Imagine you're in Starbucks buying your café latte. As you hand over your coins, the barista tells you the money you're giving him is unacceptable. What do you do? You might politely point out that your coins are universally exchangeable, and thus he is a fool to refuse your attempted payment. If that fails, you might resort to some good old-fashioned Anglo-Saxon phraseology. If you're in a particularly aggressive mood, you might lean across the counter, grab the barista by his apron strings and nut him.
If, though, you were an economist, you might gently remind the barista that your coins are backed by the Bank of England. They will always, therefore, be acceptable because the Bank of England, through its inflation target, has made a public commitment to safeguarding the value of money.
This is true, but only up to a point. Notes and coins are generally acceptable unless there's either an enormous counterfeiting problem or a major difficulty with inflation.
In the Weimar Republic, under the twin strains of reparations and macroeconomic incompetence, inflation swiftly became hyperinflation and people had to wheel their near-worthless notes and coins around in wheelbarrows.
In some parts of Germany, notes and coins were replaced by other currencies. Cigarettes, for example, became increasingly acceptable as a means of exchange. Cigarettes, though, were not produced by the central bank, nor were they in any sense normal "money". They were good enough, though, to serve as both a medium of exchange and, within limits, a store of value, and therefore they had, for a while, the properties we commonly associate with money.
This little story should be enough to convince you that money can exist independently of central banks, an observation that sometimes seems to be forgotten. It's easy to prove historically, of course, because we know of societies whose monies ranged from shells to jewellery to animal teeth. But it's also the case that money today can easily be created – and destroyed – without the involvement of the central banks and their printing presses.
In the UK, for example, the value of notes and coins in circulation is a little short of £50bn whereas M4 – a broad measure of money supply which includes all sorts of interest-bearing deposits – is well over £1trn.
Economics textbooks try to tie these narrow and broad definitions of money together using the so-called deposit multiplier. The attraction of this device is its arithmetical elegance. Sadly, though, it's not connected with reality. But the idea behind the deposit multiplier,is straightforward and does demonstrate something about the creation of money at the stroke of a pen (or, these days, at the touch of a keyboard).
Suppose I walk into a bank with a suitcase of money. Assuming that the bank has no suspicions about money laundering, its manager will take my money and perhaps put it on deposit. The bank then loans 60 per cent of my money to another customer by creating a deposit in that customer's name. The customer then spends some of his money which then is deposited by the recipient in another bank which can now also create new loans. It's not long before the value of deposits far outstrips the amount of notes and coins in circulation. Put another way, if everyone simultaneously tried to withdraw funds from banks, the system would topple over. There simply aren't enough notes and coins to go round.
So how does the system work? Ultimately, it works through trust. We trust banks to look after our money to ensure that we will always be able to get access to our funds on demand.
So long as we don't all demand access to our funds at the same time, the system works well. If, though, there's a panic, and everyone wants their money at once, all sorts of horrible things can happen as the depositors and now the shareholders of Northern Rock have discovered.
In a modern banking system, money is created via collateral. When you go to your bank to ask for a top up mortgage to fund next year's holiday, the friendly manager may give you a loan but the loan, in turn, has been secured on the value of your house. Imagine you bought your house five years ago on a 100 per cent mortgage. In the intervening period, perhaps the value of your house has doubled. Now with only a 50 per cent mortgage, the bank may feel more confident lending you the money. When house prices rise, money is created. When house prices fall, driving down the collateral against which loans are made, money is destroyed. Loans are called in, credit lines are shut off, and monetary conditions tighten up.
Within the banking system, the collateral value against which loans are made was rising rapidly earlier in the decade. Much of this collateral was tied up in products which, now, have turned sour. Up until the summer, most banks were happy to accept as collateral the full range of increasingly exotic products ultimately linked, at least in part, to the now rapidly deteriorating US housing market.
Now, though, mortgage-backed securities, asset- backed collateralised debt obligations and the full paraphernalia of structured products are no longer regarded as safe collateral. In many cases, there is no longer a market price.
In the absence of collateral and, hence, in the absence of money creation, there's a perceived shortage of money. And, with a shortage of money, banks hoard whatever money they can get their hands on. Each bank eyes other banks warily. Banks will still lend to each other, but only at penalty rates. As a result, interbank rates remain well above official interest rates in the US, UK and eurozone (it's also why banks are now offering higher deposit rates – your bank needs your money.)
The effects of this monetary "shortage" are already seeping out into the broader economy. One way this is visible is through the financial market reaction to the US interest rate cuts seen so far. Outside the housing market, there's not much sign of the US economy weakening at the moment.
One might have thought, therefore, that rate cuts would be greeted well by equity investors (lower rates are good for growth) and not so well by government bond investors (in the absence of economic weakness, lower rates might lead to inflationary risks).
And, for a fleeting moment, that's exactly what happened. Following the Federal Reserve's decisions to cut policy rates in August and September, equities rallied and bonds sold off. But the initial reaction didn't last. More recently, equity prices have plunged to levels last seen before the initial rate cuts while bonds have shown an explosive rally, with yields dropping like a stone.
Why is this? Basically, any asset that looks a bit like money has become very attractive. Ten-year government bonds aren't entirely like money – try buying your café latte with one of those – but they're a lot closer to money than equities, which ultimately give you exposure to only one company at a time.
The hoarding of money – and near-money substitutes – points to a banking system in crisis. Central banks may still be hopeful that 2008 will be a reasonable year for economic growth. If, though, there's any hope of achieving a reasonable outcome, our policymakers will have to work a lot harder to get the monetary system working again, whether through rate cuts or through an increase in acceptable assets against which central banks can supply money to the banking system as a whole.
Money is, after all, the lubricant that allows our modern economic systems to function. Without it, our economies will simply grind to a halt.
Stephen King is managing director of economics at HSBCReuse content