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  • Showing only topics with the tag "money". Back to normal view
    1. How many different currencies are there? It depends on how you slice them

      When I last wrote about money, some people liked it but u/MimicSquad had issues with my simplified explanation. After thinking about it, I'm going to try again. I don't want to make my "casino...

      When I last wrote about money, some people liked it but u/MimicSquad had issues with my simplified explanation. After thinking about it, I'm going to try again. I don't want to make my "casino world" analogy too complicated, but I will make some changes so that we can talk about payments. (Caveat: I'm not a financial expert, but this is how I think it works.)

      So let's say there is a town with two casinos. In the Yellow Casino, gamblers use yellow plastic chips, and in the Purple Casino, they use purple plastic chips. Otherwise, they are much alike. Each casino has a teller window where gamblers exchange the national currency (which we might call green money) for its own chips.

      So there are three currencies (yellow, purple, and green) and two exchanges (the teller windows). The casinos want their chips to be worth the same amount as green money, so their teller windows always trade them at par. (This makes yellow and purple chips worth the same amount too, even though nobody trades them directly yet.)

      Suppose that a gambler who has yellow chips walks into the Purple Casino. "You can't use those chips here," they say, "but for your convenience, we will trade you a purple chip for each of your yellow chips." Which they do. Then they send an employee to the Yellow Casino and trade the yellow chips for green money.

      This is a basic payment system. It's implemented as two trades, one visible and one hidden. The Purple Casino's teller visibly trades yellow chips for purple, and behind the scenes there is a settlement process, implemented using a trusted employee who carries chips and money to do another trade. The gambler doesn't need to know about trades between casinos, but they're essential for providing this service.

      Notice that, although the gambler carried yellow chips from Yellow Casino to Purple Casino, the second trade (a withdrawal) causes the Yellow Casino to have less money. The money followed the chips and the chips came back home.

      It doesn't need to happen quite that way, though. If Yellow and Purple agree, the Yellow casino could trade anything that's worth the same amount in return for getting its chips back. So, more abstractly, some financial asset must follow the chips from Yellow to Purple.

      Furthermore, if the casinos trust each other, they can delay settling up. Perhaps at the end of the day, the Purple Casino will have some yellow chips and the Yellow Casino has some purple chips, so they can exchange yellow for purple and they can use green money (or any financial asset) to make up the difference.

      Why settle at all? Partly because of risk. The casinos don't want to trust each other too much. If the Yellow Casino gets into financial trouble, the Purple Casino doesn't want to end up holding worthless yellow chips instead of the green money that they have more confidence in. (Also, they probably find green money more useful than yellow chips.)

      These casinos are are my thinly-disguised model for banks. To make things a bit less abstract, I'll talk about the US. There around 4,000 banks (and 5,000 credit unions) in the US. Each bank has its own computers that implement money as bank deposits. They have payment systems that tie them all together and hundreds of thousands of ATM's that trade electronic currency for cash.

      We could think of US banks as having 4,000 different currencies that all trade at par. While we normally think of the US dollar as a single currency, it could also be thought of as a federated system of many currencies, all tied together with payment systems that do lots of trades. (Nothing really changes; this is just a different way of thinking about it.) There are some currencies with special status, like paper money and coins and federal reserve accounts, but these are in addition to all the others. (You could even think of each kind of coin as its own currency, and making change as a form of currency trade.)

      There is a historical basis in early US history for treating each bank as having its own currency. US banks back then issued their own paper money, and although they tried to make them trade at par, these banks sometimes failed and were sometimes frauds, and their paper money often traded at much less than par. These days banks are much better regulated and we normally don't have to worry about such things, but much as a multicellular organism has cell walls as a sort of remnant of earlier times when cells were more independent, the boundaries between banks still matter, despite all the regulated mechanisms that make their currencies practically the same to us.

      Since each bank manages its own computer systems, there is a sense in which electronic money never actually moves outside its own bank. ​When we "move money" electronically, it's done by trading, and there has to be a payment system to bridge the gap. The timing of the trades varies, depending on the details of the settlement process.

      What about creating money? In casino world, the Yellow Casino makes yellow chips and the Purple Casino makes purple chips, but they can only make their own chips. Similar, a bank could make money in its own computer system, but they are limited in what they can do in anyone else's computers. They influence other bank's computers via trades.

      If a bad bank created a lot of their own money and then spent it (perhaps disguised as making a loan), they would still be on the hook during the settlement process, which essentially requires them to take their money back in return for a financial asset worth the same amount that wasn't created by them, such as money in their central bank account. Payments can be very complicated and there is often short-term debt involved in the settlement process, but ultimately a legitimate bank needs to honor its debts.

      It's similar to how anyone with a checkbook could write bad checks, but this will catch up with you during settlement. The physical ability to write large numbers on checks isn't a superpower that lets you buy anything. What a criminal could do with it is somewhat limited and short-term.

      Every bank has accounts with the central bank and one thing they are used for is implementing settlement. Having "reserves" with the central bank, even there isn't a legally required balance, is something every other bank needs to handle some kinds of payments. Just as you need money in your bank account to write a check and have it not bounce, banks need a high enough balance with the central bank to handle the payments their customers make. (Though I don't know the details of what sort of overdraft protections there are.)

      The only bank that can buy anything it likes without consequences to itself is the central bank, which doesn't participate in settlement like everyone else. The central bank's power to create its own money might look superficially similar to other banks, but it's special because payment is complete after the first trade; there is no further settlement after receiving central bank money. (Though a bank could trade reserves for cash if it needs it for its ATM's.)

      The end, for now. Sometimes I've been writing in a definitive way here, but keep in mind that I'm still not a financial expert and I welcome corrections from people who know better.

      7 votes
    2. Is it money? It depends who's counting

      (This is basically me blogging. I have a blog but I haven't posted in a decade, so I figure I might as well write here.) We live in a weird times when people often question basic premises of...

      (This is basically me blogging. I have a blog but I haven't posted in a decade, so I figure I might as well write here.)

      We live in a weird times when people often question basic premises of economics. Some populists and/or scam artists promote cryptocurrencies, meme stocks, and other unorthodox investments. It's easy to make fun of. Meanwhile there has always been a populist distrust of banks (particularly in US history) and distrust has increased since the 2008 financial crisis.

      A lot of populist distrust isn't based on any deep knowledge of how finance works, but rather a deep-seated feeling that someone must be getting away with something. And yes, someone probably is getting away with something, but that doesn't mean you need to believe every crank theory that becomes popular on Reddit.

      That being said, I'd like to tell you about my slightly unorthodox way to think about money and banking. It comes to the same thing in the end (banks still work the same way) but it seems like a useful framework.

      I'm going to set up a hypothetical example. There is a casino where gamblers use plastic chips to gamble, and there a cashiers' window where they can buy chips to gamble with when they arrive and turn them in for cash when they leave. So here is the question: are these plastic chips money?

      From a gambler's point of view, when they want to know how much money they have, they count their chips. These chips behave as essentially as money for them, and I claim that they actually are a kind of money, at least within the casino. Though this is unlikely, you could even imagine a nearby store that accepts chips for purchases and goes later to the casino to cash them in. When the store counts its money, it would be reasonable to include any chips that it didn't turn in yet. You could think of it as "cash" or (in a more orthodox way) as a "cash equivalent" but this is a matter of accounting definitions; the chips serve the same purpose in the system.

      When the casino counts its money, it never counts its own chips as cash. If they ask "how much cash does the casino have" then that's just the cash that the teller has behind the window. If they ask about the casino's financial assets more generally, if the chip is held by the cashier, it doesn't get counted at all; it's just worthless. All the chips that they gave out to gamblers are subtracted because the casino will lose cash when the gambler turns in chips before they leave.

      So the status of a plastic chip depends on who's asking and how they're counting. The chip hasn't physically changed, but its status depends both on its location and your point of view. Weird, huh?

      If someone says "this plastic chip is money," what kind of statement is this? Is it subjective? There are reasons why gamblers might disagree on the value of a chip. Let's say that, while the casino is closed, one gambler trusts that the casino will always honor its debts, but another has come to believe that they're a scam and they're never going to reopen, and your chips are worthless.

      You might think of this as a prediction. Saying that "this chip is money" is a prediction that the teller will give you cash when you go to the window and other gamblers will treat it like it's worth money, and maybe the nearby store will too.

      Such a prediction can depend on time. For example, maybe the chips could have an expiration date where the teller won't accept chips after that. So, from a gambler's perspective, the chip is money before the expiration date and no longer money after that. Or, more subjectively, a gambler might think that the casino will open tomorrow but be gone by next week.

      So we see that statements about money aren't timeless, that they depend on your point of view, that they can be matters of opinion, but they are statements people will eventually be right or wrong about. In this way they are like promises and other predictions about the future. Nobody knows what the future will bring, but there are some promises we trust over others.

      Okay, now we can look at bank deposits. What does the number in your account in the bank's computer actually do? For you and almost everyone else, bank deposits are money. (For example, they are officially part of M1.) But to the bank, they are a liability, because you can withdraw money from your account. From a bank's point of view, a deposit in any other bank is money, but the deposits in their own bank are not.

      So a key point here is that banks create money, but only for other people. They can never create money for themselves, and they won't create money for other people for free, because they will pay later. How much later? Well, that's a prediction.

      For the same reason, the teller in the casino won't just give you a chip, and the casino will have strict security to make sure nobody steals the chips. Sure, the casino owner could take a chip to a nearby store and buy something, but this is a form of buying on credit. This turns a plastic chip that's valueless for them into money for the store owner, but the casino will pay for it later.

      6 votes