Friday 16 August 2013

Lady Credit

Economics is can be seen as being primarily concerned with managing resources when faced with scarcity; the maximisation of expected utility. An alternative view is that aspects of economics, particularly finance, are concerned with managing resources when faced with uncertainty. This distinction is not new, Moses ben Maimon, Maimonides, argued that the suffering of mankind is not because they were expelled from the Garden of Eden into a world of scarcity but because they were expelled into a world of uncertainty. In the Garden of Eden humans had perfect knowledge, which was lost with the Fall, and it is the loss of this knowledge which is at the root of suffering: If we know what will happen we can manage scarcity
The first definition of economics is conventional, and as far as I can work out goes back to John Stuart Mill’s argument that
[Political economy] is concerned with [mankind] solely as a being who desires to possess wealth, and who is capable of judging of the comparative efficacy of means for obtaining that end. It predicts only such of the phenomena of the social state as take place in consequence of the pursuit of wealth. It makes entire abstraction of every other human passion or motive; except those which may be regarded as perpetually antagonizing principles to the desire of wealth, namely, aversion to labour, and desire of the present enjoyment of costly indulgences.
and the subsequent definition that Economics is
The science which traces the laws of such of the phenomena of society as arise from the combined operations of mankind for the production of wealth, in so far as those phenomena are not modified by the pursuit of any other object.
Mill distinguished the ‘science’ of economics from the “art’ of ethics, and at the end of the nineteenth century, John Neville Keynes (Maynard Keynes’ father) argued that there were two sides to economics, the ‘positive, abstract, deductive' science of Mill, and the 'an ethical, realistic, and inductive science', of the German Historical School, and the choice of approach was determined by the nature of the question. Fifty years later, Lionel Robbins, a robust opponent of Maynard Keynes, offered the following definition
Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses
Robbins adheres to the English tradition (as described by Neville Keynes) of separating the ‘science’ of economics from the 'art’ of ethics but this distinction grew into a dichotomy in the second half of the twentieth century.
The second definition, less conventional, is related to John Dewey’s argument for Pragmatism: that traditional philosophies had focussed on a forlorn ‘Quest for Certainty’ in an attempt to replace ‘belief’ (or judgement) with 'knowledge’. In doing this, abstract, deductive approaches dominated knowledge generated in practice. Whereas academic scholarship attempted to ignore the issue of uncertainty and randomness, vernacular knowledge had to face the brute fact head on. In the context of economics the effect was to start with a 'rational agent' handling physically tangible objects and then deduce hypotheses independent of ethical considerations. These hypotheses rarely stood up to empirical testing, resulting in the emergence of Behavioural Economics in the final quarter of the century. The Pragmatic approach to economics is that it should start with society, infused with morals, and then look to see how society could be improved. It is because I adopt a Pragmatic approach based on the axiom that the world is uncertain that I think Credit (associated with belief, trust), rather than Money (associated with minting coin), should be at the heart of finance.
These observations are made as a preamble to my case to support the proposition that Credit should be the central topic of Finance, not Money.  A while ago I posted a piece on the lack of financial activism, this was read as a case for Credit, which was an afterthought in the original piece.
Theories of money can be categorised into two classes: commodity theories or representative. theories Commodity theories hold that money derives its value from some object with intrinsic value (gold, silver, copper, iron, cigarettes, wheat, etc). In the European tradition this idea goes back to Aristotle (at least) who argued that money emerged to facilitate exchange and to overcome ‘the double coincidence of wants’; that in order for exchange to take place the two parties must desire what the other has. In neo-classical economics ‘money’ is simply a technical device that facilitates transactions and does not represent any single commodity, or even the labour that goes into a product, but all components of the economy. As such, while it is all’ commodities it is also totally separate from the ‘real’ economy (it is as if money is deified, everywhere but nowhere). Money should be controlled because it represents a measure; allowing it to grow or shrink is as problematic for economics as allowing the ‘standard metre’ to grow or shrink would have to physics; this quantity theory of money dominated the monetarist rhetoric of Margaret Thatcher and Ronald Reagan.
The narrative that money emerges out of barter has become part of received wisdom and as with most ‘common sense’, it has no basis in fact. Just as astrophysicists use telescopes to look back in time, anthropologists visit isolated communities to see how society evolved, and the evidence of this research is summarised by Caroline Humphrey (a.k.a. Lady Rees of Ludlow)
Barter is at once a cornerstone of modern economic theory and an ancient subject of debate about political justice, from Plato and Aristotle onwards. In both discourses, which are distinct though related, barter provides the imagined preconditions for the emergence of money ...[however] No example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money; all available ethnography suggests that there never has been such a thing. [Humphrey, 1985, p 48]
What actually happens in practice is that when individuals knew each other, exchange was based on reciprocity; a gift would be given in the anticipation of it being reciprocated in the future (when they don’t know each other there is barter, but in such situations money cannot emerge because cowrie shells might be important in one society, and gold in another). One of the most famous stories illustrating the role of reciprocal exchange has concerns an anthropologist who after spending some time with bushmen, gave one of them his knife. When visiting the group some years later, anthropologists discovered that the knife had been owned, at some point in time, by every member of the community. The knife had not been communally owned, its ownership had passed from one person to the next and its passage was evidence of a social network in the community, just as the motion of planets is evidence of an, otherwise invisible, gravitational field.
One of the most studied examples of these sorts of systems was that of indigenous people around Vancouver in Canada. A young man would lend five blankets to an older, richer person, for a year and they would be repaid with ten blankets (going to an American school in the 1970s I learnt the pejorative term ‘Indian giving’). A similar situation existed in the Southwestern Pacific were strings of shells, whose value was purely ceremonial, were lent by a young man, sometimes to an unwilling borrower, at very high rates of interest Homer and Sylla [1996, pp 22—23]. Many cultures had similar systems where by a gift had to be reciprocated by a greater gift in return these systems played a critical role in gluing society together by establishing bonds between the rich and poor, the old and young.
One particular manifestation of gift giving is sacrifice. Just as gift giving amongst humans creates a contract between them, giving a gift to a god obliges the deity to return the favour. Sahlins [1972 (2003)], Mauss [1924 (2001] At about the same time as cities began to appear people started making ornaments out of electrum (an alloy of gold and silver), copper and gold, metals found naturally in nature. Metals have an almost unique, natural, physical property; they reflect light. The only other material that stone-age humans would have come across that reflected light would have been water, which along with sunlight is the basis of life Diamond [1998, pp 362—363], Betz [1995], Landes [1999, pp 70—73]. The first time a human spotted a nugget of gold sparkling in a river bed they must have experienced a sense of awe, here was an object that seemed to capture life-giving sunlight and water.
Religiously significant metals became important as temple offerings and temples began accumulate large reserves. Followers of the religion would look to acquire the metal, to enable them to make an offering to the gods, and so the metal became the commodity in the most demand. The Ancient Egyptians, who had easy access to gold, used Cypriot copper for their religious offerings while the Cypriots used Egyptian gold. In Mesopotamia, the metal of choice was silver. Pryor [1985], Eagleton and Williams [1997]. When ‘Currency Cranks’ or ‘Bullionists’ argue that the economy would be improved by reverting to a Gold Standard because gold has an ‘inherent value’ they need to explain where is the value in gold, apart from its inherent symbolic, representative, value.
We don’t know much about economics in the ancient cities apart from for Mesopotamia, which has left hordes of clay tablets describing financial transactions. The economy was dominated by the temples who received rents and tribute, provided religious services and loans. The cuneiform tablets recorded the debits and credits associated with these activities. The transactions were denominated in shekels, crude bars of silver. Coins, metal tokens, rarely, if ever, actually changed hands. Later, we read in Homer that the Greeks priced goods in terms of oxen, the animal that was reserved for sacrifices to the gods, and then the treasury of Athens, the richest Greek city after the Persian Wars, was in the Temple of Athena and Jesus cast the money-lenders, exchanging worldly Roman money for divine shekels, out of the Temple.
As states emerged money became defined by the state, fiat money or chartalism. Fiat money is central to Modern Monetary Theory that argues money is created when governments pay for services using tokens, which it then redeems through taxation. This theory contradicts Monetarism in arguing that national deficits are not necessarily detrimental to the economy.
There is firm evidence to support money being a state creation. Money appears in Europe at the time the Greek city states became reliant on mercenary armies. Cities paid soldiers in gold to conquer some community, the soldiers then spent the gold in the colonised lands and the state recovered the gold by taxing the colonised merchants and innkeepers using the tokens that the soldiers had paid for food and lodgings. Greek and Roman citizens never paid tax, only the conquered paid for the privilege and were bound to the conqueror by having to exchange their resources for the Imperial currency. The model would survive and drive colonialism in the modern age, in the 1920s the British taxed Kenya at a rate of about 75% of wages, forcing the colonised to grow cash-crops to be consumed by the colonisers. The Belgians did not tax the Congo — they relied on forced, rather than ‘free’ wage labour Ingham [2004, p 76].
Monetarists have long argued that the fall of the Roman Empire was facilitated by an economic collapse caused by a dilution of the currency resulting in inflation. The Monetarist explanation is that the Emperors’ needed more coins to pay their armies and since they had a fixed amount of gold bullion to make coins, the coins had to be debased. Since the ‘gold price’ of goods was fixed, the ‘money (coin) price’ had to rise, because with debasement more coins were needed to deliver a fixed quantity of gold. Advocate of fiat money theories counter argue that the Emperors raised taxes in the core provinces of Gaul, Spain and the Middle-East, and spent these taxes in Rome (public entertainment) and the frontier provinces (on the army). The core provinces obtained coins, tokens that enabled them to pay taxes, by selling goods to Rome. As long as this circulation was maintained all was well. However a combination of factors, over-reach by the Empire, natural famine and a decline in the supply of slaves — the main means of production— began to disrupt the circulation. Since the state still had to pay the army, coin flowed into the system, but taxes did not drain it out again and more money chased fewer goods, resulting in the inflation Ingham [2004, pp101—104].

Charlemagne reinvented the Roman empire in the West, and part of this process was the re-introduction of the Roman monetary system into an 'un-monetised' feudal economy where exchange was rare, that is one without currency circulating.  Because coin was scarce, Charlemagne's bureaucrats specified the exchange rate between common goods and money in order that the taxpayers could pay there tax.  If you were a small holder and had been assessed for one shilling tax, if you did not engage in the market economy you would not have a shilling, so the government told you a shilling equated to a cow.  This fixed the prices of cows, an unintended consequence, since Charlemagne's bureaucrats  probably couldn't care less about what was happening in the market place.  However the impact was enormous - there was no incentive to move goods from places of abundance to places of scarcity.
Fiat money is representative money but not necessarily credit money. In the Roman Empire banks did not exist, and the state could not fund its activity by borrowing from the market, as states started to do in the medieval period. There was a credit-debt type relation in the Roman economy, the state was buying goods with IOUs, in the form of the coin, which it redeemed through the tax system. If you were living on the Danube and felt the presence of the Goths more keenly than the Legions, you might well not bother to trade your produce for Roman tokens, causing scaricty at the centre and disrupting the circulation of currency.
Credit theories argue that buying and selling is about exchanging a good for credit. When I do work my employer gives me an IOU (ideally in the form of fiat money, which is in demand because I must pay taxes), I then offer this IOU to a grocer for food. If the grocer trusts the credit’ of the writer of the IOU, they will accept the IOU. The government can print as many IOUs as it likes, but if it issues too many, the grocer may lose faith in the Government’s fidelity to repay its IOU. If the grocer thinks there is a 50:50 chance of repayment, they might ask for twice as many IOUs. If the Chines feel the US government will not honour its promises, the USD/REN exchange rate will fall, an inflation will appear in the US and Chinese growth will slow.
I may want to buy something, like a house, that requires a more money than I have, I do not have enough IOUs to hand. In this case I can go to a bank, which can be seen as a technology that converts my own credit’ into money: banks make tangible an agent’s intangible credit Keynes [1971, chapter 2] just as machines make energy tangible as heat or motion. Governments have a role in this process by regulating the interest rate it will demand to realise banks’ credit, and banks use their realised credit to realise their customers’ credit.
Banks, in realising their customers’ credit, are often seen as feminine institutions
They create the new money which sets the wheels of production turning again. But they cannot procreate without a spouse. The newly born money must have a father as well as a mother. Someone must take the active, positive role of borrowing, spending, and employing, or the banks will remain barren. Winder [1959, p 81] quoting Strachey
In the early eighteenth century this identification of femininity with the concept of credit was widespread, and described in detail by Daniel Defoe. Between 1706 and 1709 Defoe published various articles on Lady Credit in his periodical, the Review of the State of the English. In 1706 he introduces her as
Money has a younger sister, a very useful and officious Servant in Trade ...Her name in our Language is call’d CREDIT ...
This is a coy Lass ...a most necessary, useful, industrious creature: ...[and] a World of Good People lose her Favour, before they well know her Name; others are courting her all their days to no purpose and can never come into her books.
If once she is disoblig’d, she’s the most difficult to be Friends again with us de Goede [2005, p28 ]quoting Defoe, 1706
Today, Defoe’s imagery may appear quaint, but he captures the elusive nature of ‘credit’.
The use of gender imagery to represent concepts like ‘credit’ is nothing new, the Greeks represented luck as the feminine, and unstable, Tyche and the Romans developed the idea into the unpredictable Fortuna, with luck, or good fortune, becoming associated with wealth. This imagery developed with the sixth-century, Christian, philosopher, Boethius writing in his Consolation of Philosophy
I know how Fortune is ever most friendly and alluring to those whom she strives to deceive, until she overwhelms them with grief beyond bearing, by deserting them when least expected Boethius [(2010, Book II]
Defoe’s Lady Credit is as fickle as Fortuna but has a particular feature, her coyness; the more you chase her, the less likely she is to respond,
for as once to want her, is entirely to lose her; so once to be free from Need of her, is absolutely to posses her. de Goede [2005, p29] quoting Defoe, 1709
In 1709 Defoe describes how stock-jobbers, the most speculative of animals, treated Lady Credit,
The first Violence they committed was downright Rape ...these new-fashion’d thieves seiz’d upon her, took her Prisoner, toss’d her in a Blanket, ravish’d her, and in short us’d her barbarously, and had almost murther’d her de Goede [2005, p34 ] quoting Defoe, 1709
Commodity theories are more popular than representative theories because they are perceived as simpler, and hence have the veneer of common sense logic. It is obvious that if money is a tangible, physical asset its quantity should correspond to some calculation of tangible of tangible objects. Since the physical planet is a closed system money is scarce and in this framework Ayn Rand’s argument that selfishness, the dominance of one’s own interests, is a virtue and altruism a vice, is inevitable.
For me, commodity theories are on an intellectual par with flat-earth theories and the enigma is why they persist. Society accepts that energy’ exists and its existence is manifested in heat and work, but are queasy that credit’ exists and is manifested in money. I think the issue is that most of us are taught about energy from an early age, there is a widely held coherent story that has developed over 150 years that we can tell our children. No such consensus exists with regard to the nature of money, and I think this is because science’ is uncomfortable about discussing the idea of credit, which seems tied up with moral ideology, it is much easier to talk about tangible things’. One observation a scientist might make is that the problem is energy is conserved whereas credit is not, but the obvious point to make to parents is is the love for children conserved (i.e. if a second child is born, does the familial love divide between the two with a corresponding loss of welfare)? If science accepts that everything is ideological but this is not the central issue: a consensus, which is objective by not being subjective, is what is needed, and consensus is developed through rational discourse (or Habermas’ communicative action).
That is the theory, now the practice. Why did Long Term Capital Management fail? LTCM had a simple business model, speculate on mis-pricings in the market and then borrow money in anticipation of the prices correcting themselves. The obvious risk in this model is that you are not as smart as you think you are, and that the market gets the prices right and you are wrong. The less obvious risk is that Lady Credit will abandon you in your hour of need. Donald MacKenzie MacKenzie [2003] summaries five explanations
  1. The partners in LTCM were guilty of greed and gambling (consciously reckless risk-taking); 
  2. LTCM’s partners had blind faith in the accuracy of finance theory’s mathematical models. 
  3. LTCM was over-levered too high a proportion of its positions were financed by borrowing, rather than by LTCM’s own capital. This third hypothesis, however, explains at most LTCM’s vulnerability to the events of August and September 1998: it does not explain those events. The most common explanation of them is: 
  4. On 17 August 1998, Russia defaulted on its rouble-denominated bonds and devalued the rouble. However, superimposed on the flight-to-quality, and sometimes cutting against it, was a process of a different, more directly sociological kind: 
  5. LTCM’s success led to widespread imitation, and the imitation led to a superportfolio’ of partially overlapping arbitrage positions.
   Most of these narratives of the failure of LTCM focus on the obvious risk, that the managers were dumb (which encompasses reckless and imprudent in borrowing). MacKenzie’s own explanation focuses on the markets as a complex network, and it was the interactions in the network that caused the problems.
MacKenzie highlights a fax that LTCM sent to its investors on 2 September
the opportunity set in these trades at this time is believed to be among the best that LTCM has ever seen. But, as we have seen, good convergence trades can diverge further. In August, many of them diverged at a speed and to an extent that had not been seen before. LTCM thus believes that it is prudent and opportunistic to increase the level of the Fund’s capital to take full advantage of this unusually attractive environment.
LTCM were acknowledging that they had made losses but in the crisis there was opportunity. Unfortunately this private fax became public and all that was communicated by it was that LTCM was making losses. This had the immediate effect that any assets that LTCM had a large holding of were sold in anticipation of a fire sale by LTCM, this depressed the value of LTCM’s holdings further. Speculators simultaneously started betting on LTCM’s failure, further depressing the value of their assets. As a result LTCM’s credit evaporated, the market lost its faith in the firm to repaid its loans and the firm could no longer fund its positions and collapsed. LTCM’s strategy was fine, the assets it held were mis-priced and eventually converged, but LTCM went bankrupt before the doubling strategy, the martingale, paid out.
Because the popular narrative, which created the consensus amongst the public, policy makers and practitioners alike, focused on the stupidity of LTCM rather than the collapse of credit in a social network, a decade later the Financial Crisis occured. Many commentators argued at the time that the Crisis of 2007-2009 was unusual in that it was a solvency crisis, not a liquidity crises, but I think this is a bit naive. French and German banks should have suffered similar losses to US/UK banks at the time but they did not, probably because they threw away their models that told them they had made losses. As a result they did not appear insolvent, and so retained some of their credit. Today finance is placing greater emphasis on credit risk, but the mainstream has responded to the Crisis more by a lurch to the empiricism of behavioural finance rather than engage with the metaphysics of faith, hope and charity around Lady Credit.


O. Betz. Considerations on the real and the symbolic value of gold. In G. Morteani and J. P. Northover, editors, Europe: Mines, Metallurgy and Manufacture, chapter 2, pages 19—28. B. B. Price, 1995.
Boethius. The Consolation of Philosophy (Trans. W. V. Cooper, 1902). University of Virginia Library E-text centre, (2010).
M. de Goede. Virtue, Fortune and Faith. University of Minnesota Press, 2005.
J. M. Diamond. Guns, Germs and Steel: A short history of everybody for the last 13,000 years. Vintage, 1998.
C. Eagleton and J. Williams. Money: A History. British Museum Press, 1997.
S. Homer and R. Sylla. A History of Interest Rates. Rutgers University Press, 3rd edition, 1996.
C. Humphrey. Barter and economic disintegration. Man, 20(1):48—72, 1985.
G. Ingham. The Nature of Money. Polity Press, 2004.
J. M. Keynes. The collected writings of John Maynard Keynes. Vol. 5 : Treatise on money 1: The pure theory of money. Macmillian, 1971.
D. S. Landes. The Wealth and Poverty of Nations. Abacus, 1999.
D. MacKenzie. Long-term capital management and the sociology of arbitrage. Economy and Society, 32(3):349—380, 2003.
M. Mauss. The Gift: Form and Reason for Exchange in Archaic Societies. (Routledge), 1924 (2001).
F. L. Pryor. The origins of money. Journal of Money, Credit and Banking, 9(3):391—409, 1985.
M. Sahlins. Stone Age Economics. (Routledge), 1972 (2003).

G. Winder. A short history of money. Newman Neame, 1959. 


  1. Your discussion of LTCM at the end, reminds me of May's approach to looking at confidence effects in the inter-bank loan network:

    Arinaminpathy, N., Kapadia, S., & May, R. M. (2012). Size and complexity in model financial systems. Proceedings of the National Academy of Sciences, 109(45), 18338-18343.

    Do you think this is on the right track for the sort of pragmatic views of finance (and science more broadly) that you have been discussing? I've been a very captivated (although silent) reader so far, looking forward to move. I would love to read your views on May's connection of ecology and finance.

  2. Essentially market has no way of self-correcting itself, the collective wisdom is an ensemble of individual ignorance, that gets hidden by following what others are doing.

    Bandwagon behavior, and coupled to it the 'free-rider' problem has wide scale ramifications from equity and derivatives trading to public accountability in capital raising and deployment and in many other areas including the simple experiment of finding the best candidate for a job amongst a large number of applicants. The behavior in most bourses as the opening bell is sounded till the closing has similarities that can be attributed partially to the effects of information asymmetry or sometimes to potential difficulty to actually get a mathematical solution to a complex problem where unknowns are either large or a simplistic linear model may not be the right fit to get as close to the reality as possible. Relying on availability heuristic or copying the behavior of others is the more ‘sensible’ response, which may not be the more rational one. The engines through which these actions get guided or influenced is a more recent study where market participants could actually be incentivized to act on signals of others rather than actively seek information for a more personal inquiry. Inquisitorial journey into areas where timely information and perfect information could be rarity further compounds this problem plaguing financial markets in particular.

    Abhijit Banerjee in his seminal paper in 1992, titled, “A Simple Model of Herd Behavior”, introduced the topic of ‘everyone doing what everyone else is doing although private information suggests doing something quite different’. His simple model brought to the fore the disastrous consequence of such an eventuality, "In equilibrium we find the reduction of informativeness be so severe that in an ex ante welfare sense society may actually be better off by constraining some of the people to use only their own information." The Nash equilibrium that creates the most efficient solution is itself based on sequential acceptance of other’s choices which are themselves based on choices exercised prior to theirs, which may or may not be based on rationale. Lack of informativeness in the final outcome is a very pretentious denouement of the bandwagon effect.

    Collective conclusion of the market based on sequential reasoning, where informativeness is itself scarce and on a shaky ground leads to the general argument that when the market as a whole could be taking an irrational decision, the chances of that being deciphered and acted on by an individual participant is remote. When market itself is one third unwise, as individual participants respond seeing the response of others as in the Asch experiment, the self-correcting principle of the market falls flat, or at least the mathematical fallacy is no more on a shaky ground.
    This leads us to the conclusion that bubbles can only burst when the crisis is full blown, when the collective conclusion leads to this denouement where the Nash Equilibrium shifts; the collapse of a paradigm only needs one small nudge against a mountain of wisdom that is more unwise.

  3. It may seem like a small point, but I think it is significant.

    You say "One particular manifestation of gift giving is sacrifice" - I'd say that works the other way round. That, if you like, gift giving was born of sacrifice.

    I think the chronology is important because it tells us something about money. You quote Ingham. The sentence of his that has stayed with me is;

    "The very idea of money, which is to say, of abstract accounting for value, is logically anterior and historically prior to market exchange."

    Ingham uses this truism to make case for (broadly speaking) State Theory. But for me, the sentence point to something far more profound. It says Money exists at very deep level in our minds.

    Perhaps this is why commodity theories are so sticky. They recognise Money as a reality - of which I think it is an aspect - whereas 'social relations' theory abstract it. And this conflicts with something both primal to our nature and also mundane to our lives.

    As usual, excellent stuff Tim. Thanks. I've read no Defoe. I really must remedy that. I love the sexualisation/gendering stuff. That's very interesting for a Freud fan like me !

  4. I agree the chronology is important. I have it in my head that anthropologists believe personal relationships precede religious beliefs, but don't know where that comes from



  5. Credit given is the counterpart of subjective probability, and one could say something about 'rational' constraints on credit. Under stable conditions one would expect credit given by successful lenders to be rational, in some sense. But there are exceptional conditions under which, as for mortgages around 2006-7, credit may be irrational or at least misguided or risky, in some sense.

    Discussions around probability under conditions of reflexivity tend to degenerate into quasi-religious wars. A theory of credit would need to address the same technical issues, but may be able to avoid the controversies.


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