I’m selling short on invisible giraffes.

Several people have asked me lately what it is that’s gone wrong with the economy lately, although why they think I should know I have no idea.  According to the news it’s all about bad debts in the mortgage market, with banks giving loans to people who couldn’t afford to repay them and the value of the housing market dropping recently.  However, that seems simplistic to me.

I was reading an article this morning which made me think about how illusionary the whole economic system is.  For most people, myself included, we give up some of our time to someone else in return for a reward, normally represented by money, which we can exchange with other people for things that we want.  That’s about as far as my knowledge of economic systems go, it’s just a more convenient way of transferring our skills between people without having to create huge barter chains where we all exchange services.  Money is basically a promissary note, equivalent to a certain about of stuff, either goods or services.  What form that note takes is immaterial, as long as we all agree that it has value.

However, once you have a physical thing which you’re exchanging with other people in place of something else, then there’s a danger that people mistake the token for the actual goods or services and reason that if you create more tokens, then everyone gets richer.  This is the foundation of the modern day economic system, since any link between money and something physical (like gold) was removed.

This is still fine, as long as everyone retains the belief that the tokens are still worth something real at the end of the day, as as long as the people who make the tokens don’t go made and make too many, then we accept it and everything continues as before.  Of course, if whoever makes the tokens makes too many then they become devalued, inflation kicks in and the economy begins to fail, as is currently happening in Zimbabwe for example.

Now things start to get a bit dangerous.  If you’re not linking your tokens to anything real, then you can start to claim that situations in the future might have value.  For example, I might be a trader in grain with a ship full of corn three weeks out of harbour.  While it’s at sea on the boat, I can’t eat the corn, but in three weeks I’ll have lots of food, so, I can use that grain as capital against someone else giving me some money now, in the knowledge that in three weeks time I’ll be able to give them some grain in exchange.

So now we have embedded the element of risk in the transaction.  If my ship sinks before it gets to port I’ll have nothing and won’t be able to repay my debts.  But, as long as everyone is aware of the risks, then this sort of transaction speeds up commerce and is still basically ok, as long as everyone trusts everyone else.  The insurance industry grew up from traders banding together to average out these risks to make sure that things on the whole worked out smoothly.

With the advent of the stock market, things got a bit more dangerous again.  Shares are just another form of token, but linked to the worth of a company in the stock market.  What that share is worth however doesn’t always depend on how well the company is doing, just how much it’s perceived to be worth in the current marketplace which can depend on any number of things, many of which are completely outside of the company’s control.  Now the risks which might affect my investment aren’t just things which might happen to my stuff directly, like my ship sinking, they could be anything, from someone hearing a rumour that my company is about to go bust, to another completely different company failing and spooking the market.  This reliance on confidence has at least something to do with the current economic problems, but there’s another couple of steps in the chain of illusion to go yet.

Normally, in order to invest in a product or company, you’d buy shares in it in the hope that their value increases.  However, if you think the value of something is going to go down, it’s still possible to attempt to make a profit from a falling price.  You borrow some of the shares in question with an agreement to give them back at a date in the future, then sell them, banking that when the time comes to give them back, you can buy some more at a cheaper price and hence make a profit.  This is known as short selling in the market and can lead to share values being driven downwards as traders try and lower the price of a company in order to increase their profits.  Obviously any situation where someone can profit by reducing the value of a company can lead to problems if it’s done too aggressively but at least there is still something concrete being traded, the share in the company, even if it’s value at the current moment is somewhat less concrete.

The article I mentioned at the beginning of this digression takes this trading element to another level however.  Apparently some organisations have been attempting a short selling based trading position but without actually having the shares to sell in the first place.  This is called naked short selling.  I think that the price of company X is going to decrease, so I sell you 10,000 shares in the company at the current price, even though I don’t actually have 10,000 shares to sell.  When the time comes to deliver those shares, if the price has gone down then I’m ok, I can buy them at the lower price with the money you’ve paid me, deliver them and no-one is the wiser.  However, since I didn’t have the shares at the time I made the initial offer, I’m effectively trying to conjour them out of the air.  I’ve moved from not linking my tokens to anything concrete, to not even having any tokens at all.

Just as if a government tries to print too many ‘money’ tokens, the value of each token decreases, so if someone creates too many ‘share’ tokens it seems to me that the same thing will happen and I suspect that’s what’s been going on.  Of course, the value of the ‘share’ tokens going down benefits me as the short seller, providing that I can buy enough at the lower price to meet my commitments to deliver your shares, but if too many people start doing it and more ‘share’ tokens are conjured into the air than actually exist, then I can’t deliver on my deal and confidence in the market drops even more, which makes the value of even the real tokens drop and you get into a vicious cycle.  Suddenly no-one trusts the value of the tokens anymore, and the system falls to bits.

Governments around the world as I see it are now trying to pump their tokens back into the system as trustworthy agencies whose tokens have real value.  I hope it works.

Incidentally, as I mentioned at the beginning, I know nothing about economics, so if anyone can explain what’s going on to me then I’d appreciate it!