Is Banking and Finance Real or Just a Game?

The current economic crisis, regarding mortgages, CDOs, tranches, derivatives and other exotic games on wall street has got me thinking alot about money and finance and what our modern system of money really is. I never truly understood before that in fact, banks don’t have any money in the vaults. There’s nothing substantial in the vaults, its truly nominal. There’s a series of long term mortgages and other assets that the bank invests my money in when I go to the bank to deposit my paycheck.

There’s a computer system with an array or an excel spreadsheet (maybe not technically, but in essense), containing things like (“John Doe”, “$24.00”) and that’s all there is to John Doe’s money. Economists say actually greenbucks are merely a small portion of the economy and with a lot of people, including myself, being paid through direct deposit, its more virtual than ever I think.

I got paid this morning through direct deposit. The computer system subtracts a number associated with my empoyer and adds that number to my system. That’s it? In this case its with the same bank so I assume so.

I had realized this all in theory for a long time, but the collapse got me thinking about it in practice, and I started thinking about World of Warcraft. In World of Warcraft there’s a similar entry in their computers saying, 350 gold, 36 silver, 23 copper. That made me think, is there any more reality to my bank deposits that go up from payroll than there is to my World of Warcraft account balance that goes up from selling robes on the Auction House?

Is finance merely virtual, or is there anything really real to it? I’m starting to think its a fiction. What’s to prevent a “Server Reset” from replacing that array of bank deposits with all 0s, especially since the cash is sent out to build houses and to other places.

Is this all just a game that works only until we realize its just a game? I went and withdrew a small amount of cash from the bank today to ensure if the music stops I’ll have at least some fancy green paper.

I think it depends on how you define “real” and “game”

But I will say this: Those spreadsheet entries are just as real as the green paper. Neither has any intrinsic value. They only have value because the government says that they do.

Or what about a plumbing license? Fundamentally it’s just a piece of paper, no different from being a 10th level druid in some online game.

Increasingly, property in the world consists of abstract entities which represent only relationships between and among people. Or which are proof of some status or qualification.

Even ownership real property, such a piece of land, hinges upon a piece of paper known as a “title” or a “deed” and the willingness of authorities to enforce what is written down on other pieces of paper, known as “laws.”

So I would say that banking and finance are about as real as anything else in this world relating to property and the relationships among people.

Thats true. I never thought about how many of these types of things that only have an effect because people and especially the government, consider them to have an effect. So if I’m on a property and I have a deed, its only the extent that that is respected that allows me to really consider myself to own the place. Makes sense, considering eminent domain and its increasing use for commercial uses and how that effects property in general.

So I guess that makes banking real in the sense of its an agreement between parties in writing, but the thing that trips me up and possibly others is when we think that there’s some substantial physical backing behind that written agreement. The proverbial vault that seems like it should contain our money. Its in writing, but not much else can be said.

It’s not just the government. We as a society agree that printed money is a valid form of exchange. As long as we all agree to that, it’s true.

That’s what happens when they talk about the dollar rising and falling. The dollar is only as good as the economy backing it. When you hear about the dollar rising or falling against the yen or the euro or the Brazilian real, that means that the perception of our economy by other nations is rising and falling.

Internally, that is what happens with inflation. When inflation goes up, it generally means that the percieved buying power of the dollar is less. This happens for various reasons, but the simplest example is if the Bureau of Engraving and Printing decided to start cranking out millions of dollar bills. The value of the dollar would plummet and prices would go up. THis is what happened to Germany in the 30s with hyperinflation.
As you may have guessed by now, the bank doesn’t need to keep your actual money is a little burlap sack with a “$” on it. It just needs to keep enough money to pay people when they need it. The rest they lend out to home buyers or businesses or car buyers or whoever. They make money by charging interest on what they loan out.

That’s part of the problem now. Basically what has happened is that banks lent a bunch of money to people who now can’t pay it back. So the banks aren’t making any money. Because they don’t have as much money, they are leary about lending out any more so businesses can’t finance growth and home buyers can’t buy homes.

The reason it happened is that CDOs (specifically RMBS) are basically groups of mortages bundled together and sold off to investors almost like bonds. Bonds are debt instruments. Basically when you buy a bond, the issuer of the bond now pays back part of it’s loan to you instead of the bank. This should not be confused with a stock which is part equity or ownership in a company.

Anyhow, the basic problem with the CDOs is that the investors that bought these
instruments were unable or unwilling to adequately assess the risk, combined with the original lenders giving loans to people who probably couldn’t afford them.

Risk is a big part finance. What is the likelyhood of a stock going up? What is the liklihood of a borrower skipping out on their loan? What are the chances of prices going up? And so on. That’s why you have these complex financial instruments like CDOs, mutual funds, futures, and so on. They are attempts to reduce risks by either dispursing them among multiple parties or useing hedges to counter risky investments.

That’s actually why a lot of banker types make a lot of money. Some of these models can be extremely complex. Sometimes maybe too complex.

Games are real. Ask Las Vegas or your insurance agent.

Of course finance is real. But because it doesn’t produce real, tangible goods that you can drop on your foot, walk underneath, or put a key into, a lot of people don’t understand it.

Finance is a way of satisfying intangible desires between two different parties. Without finance as an intermedial lubricant, those wants would go unsatisfied and result in a non-optimal condition.

Two examples are the preference, or deference, of immediate consumption and the appetite for risk.

In the first, one party may have no need or desire to consume or invest now, even though they have the resources to do so. If ‘Finance’ wasn’t available, they would take their dollar bills, or their gold, or their wampum or bars of pig-iron or extra cordwood and bury it in their backyard. Or perhaps, they would have to consume resources to build a shelter to house and protect it. In that latter case, it would cost them money to retain the value of their money.

Another party may want to consume or invest immediately. The first party can give their stuff to the second party as a willing exchange of deferred consumption for immediate consumption. You could also cut-and-paste ‘investment’ for ‘consumption’ in the previous sentence.

If enough second parties want the first party’s stuff for temporary use, the first party can charge for it’s use, as well the right to get it back when the second party is done with it.

You can see where I’m going with this. The first party can also be said to be a ‘lender’, the second party can be said to be a ‘borrower’, and the charge for the stuff’s use is ‘interest’. A bank acts as the service intermediary in many cases to match lenders with borrowers, and takes a cut off the top for their efforts.

Another example is a woman who is a gold miner. Let’s call her Minnie - Minnie the miner. She owns a mine and uses her own money, time and effort to operate the mine and produce gold. Life is pretty good. But she knows (more than anybody) that the price of gold, and the mining business in general, is volatile. It’s risky. She would prefer not to have all of her eggs in one basket, to mix metaphors.

Minnie is willing to allow someone who has an appetite for a risky venture such as hers to buy a stake in her business. That person will purchase a percentage of her mining operation in exchange for some cash right now, due to Minnie. The new shareholder can then enjoy the risks and rewards of mining along with Minnie. Minnie plans to take that cash from the sale and invest it in a number of other ventures, perhaps even those that are negatively-correlated to the health of the mining industry, to preserve her savings and earn a modest return. She uses an investment bank or perhaps a broker to sell part of her mine, and then to re-invest the proceeds. The investment bank takes a cut of the top as a service fee.

In the above examples, the commercial bank and the investment bank are matching unsatisified, or mismatched, desires for preferences of consumption and appetites for risk. Like anything else in the world - automobile repair, dentistry, farming to produce food, etc. - the actors above could try and do it all themselves. That is, find borrowers or willing investors on their own and negotiate fees on their own. But that would eliminate the enormous productivity available from division of labor.

See, this is an interesting reaction. You don’t trust your money when it’s represented as an entry in a bank’s database, but for some reason you do trust your money when it’s represented as a piece of paper with some writing on it that says the piece of paper is worth so-and-so amount.

That fancy green paper is just an IOU issued by the government that promises that the government will accept that piece of paper in payment of debts you owe the government–such as taxes.

So the real question is, what in the hell is money anyway? Where did such a strange concept come from?

Back in the old days, there was no such thing as money. If you wanted a good, you’d either make it yourself, or find someone who had that good and offer to trade one of your goods for that good. But suppose you’ve got 20 chickens and want an axe, but the guy with the axe doesn’t want any chickens and refuses to trade.

Well, what if you had some other good that he would want? Or, what if you had a good that the axemaker might not want for himself, but was something he knew he could trade easily for goods that he did want? Like, say a pretty shiny yellow rock? And so pretty quickly in a barter economy you get a new concept known as a key good.

This is a good that while not everyone wants or needs, everyone knows that it would be easily traded for any other good you might want. So what sort of goods make ideal key goods? Goods that are portable, divisible, durable, hard to adulterate, and such. In some places cattle are key goods. Other places have used shells, cigarettes, whiskey, cacao beans and so forth. So even if the axemaker doesn’t have any use for cowrie shells, or cacao beans, or whatever the key good is, he knows that if he trades you the axe for cowrie shells, everyone else will be willing to trade him what he wants for his new cowrie shells.

Now, it turns out that one really common key good is small bits of rare metals. These rare metals are useful for making pretty jewelry and such, but the really nice thing about them is that they lots of qualities that make them ideal key goods. Gold can be divided into any size ingot, it lasts forever, it’s very small and dense, it’s hard to fake, and so on. So if you had small ingots of gold, you could travel around the world and find that many people would be willing to take those ingots of gold in trade for their goods.

And of course, those gold ingots can be made in standarized sizes and purities, and stamped by the government, and then we have coins, and we can make silver and copper ingots as well. These metal ingots are intrinsicly valuable, but most people don’t plan to melt the ingots down and create something out of them, they only care about them because other people will freely accept them as barter. And so comes the long-held identification of gold and money, that money somehow IS gold and gold IS money.

But of course, gold coins aren’t money any more than a bottle of whiskey or a cacao bean “is” money.

But suppose you didn’t want to carry around your gold coins. Your neighbor the goldsmith has a safe where he keeps the gold he works on, and guards and so on. So he offers to keep your gold in his safe. And in return he gives you a note saying, “Mindwanderer has 5 gold coins on deposit in my safe”. And any time you want your gold, you go the goldsmith, show him the note, and he returns your gold coins.

But further suppose that instead of a note that specifies “Mindwanderer” we change that reciept to say that anyone who posesses the note can get the gold. This way you can give people gold reciepts instead of actual gold coins, and they treat those pieces of paper as if they were gold coins. The gold coins were treated as money, and now the pieces of paper are treated as money. And note that the goldsmith doesn’t have to keep your particular gold coins on hand…any gold coins or raw gold will do, as long as he has enough to give to anyone who presents a reciept.

But note that the goldsmith can do something interesting. Suppose he takes your gold on deposit and issues you a reciept. Then Erislover comes along as asks the goldsmith for a loan of a gold coin today, which he will repay on thursday. Well, the goldsmith has plenty of gold, so he gives Erislover a gold coin, which Erislover uses to pay for a hamburger, and the hamburger salesman takes the gold coin to the goldsmith and deposits it and gets a receipt for it. Suddenly instead of one receipt for one gold coin, we have two reciepts but only one gold coin. And this is fractional reserve banking. Eventually the goldsmith doesn’t lend gold coins, he merely writes out a note to give to the borrower.

And now we have gold standard currency. Each note or reciept isn’t tied to a particular piece of gold in a particular vault, but rather can be taken to the goldsmith’s shop in return for gold. Or to the government, since the goverment has muscled in on the goldsmith/banker’s litle scheme.

And now, why bother with actually holding hunks of gold that could theoretically be exchanged for those notes? The government can issue notes that are backed by nothing, and they work just like the notes that are backed by gold, because nobody cared about the gold in the first place, all they cared about was that everyone else would take that gold or those gold-backed notes in exchange for goods and services. And so we now have today’s fiat currencies.

And why bother with notes anyway? The notes are simply receipts, there’s no reason those reciepts have to be written of fancy pieces of paper. You get a deposit to your bank and your bank tells you you have $X on account, there’s no need to represent your account with a certain number of fancy papers when it can be represented by a database entry. And so you pay for goods with a credit card, the credit card company gets paid from the bank, you pay the bank with direct deposit from your employer, the employer pays you out of a bank account. And no pieces of paper need change hands, all that changes is the numbers on various computer hard drives. And now we have electronic money.

And it doesn’t matter that the entries in the database don’t represent anything other than entries in a database, because all you care about is that you can exchange those database entries for the goods and services you want, and people accept those database entries in return for their goods and services because all THEY care about is that they can exchange those database entries for the goods and services THEY want. Of course, the problem comes when people stop believing that they really can exchange those database entries for what they want, because then they stop accepting database entries, and then no one wants database entries because no one wants database entries.

Does that answer your question?

Well played, Lemur866. Extremely well played.

I notice you quickly skipped through the part explaining WHY countries go off the gold standard. Because of course at one time the US was on the gold standard, and anyone and anytime could in theory walk into a bank and demand gold bullion in exchange for those pieces of paper.

They rarely did, of course, because gold was hard to carry around and you would have to subdivide it accurately for daily transactions. That would be a pain.

Unless, of course, the banks subdivided it in advance for you in the form of things called ‘coins’. Which banks and private citizens did for many centuries. In fact, many societies had privately minted gold coinage in circulation without government oversight at all, or a government-owned mint in service. Murray Rothbard would argue (posthumously now, God rest his soul) that there is nothing stopping that from happening again today, other than our government outlawing it from happening. And it’s hard to see how he is wrong.

So why do governments go off the gold standard? Hmmmmm. Let’s think about it. If you could redeem all of your notes for gold at any time before the gold standard, and you can’t do that if we ‘go off’ the gold standard, what would be the reason for the difference? <Think, think, think…>

The answer of course, is that the government (and banks, about which more in a moment) print WAY too much money at some point relative to the stock of gold it has on hand and conclude that there is no way it could ever redeem its notes in gold. This is called ‘inflation’.

The other reason is that with a fractional-reserve banking system, banks only need to hold a certain % of capital on hand relative to their customer deposits. If they were 100% reserved, they would always have enough ‘gold’ (or money) on hand to satisfy customer requests for cash. In a fractional reserve system, there is always the risk of looking like George Bailey on his wedding night in “It’s a Wonderful Life”. Fiat money (meaning, no gold standard) is almost a precondition for a fractional-reserve banking system.

Countries usually meet their moment-of-truth with the gold standard during time of war. The United States struggled with it’s gold standard after the Civil War and World War I. A couple of half-measures were taken, such as suspending payment of gold (e.g. “We’re still on the gold standard, it’s just that you can’t have any”) and revaluing the amount of gold equivalent to the dollar. Britain also struggled with it after World War I.

The reason for going off the gold standard during times of war is that the government needs to borrow like the dickens - from its citizens and from foreign governments - to finance the war effort. It needs to hoard the gold it has, and it also needs to avoid runs on the gold by the citizenry in time of panic.

Once the war is over, it could go back on the gold standard. But at that point it needs to pay back it’s loans and it invariably won’t have enough gold to do so. So it can either (1) revalue the currency, saying that $20 previously bought an ounce of gold, and now it takes $35 or (2) really, really tighten its belt and pay back its citizens over time or (3) just take the gold standard away, let people keep their previous dollars and think they are worth the same, and slowly-but-surely inflate their way out of the debt. Which do you think is politically easier to do? Yep. Number 3. I agree.

But the main problem with the gold standard is, as you say, that there just isn’t enough gold in the world to represent all the money. If we went back on the gold standard we’d have to declare that gold was worth an order of magnitude more than it is worth currently, in order to have enough gold to redeem for the paper.

But as I point out, gold isn’t money and money isn’t gold, gold is just a traditional key good. What’s the purpose of tying money to any one particular key good? Of course, it’s disasterous to tie money to more than one key good, because then any time the values of those goods change relative to one another third parties can arbitrage the two goods against each other and get free money from the government until the arbitrage changes the supply and demand equations to where the two goods are now worth what the goverment claims they are worth.

Putting ourselves on the gold standard doesn’t protect individuals from the chicanery of government manipulation, because the first thing that would happen is that the government would begin massive manipulations and distortions of the gold market. At least with fiat money we can have a reasonably free market in gold and gold can be treated like the commodity metal it is.

I know people like to imagine that the gold standard is the only way to avoid inflation, they especially said this back in the 70s when we went through a particularly brutal round of inflation. But then we had the last 20-30 years with very low inflation.

Fiat money is more honest than so-called gold standard currency, simply because as you say the first thing governments do in a crisis is change the rules about what that gold standard means.

Gold isn’t money. Cowrie shells aren’t money. Cacao beans aren’t money. Money is an abstraction and it seems more honest to treat it as an abstraction. Today’s fiat currency can really be thought of as tax payment coupons, the value of the fiat currency is given by the government’s promise to accept the fiat currency in payment of taxes. Sort of like an economy based the exchange of coupons issued by Tony Soprano where if you give him a coupon he won’t break your legs and burn down your house…this time.

Fractional-reserve banking, as a practice if not a standard, was done under gold standards, IdahoMauleMan.

Yes, it was. I’m sorry if I implied otherwise. In theory, there is nothing to stop a bank from taking its deposits and leveraging them to infinity if it wants to, and if it is issuing its own scrip as tender. It’s just that it is trading on its own reputation at that point, and will quickly go bankrupt if there is a sudden rush by the owners and secondary owners of its scrip to trade in their paper for gold.

Fractional reserve banking combined with government issued fiat money, on the other hand, allows for centralized control over inflation by raising or lowering reserve requirements on a uniform currency.

Sorry for the clumsy statement before.

I agree. It’s probably impossible to put the genie back into the bottle at this point, and fiat money can probably work in a large and diverse economy such as America as long as there is some reasonable control over its supply and dynamics. A central bank with strong credibility as an inflation fighter can be a pretty good substitute. We used to have that for awhile.

Some countries that have gone through severe economic times have sort-of gone back on a fixed standard when they establish currency boards. Argentina did this after its hyperinflation in the late 1980’s when it pegged it’s currency 1-to-1 with the dollar, and held 100% dollars in reserve. Substitute ‘dollars’ for ‘gold’ in this case and you get an effective gold standard.

Why “almost a precondition”? Is there a wrinkle I’m missing that justifies the hedging qualifier?

Erislover pointed out correctly that fractional-reserve systems have existed with a gold standard.

I would argue that while such systems are possible, they are probably operating on borrowed time until a significant shock such as war requires large amounts of government borrowing and a need to hoard gold. There are probably other shocks you could think of. You could also go 100% ‘free market’, do nothing, and let the financial system collapse by letting the first people in the doors of the bank get their gold, let everyone else get nothing, shrug your shoulders and walk away.

I probably wouldn’t expect a whole lot of people to trust putting their money in banks for awhile after that, however.

Yeah, I hit submit before reading posts made in the interim. Thanks to you both.

No problem.

I’ll have to go back and refresh my memory to see when fractional-reserve systems have co-existed with a gold standard, WITHOUT also having government mandates to suspend payment in specie, or some other restriction to prevent private citizens from owning gold. There have been a mismosh of these types of rules at many times in the past.

As a quick and (very) simplified example, consider a fractional-reserve system that requires banks to hold 10% capital against their loan book as reserves. Let’s say that capital was gold.

Then they loan out 10x that amount to Joe. Joe says, ‘Thanks for the loan. I’ll take it in gold.’ You can immediately see that the bank can’t do it and is technically bankrupt.

Now there are lots of other rules you could impose about maximum loan size for any single customer, etc. All of those IMHO are attempts to stuff the genie back in the bottle.

Interesting OP.

I think you’re getting at the e=mc(squared) of finance here. Everyone knows that a liability for someone is an asset for someone else, but your OP shows that the opposite is also true–an asset for someone really is often just a liability of someone else.

That is, if you have $100 worth of gold, you have an asset, but if you sell it for $100 of cash and deposit in in a checking account, you still have an asset, but the asset is more like a claim against the bank for $100 (so in some sense you’ve created a liability from the bank to you).

I’m not at home, so I can’t dig for the exact quote, but Murray Rothbard in ‘The Case Against the Fed’ (a quick, entertaining read of about 100 pages that I highly recommend) cites the exact point in history where the courts became confused by this exact point. It was from Britain at some time in the 19th century.

That is, the courts ruled that $100 in gold entrusted to a bank’s safekeeping was no longer the customers’ assets to which he/she was entitled to get back at any time, but was in fact a promise the bank was making to ‘try’ and pay it back at some point in the future. In other words, it sort-of became a loan the customer made to the bank that is at some risk of default.

60 Minutes just did a program on swaps. It was like selling insurance of the mortgage papers. Nobody knows how much is involved but estimates are about 60 trillion dollars. These credit swaps were not regulated, not reported on and were not transparent. They lobbied hard to keep it that way. That is the underlying economic problem. The contracts are extremely complex running hundreds of pages long. They were developed by mathematicians and physicists so they would be mathematically guaranteed not to lose. The math failed.
The economist on the show said they were insurance. They called them swaps to avoid insurance regulation. That was a game and a scam.

I’m sure I’m hijacking at least a little, here, but this has always been a peeve of mine.

Why do people constantly refer to gold-backed money as more real than anything else? Referring to paper money as “fiat”, presumably implies that the only reason it is worth anything is because somebody said so. Well isn’t that the whole reason gold money was ever worth anything? Because we all agreed it was?

Outside of being pretty and a good conductor, what the hell else has gold got? You can’t burn it, so I guess it is durable. But otherwise it is just as worthless as electronic files, paper, rocks, shells, and whatever else humans have used for money over the years. In fact, the hallmark of a good currency is its worthlessness. Why else would we spend it?

The gold standard is simply a historical curiosity where one currency often backed another. It simply makes sense from an efficiency and simplicity standpoint to do away with such redundancies.

I’m seeing a parallel nowadays with currency in the form of electronic files being ‘backed’ by currency in the form of paper and coins. A few generations (or less) and I would hope we get rid of this paper and metal currency entirely.