As financial professionals, we deal with money daily, but few of us have the time to step back and think about what exactly it is that we are investing, trading, or risk managing. Money is just there in a way similar to gravity or oxygen.
This lack of scrutiny has allowed money to become a source of significant misunderstanding and myth, often to the detriment of macroeconomic prognosis and investment performance. By asking a few basic questions, however, we can quickly gain a better understanding of what money actually is, or is not, where it comes from and how it flows in the economy and markets. While this knowledge on its own cannot necessarily tell us what the future may hold, it can help ensure that our views and assumptions are, at the very least, built upon a foundation that more accurately describes the monetary system in which we operate.
What do we mean by money? To properly answer this question, we would have to spend some time exploring the intersection of economics, anthropology, and even philosophy. For our purposes here, however, we skip the deep ruminations and simply group money into two broad types: commodity money and credit money.
Commodity money can be thought of as a thing that has to be obtained or produced before it can be spent and passed along to another user. The physical or prescribed limits of commodity money such as gold-backed dollars or Bitcoin mean that when one person hoards or borrows it, there is less left for everyone else to use. In contrast, credit money is more aptly viewed as an IOU that is lent into existence and recorded in some type of ledger. These accounting entries are sourced from thin air and thus do not face the same physical or prescribed limits as their commodity counterparts. Instead, the supply of credit money ebbs and flows according to peoples’ willingness to borrow and lend these IOUs into existence.
Most macro analyses and narratives we see today are driven by the logic of commodity money, even though credit money is the one that dominates actual usage. The overwhelming majority of the money we use today takes the form of bank deposits that – contrary to the commodity money view – are created by banks themselves rather than being sourced from customers. Banks create this new money via ledger entries when they extend a loan: they simply add deposits to their customer’s account on the liability side while recording the new loan under assets. This feature of modern banking systems, which shifts banks’ roles from intermediators to creators of loanable funds, has significant implications for many of the macro variables and risks that investors care about.
One such example is the quantity of money available to finance consumption and investment. Rather than being limited by the amount of previously-accumulated savings in an economy, it instead adjusts according to people’s desire to take on and extend credit. The fact that money’s quantity is determined endogenously in this way presents challenges to micro-investment theses that, perhaps unwittingly, rely on the commodity moneyesque notion of a pre-existing pool of loanable funds that grows or shrinks as people save more or less. Examples of such investment theses include interest rate outlooks that are based on the assumed savings habits of an aging population (e.g. retirees save less, so money is going to become increasingly scarce and expensive) or on expectations of rising government deficits (e.g. all that treasury issuance will crowd out private borrowers and push up rates.)
Failure to recognize the link between credit and money can also lead investors to under-estimate financial-driven risks: just as purchasing power can be created in an instant, it can also be destroyed. Complicating matters is the fact that this process is driven more by behavioural factors than by mechanical relationships – things such as households’ risk appetite and confidence in employment prospects, or banks’ trust in counterparties. If the emotions behind these factors are more volatile than the physical, slow-moving adjustment processes embedded in conventional economic models, adherents to the latter will have a harder time anticipating and explaining the swings that we actually observe in balance sheets, markets, and economic activity.
At this point, many readers are likely wondering where central banks fit into this whole money creation process. How can it be that commercial banks, households, and businesses are the ones that collectively bring money into existence when we see headlines every day about quantitative easing and central banks printing and pumping money into the economy? While central banks do indeed print money, it is a very specific type of money – namely reserves (analogous to settlement balances in Canada) – that is distinct from the deposit money discussed above. These reserves exist in a separate closed system that is only accessible by banks for settlement purposes amongst themselves. They do not flow into the economy more generally, nor does their quantity alter banks’ ability to lend. Although the latter point likely comes as a surprise to those who remember the money multiplier from their economic textbooks, this concept’s inapplicability to modern banking systems has been confirmed by several major central banks.
Although this is admittedly ‘in the weeds’, it can be very helpful for those concerned with big picture macro developments. For example, recognizing the fact that banks don’t lend or multiply reserves would likely have helped many investors side-step those calls for runaway inflation back when quantitative easing was first being introduced, including the endorsees of that now-infamous open letter to Ben Bernanke, Chair of the Federal Reserve in late 2010, suggesting that planned asset purchases present risks around currency debasement and inflation. It would have also likely tempered fears of a yield spike and equity market plummet as central banks tapered, and then ended, their asset purchase programs. More recently, it has offered reassuring clarity on what the 2019 dislocations in the repo market meant (and, just as importantly, didn’t mean) for broader markets.
Perhaps more than ever, an awareness of money and its workings can put investors at an advantage versus those leaning on more conventional playbooks. New tools and approaches are entering the discussion every day, from yield curve targeting in Japan, to the Fed’s policy framework review in the United States, to modern monetary theory globally.
Anticipating what these changes could mean for investors is challenging enough, to begin with, let alone when starting from an incomplete picture of our economy’s credit money foundations. By giving money some extra thought, however, we can more deftly navigate these shifting tides and hopefully improve our investment performance along the way.