What is Money and how does it come to be?
Posted: Sun May 02, 2021 5:15 pm
My exploration of the topic
I've been trying to wrap my head around the topic of currency and/or money recently. This is my 3 corners, hoping someone will give me the 4th. Unless relevant, I want to set aside the distinction of 'gold is money and fiat is currency' as I'm not trying to say what a good system is or trying to do historic analysis. If I say money or currency, I mean the same thing, fiat based numbers that people perceive as being valuable.
I've been reading Richard Werner's work on the creation of currency and been thinking a lot about inflation. One of the claims is that the Federal Reserve has created some large % of all money that has ever existed and I'm starting to wonder about that story. Let's set that aside for a minute and go back to Werner's 3 types of banking systems, at least as I understand them:
- Banks can only loan out deposits. There is no created money via banks. Money is created elsewhere.
- Banks can't create money, but the banking system can. This is caused by the fact that one man's assets are another man's liabilities. The fact that each bank can lend out x% of their savings creates money because each time someone lends the money the money comes back as savings from another individual, allowing the bank to re-lend the money, not knowing it was previously lent out.
- Banks create credit. As I understand it, this would be sort of like super-fiat in that it isn't even dollars but rather numbers on a ledger, handed from one bank to another. From our point of view, it looks like money, but it isn't or is it?
Werner claims in his study he found that the 3rd option is what he observed in a bank transaction under the hood.
So my first question as a reaction to this is, what actually is money? How is money created? Who can create money and during what circumstances?
Before anyone answers, I want to put some thoughts on some techniques that might either be money or ways to create money. These are the concepts of derivatives, rehypothecation and subway tokens...er... bank reserves.
Regarding money creation, some point to the federal reserve, using the open market to buy treasuries off of other entities, which puts new, previously non-existent money into the system. Then there is the US Treasury which creates bonds in the first place and sells them into the market. I recall watching Warren Mosler, father of MMT insist that the government must spend first then tax or else money could not exist. One form of this was Mosler describing the currency as subway tokens, which the issuer creates the tokens and "spends" them by selling rides first before collecting them for fairs. I don't know the mechanism he assumes the gov't creates the money from.
As I understand it, hypothecation is where some entity provides something of value or asset for cash. The asset is known as "collateral" in the jargon. The most obvious sort of example is a bank loan used to buy a house where the house is used as collateral. Rehypothecation is where the collateral is traded hands multiple times, each time the entity handing off the collateral getting cash. One problem is that an intermediary who once held the collateral might go bust and creditors might go after that asset. Why? Because you can do this off balance sheet, meaning the asset shows up on multiple balance sheets. That in a sense also appears to be creating money, which can in effect create money for even the hardest of assets.
In other versions of this, you might take out Eurodollar loans by buying a future's contract and using that as collateral to prove you have dollars. or at least that is how I think it would work. The Eurodollar system was somewhere in the range of 13 Trillion in size as of 2016, but is really unmeasured. If a contract that might cost 1K in USD creates 1 M in assets, is that money creation? Jeff Snider seems to say banks do create money and implies that the Eurodollar system is bank controlled. Throw in Werner's "banks create money" and it doubly sounds like money creation.
Then we have derivatives, basically a bet on an underlying asset. The thing is, these bets create liabilities that may be unlimited. For example, in 2018 more than 5 trillion in SP500 'shares' were handled by derivatives (See https://www.sec.gov/files/Analysis_of_P ... Pilots.pdf Search for "Table 1"). Based upon my brief analysis, this likely doesn't include future markets nor derivatives around ETFs based upon SP500. The end of 2018 Market cap for the SP500 was 22 T, making derativies 1/4th the size of the market. I have heard some say it is as big as the market at this point. I captured that data to run a thought experiment. What if I took 1 Trillion and put it into an ATM call option of a stock valued at 10 dollars, which for each call, I paid 2 dollars. The stock doubles in value at my call's expiration. One of a few things might happen:
- I make 20-12=8*1 Trillion or 8 T in cash if cash settled.
- I gain 8 T worth of shares.
- There are not enough shares (say the stock only had a market cap of .5 T after the pop) or cash and my counterparty blows up.
In effect, I used leverage to make money. My question is, where did the cash from the other side of the trade come from if the market maker chose to take on the trade themselves? Yes, I know they buy shares as a hedge to be delta neutral, but how are they getting the cash to buy the shares? Are they doing it via rehypothecation? If so, where are those entities getting the cash?
I feel like I have a sense of different bits of the elephant, but no idea that it is an elephant. Finally, returning back to the federal reserve at the start, even if what they are doing is money printing, does it matter if they are just one of many mechanisms that is ill defined, ill regulated and ill measured? It seems that the system isn't legible or even understandable. It seems absurd that Werner had to do so many crazy steps just to determine where money comes from, and even now I'm suspicious it is only one of a multitude of ways and it may vary by country. So let me repeat my questions and clarify them.
What I'm trying to learn
What actually is money? How is money created? Who can create money and during what circumstances? In asking these, I'm not really looking for subway tokens and gold style answers, I'm trying to understand what ultimately has direct relationship to our financialized system and largely what money looks like from those in high finance not the plebs on the street. In some sense, I'm trying to understand where does leverage come from? What allows leverage to be created and where does the cash that is put into the loans to generate the leverage get conjured from? In other words, if you are levered 30 to 1, who is the sucker who gave you that multiple of your cash and where did they get that cash from? If the creditor of that leverage got it from loans, where did they get the cash from? And so on. Any pointers, theories, videos or books are welcome on the subject.
I've been trying to wrap my head around the topic of currency and/or money recently. This is my 3 corners, hoping someone will give me the 4th. Unless relevant, I want to set aside the distinction of 'gold is money and fiat is currency' as I'm not trying to say what a good system is or trying to do historic analysis. If I say money or currency, I mean the same thing, fiat based numbers that people perceive as being valuable.
I've been reading Richard Werner's work on the creation of currency and been thinking a lot about inflation. One of the claims is that the Federal Reserve has created some large % of all money that has ever existed and I'm starting to wonder about that story. Let's set that aside for a minute and go back to Werner's 3 types of banking systems, at least as I understand them:
- Banks can only loan out deposits. There is no created money via banks. Money is created elsewhere.
- Banks can't create money, but the banking system can. This is caused by the fact that one man's assets are another man's liabilities. The fact that each bank can lend out x% of their savings creates money because each time someone lends the money the money comes back as savings from another individual, allowing the bank to re-lend the money, not knowing it was previously lent out.
- Banks create credit. As I understand it, this would be sort of like super-fiat in that it isn't even dollars but rather numbers on a ledger, handed from one bank to another. From our point of view, it looks like money, but it isn't or is it?
Werner claims in his study he found that the 3rd option is what he observed in a bank transaction under the hood.
So my first question as a reaction to this is, what actually is money? How is money created? Who can create money and during what circumstances?
Before anyone answers, I want to put some thoughts on some techniques that might either be money or ways to create money. These are the concepts of derivatives, rehypothecation and subway tokens...er... bank reserves.
Regarding money creation, some point to the federal reserve, using the open market to buy treasuries off of other entities, which puts new, previously non-existent money into the system. Then there is the US Treasury which creates bonds in the first place and sells them into the market. I recall watching Warren Mosler, father of MMT insist that the government must spend first then tax or else money could not exist. One form of this was Mosler describing the currency as subway tokens, which the issuer creates the tokens and "spends" them by selling rides first before collecting them for fairs. I don't know the mechanism he assumes the gov't creates the money from.
As I understand it, hypothecation is where some entity provides something of value or asset for cash. The asset is known as "collateral" in the jargon. The most obvious sort of example is a bank loan used to buy a house where the house is used as collateral. Rehypothecation is where the collateral is traded hands multiple times, each time the entity handing off the collateral getting cash. One problem is that an intermediary who once held the collateral might go bust and creditors might go after that asset. Why? Because you can do this off balance sheet, meaning the asset shows up on multiple balance sheets. That in a sense also appears to be creating money, which can in effect create money for even the hardest of assets.
In other versions of this, you might take out Eurodollar loans by buying a future's contract and using that as collateral to prove you have dollars. or at least that is how I think it would work. The Eurodollar system was somewhere in the range of 13 Trillion in size as of 2016, but is really unmeasured. If a contract that might cost 1K in USD creates 1 M in assets, is that money creation? Jeff Snider seems to say banks do create money and implies that the Eurodollar system is bank controlled. Throw in Werner's "banks create money" and it doubly sounds like money creation.
Then we have derivatives, basically a bet on an underlying asset. The thing is, these bets create liabilities that may be unlimited. For example, in 2018 more than 5 trillion in SP500 'shares' were handled by derivatives (See https://www.sec.gov/files/Analysis_of_P ... Pilots.pdf Search for "Table 1"). Based upon my brief analysis, this likely doesn't include future markets nor derivatives around ETFs based upon SP500. The end of 2018 Market cap for the SP500 was 22 T, making derativies 1/4th the size of the market. I have heard some say it is as big as the market at this point. I captured that data to run a thought experiment. What if I took 1 Trillion and put it into an ATM call option of a stock valued at 10 dollars, which for each call, I paid 2 dollars. The stock doubles in value at my call's expiration. One of a few things might happen:
- I make 20-12=8*1 Trillion or 8 T in cash if cash settled.
- I gain 8 T worth of shares.
- There are not enough shares (say the stock only had a market cap of .5 T after the pop) or cash and my counterparty blows up.
In effect, I used leverage to make money. My question is, where did the cash from the other side of the trade come from if the market maker chose to take on the trade themselves? Yes, I know they buy shares as a hedge to be delta neutral, but how are they getting the cash to buy the shares? Are they doing it via rehypothecation? If so, where are those entities getting the cash?
I feel like I have a sense of different bits of the elephant, but no idea that it is an elephant. Finally, returning back to the federal reserve at the start, even if what they are doing is money printing, does it matter if they are just one of many mechanisms that is ill defined, ill regulated and ill measured? It seems that the system isn't legible or even understandable. It seems absurd that Werner had to do so many crazy steps just to determine where money comes from, and even now I'm suspicious it is only one of a multitude of ways and it may vary by country. So let me repeat my questions and clarify them.
What I'm trying to learn
What actually is money? How is money created? Who can create money and during what circumstances? In asking these, I'm not really looking for subway tokens and gold style answers, I'm trying to understand what ultimately has direct relationship to our financialized system and largely what money looks like from those in high finance not the plebs on the street. In some sense, I'm trying to understand where does leverage come from? What allows leverage to be created and where does the cash that is put into the loans to generate the leverage get conjured from? In other words, if you are levered 30 to 1, who is the sucker who gave you that multiple of your cash and where did they get that cash from? If the creditor of that leverage got it from loans, where did they get the cash from? And so on. Any pointers, theories, videos or books are welcome on the subject.