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Anyone describing the monetary system starts with the history of money which starts with early bartering system where farmers traded apples in exchange for meat subsequently developing a more refined and efficient means of exchange. “The Ascent of Money: A Financial History of the World” by Niall Ferguson provides a very good and interesting read. I will do things slightly more different and jump straight in and start with my first entry with a satirical story of the bailout package for Ireland that I read about 1 year ago and I recently came across again.

At that time I didn’t think too much of it but considering the current financial developments and many misconceptions I decided to revisit it and now believe that these few lines can help explain how the modern monetary system,  based on credit works. The story probably helps explain the complexities of our monetary and credit system far better than anything I have come across using such few words. I will explain why but first bear with me and re-read the satirical depiction of the Irish bail-out:

How the Bailout works for Ireland

It is a slow day in a damp little Irish town. The rain is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit.

On this particular day a rich German tourist is driving through the town, stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night.

The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher.

The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer.

The pig farmer takes the €100 note and heads off to pay his bill at the supplier of feed and fuel.

The guy at the Farmers’ Co-op takes the €100 note and runs to pay his drinks bill at the pub.

The pub-owner slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him “services” on credit.

The prostitute then rushes to the hotel and pays off her room bill to the hotel owner with the €100 note.

The hotel proprietor then places the €100 note back on the counter so the rich traveller will not suspect anything. At that moment the traveller comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, pockets the money, and leaves town.

No one produced anything. No one earned anything. However, the whole town is now out of debt and looking to the future with a lot more optimism. And that, Ladies and Gentlemen, is how the bailout package works.

 And that ladies and gentlemen is a very good start to explain the modern monetary system. Why?

Although it sounds very simplistic there are many hidden truths that I would like to touch on. One of the first:

Times are tough, everybody is in debt, and everybody lives on credit”.

In the financial system everybody is in debt and everybody lives on credit but times are normal.

6 people live in this town and each owes €100 to someone else. If the hotel owner owes €100 to the butcher than obviously the butcher treats this same €100 as a future receivable, an asset. The butcher can now go the pig farmer to purchase the pigs promising him to pay €100 upon receiving the €100 which are owed to him from the hotel owner. It should become clear that this new €100 was created out of thin air based on a promise and trust. No physical note €100 note was necessary to buy pigs. This is an important point. The butcher was able to purchase physical goods (pigs) with a promise to pay in the future (debt). Credit was created but on a more abstract level so was money. Money is credit and credit is debt.

The pig farmer who now has a claim on the butcher can go and do the same until the circle of claims described in the story is completed. One person’s debt is someone else asset meaning that on aggregate the town ignoring all other assets is worth €600. The total value of the town is determined by participants in the chain and interestingly all the value/debt can be cleared with one €100 note. It sounds strange, unconvincing and utopian yet it is a quite accurate description of modern finance. The amount of physical money (central bank reserves) does not influence the amount of credit in the economy. This is clearly one of the greatest financial misunderstandings!

Admittingly there are many simplifications and assumptions which make the story work the way it does. One of main assumptions is that all participants are of the identical credit worthiness. The butcher is willing to accept the same promise (€100) coming from the hotel-owner as the hotel owner is willing to accept from the prostitute. This is not just a simplification but rather a caveat. The hotel owner as implied by the name has a hotel backing his claim making him probably the most creditworthy participant in that town, but even he is faced with some distrust.

More realistic would be for the butcher to say the following: “Hotel-owner, I’ll sell you meat for €90 and you can pay me in the future but I require €100 as collateral (an insurance that this debt will actually be honoured). The pig farmer would say to the butcher, who now not has €100 but only €90: “Listen butcher, I’ll sell you pigs but you are no hotel owner so you’ll get pigs worth €70 which you can pay in the future but I require that €90 as collateral as you only have your butcher store as an insurance and therefore are not as credit worthy. Every member in the chain applies a “haircut on members with lower credit worthiness”.

Following this new chain of events we can see that this chain of claims does not go on indefinitely. Adding more town members to the chain does not create more debt and wealth indefinitely. There is a limiting factor, a very important one, but again its not the amount of physical money in the town. Its not how many physical euro notes are available but its the amount of trust members have in each other. The overall wealth breaks down to the credit worthiness. The higher the credit worthiness the smaller will be the haircut applied to collateral and the more can be borrowed from the next person in line. Borrowing is debt and debt is money and in finance money is collateral.

Now re-read the story and instead of hotel-owner and pig farmer insert Citgroup, Barclays etc.   Decide for yourself who takes the role of the town prostitute. That is not up to me to decide. This shows that in a world based on credit and debt trust, confidence and high-quality collateral far more important than physical money (reserves). Unfortunately 4 years into the current crisis we have not yet been able to restore trust and credit-worthiness and quite frankly are starting to run out of high-quality collateral.

Although simplistic this first post should give an introduction on how the modern monetary system functions and I hope that in the following posts I will be able to explain some of the more common misconceptions and provide some more clarity.