Confidence and the financial system: buyers and sellers

The financial system depends on confidence that money owed will be repaid and, when repaid, will be worth the same as it was when it was lent. These are key issues behind the current finacial crisis.

An even more basic requirement is that sellers have confidence in the means used by buyers to make payment so that, in their turn, the sellers can become buyers.

If you doubt that the financial system - and the real economy - runs on confidence, just go to the supermarket. Pick out some food, pass over some green pieces of paper with an intrinsic worth of "not much", but printed by the government, and you can leave with your food. No one will arrest you for theft.

That is where the confidence comes in: the store believes that it can exchange these nearly worthless bits of paper for labor or electricity or more food to sell tomorrow.

The problem comes when business or individuals lose confidence that these bits of paper can actually be exchanged for something useful. Then, the value of the currency falls, prices rise, and inflation takes hold.

In Zimbabwe, a beautiful and potentially rich country now ruled by an incompetent tyrant, no one believes that a piece of paper that says 200 million Zimbabwe Dollars has real value. Last week, that piece of paper might have bought a loaf of bread: this week not even that. Annual inflation in Zimbabwe is 40,000,000% and the economy has collapsed.

On the other hand, at least for now, an equally worthless piece of paper that has the words 'THE UNITED STATES OF AMERICA", "FEDERAL RESERVE NOTE" and "ONE DOLLAR" printed on it will buy more than 200 million Zimbabwe dollars.

Confidence is everything: without it our economy collapses or is forced back to the inefficiencies of using bullion (coins or bars, representing - even having - value) made from gold, silver and other precious metals. Worse, a shortage of coins will leave us exposed to the astounding inefficiencies of barter.

One of the reasons for our great wealth is the reduction, to almost nothing, of the costs of everyday transactions. Paper money and numbers in a bank's ledger are far more efficient, and cost far less to keep and transfer, than metal coins.

Let us all hope that confidence is soon restored.