How Money Works

Mar 2013

 

“Credit is a system whereby a person who can’t pay, gets another person who can’t pay, to guarantee that he can pay.”

– Charles Dickens, Little Dorrit

 

“As much money and life as you could want! The two things most human beings would choose above all – the trouble is, humans do have a knack of choosing precisely those things that are worst for them.”

– Professor Dumbledore, Harry Potter and the Philosophers Stone

 

I remember being explained this once when I was little.

Imagine everyone is sitting in a circle. I’m holding something valuable I found lying on the ground, let’s call it gold. I’m holding gold. Gold is just an arbitrary value to mean something of value. I ask the person on my left for something in exchange for it. He doesn’t have anything but says If I give it to him, he’ll give me an amount equal to 1 dollar. At this point we’re not even sure what 1 dollar is except that it too is an arbitrary value.

He doesn’t have any money either so he asks the person next to him for 1 dollar and 10 cents since he has to give the dollar to me and gets to keep 10 cents for going to the trouble of asking. The person next to him doesn’t have anything either so he asks the person next to him for 1 dollar and 20 cents and keeps 10 cents because he has to give 1 dollar and 10 cents. The next one has to ask for 1 dollar and 30 cents and so on and so on.

This continues theoretically forever. Now you’ll notice the very act of borrowing and giving is producing 10 cents for the person asking for it.

But some people in the circle have gotten greedy. Instead of asking for 1 dollar, they’ve noticed if they ask for more they get to keep more. So one person instead of asking for 1 dollar and 50 cents asks for 10 dollars and keeps 9 of those dollars. The next person seeing this does the same, but instead asks the person next to them for 100 dollars and keeps 90.

Now the circle starts to get more complicated. Someone decides well, they only want gold so why do they even need to go around the circle? They can just ask directly. Another person develops a crush on a girl sitting in the circle and wants to trade with her as an excuse to talk to her.

But everyone else becomes afraid, what if they decide to set a special price for just the two of them? So we now start to make rules for how everyone in the circle should talk to and interact with each other. Someone in the circle decides since they have the most relative wealth they should get a larger say in how the rules are made or else they will stop trading.

2 others start to play a game where they try to predict how much another person is going to ask the person next to them and if they get it right, then they get a share of that difference. If they get it wrong they should lose some of what they have. Another person says they can predict 3 trades into the future. One person decides she can hire another person in the circle to do this for her for an agreed amount. That person thinks it’s a great deal since they only have to do what they’re told and get something.

One person starts this service where they agree to look after what everyone has gotten for a fee, they then use this amount to trade against. One person is wrong and loses everything she has so asks the person next to her for more so they can start over again. The person they borrow from borrows from another person sitting next to them.

Things have started to get so confusing that nobody remembers who owes who what so we decide to create this thing called money. Now whenever someone trades with someone they have to give them a bit of paper to signify the thing they are borrowing. The paper is called money and the denomination will be dollars. Now we know what 1 dollar is, it’s equal to one of these bits of paper.

 

But money doesn’t actually exist. It is an abstraction which is short hand for value. As value is moved so too is money. What gives value to money is the act of circulation. So long as it is in circulation it has value. But when money stops being circulated you start to run into problems.

Progressively what was a very simple system becomes incredibly complex. But it’s important to remember that nobody actually has anything. So long as there is as much gold as there are people borrowing then everyone is happy. But what people are forgetting is that none of this really exists. The very act of circulating is what creates the value.

Now that there are denominations and records, the volume of trades starts to accelerate. More trades are happening around the circle. By the time it has come around the full circle it isn’t a dollar anymore. The person is asking for a lot more. But I say, well, I don’t have that much. I only have this small amount of gold which I’ve already agreed to give to someone. So that person couldn’t have borrowed any money to begin with and that ripples through the whole circle until it gets back to me.

So one might ask, how could this have happened to begin with? Because if a trigger doesn’t go off then everything occurring after the trigger couldn’t have happened also. And they’re right. If I didn’t have enough to balance the amount being borrowed then I shouldn’t have been able to borrow in the first place.

The way this is solved is theoretically the person who makes money from just sitting in the circle and recirculating is supposed to spend it creating more value. They need to create as much value using the money they’ve borrowed to balance it. The amount of value created has to be proportional to the circulation of that value. So the theoretical value created from constantly trading is supposed to match up to the actual value created.

In our example this might mean using the 10 cents made from borrowing to dig up more gold. And for the person who took 90 dollars to use it to dig up 90 dollars worth of gold. Now what happens if they can create more gold than what they borrowed? Then that is a beautiful idea because they’ve effectively just used nothing to create something.

But it’s easy to forget that the value is not created in the borrowing but in using the borrowing as a means to an end to create more value. Like if you took a loan from a bank to start a business, it is hoped the business would earn enough to pay back the loan and then some.

It’s taking capital in place A and moving it to place B because it is more valuable in place B than A at that point in time. The growth is happening at a faster rate at place B than place A which is why the capital moves to it in the first place. Moving capital to place B accelerates that growth. The factor by which you’d measure this is time. What circulation does is put a price on time. At any given moment in time the value of circulation is zero. But over time we have growth. Thus over time the act of circulation creates value because it places capital in areas it is most needed. This process repeats ad infinitum and is what is meant by an efficient market.

The amount of money created is a function of how many people are sitting in the circle. But we don’t know how many that is, so let’s say there are n people. The amount of money generated therefore is a function of n, let’s call it t. Since n is people and populations are constantly increasing, n increases infinitely. As n approaches infinity so too does t resulting in a near infinite amount of money being created in the system. So when you wonder how money seems to always be increasing, it’s because it is. It’s because people are increasing.

Now the amount of value created is a function of t, let’s call it v. As t approaches infinity so too does v and theoretically they should be equal. The amount of value should be equal to how much money is created to balance it. The value, in our example gold, is what confers meaning to money. When v does not increase at the same rate as t, you are effectively just printing paper as nothing is being created.

What sometimes happens is people see how quickly t can be created and forget it has to be balanced by v. So whenever t is increasing faster than v, the system will eventually course correct. The key question becomes, to maintain a perfect system, how do you make sure v and t increase at the same rate? In practice this would mean verifying that whenever money is created, value is created proportionately.

But if enough people are sitting in the circle it’s also easy to forget that it is in fact a circle and every action will have an equal and opposite reaction. You can see how as moving along this number gets progressively larger. That’s because it does. Because that’s how many people are sitting in the circle.

The number of people in the circle is proportional to how much money is generated, how much value is created and how much wealth is cycled. But what is forgotten is that any action which affects a part effects the whole. So when anything happens be it positive or negative it effects everyone.

Because we’re all just sitting in a circle.

Advertisements