Don’t be scared of the game - learn the rules

People don’t understand monetary theory and so those that do can make it all sound impossibly difficult. It is not as difficult as it seems - once you learn that there are different games and different rules…

I got some follow-up questions from readers after last week's column argued for a different approach to bond markets. 'Won't we be punished for not playing by the rules?' I was asked. Let me try and explain.

What I was asked was whether a lack of confidence in any non-standard money system by money markets could lead to problems in exchange rates? Won't international currency markets devalue a Scottish Pound in retaliation for not submitting to their will? To understand the answer you need to understand that there is money, and then there is money...

You will probably assume, not unreasonably, that there is one kind of money and it is all worth the same. This isn't really true. In fact not only is there more than one kind of money, there is more than one way to count how many different kinds of money there are.

(To aid clarity here I'm going to be pretty loose with some definitions. Just please note that some of what follows isn't really how this all works exactly but is close enough for you to get the idea.)

Sometimes money is described in four forms, sometimes two. Both are relevant here. The four kinds of money are fiat money, commodity money, fiduciary money and commercial bank money. The approach that sees two kinds divides it as base money and bank money. So what does all this mean? It's actually easier than you might think.

Fiat money just means money backed by government guarantee. It is the fiat powers of governments to issue money that gives money its value in the first place. Basically you can consider money that isn't based on debt and which circulates in the domestic economy as fiat money.

Commodity money is when a commodity is traded as having an agreed intrinsic value which makes it behave like money and this basically refers to precious metal and particularly gold. Commodity money may not have the same effective value as fiat money because the commodity price is set internationally so your exchange rate will decide how much of it 'one pound' can buy; one day it will be more, another less.

Fiduciary money is important. If fiat money has value because a government (through a central bank) guarantees it, fiduciary money is basically an IOU and has value based on how much the two parties trust each other. Think of a cheque – the government doesn't guarantee a cheque, the issuing bank does. It has value only if you trust the bank.

But because of the way modern banking works, if everyone cashed their cheques at ones, the bank would struggle to pay from its reserves so you could lose all your money. It's value is only based on trust. You wouldn't accept a cheque from an insolvent bank as payment; it would have no value.

Commercial bank money is also crucial. This is what I described last week as the creation and destruction of money which is largely notional. When you take a loan, the bank magics money out of thin air and puts it in your account, and then as you repay the loan it destroys the money again and keeps the interest. Like fiduciary money, no-one is guaranteeing this money other than the bank.

And the point here is that bank money is worth less than fiat money. If you take out a bank loan you pay interest and so you have less spending power for the same amount of pounds. Each pound is effectively worth less.

The other way to look at this is to say there are two kinds of money – that which is created by a central bank and is guaranteed by government, and that which is created by commercial banks and it is the bank which is guaranteeing the money.

The first is known as base money and is made up of printed currency (banknotes and coins), central bank reserves and money government spends (public sector pay is base money because it is created by the central bank and that created money is then destroyed again via tax). Most of the rest of the money in the economy is bank money.

OK, the reason this gross simplification is helpful is that it shows that inside our economy there are different kinds of money with different effective values and different sets of factors driving that value. In other words, the money system isn't a single game you play by one set of rules but a number of different games you play, each with its own rules.

For example, you can definitely lose all your bank money (as per Lehman Brothers and Northern Rock) because your only guarantee is the bank and if it goes down, your money is gone. But you can't lose fiat money so long as a government and a central bank still exist. They can always create more. So now let's look at the difference between bond markets and exchange rates.

“The money system isn’t a single game you play by one set of rules but a number of different games you play, each with its own rules”

Bond markets are fiduciary money. The sole factor in bond markets ought to be the market's confidence that a government can repay the bond. That is why borrowing rates are higher for governments whose fiscal situation is weaker – lenders are less sure they'll get their money back.

But that has nothing to do with exchange rates. Think of those as a way (in theory) to balance international money flows. This is more like commodity money than fiduciary money. To understand this, imagine that an entire nation has a single bank account. Let's say we've got one and Norway has got one and there is only one product we each want to trade. We want their fish, they want our whisky.

When they buy our whisky they send us Krone. When we buy their fish we given them pounds. The thing is, unless we exchange it, the only place we can then spend our Krone is in Norway and the only place they can spend our pounds is with us.

Now, imagine every year they buy more whisky than we buy fish. We're getting more and more Krone, it is piling up and we have nothing to do with it. We don't want any more, so the Norwegian Krone becomes worth less for us. But imagine we're buying more fish than they're buying whisky. Now they have pounds piling up but we don't have enough Krone, which means we want more Krone. It makes Krone more valuable to us.

Of course, if the Krone becomes more valuable to us, the exchange rate changes and now imports from Norway have become more expensive for us. We shop elsewhere for fish and so the arithmetic changes again. Alternatively, they have too many pounds so the exchange rate moves in the other way. This means our whisky just got cheaper for them so they can buy more of it.

Now imagine that there are only two bank accounts in the world – yours and the bank account of everyone else. In theory, either trade is in perfect balance, you have more of their currencies than they have of yours or the other way round. If trade is in balance then that suggests the two values (of pounds and of all other currencies) are about right.

But if we are importing too much and exporting too little, then our currency needs to come down in value to put that in balance. And if we're exporting too much and importing too little, our currency will increase in value and imports will be cheaper but our exports will suffer. That is the classical way of looking at exchange rates.

The point is that there are a number of factors which can change the exchange rate. If unemployment rises, it suggests that soon fewer people will be buying things so our import demand would be likely to decrease. Same if interest rates go up – people have less money, are buying less and so our balance of trade changes. But it has nothing to do with whether government is borrowing a lot or a little. This is the exchange of commodity value, not a fiduciary IOU.

With government borrowing costs the game is to be a reliable debtor. With exchange rates the game is about producing stuff the rest of the world wants. Both are games with reasonably hard rules, but they're quite different games with quite different rules.

What I've been trying to emphasise in both these articles is that there is no free lunch. When it comes to money and money supply there isn't really a way to 'beat the house'. Borrow too much and inflation will spike, no matter where you borrow from. Have an economic slump and the value of your currency will drop whether you want it to or not.

It means that none of this is an invitation to go wild and be irresponsible because the consequences will be real and immediate. But that does not mean that, within the rules, there is only one game that can be played. And it most certainly does not mean that there is only one set of rules governing a number of different games, because there isn't.

Government borrowing must always keep a keen eye on economic performance, interest rates, inflation and unemployment. That's the rules. But it doesn't dictate where you have to borrow from, just how much of it you can do without consequence. Likewise, exchange rates are about your balance of trade and the extent to which you are a selling nation with a dynamic economy or a buying nation with a consumer culture. Those are the rules – but it has nothing to do with government bond yields.

I hope this makes sense. What I am trying hard to get across is that we've spent nearly 20 years now framing money as if it is all banknotes, there's a limited number of them and the 'financial markets' are the police. This just isn't true. There are lots of ways to do things differently.

But that does not mean there are no rules and it most certainly doesn't mean there are no consequences. It's just important that you understand the different games and the different rules so people don't go scaring you with stories that aren't true.