Atanu Dey On India's Development

Can Money Simply Disappear?

In a recent comment Ashutoshg says:

You might have heard about 7bn$ fraud at Societe Generale in France. As news says, The guy who is responsible didn’t got rich because of the fraud. He just traded badly. Bank lost it and that guy didn’t make it then, where did this money go? Who got rich? Can money just disappear? Please explain.

Indeed, money can simply disappear without a trace. But first, let me tell you a story.

Once upon a time, an Englishman used to visit a certain little island for his annual vacations. The island was a little economy chugging along fine with its own currency, a bit of domestic production, a little bit of foreign trade and a bit of this that and the other. The Englishman would go there, enjoy the sun and sand, spend some of his money and return home refreshed.

One year he did not carry sufficient cash for his needs and ended up paying his hotel bills with a check from his checking account which he held in London. As he was a regular visitor with a reputation for paying his bills, the hotel accepted his check. But instead of submitting the check to a bank on the island, the hotel management used the check as part payment for their grocery bill. The grocer, in turn, used the check to settle his shop rent. The landlord later used the check to pay for some renovations on his property. Months went by while the check circulated among the islanders, and the check was never presented to the London bank for settlement. The Englishman’s checking account balance was never debited by the amount on that check.

The question is: who paid for the Englishman’s hotel stay?

The answer, you might have guessed, is that potentially everybody on that island paid for it. The Englishman by writing that check simply added to the money supply of the island economy. Assuming that the Englishman’s vacation did not increase the total amount of goods and services produced in the economy–that is, he merely consumed a part of the total production which would have anyway occurred regardless of his presence–then his increasing the money supply in effect caused a bit of inflation in the economy. Which means that others’ money after the check went into circulation would buy a fractionally smaller amount of goods and services than before. The Englishman created money out of the blue.

The fact that money can be created out of the blue by simply scribbling something on a piece of paper is important in understanding that money is not a real thing. More accurately, fiat money is not a real thing at all, as opposed to commodity money which is. If you use say pieces of gold as money, it cannot be created or destroyed–it can only be transformed. Stuff is real but money that we normally use is not. It is either pieces of paper or simply digital bits in some computer memory.

Money is one of the most ingenious creations of human creativity. It is a way of keeping an account of who owns what. For that, first there have to be stuff that can be owned. So the stuff that you can own is the real stuff and money just keeps track of who has claims on that stuff. So if there is no stuff, money is worthless. On a deserted island with no stuff on it, sacks of money would be less useful than some stuff that you can use.

The stock market illustrates the idea of money quite well. You buy a share of some stock from me for Rs 100. I spend that Rs 100 to have a meal. Now you have claims to a share of the profits of the firm whose stock you own. Now if the share price increases on the prospects of the firm’s increased profits, and the shares are trading at Rs 120 say, then you of course have the chance of selling your share for a profit of Rs 20. However, there’s another effect. Suppose the firm had 1000 outstanding shares, when the share price moves from Rs 100 to Rs 120, the market capitalization of the firm goes up from Rs 100,000 to Rs 120,000. Suddenly it is as if Rs 20,000 of money was created. It does not mean that someone actually paid Rs 120,000 for all the shares of the company. Some people may have bought and sold shares of that company over a wide range of share prices. Those 1000 shares may have been purchased for much less than Rs 120,000. But just as money magically increases with the rise of the share price, it can equally magically disappear. So if on the news that another company is producing a better gizmo, the shares price of the firm falls, then the valuation disappears–not the firm’s factories or its inventory. Stuff is real, the share price and valuation is only nominal.

So it is that on the aggregate there are no gains when the bank lost $7 billion because on the aggregate no one really lost any stuff. What happened is the distribution of the claims on goods and services merely got reallocated.

Money is magical stuff. That is why people want more of it.

  • amar

    Atanu,

    Does this make money mithya or maya? Something with a transient/ephermeal level of existence?

    Money is something that has lesser level of existence than “real items” (quantities that money can be used to buy).

    The above reasoning does not make money something that is not non-existent, as a hare’s horn. A hare’s horn is never existent (and never will be), but there was a time when some existence can be attributed to money.

    Thanks,

  • http://sudiptachatterjee.blogspot.com sudipta

    Lovely analysis, Atanu. Thanks for clearing so much up. A couple of nights ago three of us room-mates were having a heated discussion about the effect of the introduction of loyalty bucks (on a card) by some organizations (such as our university) which allow you a discount on the regular price if you use their card. The discussion went nowhere because one of my roomies was convinced that it was criminal and was adversely affecting the economy: claiming that money was being “created” due to this. I have sent a link of this post to them.

  • Alpana Sadya

    Excellent!! I am lovin.. it.

  • http://idlinginc.blogspot.com idlinginc

    Amar,

    Money is a unit of measurement. It offers a level of abstraction, just like everything else. I don’t see why you need abstract concepts like mithya and maya to explain an abstract concept. Using unknown Indic terms would only lead to more confusion.

    Consider this, a village is producing 2 objects, eggs and apples. All you need to know is the exchange. How many apples will I get for an egg and vice versa. Suppose the village produces 5 objects, we now have to maintain a exchange table of 5c2 = 5 * 4 /2 = 10, make it 10, 10 * 9 /2 = 45, n objects results in nc2. I hope you are beginning to see the problem.

    This is the exact same problem encountered when you try to relatively measure weight, length, etc. It becomes unwieldy and inefficient. The problems in these areas are solved by standardizing on weight and length and everything else is compared to this standard. If you are considering money as mithya/maya, then length and weight are as well.

    In the good (??) old days, Gold was the standard for measuring value and everything was based on that. Since carrying Gold around is somewhat inefficient and cumbersome, paper money came into beign. Any paper money created was backed up by Gold. It carried some value. Now, we have the fractional reserve system and federal banks to screw up with this unit of measurement. If its not standardized (pegged to gold), we have a unit of measurement which is variable. Consider what would happen if we have a unit of length that varies over time. The Govt and Central Bank in addition to stealing large amount of money in the form of taxes, also has a license to print money which is not backed up by production. This creates a stealth tax (inflation or something), which devalues money over a period of time.

    The tyranny of Govt doesn’t end there. Govt also screws up the economy by distorting the information. Money carries information. It is an approximation of how much one values stuff produced. This information disseminates through a complex latticework, known as the market and every person involved in the economy takes decisions, whether to produce or not to (demand and supply), based on this information. If the information is correct, people take good decisions, eg, I would see that people value porn dvds more than apples and would shift my resources in that direction. These information channels optimize resource allocation, which are always fixed. However, Govt interferes in the information channels in hundreds of ways (subsidies, etc), thereby distorting the information that people need. This leads to a lot of people taking bad decisions. Cumulatively, a lot of people taking bad decisions (coz of the distorted information) over a long period of time, is not good, to say the least.

    Best,
    JP.

  • http://idlinginc.blogspot.com idlinginc

    Amar,

    I’ve revised my opinion after some deep thought about my last comment. Money is indeed illusory/maya/mithya. I am now an enlightened being. Fortunately, being the kind person that I am, I am willing to help you with your illusion. Sell of all your assets, send me a check for the same and you will be rid of the illusion.

    Best,
    JP.

  • joebob

    ah yes, money

    all money in a central bank economy is created with debt. the same thing would happen with gold also as gold is only worht something if someone wants to buy it and so the exchange of gold or paper is really much the same, gold just doent burn as easy.

    the housing mortgage crisis is there because clasical macro economics is dead because of global trade so low interest rates do not add as much cash to the system through business debt as is needed so in order to pump up the bucks, motgages and credit cards were issued in great quanities. but always debt is equal to cash in the system and the magic growth is neede to keep the house of cards from falling. debt and cash are cancelled out in a depression, stocks holders loose money and debt is cancelled because for the stock holders to get money for their savings someone would have had to buy the stock – the banks are safer not because they have cahs for your savings on hand but the fed is supposed to print money to make up if the bank fails. Yes the fed can print money for a bailout but the preffered method is for the bank to be bought out and the debt cancelled in some way. The pension plans – including socila security – are another means of debt cancellation. the funds just belly up and the investors loose….like Enron. Only this time is will be like thousands of Enrons.

    The biggest argument will be over wh looses and who just gets debt cancelled and who gets to buy what with the cash that remains.

    The same would apply if we were on a gold standard with the exception that there would not be a large enough supply of gold to support the velocity needed for corporations to have made all the widgets we use like this internet and the cell phones and the electronics for our cars which help the engines last as long as they do. I guess we should throw in the possibilty of a solar electric future also.

    it is of course what you have said it is and more.
    for business to do business with each other the passing of a check doesnt work. and just as obvious, we can get buy without money if we have small enough groups – - – but there is a scaling problem and it relates to how and how many people or organizations we can connect with.

    That is why paper money works and is needed and takes on a reality itself.

    Think about it. There is NO such thing as the U.S. or anyother country in the world except by acceptence of their existence just like acceptence of magic money. All the countries of the world are just magic ideas!!!! But the residences of some of those countries make atomic bombs by playing with nature – and if we dont all give up the game we call natioanlism or monetaryism then those that dont can be connected in such a way that they can use the power of nature to do us in…….all the while they are playing a make believe game called nationalism.

    in the end we are just animals with a special talent to play with make believe concepts that can be checked and refined to allow control of nature to some extend – notice i said some extend because many/some of us have become so disconnected by our made up religions and made up reasons about things that we think we can make nature do anything……but we are just animals – preditors – who have out hunted our supplies of prey and are doing what preditors do when that happens (a good reading on animal population studies will give you an idea) – the population of the preditors peaks shortly before the crash that will always happen after they have exceeded the ability of the location to sustain the numbers.

    We are going to crash. Hopefull we might learn enough about the world so the survivors might do better.

    There is an excellent book – “The User Illusion”
    http://www.amazon.com/User-Illusion-Cutting-Consciousness-Penguin/dp/0140230122

    I think we make up – tell stories – we can share in common with our culture mates so we can interact in sucessful ways (rather then anarchy) and out of those made up stories comes religion and nationalism and governements and reason we find things the way they are.

    Like magiacl money – our magical stories and illusion are what makes interactions on large scales with others we do not know personally possible.

    its all a game – if you dont want to play you have to sit in the corner and pout on your own or find enough others to play a game with that will share the rules.