Friday, July 13, 2012

The real world does not like barter

Economics from a place short of cash.

I was re-reading recently the brilliant analysis of money by A. Mitchell Innes ( and whilst agreeing with him in all he said, I thought that I could advance his critique of Adam Smith even further

To set the scene, here is a quote from the above mentioned 1913 paper:
` If we assume that in pre-historic ages, man lived by barter, what is the development that would naturally have taken place, whereby he grew to his present knowledge of the methods of commerce? The situation is thus explained by Adam Smith:
But when the division of labor first began to take place, this power of exchanging must frequently have been very much clogged and embarrassed in its operations. One man, we shall suppose, has more of a certain commodity than, he himself has occasion for, while another has less. The former consequently would be glad to dispose of, and the latter to purchase, a part of this superfluity. But if this latter should chance to have nothing that for former stands in need of, no exchange can be made between them. The butcher has more meat in his shop than he himself can consume, and the brewer and the baker would each of them be willing to purchase a part of it. But they have nothing to offer in exchange, except the different productions of their respective trades, and the butcher is already provided with all the bread and beer which he has immediate occasion for. No change can in this case be made between them. He cannot offer to be their merchant nor they his customers; and they are all of them thus mutually less serviceable to one another. In order to avoid the inconveniency of such situations, every prudent man in every period of society, after the first establishment of the division of labor, must naturally have endeavored to manage his affairs in such a manner, as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as, he imagined that few people would be likely to refuse in exchange for the produce of their industry.Many different commodites, it is probable, were successively both thought of and employed for this purpose. . . . . . . . . . In all countries, however, men seem at last to have been determined by irresistible reasons to give the preference, for this employment, to metals above every other commodity.
Adam Smith’s position depends on the truth of the proposition that, if the baker or the brewer wants meat from the butcher, but has (the latter being sufficiently provided with bread and beer) nothing to offer in exchange, no exchange can be made between them. If this were true, the doctrine of a medium of exchange would, perhaps, be correct. But is it true?Assuming the baker and the brewer to be honest men, and honesty is no modern virtue, the butcher could take from them an acknowledgment that they had bought from him so much meat, and all we have to assume is that the community would recognize the obligation of the baker and the brewer to redeem these acknowledgments in bread or beer at the relative values current in the village market, whenever they might be presented to them, and we at once have a good and sufficient currency. A sale, according to this theory, is not the exchange of a commodity for some intermediate commodity called the “medium of exchange,” but the exchange of a commodity for a credit.` 
To support this, here is a short summary of what I have learnt about barter in the last two years, the hard way - from first-hand experience.

I own a 400 acre farm (165 hectare) in the North-East of Brasil, close to the equator, which I am running with the help of my brother. Being here after living in London for most of my adult life is like travelling back in time, and I am not talking about technology. We have mobile phones, internet and cars – it is more the economics relations between people that seem to come from a time long ago. In Brazil interest rates are high and banks require solid collateral before lending, so bank credit and money are scarce. Does the exchange between people slow down or stop?  Well, no – for to give Adam Smith credit where credit is due: ´The propensity to truck, barter and exchange one thing for another is common to all men, and to be found in no other race of animals.`

Let us analyze transaction number one:
Recently I have traded two trucks of wood for a truck of bricks. Ah, barter, you say! Well, from a distance, so it seems. However, let us study the detail:
1. The bricks do not yet exist. They need to be fired with, you guessed what, the wood I have just given to my trading counterparty. 
2. Even if the bricks existed, there is only one truck available to do the transport, and as the trucker has other transports to make, the bricks might be delayed for a week or two.
So – now he owes me a truck of bricks, and he has the wood on credit.

Another recent transaction:
I swapped a chainsaw for fence posts. Again, the detail:
1. The posts are still in the forest, waiting to be cut.
2. Also, I need two thousand posts, and the chainsaw will only pay for 1500.
3. The posts take time to be cut.
4. My counterparty has other customers to service
5. I do not need all the posts at once
6. A truck can only transport 500 posts, so it will take around 2-3 weeks for the posts to arrive in my yard.
This one is a bit more involved. Initially I extend him credit, and he takes the chainsaw. After he delivers the 2000 fence posts, I owe him for 500, which I will settle in cash, but maybe not straight away.

Transaction number three: A friend arrives at the farm; he likes my second hand car parked in a barn. We start the negotiations:
1. He offers me 5000,
2. but he has no cash,
3. he can pay me in gravel.
4. In the future I need gravel for internal roads,
5. but not right now, because I am doing other things.
Does the transaction fail, as Adam Smith predicts? Well, no, for there is always credit:
6. We agree a price of 5600, and over the next 3 or 4 months he delivers me the truckloads of gravel, about 25 of them, at a rate of one or two a week. Done.

To finish with, let us look at a simpler transaction:

Transaction number four:  My friend wants a goat to barbecue for his birthday party, and he offers me a truckload of gravel. Perfect barter, you say! Not so fast, I am afraid. For my friend´s birthday is in a few weeks’ time, but he brings the gravel straight away, because he has a free slot in his deliveries. This time it is me who gets credit, but it is credit again, even in the seemingly most perfect of barter swaps.

Are four transactions statistically significant? Well, maybe no – they are just detailed examples. At the same time I know of tens or maybe over a hundred of similar transactions, involving either me or my friends, for we talk of little else during our occasional evening farmer beers. For the beers, of course, we paid with real cash.

Saturday, June 9, 2012

Do banks create money out of thin air?

How do banks create money

When I go to a bank to take a loan, where does the bank have the money from?

Do they lend me someone else’s money? Do they create it? Do they get it from the Fed/Bank of England?

No. Many people, thinking of money as of something with inherent value, have problems with thinking that banks simply create money “out of thin air”. However, with our definition of money as contracts for labour (, then it is very easy to see what is happening.

The magic happens here

When I walk into a bank, I take a loan and I sign a piece of paper pledging part of my labour to the bank. I am creating contracts for labour with the bank’s help – and the bank can give me money/bearer contracts now in exchange, because they know that I will work for them to cover those contracts.

So it is I, the guy who will do the labour, that creates the money out of thin air, by declaring that I exist and that I can back the labour contract that I sign with my labour. What the bank creates from thin air is the printouts of the contracts for labour, once as the loan agreement, which then promptly exchanges for bearer contracts emitted by the government (the dollar bills).

The accounting mechanics of it are explained very well here:

So what do we carry in our pocket? or on our credit card?

The money that everyone thinks as money are just the contracts printed on something. Now it is paper, albeit quite expensive paper.

They used to be printed on silver, on gold, on cowrie shells, on knots in pieces of string. In closer times, the futures contracts are printed on expensive paper, with expensive inks. And lately they exist on the encrypted computers sitting behind our credit cards.

The fact that silver and gold are good metals which make nice jewelry, somehow we came to think that the printing support has some value in itself. Well, it does not - as the Spanish have discovered when returning with too many galleons loaded with gold from the New World. Inflation still bit them!

All this was also analysed in a very good way and with better words than mine by A. Mitchell Innes here:

A. Mitchell Innes is a genius, way above the other money philosophers. Albeit he did not make the mental jump from money to contracts in the above paper, he remains one of the best.

Does it matter what the contract is printed on? Well, as with any contract, not really...

Did money exist before they were printed on something? Well, yes - verbal contracts are still contracts - but they were valid in small communities only. And if you were owed some future work by a few of your neighbours, and the tribe over the mountain came and killed your neighbours, your (verbal) money was gone...

Most people think that barter preceded money.  Lately, a few started to see that the so-called "gift economies" preceded money. Barter was just a way to trade, was not money - maybe through a roundabout way. And the "gift economy" is just the "verbal" stage of contract printing.

People equate the birth of money with the birth of solid support for the contracts.

The metals were indeed good as a device of contract recording, for their durability and relative resistance to forgery.

So commodity money? no, commodity money never existed - just money printed on commodity - gold etc.

What is money

What is money? 

Money is a bearer contract for labour, contract that can be enforced only within the same jurisdiction that governs that pool of labour.

The story so far:

We have been using money for a good few millennia, and we have so far failed to find a good definition of it. Most of us think of money as something with inherent value, and this is a great trap.

I have read somewhere that the greatest failure of humanity is the failure to really understand the exponential curve. Surely the failure to understand money and the way it works must be number two. :)

Yes, I have read Adam Smith, and the Money Illusion, and Benjamin Franklin and Karl Marx.

A. Mitchell Innes is the one that gets closest to it.  ( Although he has not made the jump to the final conclusion and definition, his analysis is spot on. Respect!

Closer to our times, Modern Monetary Theory (MMT) and its similar splinter groups have explained how the money flows around the system very well (
- and they are about the only ones who got it correctly. They understand what money is, in their bones, but without a formal definition.  As a result, MMT has a Public Relations (PR) problem: it talks about money in its own terms, and people at large think about money in their terms.

So here it goes again:

Definition of money:

Money is a bearer contract on a fraction of the pool of human labour available within a jurisdiction, contract that can be enforced only within the same jurisdiction that governs that pool of labour. .

Points to note:

  1. It is a contract, and therefore subject to all contract problems - enforcement, breach etc
  2. The human labour it contracts is not fixed. It diminishes with time - it is called inflation. Nominal value vs Real value. In normal times it is tractable on a weekly/monthly timescale. Longer than that... you just never know... :) 
  3. Its value is governed by two variables: number of contracts/money in circulation and the value of the pool of labour. They both vary simultaneously, so it is difficult to track it down. Also there is a great inertia to a system as big as a whole country economy, so changes take time to propagate. 
  4. Human labour is the source of all value (thank you, Marx and Ben Franklin) - whenever we buy something we essentially buy the human labour that has gone into making it. This applies to 
  5. natural resources (labour to extract it), water (water to pump it and make it potable), land (labour to set up the system of registration and ownership and (military) labour to protect it from invasion) etc.
  6. The jurisdiction limits to its validity and enforceability, as for all contracts. There is of course forex to go outside the jurisdiction, but that is just a mechanism to trade between jurisdictions. 
In short and in conclusion, money is a token representing a futures contract to be drawn on a certain division of the pool of labour and means of production.

Comments welcome.


If we have more future contracts ("money" for the rest of us) being drawn on the same pool of labour, with the same capital tools enabling them to produce an amount of goods - then it stands to reason that the value of each individual contract (unit of currency) will be smaller.

If we reach full employment, and if government spends on things that do not increase the productivity of the labour pool in 1-2 years (the time it takes for information to propagate through the system) then we have inflation - too many contracts chasing too little labour.

As a corollary of the same line of thinking - are banks richer when they accumulate a lot of money? well, no... bear in mind that the pool of labour is the same, and the productivity is less, because credit is less available... so in 2012 the banks have more money (contracts) in their vaults and on the computers, but they cannot exercise them - as the real things that they could exercise them on (the pool of labour) have stayed the same. They have created an imbalance in the system.

This is one of the functions of money: to indicate when the system is working well, and when the system is out of balance.

Back to the banks - in effect they are like someone at poker who is rich in poker chips, but he cannot find anyone to play with. In the meantime, the real economy does not have enough "tokens" to function properly - in order to go back to good functioning the government will print more "contracts" and get the gears moving again. As a consequence of the dead money in the banks, we will have inflation, the mechanism to regulate imbalances.

Tuesday, April 3, 2012

Rates of exchange

Now, where do the rates of exchange arise from?

In a way, it is a way of keeping track of the relative strengths of the economies. We need to go down to the basics: We have a pool of labour of fixed size in the short term (months time horizon), with a productivity given by their industriousness, by the capital tools they have and by the efficiency of their system of economic governance. To this we have a certain number of "drawing rights", a certain number of future contracts on the pool of labour, or "money", as we decided to call them.

If any of these parameters change, the rate of exchange with other economies will also change. If the number of money changes, the pool of labour is unchanged, making each contract less valuable.

And so on for the other parameters - if the capital tools are all washed to sea by a tsunami, the value of the currency relative to others will drop, for the new situation will not allow for the same productivity.

Monday, March 26, 2012

So what does the money do?

The short answer: it keeps track of everyone's contribution to the society - it is the signalling device that manages allocation of resources.

When one section of a society captures too much money, imbalances occur, the flow of economic activity is impeded and overall wellness drops.