The Stock Market is a Bank

People are easily confused by money. We tend to think of money as having real value, because it does have real value to us as individuals. To society as a whole, however, money is only a medium of exchange. It is just information. If I have more money, I am better off. But if society has more money, society is not better off.

Here’s one way to think about money. You go to work and do some job within this big production system called “the economy”. As a reward for your efforts, you receive an IOU for a portion of the output of the economy. That IOU is your paycheck. You can consume your portion of the economic output immediately, or you can exchange some of your right to consume now for the right to consume later. In other words, you can save some of your money.

Saving is an exchange. When you save, you are trading the right to consume now for the right to consume later. Saving is an exchange of consumption rights. You consume less than you produce now, in exchange for being able to consume more than you produce later.

For saving to work, money must retain its exchange value over time, or there must be some interest payment to make up the difference. You might be willing to save if your money loses some of its value, but not if it loses a lot of value, or if the future value is impossible to determine. In that case, you are better off spending it right away on something of real value that you could store in your basement, such as copper pipes, lumber or coal.

If you put money into stocks or bonds, that is basically the same as putting it into a bank. When you buy a stock, the seller is taking money out of the stock market to spend on current consumption. Later, when you sell the stock, you will receive money that you can spend on consumption. Of course, that is a simplification. It could be that the person selling you the stock will use the money to buy another stock, or a bond, or put the money in a bank. Savings can be shuffled around. But the point is that the stock market is just another way of saving money, like a bank. People deposit money into it and people take money out of it. The stock market is a way to exchange consumption now for consumption later.

A stock is a share of a company. Stocks can pay dividends, but that is not a requirement. Most people who buy stocks hope to make money by appreciation. They hope the price will have increased when they sell the stock, so they get back more purchasing power than they put in. But why should anyone expect this?

The conventional wisdom is that buying stocks is a form of investment. But that is a misconception. Real investment is using economic output to create or maintain capital. Building a factory or a road is an investment. Drilling an oil well is an investment. In agriculture, seed grain is an investment, grain fed to maintain livestock is an investment, clearing land for cultivation is an investment. Real investment takes place in the real economy.

Now, it is true that companies sometimes issue stock to fund real investments. But that is not the only reason why companies issue stock. And if you buy a stock, you are probably not buying it from the company that issued it. You might be buying the stock from a retiree who is selling off his portfolio to pay for groceries and rent. Or you might be buying it from a Saudi prince who is changing his portfolio structure. In most cases, you are not funding real investment.

When you put money in the bank, the bank lends your money to others. They could use that money for consumption or real investment. You don’t know what your money will be used for. If you want to fund real investment, bonds are the way to go, because companies and governments often issue bonds for explicit purposes. But most people don’t really care what the money is used for. They just care about the rate of return.

Let’s talk about bonds. A bond is the most explicit type of saving instrument. A bond is an IOU for a specific amount of money in the future. Companies and governments sell bonds in the bond market. For example, the US Treasury sells $10,000 one-year bonds. These are IOUs for $10,000 to be paid in one year. The Treasury auctions them off, so the price varies. You might end up paying $9,750 for such a bond today. The yearly rate of interest would then be 2.5%. The government gets to spend $9,750 today, and you get to spend $10,000 one year later, or put the money back into another saving instrument.

Companies issue bonds for various reasons: to fund acquisitions, to expand production, or simply to pay back existing bond holders. The latter is called “rolling over debt”. Many companies accumulate debt that they never pay off. One reason is that corporate tax penalizes companies for saving, so when interest rates are lower than tax rates, it is cheaper to use credit rather than savings to smooth out fluctuations in income and spending.

The stock market, the bond market and the banking system are all part of an integrated financial system. The financial system is a way for people to exchange shares of economic output at different points in time. Some of that output is used for consumption, some for investment. Putting money into this system is not really investment. It is saving.

Given that these are just different ways of saving, why would you expect a bigger return from the stock market than from putting money in the bank? Well, the simple answer is that you shouldn’t. Of course, this flies in the face of conventional wisdom.

But think about this. Every time a stock is traded, there is a buyer and a seller. If you make money off a price increase, that money comes from the buyer of the stock, not the company that issued the stock. The only exception is if the company buys back its own stock. Stock price appreciation might reflect the soundness of the company, but the money does not usually come from the company itself. It comes from another saver. So, even if the company is getting better over time, and that is reflected in the price of the stock, to cash in the appreciation someone else has to buy the stock.

Here’s something else to think about. Eventually every stock goes to $0, leaving someone holding the bag. The first buyer of a stock has to pay the issuer some money. The last buyer ends up with a worthless piece of paper when the company goes bankrupt or the world comes to an end. Summed over all the holders of the stock, the net return on a stock comes only from dividends and stock buybacks. And those are not guaranteed.

But if that is the case, why do stock market indexes such as the DJIA and the S&P 500 seem to go up over time?

One reason is that index appreciation is not the same as real stock appreciation. The stock indexes add and drop stocks over time. They add stocks that are on the way up, and they drop stocks that are on the way down. I haven’t done an in-depth analysis of this (it’s hard to find the data) but this would tend to make index performance look better than the performance of a real portfolio, because the index can add and drop stocks whenever it wants. It doesn’t have to realize losses. An index is not a real portfolio. It does not buy and sell stocks. It merely tracks the prices of a set of stocks over time, and the stocks in the set also change over time.

Another reason is that a lot of money has flowed into the stock market over time, more than has been taken out. Stock market indexes tell you more about the net flow of money in the financial system than how well the real economy is doing.

Where did all the money come from? The simple answer is that it was created by the banking system.

Banks also enable people to exchange consumption rights. In that sense, the banking system is just like the bond market and the stock market. Banks take the deposits of savers and lend them out to others. But this process is hidden from the depositor. The bank keeps a record of the amount he has deposited, so it appears that his money is still “there”, in his account, when in fact it has been lent to someone else. How is this possible?

When banks lend money, they are (in a sense) creating money.

Suppose that the banking system consists of a single bank with a single initial deposit of $100, from a guy named “Adam”. Call this the “monetary base”. The bank lends the $100 to someone else. Let’s call him “Joe”. They deposit $100 into Joe’s account, and they make an entry in another place for −$100, the amount Joe owes. (I’m ignoring interest for the sake of simplicity.) No net money was created, because the negative and positive parts cancel out. But the total deposits are now $200. The bank then lends out the newly deposited $100 to another person. Let’s call her “Mary”. Again, this translates into another deposit. Now the system contains $300 in deposits and −$200 in debts. The deposits can be spent now. The debts must be repaid later. This process can create an arbitrary amount of money.

Suppose that Adam grows wheat, Joe is a blacksmith and Mary tends a flock of sheep. Joe spends his $100 to buy grain from Adam and meat from Mary. Mary spends her $100 to buy grain from Adam and a knife from Joe. Adam spends his $100 to buy a hoe from Joe and meat from Mary. Mary and Joe pay back their debts, and everything is back to normal: Adam has his $100 still (he spent $100 and received $100) and Mary and Joe are back at $0. Ideally, money is created, used and then destroyed when debts are repaid. The negative and positive amounts cancel each other out, like matter and antimatter. (I am ignoring interest for the moment.)

That is roughly how the banking system works. Even though there are many different banks, the banking system functions like a single bank, because banks lend to each other, and are linked together by the central bank (in the US, the Federal Reserve Bank). The banking system is really just a big spreadsheet that keeps track of debts and deposits.

Many people don’t like fiat currency, but in principle there’s nothing wrong with it. It is conceivable that a fiat money system could work entirely on credit. Banks could simply create money and lend it to people who they think will be able to pay it back later through their productive efforts. In theory, this system could create all the money that we need, on an as-needed basis. It wouldn’t even need a monetary base. All money could be created as debt by the banking system.

However, the fiat currency system does have some major issues.

One such issue is that the ability of one person to pay back his debt depends on other people getting credit. Enough money has to be created to pay back existing debts. The creation and destruction of money must be balanced.

Another issue is that the banks have to guess who will be able to pay back their debts and who won’t. And that’s where it gets tricky. The hopes of men often go astray. Suppose that Joe borrows money to buy meat and grain from Adam and Mary, and Adam buys a hoe, but Mary doesn’t buy anything from Joe. Now Joe can only pay back $50 of the $100 he owes, leaving Adam with $100, Mary with $50 and Joe with −$50. This sort of thing happens all the time. Individuals go bankrupt, and banks accumulate bad debts.

In this example, Joe has consumed more of the real economic output than he produced. He borrowed to consume, but did not produce the goods that others wanted (or didn’t produce enough of them). Even though Adam and Mary have money in the bank at the end, they are on the losing end of the exchange, because they subsidized Joe’s lifestyle. If you have debts, and the money for those debts was created by the banking system, then in a very real sense you have a debt to society. If you owe money to the bank, then you owe future production to society.

This demonstrates that money creation can be used to extract wealth from society. The ability to create money is a form of power that is concentrated in a few hands and wielded in discretionary ways. It thus leads to corruption.

Another problem with this system is that it tends to create asset bubbles. When money is borrowed to buy assets, such as stocks, bonds or houses, it tends to make the prices of those assets increase. A pattern of rising prices then appears to lower the risk of default on loans used to buy those assets. That, in turn, leads to lower standards for lending and increases the amounts that are lent, which tends to further increase asset prices. So you have a feedback loop of increasing prices and increasing debt. Money is created and lent to individuals to buy assets, and if the prices of those assets fall there is no way for those individuals to repay their debts. This amplifying feedback loop makes the financial system unstable.

I’ll go into the pitfalls of the current monetary system in more detail at a future time. For now, I will say that it has some serious problems, but those problems could be solved by redesigning the financial system. Simply eliminating fiat currency and replacing it with something tangible, such as gold, is neither necessary nor sufficient to fix the problems with our current financial system. Money is really just information. Using a physical currency doesn’t change that.

In a future essay, I will propose a design for a stable financial system that doesn’t require a physical currency.

How did people save before we had money? The currency was goodwill. Inside your head, there is a moral accounting system that keeps track of favors given and received. Your feelings of friendliness toward other people are a reflection of their creditworthiness, or your debt to them. People did each other favors in return for goodwill that could be exchanged for favors at a later date. You might be uncomfortable viewing your feelings in this way, but that is what they evolved to do. Goodwill is a primitive form of currency for managing exchange relationships. Money has the enormous advantage that it allows for exchange between strangers.

So, whether you are putting money in the bank, buying stocks and bonds, or doing a favor for a friend, you are saving.