Money is on the mind of most people these days, with the collapse of stock markets and the bankruptcy of major financial institutions, including some names that epitomized trust. To many of us, it seems surreal that inside of a month or two our portfolio can drop ten or twenty percent even though we have been following “correct” wealth building strategies. Why all of a sudden has the worth of our investments changed so dramatically? Why can I not go up to Fort Knox with a few hundred dollar bills and get their equivalent value in gold? Just what is money anyhow? Why is our financial system set up the way it is? Why can a dollar be worth less next week than the current week?
I have been pondering these questions as I watch our own portfolio fall. This is the first in a series of periodic posts that I plan to make on the topic of money. I should point out that I am only an economist in the sense that I took one required course in economics in college. That is probably not relevant because I am not trying to explain economics, but instead I am trying to understand what money is and why it matters, which as you will find out is more an exercise in sociology than economics. In this post, I will look at the relationship between money and important intangibles, like confidence.
We all have a sense of what money is and why it is important, but it feels wholly abstract and therefore surreal. Yet we want it to be real. We crave the assurance that a nest egg of say $100,000 will always be there until we spend it and its value, if it changes, will only go up, not down. We understandably get very upset when it is not there, or its value is deeply discounted. Someone screwed us. Who? Why? How can we prevent this from recurring?
To understand money you have to go back to ancient times before money even existed. Back then, we all survived on our wits. Few of us though actually survived entirely on our own wits. Instead, we were part of a clan or a tribe. We generally worked together for the common good of our clan because we learned when our clan prospered we were all better off. We could not all be masters of everything.
This worked for a while until we encountered more powerful clans. If we had things the other clan valued a battle often ensued. After a while, clans saw some value in federating. We learned that there was power in joining into larger and larger groups that shared similar values, such as a common culture or language. Thus, we evolved feudal societies and early rudimentary civilizations, like the Sumerian dynasty.
When a nation reached sufficient size and complexity, the barter system broke down. More efficient ways of exchanging value were needed. Hence, money became a necessary invention. The value of money is easy to understand, but what is easier to miss is the context that money represented. Aside from an objective measure of wealth and a means to acquire life’s necessities, money also meant that we were vested in our nation. With a common currency of exchange, we had every incentive to bond together. Money promoted peace, integration and the survival of the nation.
The downside was that a form of currency was valuable only while the nation existed. If the money were coinage, it might retain some value, but more often (particularly in modern times) if the currency was a paper currency it became worthless as the nation disintegrated. Zimbabwe is but the latest example of a country whose currency became essentially worthless because it became a failed state. In general, the value of a currency is directly proportional to the cohesion of the state and the industriousness of its citizens. It is affected by many other factors. In modern times, one of these major factors has been international trade.
As you may have noticed over the last few years, the value of the dollar has been falling in relation to most other currencies. What does this mean? Aside from the facts that our goods tend to be cheaper to purchase with other currencies and it costs more for Americans to travel overseas, when the dollar falls in relationship to most other currencies it signals a societal problem. Either America is doing some things wrong compared with other nations, or other nations are doing things better than we are. It amounts to the same thing.
If you think about our societal cohesion lately, you should ponder the discord in the current presidential campaign. For example, a McCain-Palin supporter hung Barack Obama in effigy from a tree in his front yard. Perhaps this has happened in other presidential campaigns, but I cannot remember it happening in my lifetime. That it happened at all is potentially an ill omen for America as is the Alaskan Independence Party, that Sarah Palin’s husband belonged to.
Obviously, the United States government and many of us as private citizens have lived beyond our means. With all the financial bailouts, the federal government may add a trillion dollars to our national debt this year. The rise in unsecured credit card debt is well established and is at record levels. While by itself this is unlikely to cause our nation to break apart, it does suggest that we are seriously off track. A responsible government would have noted this trend and changed policies to disallow it. Ours did not.
Most governments no longer have vaults filled with precious metals to back up their currencies. Since 1971, the dollar has been a fiat form of money, meaning that the government declares it has value simply because it says so. China for example owns about a trillion dollars of U.S. Treasury debt. It cannot cash it in for gold or bullion. Their value lies in the fact that the U.S. Treasury assures China that they can be redeemed with interest at a future time, to be paid out in the future value of the dollar. By purchasing our treasury bills then, China is essentially betting that it believes that this nation will be around when these bills come up for redemption and is betting they will have retained substantial value. They are betting that the United States, as a two hundred year plus democracy, is not going to go seriously off course for a sustained period. As a consequence, by lending its money to the United States, it is not only generally put toward a productive use but retains its value, offering some stability in an inherently unstable world.
If you are an American, whether you like it or not you too are a shareholder in the United States of America. You do not have to hold Treasury bills or Savings Bonds to be a shareholder. You simply have to live here, or have your livelihood depend on the success of the USA. When things get seriously off course, as they have recently, it is in your financial interest to take actions to correct it. The primary means of correcting these problems is to elect new leaders who are looking out for the solvency of its currency and prosperity of the nation as a whole.
The value of the dollar then, and your wealth, is intimately linked with our overall confidence in our government and its markets. Clearly, we veered off course by creating financial instruments like risky mortgage-backed securities whose value was impossible to measure. The rest of the world, driven by greed, generally looked the other way also. Thus, our inability to adequately regulate our markets, as well as our sustained inability as a nation and as citizens to live within our means, mushroomed into a global crisis of confidence. The United States was supposed to be the world’s financial pillar. With no way to assess what these new types of assets were worth, but with plenty of evidence that the United State is vastly overextended, fear drove the market, with the most fearful anxious to redeem securities into something they believed to be of enduring value, such as gold. This in turn created a cascading effect and lowered prices generally for all forms of securities. The value of our securities then is directly proportional to the level of trust and confidence that we have in our governments and financial institutions.
Our portfolio values may recover when we know their actual worth. Of course, they are currently discounted by the collapse of so many financial institutions and our bloated government and personal debt. To be prosperous again we must have transparency in our financial markets (a much harder thing to do with so much electronic trading). We also have to have confidence that consumers will start living within their means and (just as importantly) creditors will not allow people to live beyond their means. Money invested into products and services that inflate the value of money is not a real investment. Money that is invested into products and services that we all find useful and innovative builds wealth, and thus confidence, and thus makes us wealthier.
The United States of America can also become wealthier by becoming united again. We have let partisans on both sides of the aisle pulls us apart rather than allowed pragmatic politicians to move us together again. Back in 1994, Newt Gingrich led a Republican revolution on Capitol Hill. While his intentions were noble, the effect was to unleash a new and dangerous level of partisanship that eschewed compromise. Both Senators Obama and McCain promise bipartisanship if they are elected president. The best president though will be able to do this as well as intelligently guide government policy to make financial markets more transparent and to direct resources that build genuine wealth.
As a de-facto stockholder of the United States of America, you should insist on leaders who will deliver on the bipartisanship pledge and who can demonstrate clear pragmatic leadership based on sound economic principles, not ideology. Your portfolio will thank you.