After the hail of fire that daring to suggest gold might be overpriced drew upon reposting my latest gold-bubble article on Seeking Alpha, I decided to stay away from writing anything that implies “value” is nothing but a social construct. But then I heard two programs on my NPR station last week that featured refreshing takes on economics, trading, markets, and the meaning of money. Seasoned investors and veteran economists might find these programs trivial—but I humbly submit that it’s important to look outside the bubble to get some perspective.
Cutting right to the chase, there’s last week’s This American Life program entitled, “The Invention of Money”. Prompted by reports that more than a trillion dollars “disappeared” when the housing bubble burst, contributors started to investigate what money really means. Planet Money correspondent Jacob Goldstein asked his aunt, a savvy, successful business-woman, “Where did all that money go?” and her reply was, “Money is fiction.”
Now, before you jump all over this, I beg your patience to read the rest of the post. The take-away is that money is, and always has been, fiction. Whether it’s represented by salt, stones, metal coins, silver or, yes, gold, value is just a social contract. As TAL host Ira Glass put it,
The answer to the question, “Where did all the money go when the housing market collapsed?” turns out to be that the money never existed in the first place.
Goldstein follows up with research about the seemingly unusual, but in fact universal, story of money as recognized by the people on the Micronesian island of Yap (about midway between Guam and Palau). The people of Yap used massive limestone coins, weighing thousands of pounds, as a currency. Over time, they realized that is wasn’t practical to move these stones when ownership changed. The concept extended so far as to recognize a stone that was mined from another island but lost at sea as still existing for the purposes of monetary value. Kind of like money in the bank, eh?
Glass follows up with this observation:
Long ago, we used to use gold, and if you wanted to buy something, you had to carry around these heavy, shiny pieces of metal. And then we decided, no, let’s just leave the gold in a bank. Instead of the gold, we’re going to carry around these pieces of paper. The paper says, Yes, there’s gold, [and] you can take it to a bank and swap it for gold….
By 1971, when the Nixon administration decided to float the dollar, the connection between currency and gold was severed; money became a purely social construct. But here’s the dirty secret that precious-metals enthusiasts deny: Money—as represented by paper, real estate, gold, silver, salt, or giant hunks of limestone—has always been fiction.
“There’s No Place Like Home”
Case in point: Brazil in the late ’80s and early ’90s—the very exemplar of modern hyperinflation. The TAL story goes on to examine how Brazil ended that nearly 10-year period of hyperinflation. The new finance minister in 1993, Fernando Henrique Cardoso, called on some of his college friends, who had researched economic psychology, especially as it relates to inflation, for help. They came up with the Plano Real.
In addition to addressing the fundamental causes of inflation—essentially, no longer printing more and more money—the Plano Real included an unprecedented scheme for restoring the people’s faith in money. As summarized by Planet Money correspondent Chana Joffe-Walt,
People were the problem. People had to be tricked into thinking that money had value, when all signs told them that was absolutely not true.
The Brazilian finance team created a new currency that was artificially stable, and eventually everyone accepted it. The lesson, Joffe-Walt concludes, is that, like Dorothy’s way home in the Wizard of Oz, “For money…that’s all you need—people to believe in it.”
The Fed’s Turn
Act II of the TAL show begins, after an explanation of what the U.S. Federal Reserve is and what it does, with this provocative statement from Glass:
Since 2008, when the current financial crisis took hold, the Fed has done all kinds of things that central banks just don’t do…stuff that would’ve been unthinkable in the past—and it’s all happening on a scale that is bigger than the Fed has ever tried in its history. Basically, the Fed has gone to Central Bank Crazy Town; and the danger, if the Fed screws up, is that the fiction we call the U.S. dollar loses value, that people stop believing in it.
The story goes on to explain how the Fed usually “creates” money (contrary to popular opinion, it doesn’t “print” more money; under normal conditions, it just drives interest rates lower by purchasing Treasuries from banks, which means the banks have more cash to lend out into the economy) and what was so unprecedented about the way it started doing so in the Financial Crisis: lending out money in return for all kinds of collateral that it never would have taken before—e.g., mortgage-backed securities, real estate, corporate stock and, eventually, ordinary (not subprime) home mortgages.
So far, so good. But the rest of Act II mostly just rehashes what we already know about how the Fed took the extraordinary step of invoking its power to act as a “lender of last resort” in times of financial crisis, making loans not just to banks, but to hedge funds, insurance companies, and corporations like Verizon, GE and Harley Davidson, taking higher-risk assets like corporate stock and toxic derivatives as collateral.
The one other highlight of this segment is the explanation that none of this adds to the Federal deficit, as most people seem to think:
The deficit is when the Federal Government spends more money than it collects in taxes…the Fed is not part of the Federal government, so [the deficit] has nothing to do with this. [Any money the Fed might lose doesn't affect taxes because], first of all, it’s not part of the government and second, even if it were, every year the Fed makes a profit…the Fed never loses money…. In 2009, at the height of the crisis, it made $47 billion. And that profit they always turn over to the Federal Government, so it actually reduces the deficit.
The show ends with a point-counterpoint about the merits of the Fed’s actions that’s fairly generic, except for this quote from Princeton Professor of Economics Alan Blinder: “These very, very unusual things that the Fed did are things that either never going to be repeated again in your lifetime, or, if they are, it’ll probably be a long time from now…once you get back to normal, this is not going to be part of the Fed’s everyday way of doing business.” This is something right-wing Fed-haters just don’t seem to get, as obvious as it is.
Play Money—at the Speed of Light
The other NPR documentary show I recommend from last week is Terry Gross‘s Fresh Air interview with financial journalist Felix Salmon on high-frequency computerized trading (HFT). Salmon wrote an article for the January issue of Wired magazine, entitled “Algorithms Take Control”, that explains how computerized trading is on the way to dominating both short-term and long-term market movements. What’s happening in the server rooms on Wall Street makes the Fed look like Mister Rogers.
In the January 13 interview, Salmon talks about how algorithms are programmed to look for enormous numbers of patterns, using huge sets of data that are humanly incomprehensible because of their sheer size and breadth, to make trading decisions in milliseconds.
They’re looking at everything from weather forecasts to Twitter streams to whole areas of data which you an I can probably never think of…and they’re learning from them in…almost artificial-intelligence-type ways. They’re looking at economic indicators, they’re looking at fundamental indicators, they’re looking at technical indicators—anything you can imagine.
What’s more, for those readers who don’t watch the tick charts enough to have noticed this, there are trading algorithms designed to trick other algorithms into buying when they want to sell and vice versa.
In an effort to get any slight edge, investment banks’ HFT systems have to be “faster than anyone smarter and smarter than anyone faster.” Trading firms even go so far as to hire experts on microprocessor architecture as consultants to help them make their algorithms run a few nanoseconds faster.
Gross asks Salmon what role HFT played in the May 2010 “Flash Crash”, and the answer is that algorithmic trading caused it. For those of you who had tired of the story by the time this came out, here’s how Salmon explains it:
One relatively obscure mutual-fund company…wanted to hedge its positions against the eventuality that the market would fall. One of the ways you do that is sell stock-market futures…and they made a relatively large trade in the futures market [using computerized trading], like everyone does these days. [The trader] said, sell these futures, and make sure you do it in the next 20 minutes. That’s a very short amount of time to do a trade that big.
The trade moved the market enough to trigger all the other algorithms to sell, and poof, the Dow drops 600 points in five minutes. And the scariest part is, in Salmon’s words, “We have no real mechanism for stopping this from happening.”
The main danger about algorithmic trading is that we simply don’t understand it. We don’t understand how…stock markets work…. We don’t understand the feedback loops between them; we don’t understand what causes individual stocks or entire market indices to move. We have an incredibly complex system with only the most rudimentary controls.
(Gold) Bullet Points
So what have we learned?
- The value of money, in all forms—including gold—entirely depends on people’s belief.
- Central banks create and destroy money all the time, and “printing money” is an ordinary, everyday thing that’s extremely unlikely to lead to financial Armageddon.
- What’s more likely to destroy the global financial system, sucking the value out of any and all assets—again, including gold—is Wall Street playing with fire: exotic derivatives, sub-prime mortgages, overvalued story stocks, high-speed computerized trading, etc.
There’s nowhere to hide, folks, except in demanding smarter regulation of the financial markets (tougher in some areas, but more flexible in others). If another financial collapse comes, the fault will lie not in the stars, but in our politicians (and we who vote for them, or fail to vote at all).Homepage photo courtesy of Flickr user kodomut under Creative Commons license.