Does anyone fully understand the role that money plays?

While economists may struggle to figure out the role money plays, at its heart is trust; and if we are to emerge from the bail-out we need the bond markets to trust us

Tue, Aug 13, 2013, 11:33

Trust is at the heart of any financial system. Any transaction of any kind involves an element of trust. Most obviously, when goods and services are exchanged for pieces of a paper that are intrinsically worthless (money), we obviously are investing a lot of belief in some magical quality possessed by that paper. Barter economies that have no use for money exist mostly in fiction; any actual experience of money-free economies has been limited and not spectacularly successful.

But money is mysterious. As economists have developed increasingly sophisticated mathematical models they have mostly found it difficult to figure out the role that money plays in those toy representations of the economy. In a way, as economists have borrowed from the mathematics of quantum physics, their search for a role for money has mirrored the physicists’ quest for the elusive particle called the Higgs Boson. Money clearly exists but economists struggle for a theoretical rationale. The Higgs Boson has existed in theory for years but has only recently been glimpsed, somewhat briefly.

Once we start thinking seriously about money, things get tricky. I am convinced that the number of people who truly understand the role that money plays is similar to the number of scientists who properly understand the equally weird world of quantum mechanics. The number may actually be close to zero, but I’m not sure.

Can money be measured? That’s where the problems start. The original monetarists thought it could be both measured and targeted. That didn’t turn out too well. Quantitative Easing (QE) is the descendent of those original attempts to target monetary growth. Again, few people seem to genuinely understand why we observe all the world’s central banks massively growing the money supply. Commentators argue over the meaning and significance of low interest rates. The original monetarist, Milton Friedman, is probably spinning in his grave. He is somewhat out of fashion today (see Paul Krugman) but would be fully aware of money’s weird qualities. An example of which would be his pointing out that low interest rates (and bond yields) are a clear signal that central banks have been running monetary policy way too tight. Counter intuitive certainly, but that’s money.

We need more money to be printed because the money supply, properly measured, collapsed during the financial crisis. Something called the shadow banking system simply disappeared, taking with it a rather large proportion of the stock of money that had been sloshing around the global financial system. And that missing money has yet to be fully replaced, but the efforts of the US and UK central banks are now showing signs of bearing fruit. The European Central Bank (ECB), by contrast, has rarely seen a shrinking stock of money that it didn’t like.

Of course, all of this makes commentators and politicians of a particular type simply explode. For these people an expanding money supply simply means inflation; the sooner we get back on to the gold standard the better. This lack of trust in central banking is often offered as hard headed realism, to be contrasted with the mumbo jumbo of monetary theory. But the advocates of a return to the gold standard are as faith based as any other zany cult follower. Their trust in gold is absolute, but is absolutely based on flimsy empirical foundations.

Central banks are very concerned with the inflation consequences of what they do. When they obsess about inflation expectations they are measuring the trust that the system paces in them to do the right thing. For all the rantings of the gold bugs, that trust looks to be solid.

Borrowing money, a key financial transaction, is mostly based on trust. The Fianna Fail spokesman for Finance, Michael McGrath, writing today in The Irish Times, speaks directly to the trust that he thinks has been built up between Ireland and the international bond markets over the past few years. It seems that the Troika, and others who think that austerity can be slowed down a touch, do not agree with him . Can we be trusted to honour our obligations? That isn’t just a question about our honest intent - sometimes circumstances simply dictate that we can’t repay the money we owe. On either count I suspect that the Troika thinks we have a lot more to do to regain their trust. But, at the end of the day, it’s not the Troika’s lack of trust that matters: if we are to emerge from the bail-out, it’s the opinion of the bond markets that is all important.

Those bond markets know that we can be trusted, provided we can get growth back to the economy. That probably requires growth to be seen in reality, rather than predictions. A bit like the Higgs Boson.