in a different village than where it was printed.

If we go back in time a period before ATMs, wire-transfers, widespread literacy, etc, then a piece of paper written in Timbuktu is not likely to get you very far in Kathmandu. You could take your apples and deer-haunches and shoes around with you to trade, but the earliest naturally-emerging currencies tend to be hard things that were rare and easily-identifiable (jewels, colored shells, etc), and they frequently coincided with the personal decorations of the rich, in a self-reinforcing feedback loop (people with a surplus of time and food could decorate themselves with pretty things, which became valuable as status symbols, which made them more valuable as decorations, which made them more valuable as barter objects, which made them more prestigious shows of wealth, etc).

Gold emerged as a sort of inevitable global currency, before people even thought of it as currency. It is rare, portable, easy to identify, can easily be made into jewelry, and can be easily quantified (unlike, say, jewels or seashells, which are harder to treat as a “substance”). Once word got around that rich people like it, it became easy to barter with anyone, anywhere, for anything.

In the early stages, it was not really the same thing as “money”, it was just an easy thing to barter. But it had money-like characteristics:

  • If someone walked into your apple-orchard offering to trade a yellow rock for apples, you might look at them a little funny. What use does an apple-grower have for a yellow rock?
  • But if you know that rich people in town covet this soft yellow metal as something they can make jewelry out of, then you might be happy to trade apples for it.
  • Once everyone knows that rich people will trade for this stuff, it becomes something like actual currency: neither the hunter, the shoemaker, nor the fisherman in town has much use for it, but because they know they can redeem it for the stuff they do want and need, it becomes a sort of transferable IOU that can be redeemed anywhere, i.e., money.

The early history of paper money did not evolve the way I described in the earlier posts (although it could have, and would have got to the same place). Instead, the early history of paper money was certificates issued by storage-vaults of precious metals (i.e., early “banks”). Instead of carrying around yellow and silver rocks, you could deposit them somewhere and get a piece of paper entitling the holder to withdraw a certain quantity of gold or silver or whatever.

(via reddit)

Germany Should Exit the Euro

Red Jahncke posits that it should be Germany, and not Greece, that should exit the euro. The stance is controversial, but here is his logic:

A Greek exit from the currency union would make the situation even worse. There is no mechanism to decide, or deal with, whichever nation might be next, and even that presumes that exits could be managed. The more terrifying prospect is that the other afflicted countries might exit in an uncontrollable panic, complete with bank runs, failures and general disarray. The accompanying repudiation of hundreds of billions of euros in debt would overstrain the European financial system, even Germany’s. The global economy would be paralyzed as everyone wondered which domino would be next to fall.

What, then, might a German exit do? With integration and multiple restructurings so unlikely and withdrawal of the weak members so fraught, it might actually be the best of all available options.

A single, powerful nation would have the best shot at executing a relatively swift exit that would be over before anyone could panic. No agonizing over who exits and who doesn’t. Stripped of its German export powerhouse, the euro would depreciate sharply, but would not become a virtually worthless currency, as, for example, any re-issued Greek drachma surely would. With the euro devalued, a Greek exit and devaluation would be relatively pointless. So, no contagion or bank runs. With new exchange rates making all the non-euro financial havens prohibitively expensive, and with the threat of forced conversion into devalued national currencies removed, depositors in southern Europe would lose their impetus to run.

Additionally,

Germany’s exit would provide immediate benefits to all the remaining euro-area nations. The currency depreciation would radically improve their trade competitiveness — exactly what many observers have said the weaker nations in the south need most. The euro area’s balance of payments would improve, providing sorely needed funds to service its external debt. The benefits would accrue to the euro area as a whole, as opposed to serial exits at the weak end of the spectrum, which would crush one weak nation after another, with each exit increasing pressure on the next candidate.

Read the rest of the piece here.

The Global Financial Crisis in One Infinite Run-On Sentence

This one long run-on sentence describes the global financial crisis:

In the beginning man created the housing bubble when dishonest banks loaned money to unqualified home owners whose jointly illegal activities were ignored by a sleeping financial press and an incompetent regulatory army who both failed to awaken the FBI and SEC and other financial-crime prosecutors from pursuing criminal charges including those against Wall Street bankers who knowingly sold bad assets with grossly erroneous ratings to highly leveraged investors (including themselves) who had all gorged to the hilt on the FED’s cheap money leveraging their losses and destroying their entire equity accounts which bankrupted our major financial institutions  who were saved by bailouts but not before triggering a global financial crisis during which all lenders on all continents lost all faith in each other because they all knew about their own garbage mortgage holdings bundled into black-box securities whose staggering losses panicked banks again due to the known unknown of massive pools of unregulated derivatives which pay off in the event of a financial default and whose opacity re-double-spooked investors thereby multiplying a crowded stampede into high-quality high-liquidity assets and setting the pattern thereby for what we can expect to be an endless loop of panic lasting a decade or two as terror is continually re-discovered by global markets now concentrated on European banks who made overleveraged housing investments many in housing bubbles much more crazy-Ponzi than that of America’s 120-year-power-ball bubble and further exacerbated by bankers depending upon the ultra safety of sovereign-debt requiring that old magical no-money-down equity investment for their loans to European governments of which many or all are now strangulating themselves after having accumulated 60-plus years of socialist labor laws and entitlement obligations but now those asphyxiating restrictions and promises are revealed as unworkable and un-payable when new borrowing must end and is unaffordable but still the Europeans while they are pathetic and bankrupt they have not achieved the scale of otherworldliness which is The Great & Terrible Japanese Zombie…

You can finish reading the rest of this masterpiece over here. Why is it a masterpiece? Because once you reach the end, you are requested to continue at the beginning… So it’s an infinite run-on sentence describing the financial crisis!

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(hat tip: @counterparties)

Financial Bombshell of the Day

The details unveiled in the Bloomberg Markets Magazine piece “Secret Fed Loans Gave Banks Undisclosed $13B” are stunning. And here we thought we knew everything we knew about the 2007-2008 financial crisis. Think again:

The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. Now, the rest of the world can see what it was missing.

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue.

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse.

This statistic is just astonishing (half the value of U.S. GDP!):

The amount of money the central bank parceled out was…dwarfed the Treasury Department’s better-known $700 billion Troubled Asset Relief Program, or TARP. Add up guarantees and lending limits, and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the U.S. that year.

There’s a lot more quotable material here, so I suggest you read the whole thing…

Michael Lewis Goes to Ireland

I’m a huge fan of Michael Lewis’s writing, having read Liar’s Poker, Moneyball, and most recently, The Big Short (all of which I recommend). In his latest piece for Vanity Fair, “When Irish Eyes are Crying,” Michael Lewis travels to Ireland to ascertain why the country is undergoing a financial crisis. It’s a lengthy and spectacular account of Ireland’s woes: population decline, real estate bubbles, and so much more. I pull the most notable quotes below.

On the spectacular population decrease of Ireland, and even more remarkably, the country’s likelihood to default (as judged by one firm):

In recognition of the spectacular losses, the entire Irish economy has almost dutifully collapsed. When you fly into Dublin you are traveling, for the first time in 15 years, against the traffic. The Irish are once again leaving Ireland, along with hordes of migrant workers. In late 2006, the unemployment rate stood at a bit more than 4 percent; now it’s 14 percent and climbing toward rates not experienced since the mid-1980s. Just a few years ago, Ireland was able to borrow money more cheaply than Germany; now, if it can borrow at all, it will be charged interest rates nearly 6 percent higher than Germany, another echo of a distant past. The Irish budget deficit—which three years ago was a surplus—is now 32 percent of its G.D.P., the highest by far in the history of the Eurozone. One credit-analysis firm has judged Ireland the third-most-likely country to default. Not quite as risky for the global investor as Venezuela, but riskier than Iraq. Distinctly Third World, in any case.

Michael Lewis met with Morgan Kelly, a professor of economics at University College Dublin, who:

learned that since 1994 the average price for a Dublin home had risen more than 500 percent. In parts of the city, rents had fallen to less than 1 percent of the purchase price—that is, you could rent a million-dollar home for less than $833 a month. The investment returns on Irish land were ridiculously low: it made no sense for capital to flow into Ireland to develop more of it. Irish home prices implied an economic growth rate that would leave Ireland, in 25 years, three times as rich as the United States.

Kelly wrote two newspaper articles, forecasting the imminent financial collapse in Ireland. His second article explained:

In 1997 the Irish banks were funded entirely by Irish deposits. By 2005 they were getting most of their money from abroad. The small German savers who ultimately supplied the Irish banks with deposits to re-lend in Ireland could take their money back with the click of a computer mouse. Since 2000, lending to construction and real estate had risen from 8 percent of Irish bank lending (the European norm) to 28 percent. One hundred billion euros—or basically the sum total of all Irish public bank deposits—had been handed over to Irish property developers and speculators. By 2007, Irish banks were lending 40 percent more to property developers than they had to the entire Irish population seven years earlier.

But it took a year for Kelly’s name to become widely known:

It wasn’t until almost exactly one year later, on September 29, 2008, that Morgan Kelly became the startled object of popular interest. The stocks of the three main Irish banks, Anglo Irish, A.I.B., and Bank of Ireland, had fallen by between a fifth and a half in a single trading session, and a run on Irish bank deposits had started. The Irish government was about to guarantee all the obligations of the six biggest Irish banks. The most plausible explanation for all of this was Morgan Kelly’s narrative: the Irish economy had become a giant Ponzi scheme and the country was effectively bankrupt.

I love this narrative from Lewis:

A banking system is an act of faith: it survives only for as long as people believe it will. Two weeks earlier the collapse of Lehman Brothers had cast doubt on banks everywhere. Ireland’s banks had not been managed to withstand doubt; they had been managed to exploit blind faith. Now the Irish people finally caught a glimpse of the guy meant to be safeguarding them: the crazy uncle had been sprung from the family cellar. Here he was, on their televisions, insisting that the Irish banks were “resilient” and “more than adequately capitalized” … when everyone in Ireland could see, in the vacant skyscrapers and empty housing developments around them, evidence of bank loans that were not merely bad but insane.

It seems like the lending practices in Ireland were even more lax than at the height of the housing boom in the United States:

An upstart bank, Anglo Irish, had entered their market and professed to have found a new and better way to be a banker. Anglo Irish made incredibly quick decisions: an Irish property developer who was an existing client could walk into its office in the late afternoon with a new idea and walk out with a commitment of hundreds of millions of euros that night. Anglo Irish was able to shovel money out its door so quickly because it had turned banking into a family affair: if they liked the man, they didn’t bother to evaluate his project.

How was the real-estate bubble different in the United States compared to Ireland?

The Irish real-estate bubble was different from the American version in many ways: it wasn’t disguised, for a start; it didn’t require a lot of complicated financial engineering beyond the understanding of mere mortals; it also wasn’t as cynical. There aren’t a lot of Irish financiers or real-estate people who have emerged with a future. In America the banks went down, but the big shots in them still got rich; in Ireland the big shots went down with the banks.

A telling passage about the history of the Irish people and their pride:

The Irish nouveau riche may have created a Ponzi scheme, but it was a Ponzi scheme in which they themselves believed. So too for that matter did some large number of ordinary Irish citizens, who bought houses for fantastic sums. Ireland’s 87 percent rate of home-ownership is among the highest in the world. There’s no such thing as a non-recourse home mortgage in Ireland. The guy who pays too much for his house is not allowed to simply hand the keys to the bank and walk away. He’s on the hook, personally, for whatever he borrowed. Across Ireland, people are unable to extract themselves from their houses or their bank loans. Irish people will tell you that, because of their sad history of dispossession, owning a home is not just a way to avoid paying rent but a mark of freedom. In their rush to freedom, the Irish built their own prisons. And their leaders helped them to do it.

A summary from Michael Lewis:

The blunt truth is that, since September 2008, Ireland has been, every day, more at the mercy of her creditors. To remain afloat, Ireland’s biggest banks, which are now owned by the Irish government, have taken short-term loans from the European Central Bank amounting to 86 billion euros. Two weeks later Lenihan [Ireland’s Finance Minister] will be compelled by the European Union to invite the I.M.F. into Ireland, relinquish control of Irish finances, and accept a bailout package. The Irish public doesn’t yet know it, but, even as we sit together at his conference table, the European Central Bank has lost interest in lending to Irish banks. And soon Brian Lenihan will stand up in the Irish Parliament and offer a fourth explanation for why private investors in Ireland’s banks cannot be allowed to take losses.

I like this note from Lewis (first time I’m hearing of it):

There is an ancient rule of financial life—that if you owe the bank five million bucks the bank owns you, but if you owe the bank five billion bucks you own the bank—that newly applies to Ireland. The debts of its big property developers—now generally defined as anyone who owed the bank more than 20 million euros—are being worked out behind closed doors.

And a whimsical aside: how do the Irish view America, and Americans view Ireland?

Two things strike every Irish person when he comes to America, Irish friends tell me: the vastness of the country, and the seemingly endless desire of its people to talk about their personal problems. Two things strike an American when he comes to Ireland: how small it is and how tight-lipped.

The entire piece is worth reading for the wonderful narrative and Michael Lewis’s conversations with Morgan Kelly, Joan Burton (Labour Party’s financial spokesperson), as well as bankers and commercial real estate developers.

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Thanks for Jodi for pointing me to this piece, who has an excellent reading list of her own here and here.