Greetings,

This week we began our look at economic theorists throughout history and some basic principles surrounding economics in general.  This will culminate when the students form rival companies and compete with each other, with the rest of the school as customers.

We spent most of our time trying to understand exactly what money really is, and how it functions.  The title of this post is taken from a book by the famous economist Hernando de Soto, but it also describes my own personal feelings.  Money has a fungible, mysterious identity, but hopefully we reached common ground on a few key ideas.

We often make the mistake of thinking that money is a “real” thing, that it has a natural and inherent value to it.  Rather, money symbolizes or signifies some agreed upon purchasing power.  A strict barter economy makes much more sense after all. If two people exchange a bushel of wheat for a barrel of apples, we immediately see how both sides get value from the transaction.  Although even the wheat and apples do not have absolute fixed values.  If you hate apples, they would not be worth much to you.  If the wheat harvest failed it would have greater value than in previous years.  Still, the transaction seems rooted in understandable reality.

But, I wonder, who was the first person who decided to trade away something tangible and useful, such as bread or animal skins, for shiny rocks?

Of course money  has many advantages to barter economies.  They function much more efficiently, for one.  Shopping is much easier with a pocketful of coins, as opposed to a wagon load of things to trade.  However, a money economy depends on shared societal belief to a much greater degree than barter.  Society must take a collective leap of sorts, for what would happen to our economy if one day the managers of grocery stores said, “Why should I give you this bread and milk?  All you’re giving me in return are these small pieces of paper!”

So, the value of money depends at least in part on a shared, created belief.  But this does not mean that money can simply be invented out of thin air.  Money may not be fully real, but it must be based on something real, be it labor, a product — something.

After laying that groundwork we began our quick look at economic theorists throughout history.  We started with a brief comparison between the Dutch and Spain around the turn of the 17th century.  Spain had an overseas empire that allowed them to bring piles of silver into the country.  The Dutch too, had some overseas trade, but they helped pioneer the idea of the corporation and the stock market.  At first glance, we might expect a mountain of silver to defeat a nascent stock market, but in fact the reverse happened.  How could this be?

When the Bush and Obama administrations gave bailout packages to various financial industries, many commented something along the lines of, “If the government is going to give out all that money, they could just give it to families, and each would receive $35,000.”  Would this have worked?  I asserted that if this had been done, everyone would have more money, but no one would be any richer.  If everyone is special, no one is.  Prices would likely rise, and inflation would kick in.

This happened in Spain.  The supply of silver increased significantly, but prices even more so.  Part of this had to do with how the Spanish used their silver, but the basic principle still holds.  Their silver created no wealth.  In contrast, the Dutch stock market created a system whereby the flow of capital could be constant, and that money would be used to further develop companies.  Thus, the stock market would have a better chance of reflecting “real” value than a pile of silver.  Of course, this serves as only a cursory explanation.

John Law had a checkered career as a financial advisor, but he came up with a couple financial innovations that have done much to influence modern finance.

• Credit is Money

Money’s value comes from the fact that people trust it.  Without trust, money could not function.  Thus, trust forms the basis of all purchasing power.  Suppose you had no actual money to your name, but did possess a notarized I.O.U. from Bill Gates for $1 million, payable by the end of next week.  We surmised that you could use that credit as money, or at least to secure a loan.

When we use credit cards, for example, no money changes hands at that moment.  The store trusts the credit companies to pay them, the credit companies trust us to pay our bill.  Credit would not work without trust, but we can take it one step further.  Trust can function like money.

• Credit and Governments

Law argued that since governments have the power to tax, they can issue money against themselves in a crisis.  Borrowing against yourself would force governments, he argued, to pay it back.  To not recollect the money would de-legitimize their whole standing with the people and destroy their currency. If the people don’t trust the government to pay it back, then you have bigger problems than mere financial difficulties.  The government itself would collapse.  Given that this option comes with more pain than repaying the loan, Law thought, governments would choose to recollect in the form of taxes later.

Governments certainly have used this idea numerous times, sometimes with great success, other times it has led to disaster.  But that is part of Law’s point.  Governments risk a lot through this mechanism, and if they’re not “good for it” than they don’t deserve to govern.

In his book, The Cash Nexus, historian Niall Ferguson speculated that one reason why democratic countries have more financial success than other forms of government is the flexibility given through governing by consent.   Since governance through consent has more stability, these governments have more trust in the international community.  This trust leads to more purchasing power.

Next week we’ll look at Adam Smith, Karl Marx, Keynes, and Hayek.  Have a great weekend.

Dave Mathwin