Data Inspired Insights

Tag: monetary policy

4 Reasons Fiat Money is a Great Idea and One Catch

In the world of economics and finance there are many complex topics that are poorly understood in the wider community. Differential calculus, options trading and multiple regression to take three examples. However, money and the monetary system is another topic I would quickly add to this list. The difference when it comes to money, however, is the number of people who believe they do understand the system. This leads to a range of misunderstandings including:

  1. Money in modern economies is still exchangeable for gold
  2. Printing of money will always lead to high levels of inflation
  3. Balancing a household budget is a suitable analogy for balancing the budget of a Government
  4. Paper money is worthless and doomed to fail

There is a lot of myths to dispel in that list. In this article we are going to tackle the question of why money works, even when not tied to a physical commodity (known as “fiat money”[1]). To do this, let’s start by imagining a world where there is no money. Instead of paying for things for money, everyone now has to barter for goods. What issues would people have in this system?

1. Coincidence of Wants

In a world where everyone has to barter to exchange goods, the first problem you are likely to encounter is described as the coincidence of wants. Imagine you are a pig farmer and, sick of eating pork for every meal (hard to imagine I know), you decide you would like to trade a pig for some wheat. The first hurdle is finding a wheat farmer who actually wants a pig. This is the coincidence – that you have pigs and want wheat, and that someone else has wheat and wants pigs and that both these wants occur at the same time.

Even in a simple agrarian village with only a limited number of food related products, you can already see the difficulties that will arise. Wheat is only available at certain times of the year and that will not coincide with the production of many other products. Some people may simply not like certain products, making it difficult for people producing those products to do any trading with them.

Introducing money into this scenario cleanly solves this problem by providing something to trade for what everybody wants at any given time.

2. Divisibility of Money

The second major problem in a barter system is the indivisibility of goods. Let’s go back to the pig farmer example and imagine again you want to trade pig for wheat. Assuming we find someone who wants to trade with us, how much of each do we actually trade? A pig is probably worth quite a large quantity of wheat, so what do I do if I only want a little bit of wheat? I’d have to kill my pig, give some of it to the wheat farmer, then hope I could find someone to buy the other parts of my pig. What about people producing even larger goods that can’t be sold in parts at all, such as a horse trainer or a house builder? They would constantly be forced to trade their goods for huge quantities of other goods.

Money solves this problem because it has the property of divisibility. I can sell a pig for $100, then split that money up to buy as many different types of goods as I want.

3. A Store of Value

The third problem in our moneyless world is that many of the goods we trade have limited lifespans. As a wheat farmer, if I have a good year and have extra wheat, what can I do with my extra wheat? I need to trade it for something or it will go off and be wasted.

In the past, this was such a problem, nearly every culture developed ways to preserve seasonal produce. Think about how many cultures have cured meats (prosciutto, jerky, spec), preserved fish (bacalao, pickled herring), pickled vegetables (cucumbers, onions, beans, peppers, achar) and fruit preserves and jams. Many of the most popular foods today were developed largely as a way to store produce over extended time periods in the days before freezers and refrigeration.

Although money doesn’t stop food spoiling, it does allow a farmer to sell off their seasonal produce for something that does not need to be preserved. That money can then be spent as needed in the future to purchase other goods. In the simple world of our example, that may simply mean buying preserved goods during the winter to survive until the next season. In a more complicated world it helps us do many things including to save for more expensive purchases such as a TV, a car, a house or our retirement.

4. Practicality

Continuing to build on the farming example, let’s imagine that the people of this particular farming village are trying to decide on a given (non-money) product that will become the unit of trade for everyone. Keeping in mind the points above, what would be the best options?

It would need to be something that could be easily divisible, which rules out livestock and any large objects such as furniture, tractors, houses and so on. It has to be something that doesn’t go off or require preservation, which rules out vegetables, fruits, grains and so on. What if they decided to use something that met these basic conditions like salt or honey?

Here we run into another issue that is neatly solved by money – practicality. Even trading in a commodity such as salt or honey would face a number of hurdles:

  1. Every transaction would need to be weighed or measured out to ensure the quantity exchanged is correct
  2. People would have to carry around honey or salt to complete transactions, and for large transactions, that could be a significant burden
  3. There would need to be some measure of the quality of the commodity being traded. How pure is the honey or salt? Do salts from certain places carry more value? Has the honey been diluted?
  4. People would have to find ways to store large amounts of these commodities in a such a way that they are safe and don’t get stolen, eaten or washed away

Problems 3 and 4 could be alleviated by some third party fulfilling the role of a salt or honey bank. This bank could verify the quality of the commodity and store large quantities of these commodities on behalf of their customers (for a small fee of course). It could even provide facilities allowing customers to access their deposits. This could be done by allowing access to the commodity itself, or by issuing some sort of official document or paper that the holder could bring to the bank to exchange for the commodity (it’s starting to sound pretty close to money at this point right?). But even in this case, the commodity would still need to be stored somewhere physically.

All these concerns are things we don’t have to worry about in a world with money. Notes and coins are extremely portable, meaning people can carry even very large amounts in small leather foldy things (let’s call them “wallets”). They come in predefined amounts which mean they don’t have to be measured out and quantities can be quickly verified. Finally, in a fiat money system, the vast majority of money doesn’t need to be physically stored, it is stored as numbers in a bank account.

The Catch

The catch in a fiat monetary system is that it is essentially a system built on mutual trust. For me to accept money as payment for goods I am selling or services I am providing, I must believe that I will be able to trade that money for goods and services, of approximately the same value, in the future. The person I purchase those goods or services from, in turn, must also believe the same thing, and so on down the line. If, at any given point, people in general stopped believing money would be able to be traded for goods or services in the future, the fiat money system would collapse very quickly.

We can see some examples of this in the real world in countries where hyperinflation and/or currency controls have occurred. In most cases, the local currency often becomes close to worthless as people substitute to either a more stable currency (typically the US dollar) or hard commodities. Luckily, these occurrences have usually been limited to small and poorly run economies and have not seriously impacted the legitimacy of the fiat money system overall.

What would happen if the population of a major developed economy stopped believing their currency would be accepted in the future? At that stage all bets are off. There is a substantial community of people that does have this concern, and are preparing for this scenario by buying hard commodities such as precious metals. But realistically, they should also be buying guns, canned food and digging a shelter in the backyard, because a failure of the monetary system would be a complete catastrophe.

Overall

Looking at the above points, we can see there are a large number of advantages to fiat money. Many of the transactions we undertake every day would become extremely burdensome in the absence of money. A lot of larger business transactions would be impossible in a barter system. Although money introduces some its own complications, it is hard to argue that the world would be anywhere near as complex or advanced if we had persisted with a barter system or a commodity based trade system.

Money in Three Charts

To finish off, let’s take a look at some stats on the values and volume of currency on issue for the worlds reserve currency, the US dollar. All the underlying data and more is available at the Federal Reserve website for those interested. I’m trying out some new interactive charts so please click, play and let me know what you think!

Chart 1 – Value of US Currency in Circulation by Denomination

Chart 2 – Volume of US Currency in Circulation by Denomination

Chart 3 – Comparison of Different Measures of Money Supply

For those that are unfamiliar, there are different ways of measuring the total money supply. The following chart compares 3 different measures – M1 money supply, M2 money supply and cash. This data is from the Federal Reserve of St. Louis website.

[1] Fiat money is money that derives it value only from Government rule or regulation. This is as opposed to commodity or representative money which is tied to the value of an underlying commodity.

Australian Housing Bubble – Further Reading

Over the past 2-3 months, the mainstream media coverage of housing prices in Australia has exploded. Every commentator appears to have had a piece on this topic and was waiting for the right time to publish it. That right time is apparently now. For those interested in additional reading on this topic, here are some of the better pieces I’ve come across:

The banks and real estate: a Ponzi scheme that could ruin us? – Ian Verrender | ABC News

The housing crash we had to have: A Gen Y perspective on the bubble – Matt Ellis | Rational Radical

Another interest rate cut will fuel a housing bubble in danger of bursting – Greg Jericho | The Guardian

It’s not Hockey’s job comment that should worry us most – Michael Janda | ABC News

Blowing bubbles: the tricky task of tackling Sydney’s property market – Amy Auster | The Conversation

4 charts of the ‘largest housing bubble on record’ – Wolf Richter | Wolf Street

The Sydney housing bubble to pop – but how? – Michael Pascoe | The SMH

The mother of all housing bubbles – Chris Joye | The Australian Financial Review

Why the RBA doesn’t want to cut rates

The first Tuesday of the month is interest rate day in Australia, the day the Reserve Bank of Australia – the Australian equivalent of the Federal Reserve – announces any changes to the official cash rate. The decision for June was to leave interest rates on hold at 2.0%.

In a situation that will feel relatively alien to readers in the US, Australian interest rates have never really been close to 0, but have been falling since late 2011 (see Chart 1).

Chart 1 – Australian Cash Rate vs. US Federal Funds Rate

RBA_chart_1_1

What has been leading to falling rates in Australia over a period where the US has been slowly recovering and the Fed Reserve is slowly edging back to normalizing interest rate policy? As is usually the case, a mix of factors are involved.

Iron Ore and Coal Prices Return to Earth

A story that most people outside Australia have at least heard about is the large mining boom Australia has been enjoying over the past decade or so, and that it was largely driven by demand from China. What they may not know is that this mining boom has been largely driven by just two commodities (well technically three) – iron ore and coal (two types of coal – thermal and metallurgical). Chart 2 shows the prices of iron ore and thermal coal[1] in AUD/tonne since the 1995.

Chart 2 – Iron Ore and Thermal Coal Prices 1995 to Present

RBA_chart_1_2

From this chart, we can clearly see the huge increase in prices that boosted the Australian economy. This was particularly pronounced for iron ore which went from between AU$16-AU$17 a tonne for most of the 90s to over AU$180 a tonne in 2010 and 2011.

Aside from generating huge profits for anyone who happened to own a coal or iron ore mine, what this price rise also led to was a large amount of employment in areas that weren’t just digging up the commodities themselves. This included:

  • Exploration of possible new mining sites – at AU$180 a tonne everyone wanted an iron ore mine
  • Building infrastructure that facilitated the large-scale digging up and exportation of these commodities – ports needed to be built and/or expanded, mining pits dug, roads paved and so on
  • Providing services to mining companies – lawyers, accounts, caterers and so on

After peaking in 2010/11 though, things started to go into reverse. By late 2013, much of the investment in infrastructure had run its course and the people who were employed to build that infrastructure were no longer needed. Prices were falling, bringing into question the viability of a lot of higher cost mines (and the mining companies running these mines) set up during the boom period. In short, a lot of people formerly employed on mine sites or in mining services roles were finding themselves looking for a new job and the rest of the economy was (and still is) struggling to pick up the slack. This in part is because of the …

High Exchange Rate

For those that haven’t decided to brave the 20+ hours of flight time to visit Australia in the recent past, Australia has become an extraordinarily expensive place. Sydney and Melbourne have been consistent fixtures in the world’s most expensive cities to live lists over the past 10 years.

Most of this was driven by a very strong Australian dollar, which was in turn driven mostly by the mining boom. In addition to buyers of commodities needing Australian dollars to buy the products they wanted, Australia became the target of a large volume of carry trade with currency traders looking for a relatively stable economy to park money at a relatively high interest rate. As a result of this, at the height of the mining boom, the AUD was buying almost $1.10USD.

Since that peak, the Australian dollar has depreciated around 30% (see Chart 3), easing a lot of the price pressure. However, as of 2015, Sydney and Melbourne still rank 5th and 6th on the world’s most expensive city list, as provided by the Economist Intelligence Unit’s (EIU) bi-annual Worldwide Cost of Living report.

Chart 3 – AUD/USD Exchange Rate 1995 to Present

RBA_chart_1_3

The RBA has publically been stating that they believe the value of the Australian dollar is too high in an attempt to talk down the value of the Australian dollar (often called ‘jawboning’) and provide a boost to the non-mining sectors of the Australian economy. They have also progressively lowered the cash rate from 4.75% in 2011 to 2.0% today, in an attempt to stem the carry trade. As we have seen, to some degree they have been successful, but the exchange rate is still higher than they (and many other commentators) believe is optimal.

Unfortunately, some bumbling on the part of the RBA (or the execution of a plan that no one else understands) has blunted some of their efforts. At the previous monetary policy meeting at the start of May, the RBA lowered the official cash rate from 2.25% to 2.0%, but removed any talk of further cuts from the publically released meeting minutes (removing the “easing bias”). Doing this then had the opposite of the desired result and caused a spike in the Australian dollar.

Chart 4 – Consumer price index; year-ended change 2000 to 2015

RBA_chart_1_4

So why are they removing the easing bias? Why don’t they just slash rates further – after all inflation is running below the target band (see Chart 4)? The problem is they are worried about the…

Bubble in House Prices

The RBAs hesitancy to cut interest rates further is mostly due to a concern about further encouraging investment in housing and contributing to rising house prices, which look to be well into bubble territory.

For those that aren’t too familiar with Australia, particularly the modern, post ‘put-another-shrimp-on-the-Barbie’, Australia, being a property tycoon has become something of a national obsession. Home renovation shows are everywhere and are getting huge ratings. Morning news regularly holds interviews with the latest property ‘success story’.

This obsession has led to Australia becoming a world-beater when it comes to levels of household debt. The Australian Bureau of Statistics (ABS) produced a great series of charts in May 2014 showing some alarming statistics. See below for some of the highlights:

Chart 5 – Household Debt vs. Annual Income[2] in Australia 1987 to 2013

RBA_chart_1_5

Charts 6 and 7 – Household Debt vs. Annual Income – Various Countries 2001 to 2013

RBA_chart_1_6

RBA_chart_1_7

After 20 years of Australians continually buying properties off each other for ever-increasing prices, funded mostly by increasing level of mortgage debt, something changed. Perhaps it was the median house price in Sydney soaring past AU$900,000 (approximately US$700,000 at today’s exchange rate). What ever triggered it, in recent months, the talk in Australia has become all about a bubble in house prices, particularly in Sydney and parts of Melbourne. The Secretary of the Department of the Treasury, John Fraser, recently became the latest high profile public figure to weigh in:

“When you look at the housing price bubble evidence, it’s unequivocally the case in Sydney, unequivocal,”

More over, he drew a direct link between high house prices and low interest rates:

“It does worry me that the historically-low level of interest rates are encouraging people to perhaps over-invest in housing,”

And there is plenty of evidence to support the notion that the rise in housing prices is increasingly due to investors as opposed to owner-occupiers (see Chart 8).

Chart 8 – Investor Housing Credit as a Percentage of Total Housing Credit 1990 to 2014

RBA_chart_1_8

Meanwhile, belying the sparkling reputation the Australian Government has earned internationally in recent times[3], the Government has all but ruled out taking any meaningful action to reverse key policies that are currently encouraging investment in property – negative gearing and the capital gains tax concession being two of the main culprits. When asked in a recent session of question time by the leader of the Opposition Bill Shorten to respond to the comments from John Fraser, Prime Minister Tony Abbott responded as follows:

“As someone who, along with the bank, owns a house in Sydney I do hope our housing prices are increasing,”

Summing Up

All this leaves the RBA in quite a pickle. Relatively high interest rates (by the standards of developed nations internationally) continue to keep the exchange rate at higher than desired levels, which makes Australia an expensive place to do business. This in turn harms Australia’s two big non-commodity exports – higher education and tourism – just when they need to pick up the slack from a cooling mining sector. But lowering interest rates risks further fueling a bubble in house prices which the Government seems quite happy to ignore.

I don’t imagine there are too many people who would like to be in the shoes of RBA Governor Glenn Stevens right now.

Keep an eye on this space for further updates as this all unwinds.

 

[1] This is an example of that classic Australian trait – sarcasm

[2] Gross disposable household income received during the previous year.

[3] If anyone can find a good historical price series for metallurgical coal, I’d love to hear from you

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