The Cyprus debacle continues to expose serious flaws in our understanding of money. Specifically, Cyprus highlights three key important lessons about money:
- Money is built around trust. Without it, money is useless.
- A nation that cannot create its own money or lacks monetary unity is at a substantial (and unnecessary) economic disadvantage.
- Modern money, being mostly electronic records (at banks), is inherently fragile.
1) Money is a social construct that we create in order to more conveniently transact business. I like to think of money as having “moneyness”. That is, anything can serve as money, but the trouble with money is getting others to accept your money as a final means of payment. Some things are more widely accepted than other things as a final means of payment and therefore serve as having a higher level of “moneyness” than other things. Gold for instance, has a moderately low level of moneyness because it is not widely accepted. Electronic bank deposits, however, are accepted at most businesses for final payment and therefore have a high level of moneyness.
Modern money is mostly electronic money that is regulated by the government and organized through a complex payments system that is dominated by private banks who compete to issue money as debt. We use this system because it is organized, regulated and technologically advanced (ie, it’s better than lugging around gold bars as a medium of exchange). That means the system is built in large part on trust. We trust that our electronic records will be maintained accurately and that the integrity of the system will be upheld both by the entities who compete to run this system as well as the regulators who oversee that system. When the system begins to appear fragile or chaotic (as is the case in Cyprus) the very cornerstone of money begins to buckle.
2) The Euro crisis has exposed the great flaw in the Euro’s design. That is, the nations are very similar to states in the USA in that they are users of a currency without a floating exchange rate. Therefore, there is no rebalancing mechanism should a systemic disequilibrium occur (like trade imbalances for instance). In the USA, there is political unity that allows a federal entity to collect funds from all of its participants in a rather unequal fashion. That is, the rich states pay more into the system than the poor states and the poor states get an unequal amount of the funds via this federal entity every year. That eliminates the risk of a solvency constraint for the poor states who would otherwise become increasingly like Greece over time. In other words, redistribution powers the USA from becoming like Greece. I know “redistribution” is a dirty word in some circles, but it’s as American as apple pie in the case of our monetary system’s design.
Europe’s nations not only can’t produce the currency that would eliminate the risk of a solvency crisis, but also do not have the advantage of this system of redistribution. The result is solvency crisis and severe austerity that doesn’t come with the help of federal funding.
3) Money is fragile. We like to think that money is something we can touch or feel, but I think paper bugs AND gold bugs are wrong. Yes, money CAN BE a physical thing, but today’s money is mostly just records in electronic ledgers. That’s disconcerting to many, but the natural evolution of money from unspoken bonds (apes for instance, have been proven to use modern forms of intangible money as promises) to physical things (like the gold standard) to the current electronic system.
Our money is created almost entirely by banks who compete to issue this money as debt. So the value of our money is distributed by entities who are inherently profit driven which can create an inherent instability if it is abused by these entities or its users. We must better understand this reality so that we can understand the essential elements that make our money system function. Contrary to most economic thinking these days, money is not something that is “multiplied” or originates with the government. It originates with private entities INSIDE the banking system.
Once we understand that money is fragile we might be more cognizant of the reality that it not only requires some oversight. but must be protected not only for the sake of individuals, but for the sake of the society that relies on its existence.
For more on this subject please see the following:
- Understanding the Modern Monetary System
- Understanding Moneyness
- Understanding Inside & Outside Money
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.