But the volume of trading in financial instruments, i.e. the activity of financial business, is not only highly variable but has no close connection with the volume of output whether of capital goods or of consumption-goods. – JM Keynes
Over the last forty-years, money was untethered from any objective value and became another product to trade. Money became, in many respects, simply another trade in the entirety of a financialized economy. One component of the definition of financialization is “to make trade-able”. However, a monetary system, and even more so an economy, which become entirely trade-able, are prone to instability and catastrophic volatility. Unless you’re purely a speculator, instability is the exact opposite of what you want from a sound money system.
Previously, I explained Keynes very helpful notion that, in part, money is valued through its constant interaction with the rest of the economy. Money gains value from an economy’s wealth, debt and prices. He placed the various valuing mechanisms into the categories of Money of Account and the General Purchasing Power of money. Again, for this exercise, it’s not necessary to go into detail on Keynes’ definitions, for as he remarks in the Treatise:
The fundamental equations of Chapter 10 are in themselves no more than identities, and therefore not intrinsically superior to other identities which have been propounded connecting monetary factors.
Phew, what trouble such honesty could cause our economic priesthood today! However, the point to be made is, at all times, money constantly interacts with the whole financial system and economy to gain its value. When an economy becomes completely financialized, that is trade-able, and money is removed from all fixed standards, you allow traders to gain too strong a hand in valuing money, thus increasing volatility.
The so-called “financial innovations” of the last three decades have added further to this instability. Financial innovation was a way to make money more trade-able by adding layers of “swaps” and “obligations” on top of the real assets. This process let the entire banking system carry less reserves – money in the vault – allowing more money, liquidity, into the system. Innovation meant formerly illiquid stores of money, such as long-term mortgages or government bonds, became trade-able, all adding to the overall volatility and instability of the system.
Thus a system in which everything is trade-able, demands a greater volume of money to keep things liquid, literally becoming addicted to greater liquidity, which, as Keynes notes in the opening quote, does not necessarily impact the real economy. What helped along the great elite financial panic in the fall of 2008 was a fall in liquidity, instigating a fall in inflated prices. Suddenly with no excess cash to keep inflated asset prices afloat, the entire system began a major contraction, racing to reach what would be more realistic levels in a system that was not so trade-able, that is liquid.
However, the Fed, other central banks, and governments stepped in to boost “liquidity”, flooding market with dollars, euros, et al, not allowing a deflation in prices and thus transferring the inflated values of assets and the layers of “financial innovations” on top of them, into the currencies themselves. An aside, a better outcome would have been gained by allowing the deflation of financial assets and instead the government flooding the real economy with money to first and foremost keep unemployment from steeply rising. But Ben rolled the dice and how this eventually plays out will be interesting to see, but volatility is increasing in currency markets and as Keynes noted:
…this tendency towards sympathetic movement on the part of the individual elements within a banking system is always present to a certain extent and has to be reckoned with…in the case of the world as a whole, the tendency to instability by reason of sympathetic movement is a characteristic of the utmost practical importance.
In a global monetary system that is hyper-trade-able and currency value is derived in a great extent from trading, volatility combined with what Keynes termed “sympathetic movement” can create great instability.
What we need to begin to do is re-tether money, make it less trade-able. This can be done various ways, for example by keeping mortgages on the originating banks’ books, making it much more difficult to trade such things a municipal bonds, or tying certain money or amounts to fundamental commodities like grain or oil. The question of how to solidify excessively liquid money is quickly gaining the utmost importance.
Next: Tethering Money