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The question is often posed: “What is money?” How it is defined? What makes it well or ill-suited to its purpose? And most often, “How do you get a more of it?” Money is often defined among three uses: a medium of exchange, a unit of account, and a store of value.(1) It is argued that commodities are least accepted for daily actions, and are therefore no longer money, or that today’s fiat currencies are inflating regularly, and are not money as they have no store of value, but it’s the overlooked “Unit of Account” function that is the most critical to today’s financial world. “Unit of Account” sounds so actuarial—what exactly does it mean? Since double-entry accounting was developed in Venice in the 1200s,(2) the ability to measure one’s finances based on the “unit of account”—be it Deuchmarks or Ducats—has revolutionized capitalism. Göthe called it "one of the finest inventions of the human mind." Before then, accounting could be likened to an extended flea market, where one traded like for like: pepper for provender; silk for silver. You haggled for each item, weighing distance, speed, how well you knew or liked the person, and the odds of getting back from market unharmed. If you had a roll of silk, what was it worth? Before the standardization of double-entry accounting, that would depend a great deal. Given that you purchased it through people with whom you had personal relationships—a system of favors and preferences—it wasn’t easy to know what it was worth when purchased, or due to the dangers and variables at market, whether there was a “profit” when you sold. How can anyone know whether they are solvent or bankrupt under such conditions? Take “The Merchant of Venice.” In Shakespeare’s play, Antonio is a merchant—not surprisingly—of Venice. He is considered wealthy, however all his assets are tied up in shipping ventures along the Mediterranean. Here is our example of pre-“Unit of Account”: is he rich or poor? He has no money. There is no insurance because one can neither value the risk nor the present or potential value of his assets. Antonio cannot go to a bank, for without being able to value of his assets, his cash-flow, and his earnings, how could a bank extend a line of credit? He is overextended with friends and family and so borrows from a private lender named Shylock—from where we get the modern slang. As this lender has no insurance against Antonio’s default and Antonio’s assets are all at unknown risk, the terms are unusual. --A highly inefficient method of economic measure and transfer, later found to be equally complicated to resolve in the courts. Who benefits? This was life before double-entry accounting, and in countries such as India they still measure the economic frictions from the time spent haggling over daily purchases. Bargaining may be a social event but it also slows the velocity of money and complicates decisions on what one can expect to make. Imagine every person negotiating their own price at McDonald’s Drive-through: one bad negotiator could ruin the week! Would you hire professional negotiators who determine the daily solvency of your company from the local sophomore class? You can see that the more accurately and consistently valued goods are, the better and faster the economic decisions can be. This is what happened in Europe, slowly at first, but ever-faster after the Renaissance rules Shakespeare describes. Look at the commodity exchange and you know instantly the price of bacon, bauxite, or Thai Bhat. The volume and standardization allow for certain price-discovery not only now but far into the future. In a thousand tiny ways, this accuracy in mark-to-market advances the speed and efficiency of the whole system. People can buy equipment on loan, extend exact lines of credit, or get insurance for a Mediterranean cruise…even against Venetian pirates. In short, they have a detailed feedback mechanism that reports on just how good or bad each economic decision was. What is a “Unit of Account”? It is the most important aspect of money: it is INFORMATION. Money, in modern terms, is best not seen as a medium of exchange. Yes, people use Euros, Dollars, and so on, but today’s world is as likely to use a 30-day line of credit, an interest-rate swap derivative, or an international stock and bond portfolio. No THING is “exchanged”. Instead, data markers are moved through fiber-optic cables. Those markers are INFORMATION. Hard-money advocates point out that today’s currencies cannot be money because they have no inherent “value”. But this belies how easy it was to cut the gold backing and turn gold certificates into fiat currencies—on August 15, 1971 the gold standard ended and world didn’t notice.(3) Life went on as before. This is because the primary use of money is as an exchange of INFORMATION. It gives feedback to the capital system to tell economic actors if their daily decisions are working or not. The “store of value” function is unnecessary to accomplish one’s daily work. Or is it? The success of the Western Capitalism is based not so much on work or on resources—for the world is filled with hard-working people and resource-rich countries--but on removing economic frictions: the inefficiencies in the creation, delivery, and consumption of goods. If people know what materials are worth, how much it costs to move them, and how much the market will pay, they can PLAN, they can take on bigger projects, further ahead, with more certainty of success. Without a clear and honest price-discovery, secure into the future, the economy wouldn’t know what to make, where to send it, or whether people wanted the goods at all. Banks couldn’t lend with the best rate of interest and insurers couldn’t write policies that keep them both solvent and paying claims. People wouldn’t know how much they need to save--never knowing if their ship was sunk or would come in; if they were rich or poor—nor how much risk they could take. In short, we’d be in the 15th century. But today we live in a modern world where mark-to-market is a fact in excess of 4 decimal places. Money and the supporting financial instruments tirelessly circle the globe at the speed of light. Financial Clearing exceeded $1,000 Trillion in 2004, with a Global GDP of $40 Trillion dollars.(4) Double-entry has been the norm for 400 years, with the informational aspect of money in a digital world beyond dispute. What could possibly unseat such a giant? In a word: inflation. Ludwig von Mises wrote: "There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved." But why can’t booms go on forever? In a fiat world, why can’t credit and debt expansion continue forever as modestly as it has during the previous 95 years? Why not add ever-more zeroes? You sometimes hear the phrase “misallocation” or “malinvestment” of resources. And at all times and places, people make investments that don’t prosper. The Business Cycle and Kondratieff Wave suggests that these bad investments are made and go bad in seasons. But why? Are people somehow smarter at one time than another? Are they more blinded to risk? And how can the same miscalculations occur with such regularity for 500 years? If the errors last for so long, why do people come to their senses long after the previous ways were forgotten? Like an ecosystem, a monetary system is a balance between producers and consumers; between savers and borrowers; between workers and investors; between the financial sector and the productive sector. The Unit of Account function tells people how to keep that balance: what they should do, what they can afford, how much they should save, and how brave or cautious they should be. Is it worth going to work today? Can I afford breakfast? What’s the internal rate of return on a long-dated foreign bond and the cost of portfolio insurance at 4:13pm PST? To the economic system, these are all equal questions: where is the best place to apply one’s time, attention, and resources. Churchill said “Democracy is the worst form of government, but it's the best we've got.” Similarly, capitalism—trading--has failings as a system, but so far it’s the most spontaneous and efficient method of accomplishing the business of life. But how can inflation—adding money—upset this balance? Why should it matter how much money is in the system? Meet Magic MongoLet’s suppose Magic Mongo, the beach-hopping genie, distributes magic purses to his favorite group—the surfers. This purse has but one power: whatever money you put into it increases by 3.43%, the long-term rate of inflation, and this money doesn’t come from somewhere else, it’s created by magic.(5) Seems harmless enough. At first the new money sends price signals to the sandal and board manufacturers that there was extra demand. The price of sandals and boards rise followed by the price of tickets to Hawaii. Airlines buy planes to carry the added traffic, Boeing stock rises with airline parts manufacturers and employees of every knock-on industry back to the aluminum mine. With the money these Currency-Surfers add to the system they buy real estate in Maui and Australia. Their own inflated bidding collectively raises the price of their own houses, making them all rich. With the increases of their new Real Estate, Surfboard and Sandal businesses, they slowly become millionaires who can lobby Congress about the environmental and no-shirt, no-service rules. Lawmakers then give advantages to the surfing crowd that disadvantage other interests in the country and economy. Sound outrageous? Not at all. This is what goes on in banking and finance industry every day. But what’s the harm? It’s only 3.43%. None at first, and that’s the danger—economic structures are generationally slow to change. Let’s move forward 35 years—one half of the Kondratieff cycle.(6) Mongo Destroys the WorldAt this point, the Currency Surfers have held unfair advantage for almost two generations. Congressmen and lobbyists are now all Surfers and ex-Surfers. Their children are all millionaires who know each other from the beaches of the world. Associated groups like skaters and climbers have been pulled upward by association and owe their livelihoods to the Surfers. They have a similarity of beliefs and a unified surfing agenda. Everything they touch prospers and no one can remember a time when there was either work or risk. The 3.43% is compounding on billions now and has inflated this one sector of the economy while starving the others. Notice that although the money was created anew, due to the price signal it has the same effect as if it were stolen from the other sectors. Slowly the economy comes apart: the coasts are overbuilt while the houses and population of the heartland have collapsed. The farming, mining, manufacturing, and energy industries are in disarray from noninvestment. The price signals have told millions of people for dozens of years not to pay attention to food, water, or medicine; to roads, rails, ports, and pipes; to ignore the center and overbuild the coasts. It has told them not to work but to play. Not to save but to spend. It has diverted wages of manufacturers away from production and shuttered the plants. Productive people are not producing and what they are producing is of the wrong type for what is needful to the health of the economy and the world. And this is where we are today. The price signals for vital goods have been held too low too long, creating a myriad of weaknesses and inefficiencies in the supply chain. The 2,000-mile Caesar salad and the globe-circling PC manufacture are but two examples of inefficient dislocation from chronically bent price signals. Marginal industries like financial clearing are at a ratio of $1,000Trillion churn to $40Trillion use or 25 times the true need.(5) Derivative turnover is $1,400Trillion or 35 times the total production of the world in a year(8). This follows the number, salaries, and influence of the people in those industries. It’s not to say these occupations are not important: they’re simply OUT OF BALANCE. And the small but constant wrong signal of inflation that has made it that way. The primary value of money is INFORMATION. It’s a LANGUAGE, a means of honest communication among men. Inflation, in all places and to all men, introduces a secret lie into that honest exchange. They misunderstand each other. Slowly and surely cooperation degrades over time until nothing can be accomplished efficiently. People cannot get what they need to live but they don’t know why. The former things—savings, hard work, planning—stop working. People begin to fight over the misunderstandings. With no way to predict the future, they live for the moment and turn to gambling, drugs and pleasure. With increasing desperation but no means of helping themselves, they turn to theft and violence on a personal and national scale. Hemingway said, “The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.” Eventually—as took 70 years in Russia but only 4 years in Weimar Germany--the inefficiencies bring the economy to a virtual halt. Cooperation ends and with it, the conditions of the 15th century begin: war, poverty, uncertainty, and the free-currency trade we call the black market. Factories go idle while people need goods. People starve with full granaries and turn to strongmen like Napoleon or Hitler who strike out at other groups, other countries, looking to cure a disorder that is in themselves. And this is the true tragedy of inflation. For what was it caused by? A misunderstanding of only 3.43%, introduced through the whole system. The universal language of commerce carrying a small but hidden lie. When the lie becomes too burdensome and the language no longer functions, the people stop using the currency and it vanishes. This is a hyperinflation and it has little to do with ledgers or with zeroes. People then move to a sounder medium of exchange and a more honest means of communication. This process of reconstructing the disordered economy may be called a “Depression” or “Recession”, but with new stability and honest price signals, the economy regains the ability to plan and specialize and again begins to prosper on the efficiencies of cooperation and planning—until the next time. THIS is why one cannot inflate forever, adding more debt and more zeroes. While it’s mathematically possible, the real economy becomes so unhealthy it can no longer support the ledgers—or the people. Remember the story of the 7-foot chopsticks?(8) Instead of a palace of cooperation we create a Tower of Babel. What is that dollar you pay out at the counter? What is money? It’s an informational storage device that marks how much work you’ve done, how much value you’ve provided and therefore how much you are entitled to take back out—or it should be. Inflation bends this signal in favor of the first-holders and that is why it is theft. It is also why a firm basis for money is essential—it prevents this theft, yes, but more importantly it keeps the price signals true which keeps the real economy functioning as efficiently as it can. Will Rodgers said, “If you find you’re in a hole, stop digging” –Or better, “If you don’t want a hole, don’t start digging one.” Because there IS no means of avoiding the final collapse of a boom brought about by credit expansion. At this time, however, inflation is already a reality throughout the world. Monetary inflation rates are listed as: Australia 11.2%, Britain 14.2%, Canada 8.6%, China 16.9%, Russia, up to 48%, Sweden 10.6%, and the US, estimated at 11% and rising.(8) Malinvestments abound in the US and the world. I read recently that there are 4 levels:
Of the Philosophical level Buffett has said, "In the short term the market is a popularity contest; in the long term it is a weighing machine" --for tactically and strategically, the popularity of market malinvestments can persist a long time. On the evolutionary level, the deadly potential of modern war may demand we develop a more certain means of cooperation than the price signal. In investing, the malinvestment is the underlying inefficiency that creates the opportunity. It means that part of the economy—the business of creating and providing—needs attention. By focusing our resources on it, we help put this neglected sector back in order. In doing so, the sector will provide useful service to fellow men and our investment will eventually become correctly valued. In the short term there is money to be made in all sectors, but why fight the trend? Take the tech boom: in ’94 people needed network equipment to get connected while in ’99 there were too much equipment despite that their stocks were high and still rising. Watching the economic need and not the stock price would have helped you move away from an overbuilt part of the economy and into a neglected one like food, water, or infrastructure. You may notice that over the long term the moral path of helping others is also the surer and more profitable one. Thinking of money primarily as information gives a more valuable thing: perspective. In trading, when we are successful, it’s not a random prize like a lottery: it’s a signal that what you’re doing is correct, that what caused you to take that position is true.(10) The market is TALKING to you using the language of commerce. When you “win”, it is telling you, “yes, this sector needs your attention, people need the goods you are providing.” When you “lose”, the market is saying, “No thank you, this sector, this company, does NOT need attention right now, please look elsewhere.” You bought information. You’re in a dialogue. If you take the lesson quickly and hear clearly, your actions will be much more accurate and help the economy that much more. For traders, that means more profitable trades with less time lost. In the larger view, this helps the economy function smoothly, and thus help people get the things they most want and to cooperate and prosper together. And isn’t that what we’re here for?
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