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Market Commentary: What is Money?

“… There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says ‘Morning, boys. How’s the water?’ And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes ‘What the hell is water’?

…but if you’re worried that I plan to present myself here as the wise, older fish explaining what water is to you younger fish, please don’t be. I am not the wise old fish. The point of the fish story is merely that the most obvious, important realities are often the ones that are hardest to see and talk about.”

- David Foster Wallace, Commencement Address, Kenyon College, May 21, 2005

Dear Family, Friends, and Clients, 

What exactly is money? It seems obvious at first glance. Our intuition tells us that we clearly understand the concept; but when we sit down to formulate a proper response, the ability to grasp seems just out of reach. 

mon·ey

 noun, plural mon·eys, mon·ies.

  1. any circulating medium of exchange, including coins, paper money, and demand deposits.
  2. paper money.
  3. gold, silver, or other metal in pieces of convenient form stamped by public authority and issued as a medium of exchange and measure of value.
  4. any article or substance used as a medium of exchange, measure of wealth, or means of payment, as checks on demand deposit or cowrie.

SOURCE: Random House Webster’s Unabridged Dictionary

That definition does not seem to clear it up at all. It inspires more questions than answers; and if you are wondering what “cowrie” is, it is a type of shell. Money is ubiquitous. We use it almost every day. Whether we pull out our credit card to buy lunch or have folded dollar bills in our wallet to tip the waitress, every transaction that we complete involves money to some degree. With this in mind, it is very important that we have a firm grasp on what makes a given substance money, which characteristics are necessities, and what the implications are for converting money into goods and investments, and goods and investments into money. 

We also need to understand what is not money. A major catalyst for difficulty in keeping our spirits elevated during periods of stock market calamity is a mistaken perception that stocks and bonds are money. Expecting securities representing claims on future income to act as stores of value in a system characterized by fluctuating interest rates is a recipe for disaster. Warren Buffet has said that interest rates act like gravity on the prices of assets, especially assets encompassing payments to be received years or decades in the future. Realizing that the future income is still due, but the lens through which we see it-  interest rates- has changed, can allow us to focus more clearly on the big picture. It is scarcely sufficient to focus on the big picture when importantly, that picture is in motion. Hopefully, a careful and reasoned examination of the facts will help to add color to the portrait.

“The thing that differentiates man from animals is money”

-Gertrude Stein

I like to imagine that ever since the first caveman realized that he hated touching live fish with his bare hands, he looked to outsource tasks he disliked or was not particularly good at to others who were better suited to accomplish certain goals. For many thousands of years populations of nomadic hominids would encounter each other and trade various items that were rare to their clan, but perhaps plentiful to others. Over time it became clear that trading was easier if some common factor could be used to better equalize value, or to facilitate trade in situations where both tribes did not necessarily have something the other wanted. In this environment, having money was a great advantage. You always had something that would be in demand in chance encounters with other people, and willingly trading was safer for both sides than using the club to get what you needed.

Countless objects have functioned as a crude form of money over the vast expanse of time. In recorded history dozens of various commodities have facilitated commerce by being readily exchangeable for goods, services, and time. The ancient Aztecs used cocoa beans to facilitate exchange, but as proof that value is in the eye of the beholder to a similar extent as beauty, European pirates dumped a shipload of valuable beans overboard, mistaking them for a cache of rabbit droppings; to what they may have ascribed the intended purpose of such a collection is lost to history. 

Many cultures, including isolated island societies, have used various shells as currency. While they worked well to move goods on a local scale, visiting merchants found very little value in cowrie that may have been rare on a particular island, but extremely common on the scale of the ocean, and served no useful purpose. Imagine being the richest family on the island, with a storehouse full of valuable shells, only to be told to “go pound sand” by visiting merchants because your money holds no real value in international trade. Many times, even tribes in close proximity would find their neighbor’s shell currency devoid of value.

Societies have used livestock, grain, vegetables, tobacco, cotton, and salt as forms of money; unfortunately, these goods eventually are consumed, rot, or lose their freshness, so their ability to store value is lacking. In addition, livestock like cattle are not very effective for small transactions, because you cannot very well just use a hoof to pay for a hotel room and keep the integrity of the rest of the animal intact for future spending. 

Eventually, many civilizations that develop the appropriate technological capabilities evolve to using various forms of metal as money. Metal is durable, interchangeable, and homogenous. It can be used to make useful tools and be readily converted back into a standardized form. Gold has historically been valued by most cultures because it is beautiful, it is easily divisible into smaller uniform quantities, it does not rust or corrode, it is rare, it holds value in inter-society transactions, and it is virtually indestructible. Using gold as currency allowed merchants to convert entire shiploads or warehouses of goods into a compact, easily transported commodity.

In order to be considered a reliable source of money, several characteristics need to be present: 

  • Medium of Exchange: A medium of exchange is an object or substance that facilitates transactions between buyers and sellers. All the various commodities listed above could function as Mediums of Exchange. The most important consideration is that both buyer and seller can readily determine the value of the money in relation to the goods. This is much harder to do in a barter system. If you wanted to exchange shoes for chickens, it may be difficult to tell how many chickens are fair value for a pair of shoes. In addition, if you wanted to trade milk for apples, but the dairy farmer does not eat apples, you may need to go to the bakery and convert apples into bread first. Having a common medium of exchange simplifies the process of converting goods into comparable values. 
  • Store of Value: A store of value is easily accumulated, set aside, retrieved and still useful as a Medium of Exchange in the future. Cattle are a poor store of value because they require constant food, water, and protection, and even with utmost care they still eventually die; tobacco loses its flavor over time; grain eventually spoils. Paper money is typically flouted as an effective store of value; however, if you look at a chart of inflation since 1913 (see below), you may take pause in considering this to be true. One of the greatest dangers of putting too much faith in paper currency, is the potential for inflation to eat away at purchasing power over time.
  • Unit of Account: To be an effective form of money, a currency must be easily divisible and countable. This is most easily illustrated in our current paper money. We have bills of various denominations printed and coins of smaller units minted so that any positive numerical figure is easily reached. This is much more difficult in cattle and shells. In salt and grain, a standard measure needs to be agreed upon, whether it be pounds, kilograms, bags, or some physical dimension. Imagine trying to negotiate the sale of a house for an indiscriminate amount of chocolate! We find in certain situations like prisons and post-communist societies in Eastern Europe that cigarettes form a reliable Unit of Account because cartons can be broken into 10 packs, which can be broken further into 20 cigarettes. While we do not recommend smoking, the currency itself is much more valuable in the hands of a non-smoker.

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KINGS of LYDIA. temp. Sadyattes. Circa 630-620 BCE. EL Trite – Third Stater (13mm, 4.70 g). Sardes mint.

The first recorded society to stamp coins into a standard form with a recognizable picture (a lion) was the Lydians, a close neighbor to the Ionian Greeks, around 650 B.C. The coins were made from a naturally occurring alloy of gold and silver called electrum. It is said that the Lydian river Pactolus, near the capital city of Sardis, was rich with gold remaining from the baths of King Midas, who washed away the embarrassing gold dust that emanated from his famous touch. The history of the Lydians was cut short by an errantly optimistic interpretation of a fortune teller’s prognostication that “War with Persia will lead to the collapse of a great nation”, apparently confirmation was not sought in regards to which great nation would fall. The ruler who lead them to their demise was Croesus, of the saying “Rich as Croesus”, who upon capture became a wise and loyal counsel to Cyrus the Great. 

The Ionian Greeks had learned of the value of commerce from their rich neighbors, which spread through the islands and to the Greek mainland. Having standardized money that was trusted by buyers and sellers facilitated transactions on a much greater scale than both barter and systems of weighing raw gold or silver, which was subject to fraudulent scales. The ability to convert labor into a standard unit of money also helped the common people enter the world of commerce and forced them to begin utilizing simple counting and arithmetic, which expanded the intellectual capacity of the nation. Having a reliable store of value allowed the wealthy to use their time to write, paint, sculpt and philosophize without need to tend to perishable commodities. Temples and priests found that this new form of tribute was much easier to convert into anything they wanted. Most importantly, the governments that minted the coins found this new form of money much easier to collect in taxes than grain and cattle.

There are three major classifications of Money:

  • Commodity Money: Commodity money has value in its own right and is utilized as a medium of exchange to facilitate trade. Gold and Silver are classic examples of commodity currency. Salt was used by Romans to pay soldiers for their service, the word “salary” is derived from the Latin root “sal” which means salt. Various other food items, animals, and dry goods have been used as commodity money over the ages. The main issue with pure commodity money is that it is not very flexible in supply. There is a limited amount of gold and silver in the ground, and a relatively fixed amount of it is mined every year, this limits the ability of the ruling class to tinker with the money supply to meet their goals. It is likely that supply and demand dynamics between gold and silver ended bimetallism in the United States in 1873, which isolated gold as the only “true money” until the end of the gold standard in 1972. Much of this shift was started by the exploration of the West and began with the California Gold Rush in 1849.
  • Representative Money: Representative money is a claim on some other commodity that wields the full power of that commodity until it is widely debased and loses value. The ancients realized that carrying around a load of commodities was not the most effective way to deploy purchasing power. In Egypt, Babylon, India, and China the temples began storing physical commodities and issuing receipts that could be converted back into the commodity at a later date. This was a much more convenient and safe system. However, since not everyone would claim their receipts at the same time, and as the receipts began simply changing hands as a form of currency on their own, the temples realized they could issue a lot more receipts than they had commodity in storage, and the idea of fractional reserves was born. To the west, in Rome, the habit of clipping small pieces of coins and melting them together to slowly grift the value away became troublesome enough that it became necessary to mint valueless coins, or tokens, which could not be debased. It became possible to mint an unlimited number of tokens that would be theoretically converted back into physical commodities. The United States used Representative Money until August 15, 1971 when President Nixon suspended the conversion of dollars into gold, at the time the price per ounce was $35.
  • Fiat Currency: When a currency is no longer intrinsically valuable or convertible into anything with intrinsic value it is considered Fiat Currency. Some economists reject the term “Fiat Money” because Fiat, by definition, is not a reliable store of value. After the Gold Standard was terminated, the US Dollar became a pure Fiat Currency. It is not convertible into anything of value, and its worth is declared by the US Treasury. This is the system that we currently utilize. The dollar bills in your pocket, and the digital dollars in your bank account do not have any value on their own, they are not convertible upon demand into anything of value, and the ability to exchange them for goods and services is limited to counterparty’s willingness to accept them, and the mandate of the US Government that they are “legal tender”.

An Introduction to Fiat Currency:

“All these pieces of paper are issued with as much solemnity and authority as if they were of pure gold or silver... and indeed everybody takes them readily, for wheresoever a person may go throughout the Great Kaan's dominions he shall find these pieces of paper current, and shall be able to transact all sales and purchases of goods by means of them just as well as if they were coins of pure gold.

— Marco Polo, The Travels of Marco Polo

Fiat currency was first used in China in the 11th century and did not gain usage in Europe until the 15th Century in Spain for a temporary period. Sweden experimented with fiat currency, but the adoption was not widespread. In 1685 there was a serious shortage of gold and silver coins in New France, part of present-day Canada. Jacques de Meulles, the Intendant of Finance, devised a brilliant plan to circumvent the shortage of hard currency by confiscating all the playing cards in the territory and signing the back to convert them into currency. While they were technically intended to be redeemed for gold in the future, many of them traded at face value for a long period of time without intention of being converted. The Territorial Government eventually claimed them legal tender, and to this day the Royal Canadian Mint produces replica playing card money; however, the present day incarnation is made of 92.5% Silver with Gold edging, so its commodity value is greater than its purchasing power by about 4-to-1.

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Source: Library and Archives Canada/C-017059

Fiat Currency in the United States:

Fiat currency was first issued by the Continental Congress in June 1775 leading into the Revolutionary War. This money was not backed by anything tangible and ended up worthless. The issue was originally intended to be retired 7 years after printing by way of a special tax on the various colonies, an idea which was quickly abandoned shortly after the first printing. At the beginning of the war the entire money supply in the colonies was $12,000,000; over the next 5 years The Continental Congress printed $225,000,000 in additional currency (and the states printed $200,000,000 of their own). At the end of the war it took 168 Continental Dollars to buy 1 Dollar of gold backed currency. The old saying “not worth a Continental” comes from this experiment in fiat currency.

Almost 100 years later, during the Civil War, the Confederate States issued their own currency that was only backed by a promise to pay at the conclusion of the war. The Greyback, as it was known, was originally issued in the first series for a total of $1,100,000 in currency. By the end of the war over $1.095 Billion in currency had been issued, and conversion would have been approximately $.06 on the Dollar. The price level rose from 100 in 1861 to 9,211 at the end of the war or 2,275% annual inflation.  Early on two men signed each bill as it was printed. At the end of the war 200 clerks were employed signing the massive pile of bills, which were hand cut with scissors. Oddly enough, even though the currency was worthless at the end of the war, today it holds great value to collectors. Recently a $1,000 Confederate bill was sold at auction for $35,000, reminding us once again to “think long-term”.

“The best way to destroy the capitalist system is to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

-John Maynard Keynes

The funds in your investment accounts considered cash are not sitting in a vault somewhere containing piles of paper currency. The fund manager selects up to 10 banks in which they can deposit funds of up to $245,000 each to gain FDIC Insurance on the deposit amount and any accrued interest. If you own a money market account, the funds are kept in very short-term securities issued by the US Government with maturity of no greater than 13 months. These securities are considered safe in the sense that the United States is unlikely to default, and since the US currency has reserve status, the US Treasury could simply print additional money to pay these debts. Default Risk is not our major concern when it comes to the funds in your money market accounts, or your bank account. Even FDIC Insurance doesn’t cover the risk that we find most troublesome when it comes to piles of cash, whether they be in the form of bills in a coffee can or mattress, balances in your savings account, or assets in your money market funds. That risk is inflation.

Inflation is a silent tax imposed on citizens by government manipulation of the money supply. It is barely noticeable in a moment, but when you sit down and think about how much your first house or car cost, or the price of a night at the movie theatre when you were in high school, or how much a gallon of milk cost when you first moved out on your own, you can clearly see the work of inflation. The reason inflation is so insidious is that it does not take money out of your account, it makes your money less valuable because it can buy less stuff; silently, a little at a time, year after year. 

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As can be seen by a simple glance at the chart of purchasing power above, inflation was relatively stable in the United States until 1913. Prices would increase during times of war due to scarcity and crowding of usage of money to cover costs of an increasing military, but this would normally dissipate during times of peace, and occasionally periods of deflation would reset the table. It was not until 1913 that inflation began to rise precipitously. Two major events happened in 1913: The income tax was reinstated after a brief stint starting during the Civil War (1861-1872), and the Federal Reserve Act was passed into law by Congress.

After the creation of the Federal Reserve System inflation rose significantly, and periods of deflation became much rarer. A keen eye can see another inflection point on the chart above where inflation takes a more parabolic turn. This was August 15, 1971, when President Nixon formally closed the gold window, and officially converted the United States Dollar into a pure fiat currency. Since the tether of money to gold has been severed, the money supply is much more flexible and money can be created and destroyed very quickly by the Federal Reserve. This article does not intend to interject an editorial comment on the state of affairs, it simply attempts to state the facts of the situation.

“Wealth consists not in having great possessions, but in having few wants.”

-Epictetus

What a fascinatingly boring historical journey, you say- but what is the point? The point from my perspective is that sometimes what feels safe can hide risks that remain unseen. Like two young fish trying to establish the nature and logic of water, we need to step back and evaluate the ocean of money in which we swim. Holding large amounts of money may be safe in the present, but very dangerous to your goals over a lifetime. It is “stress relieving, but not goal achieving”. This is not to say that you do not need to keep some liquid assets available, this is a necessity and in accordance with our principles. There may be periods of time where we suggest higher amounts of cash to protect your income needs, and to avoid severely overpriced securities.  The moral is that as long as the future remains opaque, we should make decisions that are most likely to help us find success over our entire lifetime, and history shows that holding all of your assets in any single security, even money, can lead to disaster. 

Stocks and bonds are not money even though they are measured in dollars. Their continuous repricing can be a disadvantage when it leads us to believe that the value of these securities can fluctuate by 20% in a day. But really what we own in both cases is a stream of income. From our bonds we expect interest and principal payments at a set amount and time. This fixed payment arrangement makes bonds a poor investment during periods of high inflation. From our stocks we expect earnings and dividends and the residual claim on all the assets once bondholders have been paid. Through all vicissitudes, if that stream of income remains intact, and our expected rate of return is above inflation, we will remain whole, even as the price fluctuates. During periods of uncertainty, buyers of stocks demand higher future returns to compensate for the unknown. This demand manifests as a temporary drop in prices. Usually, when the period of calamity has been resolved and the future again looks bright, the streams of income return to their normal value assuming they have not been permanently impaired. This is why we have faith that our equities will recover, because we are always careful to buy at a reasonable multiple of current income. While we do watch stock prices to determine our actions, more importantly, we watch the stream of income to judge temporary or permanent impairment.

We understand the pain of opening a statement that is 15% lower than the previous statement. It feels like a better decision would have been to sit in cash through that period. But if we were able to monitor the rise and fall of our accounts in real terms, we may find that after a decade of holding cash we have lost much more purchasing power permanently through the slow, sinister drips of inflation, and that our need to feel safe has betrayed us. Our mandate is to help you formulate your goals and reach them. It is not to achieve the highest rate of return regardless of risk, and it is not to flatten volatility to a linear equation. We take the needed risk to help you meet your needs, and we manage liquidity to maximize your probability of success. Cash is one of the tools in our toolbox, and we try to use it appropriately and sparingly when money is being printed in large amounts, as it currently is.

As always, we are here to help you define and reach your goals. Please do not hesitate to reach out to your wealth advisor, or me personally, if you have questions or want to discuss anything further.

Warm Regards,

Allen

 

Works Consulted:

Weatherford, J. McIver. History of Money. Crown Publishing Group, Incorporated.

Davies, Glyn. A History of Money. University of Wales Press, 2013.

Rothbard, Murray N. A History of Money and Banking in the United States: the Colonial Era to World War II. Ludwig Von Mises Institute, 2005.

White, Andrew Dickson. FIAT MONEY INFLATION IN FRANCE: How It Came, What It Brought, and How It Ended. BLACKBIRD BOOKS, 2011.