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

Episode Date: September 2, 2016

"What is money?" This seemingly simple question has the ability to drive people crazy. Is it a unit of account? Is it something about exchange? Does it have to be blessed by the government or backed by something hard? On this week's podcast, we speak with fund manager Eric Lonergan, the author of "Money (The Art of Living)," to answer this question as well as the other vexing ones that spring from it. Ultimately we get an answer that's as simple as the question itself, one that would make more sense to a typical 12-year-old than an economist.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a very big. It's a very much. It's a very much. It's a a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com

slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing Corporation Distributor. Put knowledge to work and grow your business with CIT. From transportation to health care to manufacturing, CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. Hello and welcome to another edition of the Odd Lots podcast. I'm Joe Wisenthal, managing editor of Bloomberg Markets. And I'm Tracy Allaway, executive editor, Bloomberg Markets. So Tracy, do you know what money is? It's that thing that we all want more of, right?

That's actually 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. No, but in all seriousness, you know, money is one of these things that, like everyone is 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. 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 money is, even though we sort of use it and depend on it all the time. Well, I was going to 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 assignation 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 that would be a pretty big deal that we talk about it all the time, but that don't know, don't really know what it is. But we just sort of, we just sort of skip 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 errors in thinking about what money is have huge implications for society and for,

policy 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 it sort of attempts to answer, at least get it an answer of what it really is. Great. Great. So let's bring in Eric and let's see if we can see, A, what money is and why it's worth figuring out. Eric Lonergan, thank you very much for joining us on the Outlaws podcast. It's a pleasure, Joe, and Tracy. I thought you guys were doing fine, though, without me.

Oh, really? Okay. 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'd 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. And I really didn't just want to write something that I didn't really believe in.

So I'd kind of been thinking about these issues for the best part of 20 years and this was a chance to write down the thoughts. But the other thing that became very clear to me 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 on what all of these things actually mean and are about. And at the same time, 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 misunderstanding in your view of base 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 its workings become relevant to you. And I think that's one of the reasons why people haven't given a lot of thought. So 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 understand, policymakers really didn't understand some of the essential distinction. So to take a very concrete example 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. And yet, of course, you know, we saw that in lots of countries. So I think you had like, sorry, I think you had 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 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, 200 or 300 years ago? because it seems like those two have kind of grown in tandem.

Yeah, I think that's right. And I think that what's really interesting about this area is the misunderstandings go from all the way from people who 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 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, does the government owe you anything for your $10 bill? You just get an odd look.

I mean, they might think there's something. They might be a bit of reservations about letting you in the cab. And their instinct is absolutely correct. It's not a liability. that's actually crystal clear. And yet economists 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's stock of debt and then I know how to deal with it and I can come up with equations. And that very simple point. Now, I think Paul Krugman's made that error 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 the logical conclusion of that leads Mervyn King to go, I'm doing QE, but I want you to tighten fiscal policy. And arguably, that's a really big error. So I think you're absolutely right. You've had an awful lot of innovation and opacity, complexity, entered into the financial system.

But you've also got some really simple areas of misunderstanding, which I think have deep psychological roots probably, and go back to what you and Joe were discussing right at the beginning, which is 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. Its value is entirely, I mean, it's just a digit on a screen, 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, you know, sometimes to our very acquisitive, selfish motivations, and yet the entire basis of it is a social basis. Yeah, that's one of the, so obviously you 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 manifest itself? How do these errors of our thinking, those of us who aren't economists, how do these errors manifest themselves in our lives?

Well, 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've studied it. So I think people get, when people start thinking, about it, they're much more likely to get confused. And this is what leads people 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 than money. So I think people's everyday understanding of it, which is that it's something profoundly useful and profoundly important, you know, it's not obvious to me that 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?

These kind of, what is happening within the banking system? How are deposits being created? There, I think, economics is extremely helpful. And, you know, people who aren't economists or haven't studied these things, 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 normal humans, for one 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 being involved in markets is that the human is ever present. markets are psychological phenomena. There are groups, there are emotions.

If you sit me in front of my Bloomberg terminal, and if you had a little dial that could control the S&P ticker, you could start to affect my heart rate. You could probably start to affect where blood is flowing within my brain. And there's absolutely no doubt that these evolved semi-disfunctional instincts become very, very important when you get things like recessions or financial panics. So I think those are, yeah, the role of emotion and psychology is something 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 now from a word from our sponsor. Put knowledge to work and grow your business with CIT, from transportation to health care, to manufacturing. CIT offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at CIT.com. Put knowledge to work. And we're back with Eric Launergan. 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 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, the standard answer is it's about allocating capital. So diverting capital 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 converting something that's privately owned into tradable 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 companies themselves. so what companies decide to do with retained earnings. Or areas like private equity, you get more direct allocation of capital.

But the stock market's 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. And insurance at the risk of causing people to fall asleep, insurance is, again, a difficult area to understand, but it has been profoundly beneficial because it increases the propensity of societies to take risk if we can if we can insure and diversify. And so that's why in a sense you can, you know, as 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 this through how that concept, getting that concept right, actually has played out post-crisis. Well, I think post-crisis, I would say one of the primary factors, 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 are, why interest rates are where they are.

It is in fact a more generalized risk aversion, and even more specific than that, within the financial system, is a volatility aversion. Volatility very specifically. So if you look at, you know, for example, 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 more volatile assets. So, you know, what does that really mean? Well, you can think of it almost like a biological organism,

which is the entire system experienced a very, very profound shock where, you know, most people never really thought that their high street bank could fail. They assumed that there were serious people in charge who knew what they were doing and were 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. 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,

volatility aversion 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. Now, the cost of equity capital in a lot of parts of the world is higher than it was 10 years ago. In fact, even in the United States, the S&P, which is, as you know, is one of the more highly rated markets on a higher P multiple, it's still, you know, 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 ultra-low 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've got the 12-year-old solution. Which, what are the problems with this solution is it's simple to the point of being embarrassing. So the problem is, I think a lot of the economics 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. But my observation is a very straightforward one. If you want people to spend more, give them more money. And it really is that simple. So there's interesting why there's such a high degree of resistance to this as an idea. And again, I think that's largely an accident of history. So it's very interesting. I don't know, you may have seen, you've just had Jackson Hole.

I was reading one of the papers at Jackson Hole that's just had a lot of attention. It was a paper by Christopher Sims, who I have to confess, I think is very guilty of what I said. at the outset about turning money into a liability of government because then it becomes easy to do the maths or you can fit it into your models. But, you know, again, one of the, the kind of, if you read what Christopher Sims is talking about, you have these kind of absolutely hyper-rational individuals who are expecting future fiscal policy to behave in a certain way. Again, I really don't think that's the way human psychology works. And I think, what people are not necessarily motivated by expectations.

I think a lot of our beliefs are based on what we actually observe. So the idea that you can get people to spend more money by telling them there'll be 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. 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 a 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 higher to have to make up for that 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 the model in which that's true is a model where everybody is always employed, and there's no fluctuations 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 a very interesting 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 a benign view of your prospective tax burden, because the world that you would then be operating in will be a very different one. And so there is cyclicality in economics. So you just, you don't have these stable paths that we model. So a lot of these, 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 grounds 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 a broad topic. There was another thing in your book that really struck me. and it has to do with the 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 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 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 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 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 one of the themes I try to explore in the book is this kind of two sides of money, which is the inherent interdependence and the related sort of tension, in fact, between markets and in many ways between nationalism. So it is very interesting 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 these kind of three naturally forming institutions 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 language actually has this phenomenon as well, where, of course, you have common language being used, and increasingly so,

with globalization. But you're absolutely right. So if you think of money as an institution, many countries can, in fact, import 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 dollarization with the use of dollars across Latin America, but also 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 great sadnesses post the Euro crisis. I mean, 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 2009, 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 importing institutional credibility has been deeply undermined. So if you go to countries like Italy, I remember in Italy 20 years ago,

it was absolutely perceived to be the case that European institutions improved domestic Italian institutions. Whereas I think what happened after the euro crisis was there was a profound sense that actually there was deep mismanagement in Europe that was actually causing unnecessary 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 there's no doubt that globalization and trade, I mean, this is a very interesting phenomenon 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 nationalism or to group behavior or to tribalism. And in fact, you can see markets and ultimately money as a form of conflict resolution. So this is, I think, this is the benign dimension to globalization. There are obviously lots of costs associated with that as well.

But 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 get to the end of this podcast. Well, okay. Without the answer, without the million dollar question. Well, obviously we use the term money as a general reference to wealth. So 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 other things have, if you think of your unit of account or you think of the fact that it's got a stable nominal value, or certain, you know, if you think of notes and coins where, you know, payment and settlement and clearing are all done immediately and there's no credit risk, other things can have those properties. But the defining characteristic of 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 12-year-old. gets it. Money is what you use to pay for stuff with and to get make people richer, give them more money. That's right. Wow. That was really simple. Well, Eric Laundrigan has been great to talk to you. I encourage everyone to check out your book. I see you can download it on the Kindle for $2.99. 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, Tracy. Well, Tracy, I love that. I love that topic. And I feel like 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.

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, as Eric pointed out, that reducing it to something so simple, you know, just a few words, it 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 Galbraith, and he said something like the mechanism by which money is created is so simple, it hurts the brain. And I think that's exactly what they write. 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 giving people more of it.

But perhaps we can. 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 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 have in the back of our brains, but not necessarily in that way. Right. We know that we trade with other countries and get 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 Galbraith 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 consensual. that we sort of try so hard to explain 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 Oddlots podcast. I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And I'm Tracy Allaway. I'm on Twitter at Tracy Allo. And you can find Eric on Twitter at Eric Loners, and you should check out his book and his blog,

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