Finance is...

"Finance is the web of intermediation binding economic agents to one another, across both space and time." Martin Wolf in his FT column on 30th September.

It's interesting to consider how bankruptcies or insolvency of financial players can cause a recession. After all, a debt has two sides - and if it is uncollectable, the money hasn't disappeared - it's just been transferred to one party at the expense of another. If Lehman Brothers goes bust because it can't collect $40bn of debts, then presumably the debtors (or their employees, or suppliers, or the people they bought their houses from) have gained $40bn; Lehman shareholders have lost $10bn and Lehman creditors have lost $30bn. At first glance, the economy is no worse off. Indeed even the creditors aren't as distraught as they appear, because some of them now have a claim to pursue against the lucky debtors.

And that's true, insofar as money is an asset in itself. The total amount of money in the economy has not changed and total cash wealth is preserved. However, the real damage is to the productive potential of the economy.

This potential is the capacity for firms and people to produce things of value for each other, in excess of the value used up in producing them. The amount of valuable things produced in the world is around $50-60 trillion each year. Quite a lot, though it's divided between 6.5 billion people, so we each get around $8000 worth.

For comparison, what's the total amount of money in the world? Using what's called M4 money supply in the UK, M3 in the US and EU, and M3+CDs in Japan, we can find or estimate some figures for the end of 2007:
  • US: $12 trillion
  • EU: €8.5 trillion
  • UK: £1.5 trillion
  • Japan: 1.5 quadrillion yen

These four economies represent about 70% of the world economy so it's probably reasonable to assume they contain 70% of world money supply - though admittedly the debt characteristics of other economies are a bit different to these four. We're just looking for a ballpark figure though.

Total world money supply therefore - €42 trillion, £33 trillion or $58 trillion. About the same as a year's economic output. But tiny compared to the net present value of the world's economy. Assuming a discount rate of 7% and zero growth, the NPV of the world is over $800 trillion. Assuming 2.5% growth, it's $1300 trillion. This, in a sense, represents the total real wealth of everyone in the world. But - and we'll come back to this later - this is based on the effective, productive application of resources (including human effort) continuously over time. Any downtime when resources are not being used is a permanent loss to total world wealth.

So, if the total amount of money in the economy doesn't change, does that mean economic output is not affected either? Unfortunately not.

The function of money in economic output is as a coordinator. It provides the reservoir that allows person A to do some work today, and their work be available for person B to use next month when they're ready to provide something for person C. It sends the signal to tell B that A was the most efficient person to do the work rather than D, and therefore allocates more work to A while D finds a different job. And it allows me to work hard today, accumulate a claim on future resources, and "spend" my work next year, or after I retire - while in the meantime I lend that claim to someone else who can use the resources productively.

For this coordination, it doesn't really matter who owns the money. It just matters that it can get to where it's needed at the right time, and that it retains its value reasonably well. And in a well-functioning credit system, that is rarely a problem. The people who can best use the money tend to be ones with reasonably good credit, and so people are willing to lend to them. And when the people with money don't know the people who want it, banks provide the matchmaking function in between. If those with the money (who we call lenders) are too far away from those who need it (borrowers) then a single bank is unlikely to have relationships with both. Simple matchmaking then doesn't work, so instead we have a network of intermediaries through whom the money flows.

But this relies on the intermediaries themselves being trustworthy. If they're not, then the banks won't lend to them, and if the banks themselves are not secure, the lenders won't allow them to matchmake their money.

So a potential borrower who could make good use of resources can't get them; resources, and people, sit idle; and that valuable, irreplaceable productive time is lost forever - real wealth is destroyed. The lender can't put their money to use anywhere and they earn no interest. Average world interest rates (the amount of value generated by money) are maybe 4% - so lenders could be losing $2.5 trillion in interest by holding back their money. But more importantly, the NPV of the world is falling daily. If we lose one year of growth against a 2.5% trend, world NPV is reduced by $32 trillion.

And all of this is not because we don't know how to allocate resources productively, or because innovation has stopped. It isn't even because the people providing intermediation have disappeared, or forgotten how to do it. It is simply because nobody can trust the intermediaries to transmit money to borrowers and bring it back again intact. And this is a self-perpetuating, vicious cycle because nobody will start trusting if nobody else trusts. Like the prisoner's dilemma, or like an insurance policy, the system can only operate if everyone joins in at once.

Against this background, almost any amount is worth paying to restore trust and have the system work again. It looks like governments - and perhaps Mr. Buffett - are the only institutions we have enough faith in to make this happen. Governments, which, curiously, are another self-sustaining confidence trick - we only let governments have authority over us because everyone else lets them too. Money itself, and the idea of the debt that taxpayers are taking on in these rescues, are all bound up into the same network of bubbles. But if we still believe in that trick, maybe it has just enough con left over to spill into the financial system. We better start falling for that one again or we're all in trouble.


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