The Virtualization of Money

I’ve become a news junkie over the last few weeks, and reading the financial pages, I’m starting to wonder whether it isn’t the computers themselves that have done us in. In post production, we’ve seen how the digitization of physical materials has transformed our world. The process of virtualization, of turning real things into their digital analogs, which so disrupted our lives fifteen years ago, has now insinuated itself across the culture, and most significantly, into Wall Street.

When people loaned money fifty years ago, they did it against collateral that you could touch and feel. But today, most loans are made on derivatives — complex virtual “instruments,” composed of tiny pieces of myriad other loans, made possible only in an age of ubiquitous high-speed computing. They were traded and re-traded, sliced and diced and hedged with even more complex and arcane products, with huge sums moving in “flows” and with traders handling nothing more real than a computer keyboard.

Which is all fine and good as long as nobody starts to ask the “elephant in the room” question: What’s it all worth?

It seems like traders and investors are now collectively starting to wonder whether they have sliced and diced these instruments so finely, and traded them in such complex ways, that they are really funny money — nothing more than worthless bits and bytes, suspended in the digital river only by the confidence of investors who, it seems, don’t really understand them at all.

The Fed now wants to get rid of these things by simply buying them up en masse. It’s a nice trick. Create products that the computer tells you are real. (Don’t question that computer!) And when it turns out that they represent nothing at all, get rid of them, make them disappear. There’s only one small catch. To replace the virtual thing with the real thing you need the real thing — in this case, money. And somebody has to provide it.

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10 Comments on “The Virtualization of Money”

  1. Rich Says:

    Can’t the government just print more money if we’re running short? It’s a confidence game anyway — though maybe we’re too confident in the power of our arsenal.

  2. Steve Says:

    I’m sure that is going to happen anyway — and the result will be that your money will be worth less.

  3. Larry J. Says:

    I wonder what’s going to happen to all the “quants”? The quantitative analysts who were held up as the geniuses behind Wall Street’s exponential growth over the last 10 (20?) years and, I’m assuming, one of the major causes of the current implosion.

  4. Steve Says:

    As anybody who has done complex budgeting and forecasting knows — the more complicated your model is the harder it is to see the flaws in its assumptions.

    The NY Times ran an article today about how difficult it will be to determine the value of mortgage derivatives. If you want to see just how complex these products are, take a look at the chart that accompanies the article.

    Plan’s Mystery: What’s All This Stuff Worth?
    http://www.nytimes.com/2008/09/25/business/25value.html?ref=business

    Chart:
    http://www.nytimes.com/2008/09/25/business/25value.html?ref=business

  5. jayson Says:

    Hi Steve,
    first time, long time :) i was writing about this too last night on my website. but then changed my mind before posting since it was off topic. but since you brought the topic up, i’ll finish my thought.
    American money, and most of the world’s money, like you said is now mostly just a bunch of computer servers. which demonstrates more than ever what money has become. it’s a game, like monopoly. that we all agree to play. without realizing someone’s rigged the game. If we did the math from the beginning we’d have seen that ‘we the people’ would inevitable lose.
    The math is easy. if the rules of the game state that every dollar that exists or will ever exist must be borrowed at interest. where do you get the new dollars to pay back the interest on the borrowed dollars? the only answer is to borrow more at interest. But wouldn’t that just put us deeper and deeper into debt until we were entirely in hock to some unknown debt granting entity. Well, yes and that’s pretty much where we’re at right now. But don’t imagine it’s a bad thing that the system collapses. The 700 billion dollar plan is like a junkie asking for just one more hit. Not until we go cold turkey and stop borrowing and let the game break. Will we be ready to fix the way this country creates money. Now far too few people understand or care to understand our economic system. So a similarly rigged game will probably be adopted as the solution. Like a new unified north american dollar that will play by the same rules.
    But if anyone reading this is interested, I really like this documentary about how the money game evolved. if you haven’t seen it yet, check it out:
    http://video.google.com/videosearch?q=money%20masters&hl=en&sitesearch=#

  6. Steve Says:

    There’s an interesting piece in today’s NY Times about agent-based modeling of financial systems. There’s a team at Yale looking at what happens when credit gets too loose. Here’s the key quote:

    More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere. … the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain.

    Read the article here:
    http://www.nytimes.com/2008/10/01/opinion/01buchanan.html

  7. Steve Says:

    According to another article, published Thursday and linked below, capital requirements for most of these derivatives were eliminated in 2004, when the SEC decided that the big investment banks could be self-regulating. At that time, the only dissenting voice was from a software engineer who writes programs that help such banks analyze their capital requirements.

    A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.

    His letter to the commissioners was, naturally, ignored.

    Agency’s ’04 Rule Let Banks Pile Up New Debt
    http://www.nytimes.com/2008/10/03/business/03sec.html

  8. Steve Says:

    And here’s another perspective, from the hilarious and trenchant novelist Richard Dooling, on the op-ed page of today’s NY Times:

    The Rise of the Machines:
    http://www.nytimes.com/2008/10/12/opinion/12dooling.html

  9. Ron D. Says:

    >The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain.

    Pretty fascinating. Sounds much like the “cliff effect” in digital signal processing. Everything’s cool (or is error-corrected so that it appears as such), until it gets past a point of no return. Then all hell breaks loose.

    http://en.wikipedia.org/wiki/Cliff_effect

    Oh well, guess there’s no such thing as a free lunch after all!


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