On the Language of Money and the Instability of its Supporting System
One important characteristic of the modern world is the high level of interdependence between people, firms, and nations. The first time we had such degree of interdependence was during the Bronze Age in the Middle East and Western Mediterranean (Kristiansen & Suchowska-Ducke, 2015); the time when Sumer, Ancient Egypt, Babylonia, and Assyria were all bound together through international trade. Each state had a highly centralized system, which made all fabrics of society highly dependent upon each other. Historians with expertise in this period know this tale all too well.
But the one thing more famous than the bronze tools they had is their collapse; an enigmatic event in history. Historians still cannot pinpoint a singular trigger for such widespread and complete collapse. However, one character of the narratives which best explains the Bronze Age Collapse is that it was a domino effect. At some point, civilisations just went ‘Jenga!’ and collapsed under its own weight and complexity. Such collapse would perhaps seem unimaginable in the modern age. However, we highly overestimate our ability to understand and predict the economy and society. The crisis of 1939 and 2007 should have been a ‘one in a million’ kind of event, yet it happened twice in recent history. The Indonesian version for this might be the 1998 Asian Financial Crisis.
The modern age’s type of complexity is different from what humanity had. Money nowadays binds the modern world, between and within nations. Yet, it is perhaps one of the least understood items we have. Money is a form of currency, with most of the modern version being backed by nothing but the government’s stamps. If money is merely our own creation, which we assign values to, how come that we have had so many banking and financial crises for the last 30 years? We certainly have numerous narrations and tools to deal with money. It would be wise to revisit our understanding of money before stepping deeper in theorising it.
A Brief History of Money
Perhaps this is a tale we all know too well, that before we have money, there was barter, the activity of exchanging goods and, in a way, services. However, barter proved to be too troublesome to support a complex exchange system in a society. Under the barter system, standardisation of price is hard (Humphrey, 1985) and carrying items to trade in faraway lands is too cumbersome. Humanity certainly has tried a lot of mediums, ranging from seashell, salt, and big round rock with a hole in the middle. Gold emerged victorious, because it is rare, durable, and desirable by most people. Its rarity provided it with much needed security, too.
However, gold still had its own deficiency as a universal currency form. It is too heavy to be carried around, especially for high volume and long ranging trade. Then, banks issued banknotes to ease transactions. The earliest form of banknote was found during the Tang dynasty, but they left it in the middle ages, and then reappeared in the Song dynasty. Banknotes took stronger hold in Europe, starting from Italy. People started using banknotes to exchange between them. However, whoever held the banknotes must redeem their banknotes to the original bank who stored the gold, which was also cumbersome. These banknotes lose more and more of their value the further they travel from the original bank. To solve this, banks united and enabled the exchange of banknotes to gold in their own local bank, with the golds backed by the first central bank, the Bank of England. These banknotes found their way throughout the times to become the main currency form. By separating the physical form and the transaction itself, people started to grip the concept of currency being an exchange of value (however, the value of money itself was still somewhat tied to the value of a commodity, usually gold). With the final blow to the end of Bretton-Woods system, money evolved fully into its most recent form: Fiat money, in which its value depends not on other goods, but on the trust people place upon its issuer) .
Through money (from this point on, fiat money is referred to as money) we created a glue for society. We communicate values through currencies. We can know how much a McFlurry is worth in the USA in terms of our own purchasing ability. Money also creates a hierarchy of values, through which we compare the value of goods and services with each other. We can somehow compare between the value of a factory consultant to the price of a kilogram of oranges. By systemising and ordering the values of things, we created the modern economy, interrelated with everything.
How economists view it
Fiat money depends on our perceived value of it. We ascribe value into it and its value change over time. As the saying goes, ‘Money makes the world go around.’ In economic theory, people order their valuation on goods and services by comparing their utility. Basic microeconomic theory requires various assumptions of ordering, such as reflexivity, transitivity, completeness, monotonicity, and anti-symmetry; In short, a highly functioning homo economicus, rational human beings that can calculate every information they have and very clear preference who always optimise their satisfaction. Numerous variations have been iterated by Arrow (1951), Debreu (1951), Sen (1970), and more to fit their purposes, each relaxed one or more assumptions. However, the entire assumption is needed to construct a coherent and complete chain ordering of the entire economy.
Real humans are not supercomputers that can remember all known information and adjust their preferences accordingly at all times. Most of the time, we collectively order our preferences through money. Along the way, economists succeeded in bridging the gap between macro and microeconomic theorems and created a (sort of) perfect narrative for the economy. This is all tied with money as the ‘language of the market.’
The narrative did not fit reality for all time. There are numerous instances in which the narrative fell short. Crises, recessions, and bubbles are just a few of them, not to mention the growing inequalities (Zucman, 2019) and polarisation of political stances (Ravndal, 2018; Tranter, 2013). Economists had to concede that the theory, upon which we put our belief in to explain how the economy works, does not capture all parts of human life, or even most. Some would be better explained not by the commonly used (method), but by qualitative social research. The incompleteness of the basic economy theory led not only to the wrong explanations on the economy, but also wrong and inconsistent predictions about the future, which most econometricians know all too well.
Nevertheless, one point that the classical economy theorem refuses to concede is the existence of equilibrium. The point in which our economy revolves around: our GDP in the optimal sense should be this, our inflation rate should be that, t around equilibrium should be caused by random (stochastic) shocks in the economy, and many other things. The current most popular model that is used by policy makers is DSGE (Dynamic Stochastic General Equilibrium), a method that attempts to explain cycles and growth based on applied general equilibrium, along with the impact of policies. To make the models and statistical calculations work, a great assumption must be made. Money (or currency) is the perfect indicator for the entire economy. It reflects our values, how we value goods and services — a truthful and accurate indicator of value. Instability on the value of money should be stochastic, or random. Contrary to this assumption, we are homo sapiens, not homo economicus.
The problems that arise
The theoretical basis of economy should create some sort of objectivity; the more people are involved with the currency, the more it reflects reality of an economy. As people interact with each other (in the so-called ‘market’), money becomes the unifying standard upon which we lay our preferences. There are, of course, some communities that do not use money, whether due to disconnection with the national society (such as indigenous tribes) or straight out rejection. Nevertheless, the amount is minuscule and those that function entirely without money are usually disconnected from the rest of society in terms of economic activities; otherwise, they had to use money one way or another.
The pinnacle of this narrative is EMH (Efficient Market Hypothesis). EMH states that financial assets reflect all available information, most closely associated with Eugene Fama (1970). If we fully grasp it, the magnitude of the effect of EMH is huge. Asset prices, a financial product, should reflect all available fundamental information, reaching into the information about goods and services available. For example, the asset price of a pharmaceutical company should reflect how we calculate the entirety of the pharmacy industry, the company’s efficiency, productivity, to the point of how they price their products. It is the job of financial services to narrate the available information into a coherent narrative to explain how the valuation of said pharmaceutical company is how it is.
However, EMH has faced multiple rejections. A finding in the field of behavioural economics suggested that humans usually employ hyperbolic discounting in valuing future investments, lowering the prices of stocks (Gong et al., 2011). Thaler, a prominent behavioural economist, explained that widespread hot hand fallacy had a major role in the GFC, in which investors overplayed the safety of housing values. To some extent, this is also what happened in AFC — investors overplayed the potentials of Southeast Asian countries.
The more popular example case would be bubbles (asset price bubbles). In the 2007 global financial crisis, investors overplayed the security and profitability of mortgage bonds derivatives through increasingly complex contracts (Press & Profit, 2017). Technically, the existence of bubbles can be taken as not a rejection of EMH, but then it must reject the connection between monetary prices to any kind of claim that monetary prices are rational. In some way, it is truthful — just not the way we usually think. It is filled with cognitive biases and misjudgements that the financial markets become a figure of its own (Kudryavtsev et al., 2013). A game of money untied from the real economy.
Multiple times when the financial market is liberalised, inevitable recession is looming. Southeast Asia in 1998 (Sharma, 2018), Iceland (Bergmann, 2014), Uruguay (Leone & Pérez-Campanero, 1991), The nordic countries during early 1990s, and many more have been its victims. For some reason, the people couldn’t handle financial market liberalisation. Some suggest that when the financial market is liberalised, the net effects would be positive with crises and booms considered (Lee & Shin, 2008; Weller, 2001). However, financial liberalisation affects people differently. It disproportionately affects the poor and fuels the machine of inequality (Chowdhury & Żuk, 2018). Margaret Thatcher’s reign, although highly successful, was criticised for having the largest spike of inequality in the UK. The less fortunate got the worst net effect of financial liberalisation.
Figure 1: Inequality indices in UK (Source: The Guardian). Note that the largest spike in inequality happened during Margaret Thatcher’s Reign
Somehow, even people with the most expensive ties and statistical and business expertise, reacted wrongly towards the financial market. And the other factor, as pointed out by Taleb (2007), a renowned former-option trader that bet against the 2007 crisis and won, is that not only our way of reacting is irrational, the information is hardly sufficient. We, from experts to laymen, grossly overestimate our ability and rationality in calculating the monetary value. The information needed to accurately calculate what the price should have been is not enough and the models do not leave enough room to factor in the unknown. Basic economic theorem does not leave much room for bubbles and irrational tendencies. Sometimes, it relaxes the assumptions to explain specific niches, such as gender pay gap and insurance premium pricing. But that’s all that is, highly fragmentized exceptions specific to their own niche. However, when there are clear indications of global-wide biases, aren’t those the calls for reform in the economy’s basic theorem and its assumptions? Somehow, we still believe in classical economy’s narrative. Yet, it seems to rather be the exception than the norm. An exception that hardly has consistent proof of ever actually happening.
The illusion of stability
Over the years (or decades) every country in the world has tried different ‘recipes for success.’ The western world grew their economy based on increasing economic freedom, Asian miracle countries emerged as the world’s major player through a carefully directed capitalism, and many others with their own recipes customised to their countries’ needs. However, the world is nothing without its flaws. For example, Iceland, Myanmar, and Uruguay had their banking crisis in the 21st century. Even the last two global crises happened as a product of financial mismanagement. How come?
Iceland is one of the worst countries in the world to have been affected by the global financial crisis. Due to their aggressive banking and financial growth and high dependence on incoming money (Bergmann, 2014), their economy took a huge hit when the money ran off. Myanmar’s downfall was largely due to mismanagement and illegal lending (Turnell, 2003). Economic overdependence to neighbouring countries in real and monetary aspects played a huge role in Uruguay’s crises.
We might blame them, and most other cases, as the product of ‘mismanagement’ and illegal conducts. Before the Asian Financial Crisis (AFC), Southeast Asia was hailed as a rising star and successful story of economic management. Before the global financial crisis, the USA was highly cited as the stalwart and icon of the laissez-faire economy. In 1989, USA bravely proposed the Washington Consensus, a set of ‘recipes’ for facing a crisis. The IMF recommended these steps for Asian countries that needed lending to face AFC, but it failed (Sharma, 2018). We have the guts to call them products of mismanagement due to the wisdom of hindsight, to call AFC and GFC a product of mismanagement (IMF’s advice for AFC-affected countries could also be called a practice of mismanagement), but still, that’s not going to cut it. It is, after all, a hindsight. It is good that we learn something from it (supposedly — we also have many detractors, saying that we have actually changed very little in response to the GFC), but it just keeps happening, from centralized to decentralized economies. Perhaps we need to come to terms with the fact that there is always a possibility of recession. That is no reason to not implement changes after a recession, but we have to face that we currently don’t have a fool-proof plan. However, we can, at least, narrate the influence of money and people to each other and what role they had in recessions sourced from financial systems. And of course, the nature of money is the central theme.
At the start, society as a collective used money to value goods and services. Then, we create a hierarchy of values, at first with related items (substitutes, complementary items, etc), all connected through money. Inevitably, it creates a highly complex society, with each person having their specialised role in the society. A farmer farms, an accountant accounts, and researchers research. Imagine the amazement of an average person in middle-age of Indonesia if they find out that nearly 40% of Indonesian workforce in 2018 was service industry workers. This all will work well (or at least, better than the current state) if everyone ‘communicates’ perfectly with money.
But the problem is that we do not communicate effectively enough with money. Businesses and financial institutions do not communicate their fragility and conditions, banks do not communicate how overleveraged they are and how close they are to bank runs, and individuals do not necessarily compare all available information to make a sound economic judgement and order it accordingly. We claim that we have been careful through required reports of their financial dealings, but many just keep finding loopholes that are used to game the system. Remember Enron? Or how unethical is the credit rating system in the USA (Scalet & Kelly, 2012)? Or how flawed was the concept of ‘option and swaps contract’ being accepted as a risk reducing measure without sufficiently calculating the ability of the ‘insurer’ to pay them in the case of systemic crises (and how sensitive they are to certain triggers) — In short, remember AIG? In hindsight, it might seem like some foolishness, but at the time we didn’t see it that way. We translated the valuation of a company through the system that we had (accounting systems, regulations, standard of practices), came out the value and we thought of it to be as accurate as possible, reflecting its fundamental values, yet it kept on being gamed and loopholes kept getting found. Of course, these standardisations are largely useful, but we must admit that there is a possibility, and good probability, that flaws will be found and abused. We also have certain biases that contribute to bubbles and overvaluations. Hot hand fallacies, for example, had a major role in the creation of the housing bubble of 2007, dotcom bubble of 2001, and Southeast Asia credit bubble in 1998.
The triggers and causes of recessions will be random — otherwise we would have implemented measures to deal with it. Before 2007, who knew that the USA would be brought down by some measly mortgage loan issue, except for certain individuals? We must stop treating risks as a well understood issue and start dealing with it as how it is — random with a probability to become black swans. Black swans are improbable events that caused widespread effect. Although improbable, these events shape history with great effect. Who knew that a mortgage loan crisis in the USA would cause the entire world to a recession?
Globalised Risks
When certain triggers blow one aspect of the economy, many things would be affected. For example, the popping of the USA’s housing bubble was caused by defaults after interest rate readjustment. After a lengthy process, their houses got revalued (negatively) and apparently the house they owned was worthless. Thailand’s decision to float the Baht currency triggered AFC. Banks and financial institutions bond us together through money, which increased our interdependency with each other. When they took a huge hit, such as bank runs and insolvency, everything else would also be affected. For example, a bank run could cause many bank customers to revalue their savings in the bank and realise that their money isn’t safe — Their savings could be worthless and vanish any time. The high degree of interdependence, all connected through money and collective valuation, is why we called the modern economy as a complex system.
A complex system consists of a high amount and degree of interdependence between its factors. This is what made black swans have a prominent effect to the people as random occurrences could have a widespread effect on everything, especially the economy. When one aspect gets revalued, everything else becomes revalued depending on the new position and it is usually very unpredictable on what the outcome would be. Firms and individuals all would misjudge their positions (assets they have, liabilities they are subjected to), and in the case of negative black swans, most people and firms usually realise that they are in trouble. A famine in Thailand could affect Indonesia greatly. Through international trades and investments, we increased the degree of interdependence between countries.
If we follow the doctrine of classical economy, liberalisation of trade and currency floating should have made money, or currencies, more truthful to people’s valuation. However, our insufficient ‘communication’ with money creates adverse effects which contributes to the instability of money. We would be better off to understand macroeconomics as a complex system. From that point, we can accept the probability of emergence, such as bubbles. Also, we can understand that making a complex global society, such as the globalisation we are having now, also creates new emergent properties, which is a more volatile and fragile world to the black swans.
We have increased the contagiousness of black swans through these international dealings. Granted, we do reap the benefits of specialising and adopting international trades, but at what cost? International trades and financial liberalisation already have an unequal effect against the poor, but to subject their wellbeing to whether another country can handle their crises would be irresponsible. Governments are still responsible for managing the effect of the global economy to their own country.
Strive for More
The fragility of the world’s economy is not without its benefits. If we force Nikola Tesla to grow his own daily food, we might not have cheap and widespread electricity. But we also cannot turn a blind eye towards its adverse effects. Money is the language of the economy, yet it is not understood nearly enough. Economists still use money to value growth and improvements, yet the more we connect to the larger society, the more fragile it is, and we rarely take that into account. Money still has not reflected an accurate valuation.
This is why the desk of Globalisation is born, to better our understanding about this new, modern society. From this desk, we promote a more careful management of the economy, without sacrificing too many of its benefits. For example, Covid-19 has hurt tourism devastatingly. Bali, as a region that is overdependent on tourism, has been affected negatively and its economy would take a long time to bounce back. We must be more vigilant towards the weak points a random event could hurt us. An overdependence is not something that should be taken lightly.
Author: Rama Vandika Daniswara
Editor: Executive Council Progresa ID
Illustrator: Utomo Noor
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