Money Isn’t Really Money
Or, The Mechanics of Capitalism — Part III
👋 Hey there! Welcome to a new edition of The Sunday Wisdom! My name is Abhishek. I read a lot of books, think a lot of things, and this is where I dump my notes and (so called) learnings.
I mostly write to educate myself; this is kind of my Feynman Technique in action. But if you like my writing, I would say this little hobby of mine just became a bit more purposeful. Now… time for the mandatory plug!
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Alright! Enough talk. On to this week’s essay. It’s about 3,500 words.
Q: How does money disappear when the economy collapses?
Once again, in the fashion of the last part of this series, let me start with a story. And as we are entering the last leg of this series on the mechanics of the economy, let’s discuss much much bigger economic disasters.
It’s 1999 and the Greek government is in a bit of a pickle. The European Union has just launched a fancy new currency, the euro, which would be shared by its members. But… even though Greece is part of the EU, they aren’t invited. How rude!
See, for starters, Greece had (in fact, still has) massive tax evasion problems. It’s in fact deeply ingrained in their culture (people believe that the state is corrupt and, on top of that, a major part of the Greek economy is informal, thus making it easy for them to evade taxes). It costs the country billions of euros in lost revenue each year.
Despite these problems, Greece has been spending heavily in public sector projects and programs. Although Greece has a growing GDP, it also has a massively growing debt. In fact, Greece’s debt-to-GDP ratio is well above the 60% required to adopt the euro. EU has good reasons not to invite Greece to the party.
Now… the only option Greece has is to cut back on spending or miss out on the Eurozone party. But… Greece has a long history of overspending and failing to control its public debt, so this is definitely not an option. Greece likes to spend, spend, spend.
On the other hand, Greece wants to be part of the Eurozone (countries who have access to the euro) to be able to borrow more easily and spend more freely.
What Greece needs is a miracle. Surprisingly, at this very moment, Mephistopheles… I mean… Goldman Sachs comes along with the promise of a miracle.
Goldman Sachs decides to help Greece structure a series of complex currency swap transactions that will allow it to temporarily (and superficially) reduce the amount of debt it’s required to report under the EU’s rules for joining the euro.
(The basic idea of these currency swaps is for the Greek government to borrow money in dollars or yen from Goldman Sachs and few other banks, exchange those funds into euros, and then use those euros to pay off existing Greek debt. The currency swaps would be structured as off-the-table transactions, and this means they would not have to be reported as debt to EU. What a devilish idea indeed!)
Finally, it’s 2001 and Greece has access to the euro, which has brought in not only more trade, but also better financing from banks (since the euro allows a country to leverage the financial strength of its fellow eurozone members) just like Greece dreamt of. All is well and dandy!
But… labour costs have started to rise, and without compensating for rise in productivity, it is eroding Greece’s competitive edge. This eventually causes a trade deficit, meaning Greece is consuming (importing) more than it’s producing (exporting). Thanks to easy money, the country’s debt-to-GDP ratio had reached 119% by 2007. Not good!
But… all isn’t so bad after all. Despite its debt burden, the Greek economy is still growing (all thanks to the easy access to borrowing), and as long as things keep rolling as they are, everything will be…. boom… it’s 2008 and the housing market in the US has just collapsed, followed by the banks and the stock market, thereby creating a global recession, and bringing the whole world’s economy down. Welcome to the era of The Great Recession!
The Great Recession has hit Greece like a train. GDP has fallen as tourism and shipping have taken a dive. The Athens Stock Exchange has plummeted 65% by the end of 2008. And with massive massive debt burden, the EU has made it much much harder for Greece to borrow money.
And just in case things didn’t look bad enough, surprise… it’s 2009, and it’s revealed that Greece has been cooking the books. Its budget deficit is not 6.7% but more than double of that, i.e., the Greek government has been spending much much more than they have been earning.
As we all know, when you do something like that, and then go on to lie about it, only bad things happen. Finally, borrowing costs skyrocket as the entire country’s credibility is smashed like a vase on the floor. Greece is in shambles.
But, being part of the EU has its advantages. In May 2010, the European Union and the International Monetary Fund (IMF) — an organisation that has 190 member countries and works to foster global monetary cooperation — decide to provide Greece with a €110 billion bailout to prevent the country from defaulting (i.e., failing to pay its debt).
But… free aid is never free. Greece is forced to undertake what is popularly known as austerity measures — a set of extreme measures designed to reduce government spending and increase taxes in order to address the country’s budget deficit.
This means pension reforms: reducing pension benefits and raising the retirement age to help reduce the budget deficit; this means public sector layoffs: layoffs of government employees in order to cut spending; this means privatisation: selling off a number of government-owned assets, including airports, ports, and utilities, to raise revenue; this means tax hikes: raising taxes on a variety of goods and services, to increase revenue, and many other such ‘reforms’.
These measures led to widespread protests and social unrest in Greece. But… even after such harsh measures, Greece continued to struggle with high levels of debt and a stagnant economy. In fact, due to almost no increase in productivity, Greece’s debt-to-GDP ratio had increased to 172% by 2011.
In 2012, Greece received a second bailout of €130 billion from the European Union and the IMF. However, this bailout was also conditional on further severe austerity measures, and the country continued to struggle with high levels of debt and an economy in recession.
When the government makes mistakes, it’s the common folks who pay.
When borrowers stop taking on new debts, and start paying back old debts, you might expect the debt burden to decrease… but the opposite happens.
Because spending is cut — and one man’s spending is another man’s income – it causes incomes to fall. They fall faster than debts are repaid and the debt burden actually gets worse. This cut in spending is extremely painful. Businesses are forced to cut costs, which means less jobs and higher unemployment.
If you think about it, austerity introduces a Catch 22 — the goal is to increase overall income but it has to be done by lowering overall spending, but since one person’s spending is another person’s income, this isn’t technically feasible.
When debt burden is so high, austerity alone cannot bring it down. It can only arrest the spending, but nothing more than that. Debt in the economy must be reduced. This is what happens otherwise:
Since income is low, many borrowers find themselves unable to repay their debt. This makes others a little nervous. They start thinking that their banks would collapse and they rush to withdraw their money. This in turn actually squeezes the banks, and as more and more borrowers start defaulting on their debt, without any available funds, banks actually collapse. And as the banking sector collapses, so do businesses and individuals. This causes a severe economic contraction which is popularly known as a depression.
Lehman Brothers, before they died (the bank, not the actual brothers), were giving out home loans like free coupons to whoever they could find, regardless of whether they actually needed or not. But these borrowers were usually folks with poor financial history, people who would never ever be able to repay back, not even in a hundred million years.
Did Lehman Brothers know this? Of course! Then why did they keep on giving out bad loans? Call it greed, blame it on the low interest rates, or lack of government insight, it doesn’t really matter. What matters is after the borrowers started defaulting one after another, and Lehman Brothers found itself in cold waters, the US government declined to provide a bailout. On September 15, 2008, Lehman Brothers filed for bankruptcy, triggering a global financial crisis.
This is when people discover much of what they thought was their wealth isn’t really there. They went poof just like that! So… where did all that money go? Well, to be honest, there was no money to begin with; it was all fugazi, or what we commonly call, credit.
I’ve been trying to avoid this word for a while, but now it’s time to introduce this two-faced devil after all.
I had said debt is evil, but believe me, credit is another kind of evil all together, one with the darkest of hearts. Why? Because it brands itself a benefactor, an asset. For example, if you are creditworthy, i.e., have a good credit score, it’s a sign of honour, because now banks trust you more. If you earn a good living, your credit card has better limit — all so that you can borrow more and borrow more easily, and in turn get more and more indebted. Credit isn’t an asset, it’s a liability, both to an individual and to the economy. But… it’s a necessary liability.
To explain how credit works, let’s go back to the idea of longterm transactions again.
When you buy something from a store with cash, the transaction is settled immediately. It’s a short-term transaction. But when you buy something with credit, it’s like starting a tab. You’re saying you promise to pay in the future, i.e., you create a longterm transaction. And… you just created credit. Out of thin air.
This longterm transaction is a ‘liability’ to you (the borrower) because it creates debt, and it’s a pseudo ‘asset’ for the store owner (the lender) because they’ll get it back with interest.
It’s also important to note that money is not credit. Money is what you settle transactions with. It’s not until you clear the tab later that the debt goes away and the transaction is settled.
In reality, what a lot of people call money isn’t actually money, it’s credit. For example, the total amount of credit in India, as of 2023, is about $3 trillion while the total amount of money is also about $3 trillion, thus making it into a $6 trillion dollar economy. While in the US, the total about of credit is about $88.5 trillion while the total amount of money is only about $20.3 trillion, thus making it into a $110 trillion dollar economy.
Now… back to the store. What if you break your promise? What if you take something from the store owner on credit, but run away with it (or worse, default) instead of paying back?
Then this ‘asset’ of the store owner isn’t really worth anything (hence it’s a pseudo asset). Whatever it was, it was created out of thin air, and has basically disappeared into thin air.
More appropriately, this longterm transaction failed and the credit disappeared. Poof! And since transactions are the bread and butter of an economy, if they don’t go through often, the economy fumbles. If these kinds of failures happen a lot, i.e., borrowers default, the economy collapses.
Now, when the economy is bad, and borrowers are defaulting one after the other, lenders don’t wanna be found holding their heads as their assets disappear. Thus, they agree to something called debt restructuring. This basically means that lenders would either get paid back less, or get paid back over a longer timeframe, or at a lower interest rate, or a mix of all three.
Lenders would rather have a little of something than all of nothing. Thus contracts are restructured in such a way that reduces debt. But… even though overall debt in the economy reduces, this also causes incomes and asset values to go down faster (since lenders are getting back far less than what they should have on their assets). The debt burden only continues to gets worse.
Both cutting spending (austerity) and debt reduction (debt restructuring) causes deflation, i.e., the purchasing power of money increases over time. But while falling prices may seem like a good thing, this also signifies lower economic growth, increased unemployment, and reduced consumer demand. Definitely not good!
This impacts the central government because lower incomes and less employment means the government collects fewer taxes. But at the same time, the government also needs to increase its spending because unemployment has risen. Yet another Catch 22.
So… the only sensible option is to create stimulus plans and increase government spending to make up for the decrease in the economy. This sounds counterintuitive, but this is exactly when the government invests heavily on infra projects, all in order to increase employment.
For example, the Indian government started the massive Central Vista Redevelopment Project (i.e., revamping India’s central administrative area located near Raisina Hill, New Delhi) in late 2020 in the middle of the COVID-19 pandemic.
But these kinds of projects cause the government’s budget deficit to explode (since they start spending a lot lot more than what they are earning in taxes).
This is clearly not sustainable. If the government goes on spending more than they are earning, they will end up at Greece (the worst place to be, economically speaking). Therefore, along with spending, a sensible government also has to focus on income, and the only way a government can generate income is via taxes. So… they also raise taxes, and here’s where things get interesting.
Since wealth is heavily concentrated in the hands of a small percentage of the people, governments naturally raise taxes on the wealthy and ultra wealthy. This facilitates an indirect redistribution of wealth — from the ‘haves’ to the ‘have-nots’. The government takes money from the rich, and pays wages to the poor via various schemes and projects.
This generally causes some turmoil between the wealthy and the poor. The have-nots resent the haves for their wealth despite the poor economy; while the haves, being squeezed by the weak economy, falling asset prices, higher taxes, begin to resent the have-nots.
If this continues for long, social disorder can break out. Not only do tensions rise within states and countries, they can rise between countries as well — especially between debtor and creditor countries.
For example, during the Greek debt crisis, Germany, the largest contributor in the bailout of 2012, thought it was unfair to support Greece who had lived beyond its means and piled up debts they couldn’t repay. At the same time, the Greeks were certain that it was unfair for them to suffer years of slim budget and high unemployment in order to repay richer neighbouring countries such as Germany.
Despite all these hassle, this redistribution of wealth (coupled with austerity and debt restructuring) isn’t enough to boost the economy. Luckily, the central bank has one other trick up its sleeve to stimulate the economy — the most powerful trick of them all: printing new money.
Unlike cutting spending, debt reduction, and wealth redistribution, printing money is inflationary and stimulative. And yes, the central bank prints new money out of thin air.
Like many other countries, in response to the global financial crisis in 2008, the Indian government increased its spending to stimulate the economy. To finance this additional spending, the RBI printed more currency and made it available to the government. But, they obviously cannot give money directly to the government. So what do they do?
The central bank uses the ‘new’ money to purchase bonds issued by the government. (When you buy a government bond, you are essentially lending money to the government, and the government promises to pay you back with some extra money later.)
In some cases, the central bank also launches specific programs to purchase certain types of assets, such as mortgage-backed securities (financial schemes that are backed by home loans) or corporate bonds (bonds issued by companies to borrow money, but unlike stocks, which represent ownership in a company, bonds represent a loan to a company).
However… although the central bank can print money and buy financial assets, it cannot put money in the hands of the people, and this is where the government comes in.
After the 2008 crash, the Indian government expanded the scope of its Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA), which guarantees 100 days of employment to rural households. The program was extended to cover all districts of the country and the number of days of employment was increased to 150.
The government also introduced the Direct Benefit Transfer (DBT) scheme to transfer subsidies and benefits directly to the bank accounts of vulnerable sections of the society, such as farmers and senior citizens.
But… to really make significant impact, the central bank not only needs to pump up income but also get the rate of income growth higher than the rate of interest on the accumulated debt. In other words, income needs to grow faster than debt is growing.
Let’s take an example: let’s assume that a country has a debt-to-income ratio of 100%. This means that the amount of debt it has is the same as the amount of income the entire country makes in a year.
Now, let’s say the interest rate on that debt is 2%. So… if debt is growing at 2%, but income is only growing by 1%, the government will never be able to reduce the debt burden. Thus… the central bank needs to print enough money (for the government to add stimulus to the economy) and get the rate of income growth above the rate of interest.
(It’s important to note that printing money is always inflationary, but it’s absolutely necessary. Try to understand this: transactions is what really matters; but it doesn’t matter if it’s via money or via credit. Therefore, a dollar paid with money has the same effect on price as a dollar paid with credit. Thus, by printing money, the central bank actually makes up for the disappearance of credit with an increase in the amount of money.)
However, as we all know, printing money can easily be abused, precisely because it’s so easy compared to the other measures (remember Germany in 1920s and Zimbabwe in 2000s). Therefore, the central bank and the central government have to work together to make sure the deflationary measures and the inflationary measures are very well-balanced.
The right balance requires a certain mix of cutting spending, reducing debt, transferring wealth, and printing money, so that economic and social stability can be maintained. This way, growth would be slow but debt burdens would go down with time, eventually.
Slowly and steadily, as incomes begin to rise, borrowers begin to appear more creditworthy (i.e. they can start borrowing again). And when borrowers appear more creditworthy, lenders begin to lend money again.
Debt burdens finally begin to fall. Being able to borrow money, people start to increase their spending again. And since one person’s spending is another person’s earning, eventually the economy begins to grow again.
This type of economic expansion due to government stimulus is called a reflation, and it usually takes about a decade for everything to get back to normal.
And then… this cycle begins all over again: a period of booms and busts, followed by a disaster.
In closing, the general rules to avoid economic disasters are simple: don’t let debt rise faster than income (avoid debt burden), don’t have income rise faster than productivity (avoid inflation), and do all you can to raise productivity (increase goods and services), because in the long run, that’s what matters the most.
But… like all good advice, these are simple to understand, but not at all easy to follow, especially because there are much much stronger forces in action, such as greed, envy, fear, vanity, insecurity, pride, hope, etc. that make smart people commit stupid mistakes.
Today I Learned
Carbon dating is usually associated with archaeology, and you may have heard of it in connection with fossils, dinosaurs, or ancient artefacts that are up to 50,000 years old.
But… what if I told you it’s possible to carbon date much younger organisms, such as a recently dead human being.
But first… let’s understand how carbon dating actually works.
Carbon-14 is a radioactive isotope of carbon that is formed naturally in the atmosphere when cosmic rays interact with nitrogen atoms. Plants absorb carbon dioxide (CO2) from the atmosphere, and this CO2 contains carbon-14. Animals that eat plants also absorb carbon-14. When a plant or animal dies, it stops absorbing carbon-14, and the carbon-14 in its tissues begins to decay.
The decay of carbon-14 is a random process, but on average, half of the carbon-14 atoms in a sample will decay every 5,730 years. By measuring the amount of carbon-14 remaining in a sample, scientists can determine how long ago it stopped absorbing carbon-14 and therefore estimate its age.
But… the Cold War changed a few things.
Overground nuclear testing in the 1950s and 1960s suddenly created a spike of radioactive carbon in the atmosphere, and this was taken up into bodies and cells of living people. Then someone realised this was undesirable (to say the least) and that it might be a good idea to conduct the testing underground.
Naturally, since no more bombs went off above the ground, newer carbon 14 weren’t added to the atmosphere, and its level began to drop with time. This led to a difference in the carbon 14 levels in the nucleus of cells that were created before and after the bomb testing period.
In 2012, researchers took advantage of this difference to investigate the age of heart cells. They analysed DNA samples from human hearts and found that the carbon-14 levels in the DNA were higher than would be expected if the cells were constantly being replaced throughout life.
The researchers compared the carbon-14 levels in the DNA of cardiomyocytes (the cells that make up heart muscle tissue) with carbon-14 levels in DNA from other tissues in the body, such as liver and brain tissue, which are known to have high and low turnover rates, respectively.
This enabled them to prove that half of the cardiomyocytes of someone aged around seventy-five had been present their whole life. This essentially means… each individual cardiac muscle cell have been beating for seventy-five years continuously — that’s more than two billion contraction and relaxation cycles, without rest. This is perfection on an almost unbelievable scale.
But that’s not all! There is a tiny smidgeon of regeneration that happens too. About one percent of heart cells are renewed in a year for a young person, and it drops to half that value in a 75yo. This is just enough to cover for loss due to general wear and tear, the daily grind of anxiety and effort, and heartbreaks.
But it’s nowhere near enough to deal with the trainwreck that is a heart attack. Since heart cells don’t regenerate, there’s no way to reverse its effect. Prevention is the only cure.
Timeless Insight
If we want to cultivate growth, we need to be gardeners instead of craftsmen.
When we are merely creating something, we have a sense of control, we have a plan, and an end state. When the shelf is built, it’s built.
Being a gardener is different.
You have to prepare the environment. You have to nurture the plants and know when to leave them alone. You have to make sure the environment is hospitable to everything you want to grow (different plants have different needs), and even after the harvest, you aren’t done. You need to turn the earth and, in essence, start again.
There is no end state if you want something to grow.
What I’m Reading
Genetics, not lack of willpower, is the major reason why people differ in BMI. Success and failure, credit and blame, in overcoming problems should be calibrated relative to genetic strengths and weaknesses.
― Robert Plomin, Blueprint: How DNA Makes Us Who We Are
Tiny Thought
The curse of modernity is the segregation of ‘working’ and ‘working out’. If you work but don’t workout, you’d have poor health. If you do the opposite, you’d have no wealth.
Before You Go…
Thanks so much for reading! Send me ideas, questions, reading recs. You can write to abhishek@coffeeandjunk.com, reply to this email, or use the comments. And… if you feel like I’ve done a great job writing this piece, be generous and buy me a few cups. ☕️
Until next Sunday,
Abhishek 👋
PS: All typos are intentional and I take no responsibility whatsoever!