44: What a 12-Year Knows About Money That an Economist Doesn't

what money is? It's, um that thing that we all want more of. Right, that's actually a really uh that's a really good definition. Actually, I think we can just pretty much leave it at that. Oh we're done, Okay, good, Okay, great podcast. Uh No, but but in all seriousness, um, you know, money is one of these things that like every one, as you say, just sort of take for granted. We want more of it, We want to use it to buy stuff obviously, but it's surprisingly difficult for people

to define or to describe what exactly it is. And some people say it's a unit of measurements. Some people say it's a medium of exchange. Uh. Some people say it has to be backed by something. Some people say, it's just this completely fictitious sociological abstract. There doesn't really seem to be any clear answer of what this uh, what money is, even though we sort of use it

and depend on it all the time. Well, I was gonna say, it's kind of funny, isn't it, Because you and I obviously when we're talking about markets, we are talking about money and the ask nation of monetary values to certain assets. And then in our day to day lives, of course we are all pursuing money in one way

or another. Yet we don't actually have a firm definition of it, right, And you'd think it would be a pretty big deal that we talk about all the time, but that don't know, I don't really know what it is. But we just sort of, uh, we just sort of skipped to the next part. I think usually, yeah, if we had to define our variables for every story that

we write, we might be in trouble. Actually true, but it turns out that what money is is actually a really important concept, and that um errors in thinking about what money is have huge implications for society and for policy. That that people said, and with us today we are going to be talking with Eric Lonergan he's a hedge fund manager and he's also written a book about what is money? And um, it's sort of attempts to answer, at least get it an answer of what this, uh,

what it really is? Great? Great, So let's bring in Eric and let's see if we can, um see a what money is and why it's worth figuring out. Eric Lonergan, thank you very much for joining us on the podcast. It's a pleasure. Joe and Tracy. I thought you guys were doing fine though without me. I'm very happy to sign off right here. So I don't know why did you write a book about what money is? Why is this an important topic? Right? Well, I guess I've been

thinking about it for a long time. So there were kind of two motivations. One was to do with book writing, and then the other one was very specifically about issues around money. So I've given a talk and actually and a publisher came up to me afterwards and said, would you like to write a book about that? And it was on the sort of subject of finance and money, um, and I really didn't just want to write something that

I didn't really believe in. So I've kind of been thinking about these issues for the best part of twenty years, and this was a chance to write right down the thoughts.

But the other thing that became very clear to me, UM is I guess I experienced an awful lot of frustration during the financial crisis, after the financial crisis and then in the euro crisis, because particularly sitting in the UK, it's very curious that the UK's biggest industry, both by size and strategically is the financial sector, and yet there is I would say, complete lack of understanding of what's going on in the financial sector, and that was very,

very apparent, And so I thought, you know, maybe I could bring those two components together to try and give some perspective and what all of these things actually mean and are about UM and at the same time bring it, make it in a way that was more relevant to people's lives and had more general implications for other areas of people's lives. And does this misunderstanding of how the financial sector works? Does it stem from a misunderstand in your view of based concepts such as what is money?

I mean absolutely, so I think again, a lot of people and I remember, you know, as you do if you're if you're commuting into the city. In London, you'll overhear people talking about issues of finance, and I did hear people sort of saying, I assumed there was a

safe deposit box with my deposit in it. And so I think people one of the fascinating things if you're predisposed like I am, to think about these issues how the sort of banking system works, is most of the time you completely ignore it, and it's really very very rare that it's working has become relevant to you, and I think that's one of the reasons why that people

haven't given a lot of thought. So so there was there was a point about I think individuals getting on with their daily lives didn't really understand what was going on behind them, what was keeping what was the lifeblood of the economy, and we didn't really understand that or think about it until it stopped. And then the other thing I think is is that people really didn't under

to policymakers, really didn't understand some essential distinctions. So to take a very concrete example that that I think is important is I think if you understand money correctly, you can't simultaneously engage in quantitative easing and austerity because it's completely inconsistent. Um And yet of course you know we

saw that in in lots of countries. UM. So, so I think you had like, sorry you, I think you have this level of misunderstanding right at a very basic, everyday life level of what does it mean to have a deposit all the way through to what's been happening with with macro policy. But how much was the confusion about money and finance post the financial crisis, about the evolution of financial markets and the financial industry, the idea

that everything became electronic. We had very very big numbers, Everything was sort of abstract versus actual confusion about what money is or was, say, two hundred or three hundred years ago. Because it seems like those two have kind of grown in tandem. Yeah, I think that's right, And I think I think that what's really interesting about this area is the misunderstandings go from all the way from people who have have paid very little attention to the

financial sector all the way through to experts. So, for example, I find it very interesting that economists, an awful lot of economists think of money as a debt. I mean down to the point of, you know, thinking of a of a a dollar bill as a liability of the government, which I think is actually just a very basic analytical error. Now, what's interesting about that is is that you know, if you said to a cab driver, ah, does the government know you anything for your ten dollar bill, you just

get an odd look. I mean, they might think there's something, they might be a bit have reservations about letting you in the cab. And their instinct is absolutely correct. It's not a liability. Um. That's that's actually crystal clear. And yet economists have have have made it a liability because in their models it's much more easy to deal with it if it's a liability, because then it's just part of the government stock of debt, and then I know how to deal with it, and I can come up

with equations, and it's and and that very simple point. Now, I think Paul Krugman's made that error. Uh. And Paul Krugman, he's a Nobel Prize winning economist. Now I need to be a little bit careful saying it, because you're a bit worried saying he's made a basic analytical error. But but the logical conclusion of that leads Mervyn King to go I'm doing Quwie, but I want you to typen fiscal policy, and arguably that's a really big error. So

I think you're you're You're absolutely right. You've had an awful lot of innovation and opacity complexity entered into the financial system. You've also got some really simple areas of misunderstanding which I think have deep psychological roots, probably and go back to you know what, what you and Joe were discussing right at the beginning, which is one one of these psychological discomforts, is the fact that something that is so important to us, which is money, has no

value in the sense that most goods have a value. Um. It's its value is entirely I mean it's it's just a digit on a screen, um, and its value is entirely contingent on the fact that other people will accept its use. So it's intrinsically social. So you also have this very intriguing aspect with money that it goes to sometimes to our very acquisitive, selfish motivations, and yet the

entire basis of it is a social basis. Yeah, there's one of the So obviously you make a point out that this error that professional economists make about thinking of debt, thinking of money as a liability of the government leads to profound policy errors. What are some of the misunderstandings that people who aren't economists have about money? And how does that, um manifest itself? How do these errors of our thinking, those of us who aren't economists, how do

they How do these errors manifest themselves in our lives? Well, that's a that's a really good question, Joe. I mean, actually, I think most people's intuitions are it's a very interesting area. I think people's intuitions may well be better than the people who have studied it. So so I think people get when people start thinking about it, they're much more likely to get confused. Um. And this is what leads

people to to to either assume. I mean again, you found there were people who assumed that the dollars were still backed by gold. So people, once people start to look at it, they try to seek a greater degree of meaning or a stronger basis in a sense of the money. So I think people's everyday understanding of it, which is that it's something profoundly useful and profoundly important. Uh, you know, it's not obvious to me that by by

studying economics, you get to have a deeper understanding. I think where people's understanding is very weak is more broadly when you look at the financial system. So what is the role of the stock market, Why do we have stock markets? What is involved in investing? Um? These kind of what? What? What is happening within the banking system? How are deposits being created there? I think economics is

extremely helpful. Um and and you know, people who aren't economists are having studied these things, uh, you know, really don't have a high degree of understanding. There's also, then, of course, a very interesting other dimension to all of this, which again economists tend to exclude. But but but normal humans for want of a better term, talk about all the time, which is the whole emotional side of these things.

And so one of the things I learned an awful lot from from being involved in markets is that the human is ever present. Markets are psychological phenomena. Uh, there are groups, um there our emotions. You know, if you sit me in front of my Bloomberg terminal and if you had a little dial that could control the you know, the the SMP ticker, you could start to affect my heart rate you could probably start to affect where blood

is flowing within my brain. Um And there's absolutely no doubt that these evolved, semi dysfunctional instincts become very very important when you get things like recessions or financial panics. UM. So, so I think those are Yeah. That the role of the role of emotion and psychology is is something that that that we will all talk about, but you won't find in any very rarely will you find it in

an economics book. Let's take a quick break. Note from a word from our sponsor, but knowledge to work and grow your business with c i T from transportation to healthcare to manufacturing. C i T offers commercial lending, leasing, and treasury management services for small middle market businesses. Learn more at c i T dot com put Knowledge to Work. And we're back with Eric Lonergan. He's a hedge fund

manager and the author of a book about money. And we're just talking about the sort of psychological elements of markets and misunderstandings about markets, and I wanted to uh talk about ask one question about this. You make a really interesting point in your book that if you were to ask people, including most financial market practitioners, what the point of financial markets is they would actually get it wrong.

Most people don't understand the purpose of financial markets. What do most people say financial markets are for and what are they actually for. Well, if you take the stock market as an example, that the standard answer is it's about allocating capital. It's so diverting capital to its to its best uses now, But if you actually think about and reflect on it, that's not really why we have stock markets. So historically, the origin of stock markets, and

it remains their function today, is actually about diversification. In fact, stock markets are a very early form of securitization, which is the converting something that's privately owned into tradeable securities. So if you go back in history and see why did we set up joint stock companies, was largely to facilitate trade because people wanted to diversify risk. So the idea was you had a rather risky venture if you

were sending ships overseas to engage in trade. No single individual would want to commit all of their capital or they wouldn't engage in taking on that risk, and so joint stock companies were set up to diversify that risk. So if you look at actually who does the capital allocation. It's not really the stock market. Most of it is

done by by companies and stuff. So what companies decide to do with retained earnings or if you are areas like private equity, you get more direct allocation of capital. But the stock markets primary function is in fact insurance. It's actually to diversify risk. So most of what financial markets are trying to do is precisely that. It's actually insurance um and insurance um at the risk of of

of causing people to fall asleep. Insurance is you know, it is again a difficult area to understand, but has has been profoundly beneficial because it increases the propensity of society is to take risk if we can, if we can ensure and diversify. And so that's why in a sense you can, uh, you know, societies we may be willing to invest in much more risky things than we

would otherwise be willing to do as individuals. It feels to me like those are key concepts to grasp again in the aftermath of the financial crisis, when we have a lot of investors who were risk averse, and we had a bunch of central banks who were trying to stimulate the economy through, to borrow your phrase, the allocation of capital, walk us through how that concept, getting that

concept right actually has played out to post crisis. Well, I think a post crisis I would say one of the primary factors again which isn't really again talked about an awful lot, is actually a psychological one. So what I think is much more consistent with evidence rather than a lot of this talk about things like secular stagnation and why interest rates are where they at? What why

why interest rates are where they are? It is in fact a more generalized risk aversion, and more even more specific than that within the financial system, is is a

volatility aversion, volatility very specifically. So if you look at um, you know, for example, that the difference in pricing between more volatile assets like equities versus assets that are perceived to have very low levels of volatility, like parts of the fixed income market, there are very very elevated levels of risk premium in the in the more volatile assets. So you know, what, what does that really mean? Well, you can think of it almost like a biological organism,

which is the entire system experience. It's a very very profound shock where you know, most people never really thought that their high street bank could fail. Um. They assumed that there were you know, serious people in charge who knew what they were doing, and we're in control of the system. And they discovered that all of those kind of truths were actually based on very shaky foundations. And so it's as if the organism is recoiling from that, and that is actually reflected at lots and lots of

different levels. So um, and that is one of the reasons, in fact why interest rates are in fact so low, is that you have this residual degree of of volatility a version or risk aversion. So people talk about zero interest rates. Again, what's very interesting in most economic models, there's just one interest rate. In the real world, there are loads of interest rates that go into your cost of capital, and perhaps the most important is the cost

of equity capital. And the cost of equity capital in a lot of parts of the world is higher than it was ten years ago. In fact, even in the United States the SMPO, as you know, is one of the more highly rated markets on a higher p multiple, it's still relative to pre crisis on not dissimilar cost

of equity to where it was pre crisis. So Although interest rates on effectively cash substitutes have absolutely collapsed, interest rates on lots of other assets that affect people's investment decision making and reflect their psychological disposition are still very elevated. So the idea that there are multiple interest rates that affect the economy and so keeping benchmark interest rates ultralow might not be as effective as central bankers might want

it to. You've written about that, and you're advocating a different approach to deal with that problem, right, In fact, you're advocating more money essentially. That's right. I'm I've got the twelve year old solution, which what are the problems with this solution is? It's it's it's it's simple to

the point of being embarrassing. So that the problem is I think a lot of the anomics profession is very resistant to it because if it works, people are going to say, why on earth didn't you do this sooner? It's so obvious. Um. But but my observations are very straightforward, and if you want people to spend more, give them more money, um. And it really is that simple. What's interest? And so there's interesting why there's such a high degree of resistance to this as an idea, and I again

I think that's largely an accident of history. So it's very interesting. I don't know, you may have seen, you know, you've just had Jackson Hole, who was reading one of the papers at jackson Hole has just had a lot of attention, was papered by Christopher Simms, who I have to confess, I think is is very guilty of what I said at the outset about making turning money into a liability of government, because then it becomes easy to

do the maths or you can fit it into your models. Um. But you know, again, one of the the kind of if you read what Christopher Sims is is talking about, you have these these kind of absolutely hyper rational individuals who are expecting future fiscal policy behave in a certain way. Again, I really don't think that's the way human psychology works. And I think what what people are not necessarily motivated by expectations. I think a lot of our beliefs are

based on what we actually observe. So so the idea that that you can get people to spend more money by telling them they will be in higher inflation in the future, I just don't really think is how human beings operate. People are absolutely likely to spend more money if they see their income increasing and if they expect that either to continue to increase or they then see

that as their sales increasing if they're running a business. Um. So I think people actually need to see it and experience it, and that is much more likely to change what people believe and how they behave and what they think. Right.

One of the arguments against, say, more aggressive fiscal policy you hear is that, well, sure people will get more money, but then somehow they'll know that in the future their tax rate will be hired they have to make up for their at spending, and therefore it won't do anything. But you say, that's not really how humans think. That's just like how humans might think on an economic model. Yeah,

and it's also not obviously rational, right. So so the model in which that's true is a model where everybody is always employed, um and there's no fluctuations in our in our productivity or there's no changes in our circumstances that are that significant. So I think it's absolutely rational if you get an effective policy. So it's it's very

instinct question. If I said to you, right, you're going to get if you're in Europe at the moment, which is in a quasi depression, if there was going to be corporate tax cuts and household tax cuts, income tax cuts across the whole of the Eurozone, what would you as an individual think about what the implications are for your long term tax burden. Well, if you think that's successful, it is conceivable that you would probably have quite a

neutral view. You might even have the n iron view of your prospective tax burden because the world that you would then be operating in will be a very different one. Um and so there is cyclicality in an in in economics, so you just you don't have these stable paths that we model. So a lot of these into a lot of these ideas and economics are premised on an assumption that you just have stable paths, in which case you're

just bringing something forward to the future. But what you actually do now may impact what the future looks like. So there may actually be grands to be a lot more optimistic about the future, in which case these things are self reinforcing. We could talk about this topic forever, but there's such there's such a broad topic. There was another thing in your book that really struck me, and it has to do with these sort of intersection of money and culture, which struck me is very relevant today.

And you pointed out that money allows a society or a country to essentially import the culture of another country. So if you have a country that is has a reputation for lots of corruption and poor fiscal management, then one way to solve that is to go on the currency, say the dollar, or go on the currency of a country where uh, there's less corruption and where money is

more stable. Argentina is an example. It also sort of made me think about the Eurozone with sort of um Italy having to listen to Germany who is dictating its fiscal rules. Perhaps some elites in Italy like that because they don't have confidence in their peers in Italy to uh, you know, remain to avoid corruption and so forth. But this struck me as a very powerful concept, especially as you see the rise anti globalization movements around the world.

This fact that money allows for cultures to flow from one to the other more freely. Absolutely so. So one of the themes I try to explain in the book is this kind of two sides of of money, which is the inherentce into dependence and the related sort of tension in fact between markets and in many ways between nationalism. Um. So it is very if you look at people's financial activity. So I tend to think of money as being most

like an institution. So David Hume, the Scottish philosopher, spoke about that these kind of three natural, naturally forming institutions of of law, language, and money, And in fact, I think the economics of money are most analogous to those of language, which is very curious and and language actually has this phenomenon as well, where of course you have common common language being used and increasingly so with globalization.

But you're absolutely right. So if you think of money as an institution, um, many countries can in fact import the the institution from somewhere else. So again it completely undermines nationalism. I mean, if you think of countries that can be very proud as nations, but if their own institutions are creating financial instability, they'll adopt another currency. And the case of point of of dollarization with the use of dollars across Latin America but to in many other countries.

And there's no doubt this was part of what was happening with the creation of Europe and the Eurozone. So if you look at many countries, one of the major motivations for joining Europe was effectively to import institutional credibility from outside their own country. So they were able to use this as a kind of incentive to improve the institutional structure domestically. And I think that's one of the

one of the great sadnesses post the euro crisis. I mean, I firstly, I personally found the euro crisis profoundly frustrating because again I think a very simple monetary solution. If the ECB had introduced quantitative easing in two thousand and nine, when all of the central banks were doing so, there probably wouldn't have been a euro crisis. I think all of the evidence now points that direction, but certainly that

in that importing institutional credibility has been deeply undermined. So if you go to countries like Italy, I remember in Italy twenty years ago, it was absolutely perceived to be

the case that European institutions improved domestic Italian institutions. Whereas I think what happened after the after the euro crisis was there was a profound sense that actually there was, there was deep mismanagement in Europe that was actually causing on necessary problems in the Italian economy at very high cost. And obviously you've also then had the kind of democratic deficit that's been associated with that as well. But but there's no doubt that globalization and trade, I mean, this

is very interesting phenomena in in anthropology. As you see, if you look at the evolution of trade through time, trade is premised on the fact that people are different. There'd be no point in trading if we were all the same. So in many ways that's anathema to to

nationalism or two to group behavior, to tribalism. And in fact, you can see markets and ultimately money as a form of conflict resolution, which so this is I think this is the benign dimension to globalize a and there are obviously lots of costs associated with that as well, but east one sees that as a common theme through the evolution of money and trade through time. So if someone comes up to us and asks us what money is, what should we tell them? What's the sort of snappy answer.

I'm glad you asked that, because I feel like we can't we can't get to the end the answer without the million dollar questions. Well, obviously we use the term money as a general reference to wealth, and when people say so and so has a lot of money, they just mean they're very wealthy. But if we want to make money distinct from other assets, which is really wealth is really about assets, be they stocks or properties or owning things. I think what is the defining characteristic is

that you use it to pay for things. So so other things have if you think of that, you know your unit of account, or you think of the fact that it's got a stable nominal value, or certain times you know, if you think of notes and coins where you know you payment and settlement and clearing are all done in immediately and there's no credit risk. Other things can have those properties. But but the defining characters that the money is that you pay for things with it.

I love that It's so simple. It just goes back to you know what you were saying. Even a twelve year old gets it. Money is what you use to pay for stuff with and to get make people rich or give them more money. That's right. Wow, that was really simple. Well, Eric Wondergan has been great to talk to you. I encourage everyone to uh check out your book. It's uh, I see you can download it on the kindle for It's a great read and an important topic and one I feel like we could talk about forever

even though it is so simple. Thanks very much. Uh well, Tracy, I love that. I love that topic and I feel like, um, I don't know, I can't get enough of that topic. I think it was definitely a good one to do again, given that we talk about money day in and day out, and we never really talk about what money is. Um. One thing I would say, though, is like the definition it's what you use to pay for things. It almost

strikes me as slightly unsatisfying. And I know that I'm overthinking it, but it's just because we have so much emotion tied up to the concept. Is Eric pointed out that reducing it to something so simple, you know, just a few words, that almost feels dissatisfying, doesn't it. It does feel satisfying. There's a great quote and I can't find it right now. I think it's from the economist John gall Braith, and he said something like the mechanism by which money is created is so simple it hurts

the brain. And I think, um, that's exactly what the right like. If you it's so simple it hurts the brain because it can't be that easy. That money is just what you pay, and that we could make people wealthier by by giving people more of it. But perhaps we can the other. The other thing that I find really fascinating is sort of this idea of money being a mode of conflict resolution and money being a sort

of antidote to nationalism. And it's sort of, I think, gets at why populist movements want to kill the bankers or at least tax the bankers more, because I think it's a sort of like intuitively recognizing that money allows us to import other cultures and import other institutions in a way that sort of runs perhaps counter to people's instincts. Yeah, I think that's a really important concept that doesn't get enough attention, the entwining of finance and money with globalization.

It's one that we sort of always happen the back of our brains, but not necessarily in that way. Right, we know that we trade with other countries and get the goods and services and labor from other countries, but the idea of actually importing cultures and institutions sort of brings it home on a deeper level. Money is the great colonialist, I guess is one way of putting it well.

Put I found the quote, the gall Braith quote is the process by which banks create money is so simple that the mind is repelled, which I think sort of like gets at this whole thing, all these concepts that we sort of try so hard to explain. It could be so simple as to be painful. All right, shall we repel ourselves from this podcast? On that note, let's do that. This has been another edition of the Odd Lots podcast. I'm Joe Wisn'tal. You can follow me on

Twitter at the Stalwart, and I'm Tracy Alloway. I'm on Twitter at Tracy Halloway. And you can find Eric on Twitter at Eric Lawners. And you should check out his book and his blog Philosophy of Money dot net. Thank you for listening. Put knowledge to work and grow your business with c i T. From transportation, healthcare to manufacturing. C i T offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at

c I T dot com. Put Knowledge to Work