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Oct 2, 2012

"Money and Currency 101: What You Don't Learn at School"

by Ben Bacque

Money and Currency101: What You Don’t Learn At School!

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Ben Bacque 

Money and currency are right now less predictable, more complex, more chaotic, and paradoxically therefore more needing to be understood than

at any other time in human history. To understand the complex situation we have now, we need first to go back to basics to understand it all. What is “money”, really, and why do we have another word for it, “currency”?

Funny Money

 

The funny thing about money is that it is just an idea, the idea of “the centre of value” for all goods in an economy. Consider a super-simple moneyless market economy that trades in just 4 goods, labeled A through D, as shown in Figure 1. Here we need just 6 barter-exchange rates to trade everything, noted by lines between the let- ters (no-one trades A for A, etc – duplicates and inverse ratios are unnecessary and not shown). Line A-C might represent how many ducks per plasma wide-screen TV, B-C how many geese. We observe that as the number of goods increases, the number of relationships increases much faster: for 26 goods we need to know 325 different exchange rates (Figure 2). But by simply placing a refer- ence point in the middle, let’s call it “money”, we only need 26, as shown in Figure 3. To find the fair barter exchange ratio between two goods, we just multiply their money-ratios (“prices”) together. Now, to make it real, and practical, let’s take one of those goods, G, say, and place it in the middle. Now we can understand our en- tire market with only 25 prices in Gs (Figure 4), plus we have something real we can trade with and use as physical money, namely the good G. This thing (or things) we place in the middle we call currency.

The money-idea and the real currency G solves for us another nasty problem that barter presents. What if I have ducks, and want a plasma wide-screen TV, but the plasma-screen merchant is picky, and needs geese but not ducks? We need something to be money for us, or trade is simply too complicated. Using currency, our plasma-merchant can buy his own geese – I don’t need to find them for him. Money is a very powerful idea, and currency’s value comes from the simplification it offers.

Complex Situations

 

But even after money, through currency, has simplified things, markets and trade still get complex, so let’s delve into complexity and chaos theory to understand the fate of our fowl. Much as relativity theory rocked the phys- ics world, and quite literally the real world, complexity theory is now rocking all scientific disciplines, including economics. The theory points to two key outcomes.

The first is that complex systems obey power-law rules, not the “normal” Gaussian distribution that we came to know and hate in our statistics and risk-analysis courses. The big difference here is that power-law based systems have outcomes with “fat tails” that give rise to “black swans”: there are bigger chances of wild outcomes. Further, chaotic power-law systems exhibit a property known as bifurcation, where the system can suddenly change its behaviour by moving from one set of steady states (a “strange attractor” in complexity-speak) violently to another set. The occurrence of these shifts is not necessarily predictable or time-able, though we get hints.

Secondly, and more interesting yet is the emergent order in complex chaotic systems. The best way to understand this in terms of economics is to read “ I, Pencil”, written in 1958 by Leonard E. Read (http://www.econlib. org/library/Essays/rdPncl1.html#I,%20Pencil). It also ap- plies to currencies in some cases. What Mr. Pencil has to say (and not just about pencils, but all goods, including currency-goods) is that we can’t know why, exactly, we arrived at pencils as our solution to writing efficiently,