# What is money?

Posted by on May 29, 2013 in Complexity Science | 0 comments

The banking crisis in Cyprus once again provided an example of how hard is “money” to be understood. The Oxford Dictionary defines “money” as a current medium of exchange in the form of coins and banknotes. It’s the basis of all economic theories, and yet not a single person on earth could explain precisely the dynamics of money.

Well, to the majority of people, money merely a store of wealth and more importantly a medium for trade. How much you’ve earned equals how much worth of the object you can obtain. But the reality is that it could be quite complicated when one consider the money supply, which also contribute to inflation or deflation, or when comparing with other currencies. The mechanics of money in the global economic network is still quite unknown. If you don’t believe, take a look at this.

Money is the blood of all economies. It serves as a medium of exchange while we may not understand much about money. Therefore, to understand an economic network, the creation mechanism of money and its influence have to be clear.

## The Very Basics about Money

First of all, the total amount of notes & coins in circulation (M0 or monetary base, or simply called CASH) does not equal to the total amount of money in a system. Perhaps it has surprised no one. After all, most of our money are stored in the bank nowadays, so total total cash must be less than the total.

For £1M, what does it represent? A value for a house or a bread?

But what does £1M mean? A lot or just enough for a bread (might be 100 years later)? It quite depends the time when this question was asked. In fact, the cause of such difference is due to the use of so-called fiat money we’re currently using almost all over the world. As an interesting brief introduction of the history of money, reader may visit this fantastic presentation.

Barter or commodity money is the ancient way for trade. These are the most basic form of money in which the value stored in the money equals to the value of the material which form the money. Consider a Caesar coin, the value of the coin is equivalent to the value of the total weight of metal of the coin. So, if 1kg of bronze coin was being traded for bronze, one should receive exactly 1kg of bronze, no more no less.

In just 40 years ago, during the era of the gold standard or Bretton Woods, money were pledged to against gold or silver. In other words, the value of money were directly linked to physical substance like gold, and the value of money could be easily converted.

Fiat money, on the other hand, does not have such physical linkage. i.e. The intrinsic value of the metal which form a £1 coin is not worth for £1. From the day when notes & alloy coins were introduced, the money were detached from its own anchor – the market value of coins as metal or notes as paper. Despite the ease of carrying, such invention caused numerous trouble. Sometimes it might result in hyperinflation if money was over issued.

## Monetary Creation

In the modern world, monetary creation is through two ways, “lending” by commercial banks & “debt monetisation” by central banks.

Perhaps it might sound wried, however, by lending, banks are creating money. Consider the following scenario: Paul has £10 deposit in bank A. The bank then lend out £8 to Mary, and she deposit the amount in bank B. Then bank B again lends out £5 to Susan. So, if we count, there is now 10 + 8 + 5 = £23 of face value in total, instead of £10 at the beginning. The more turns of lending, the more is the total face value of money in an economic system.

One of the mechanism which limit the upper bound of such creation is via fractional-reserve banking. In such requirement, for any amount of deposit in a bank, the bank has to reserve a portion of the deposit in the central banks not lending it out. In turn, the total amount of money created is limited by the money multipiler. This web site has a clear illustration of the mechanism.

In UK and some countries, there is no any required reserve ratio imposed. Therefore, the theoretical amount of money could be as high as $latex \frac{1}{Reserve Ratio = 0} \rightarrow \inf$. It does sound scary because the money supply could be rocketed by such mechanism. But in practice, there still a reserve ratio where banks need some liquidity for their daily operation and the central banks control the interest rate in order to encourage/discourage residents’ spending, and effective affecting the excessive reserve.

While the commercial banks create money based on the £10, the base money or monetary base, the central banks are corresponding to the creation of the base money. This process is usually called “debt monetisation”. The basic idea is similar to the lending mechanism by a commercial bank.

Consider an economic system where it has only £100, and it’s owned by a bank, and the government has no money to spend. So the government issue a bond of £100 for the bank to purchase. Now, the bank get the bond, and the government get the money. Well, still £100 in total. But then the trick happen when the bank put the bond in central bank (Federal Reserve for US), and demand lending from the central bank, the central bank would then issue another £100 (which backed by the bond) to the bank. Now, the total base money is £200. A better illustration could be found here.

In fact, instead of gold, the US note has a print “this note is legal tender for all debts public and private” on it. Essentially all notes in the world are backed by the assets of the central banks, which are generally bonds and low-risk debts (during QE), in other words debts. So for a bond issued by a government, it hence increasing the money supply in the market. By issuing or repurchasing debt, a government could control the amount of money in the market.

## The Philosophy of Money

The fiat money is still controversial today since the government could devalue money by issuing a bond as discussed above. Eventually, the debt of government could be diluted by higher tax income due to inflation. Hence some economist calls it as “stealth tax” by devaluation of money. In fact, since 1970s, the inflation rate is no longer oscillating among mean zero but positive all the time since then. Data is available at the web site of Bank of England. This is all due to the fiat money mechanism.

Therefore, some argued, as a selfish king, a sovereign could issue debts, which could be converted to money to payoff the government expense; while citizens have no gain in monetary term. This blog has a nice analogy to the creation of money in the casino. However, of course, it has to be in mind that central banks do not really create money from nothing, but through the purchase of low-risk financial assets like government bonds.

Of course, a sword has two edges. Fiat money has its own merit. As it does not limit by the amount of gold reserve, a sovereign could easily stimulate the economy from depress via broadening the monetary base, together with different monetary policies. From a macroscopic view, the idea was to make the economy more controllable (if the majority of the fund could reach the market without captured by the fund manager). It stimulates/depromote the total output of an economy like turning the volume of a radio.

On the other hand, besides physical object, very often people are not aware that some value is created as an abstract structure rather than object. In the example by Hidalgo, the co-founder of the Observatory of Economic Complexity, he advocated a breaking concept that

“the value of a sophisticated good, such as a computer, a car or an F-22, comes from the precise way in which its parts are assembled, rather than from the materials from which they are made.”

Source: Hidalgo, César A. “The value in the links: Networks and the evolution of organizations.” Sage Handbook on Management and Complexity. London: Sage(2011): 257-569.

So by issuing fiat money, more value is created by the commissioned work (e.g. better infrastructure & health benefit) due to the hot money. In return, it may create even more wealth by increasing the efficiency of productivity, and hence the total physical asset owned and the higher competitive power to other nations, to make the country further benefit from trades. Just, on the other hand, we do worry about the debt level as well.

Imagine there is a cave inhabited by prisoners who have been chained since childhood. Behind the prisoners a fire casts a shadow of the surrounding including themselves onto a wall in front of them. However, they are not aware that the image on the wall is just a projection of their world.

What the prisoners see is a projection of their world on the wall. The real world is, however, not seen by them. The prisoners cannot move nor turn their head around to see outside the cave. They can never see those people or the things causing the shadows in real, but the projection of these objects. The shadow is thus regarded as the reality of the surrounding since they never see the real objects.

Now a lucky prisoner is set free. He can walk and explore the real world around. He soon discovers that the shadow he saw only displays a rough projection of a single aspect of the surrounding. The real world is much richer than he has imagined before.

Life in this cave resembles some aspects of human reality. What we see are mere projections, but the actual reality is always hidden without our awareness.

Alvis HT Tang is a practitioner of divergent and critical thinking, keen on pursuing intellectual discussion and linking knowledge to create new insights. He has an innately critical mind to find possible explanations for a phenomenon from unconventional angles. He is a lucky prisoner who is able to break the chain to contribute a better understanding of the actual world.

Alvis at the moment is an explorer of nature at the Centre for Complexity Science and Department of Mathematics at Imperial College London, with Prof. Henrik Jensen as the safari guide for his PhD degree.

His research focuses are firm dynamics, probability estimation, information flow in networks, evolution and emergence. In particular, the regularities of business patterns lead him to ponder the hidden mystery.

Before joining the group, Alvis has substantial experience in the technology sector for years. He obtained a BSc Physics degree at the Chinese University of Hong Kong and a MSc Applied Mathematics degree with Distinction at Imperial College London.

Specialties: Firm Dynamics, Probability Estimation, Network Analysis, Parallel Computing, Web Technology, System Architecture

Computer Languages: CUDA, C++, Node.js, Java Script, PHP, SQL, Mongo, BigQuery, .NET (C#, VB), Mathematica, MATLAB

Research Keywords: firm dynamics dynamics non-equilibrium dynamicsevolutionary dynamics, econophysics, network stability, networks, complex systems, economic networksself-organised criticality (SOC)criticality, percolation and universality.

The whole of science is nothing more than a refinement of every day thinking.

Albert Einstein