Monday, October 28, 2013

A Gross Oversimplification of Monetary Theory Through Hypothetical Monetary Systems

Monetary theory: everyone’s favorite dinner topic? Probably not. Monetary theory can seem complicated to a non-economist, and even when it is understood by parties over dinner, it is likely to fall into the two most forbidden categories of conversation: religion and politics. I realize writing this that I am probably a terrible dinner party guest, an incorrigible lunch time acquaintance, and a downright nuisance at family functions, because religion and politics is the only thing I really prefer to talk about. Well, from my perspective it’s philosophy and truth, and I consider politics merely the game of sociopaths and the morally contemptible, but we have not the time for such digressions; it’s time to jump into some monetary theory.
The truth is most people would benefit greatly from a deeper understanding of what money is, how it works, who controls it, and what outcomes monetary policy has on their daily lives. They might be more willing to change the way they spend and invest, how they feel about political spending, or more willing to see politicians as the slimy, corrupt, evil psychopathic busybodies most of them are. I’m going to do my best to shy away from often-used and more often misunderstood concepts like “inflation,” “deflation,” and “gold standard.” and instead talk about the kind of things that happen, or may happen, under different sorts of money systems.

What is money?


Above is a very straightforward video explaining what money is, and also giving a few criticism of the current American model. I’ll use a much simpler definition to speed things along, but if you have the time, it’s worth the watch, as well as Shane’s Bogosity series.
Money, quite simply, is anything that is used as an intermediary of exchange instead of direct barter. It is the middleman between production of one good or service, and consumption of another. It allows finer and more graduated division of labor, which increases efficiency across an entire economy. Without money, you would have to trade your services directly for other services, limiting your ability to provide services only to those who had a service you desired, and vice versa. If you were a basket maker, you could only get your plumbing fixed by a plumber who wanted baskets, or you would have to invest time and energy learning the skill yourself. With a system of currency, you can sell your baskets to whoever wants them in exchange for money, then use that money on whatever you need, either that day or later on.
This allows a lot more division of labor, especially as markets become broader. You can specialize in something very niche, like writing gay erotica or making pants out of hemp, and not worry about whether or not the owner of the corner store wants to trade you milk and bread for your novels or pants.
Contrary to common belief, money is not the root of all evil. It’s just a medium of exchange. It could be anything, as long as it is commonly accepted in trade, though different things can make better or worse money. Currency can be a commodity with its own value alternative value (like gold), a series of hashes, like a bitcoin, or be printed on paper. It’s nothing magical, and it’s nothing desirable for itself. It’s not wealth; wealth is things, not money. Money is only useful in helping you turn your specialized production into the many diverse goods and services (wealth) that you need and use.

So now, let’s take some time and run through a few different types of monetary systems, and see what we can expect from an economy using them. In the examples that follow we will take a few things for granted:

Divisibility- How divisible the money is, meaning how finely we can chop up the individual units and still find the medium useful, is important when currency becomes very valuable. With certain modern commodities, such as gold, lack of divisibility can make the currency unusable by those who are conducting transactions below the divisibility threshold (the point at which the currency can no long be divided). We will assume either infinite or near infinite divisibility of the money.

Counterfeiting- We will assume that counterfeiting is not present in sufficient enough quantity to make an impact.

Banking systems- We will assume a free banking system, capable of making high-risk and low-risk loans, using either full or partial reserve according to market demands.


Condition 1: Static Money Supply

In a static money supply, the total quantity of money, whether divisible or not, is fixed. This means that no new money can enter the marketplace, and zero growth of the money supply occurs relative to all other factors. With this condition, we can expect the following things:

Money increases in value relative to goods and services- this is because the amount of “stuff” available grows over time, the amount of producers providing services grows over time (typically), and the demand for goods and services typically increases over time. There is less money per person, or per unit of demand, and so money is more valuable relative to everything else.

Prices generally fall- The inverse to the above, the prices of goods and services fall over time due to increased and additive production of goods (the quantity of cars or working TVs, for example), as well as because economies over time become more efficient at producing goods and services. Capital improvements such as mechanization cause the production per capita to increase and thus further drive down prices.

Interest rates vary- Interest rates are variable between a negative amount (for full reserve banking, which is viable in a static currency situation) and a high amount depending on risk. Since money increases in value over time, it may be worth it to a person to pay a bank to keep their money secure (a negative interest rate) in a full reserve bank, secure that its buying power will be stable even if they end with less money than they put in.  They may accept very low interest rates for partial reserve systems, or take risks for higher interest rates in capital investments and bank-proctored loans.

Banking- Banks generally serve consumer demands, since people can avoid the banking system entirely with no loss of value in their money.

Is this kind of money possible?- Yes. It could technically be possible in a fiat system, though highly unlikely given political machinations, and is the end state of bitcoin’s (a type of electronic crypto-currency) “soft cap.”

Condition 2: Precious Metal Money.

There are several advantages to the use of precious metals such as gold and silver as money. First, the money has value besides being currency, meaning its value is more secure than fiat currency. If the value of the money as currency falls below its industrial usefulness, the money will be melted down and used, thus stopping the devaluation. Second, the cost of extracting the metal from the earth will keep a check on the amount of money introduced into the economy. If it costs more to mine gold than what you can get out of it in the market, it won’t be mined. With this condition, we can expect the following things:

The value of money fluctuates, but is stable over the long term- Due to the supply checks listed above, the value of money relative to other things will rise and fall according to the supply, but in the long term, say over several years, the value of money will be consistent and stable, if not increasing slightly over time.

Prices fluctuate, but remain stable over the long term- The inverse of the above, prices will generally stay stable. Producers of currency (miners, in this case), are motivated to create more money when there is high demand for it from growing consumer bases, or the price of goods falls due to efficiency, giving the money new buying power.

Interest rates- Interest rates are generally low to high; generally higher than a static system. There may be some full reserve systems due to the easy theft of money metal, but because prices are stable, consumers may be just as inclined to put their money into high-reserve or low risk investments over the short term. Investments require even payout or slightly more to be worthwhile, causing interest rates to be slightly higher than in the static system, but still variable according to risk.

Banking- Banking is a more attractive option under a metal standard, partially because of security concerns, but mainly for the divisibility factor. Since physical gold cannot be divided enough to be used on small-cost goods such as food or drink (think about trying to buy a soda with 1/1000 of an ounce of gold), a mixed system would likely emerge, consisting of some physical gold with a majority of currency being issued as bank-backed notes. The banking system would, therefore, be more present than in a static system.

Is this kind of money possible? Yes. This was the preferred standard for economic trade for thousands of years. Unfortunately, once the government took over the money trade during the 20th century, making it illegal for banks to print gold notes, the system’s demise through mismanagement was inevitable.

Condition 3: Monetarist System.

In this proposed system advocated by the great economist Milton Friedman as an alternative to the actions of the Federal Reserve, the growth of money would be regulated centrally, and be at a predictable rate each year, say 3%. This system presupposes either a fiat currency, or total control over a commodity system. The point is to produce a high degree of market confidence in the predictability of the money supply, solving the fluctuation problems associated with a metal standard, and having the additional advantage of providing alternate utility to the economy the resources that would be invested in digging metal out of the earth. Under this condition we can expect the following things:

The value of money is highly stable relative to other things- ideally the rate of growth would be pegged in such a way to the money supply at an equilibrium with growing demand, thus making the value of money stable even over long periods. However, even if the rate is off, and the value of money increases or decreases, it will be by a fixed, predictable amount.

Prices remain very stable over the short and long term- Since the money supply is growing, and not fluctuating, it will off-set the lowering of prices due to increased efficiency and supply, making items like candy bars cost the same years apart. Some argue this has “consumer confidence” benefits, allowing people to predict revenue streams better.

Interest rates are moderate to high- Because the money supply grows over time, and the price of goods remains stable, investors must receive a better than even return on their money. Usually, the lowest interest rates, for the safest investments, will be slightly more than the pegged rate of monetary growth.

Banking- Banking will seem very attractive to savers and investors under the monetarist system. Since the value of money stays the same or goes down over time, full reserve systems will be rare or non-existent. Partial reserve systems with a high reserve rate will seem most attractive for short-term savings. Savers are motivated to “put their money to work” with investments to maintain or grow its value over time.

Is this type of system possible? Yes, although it is unlikely given that it necessitates a central authority to plan monetary growth and central authorities generally have a terrible track record when it comes to being trusted not to print money. Depending on who you talk to, monetarism was tried under the Reagan administration, but this mostly false. Interest rates were raised and the inflation of the 70s stopped, but a full monetarist system has never been implemented, nor is it likely to be.

Condition 4: Fiat Money

Fiat money is money, usually printed upon paper or made of cheap metal coins, that is declared to have value by a central authority. The current US dollar, and most other world currencies, fit into this category. The usability of Fiat currency can only be maintained by force. The central authority makes it illegal to use competing currencies, and declares that anyone doing a business transaction must accept their fiat money in lieu of other things. If you look at a US dollar, it will say, “This note is legal tender for all debts, public and private.” Fiat money is generally the least appealing to the average consumer, but is the world standard because it is the most attractive to those in power. There is no need to mine gold, or have legitimate rates of taxation when you can print up the money you need and force the population to give you goods and services for it. The government also has an advantage in not suffering the effects of inflation; since they are the first ones to spend the money, it has the value of the money before the new currency enters circulation. Even a totally devalued fiat currency is still attractive to use by the population, since people must accept cheap money instead of dear money. The US uses a special variation of fiat currency that we will get into next. Here is what you can expect from Fiat Money:

Decreasing value of money- Because more money exists every year (in the vast majority of fiat systems), the value of that money decreases relative to other things. This can be by a little or a lot, depending on how much money the government is printing to finance things.

Increasing prices- The inverse of the above, prices generally increase, even as the economy gets more efficient over time. This can upset or confuse consumers, who cannot reasonably plan for future expenses, or who think revenue streams will always increase when they actually may be losing money to inflation.

High interest rates- Because inflation is high, bonds, loans, and other investments must promise high rates of return to make up for value lost to inflation. High risk endeavors become more promising as a means of recovering lost value.

Banking- Full reserve banking will be non-existent, since all savers will require a rate of return on their money just to match inflation. Partial reserve systems will tend toward more risk and lower reserve rates in order to meet the demands of savers for their returns. Bank failures can happens swiftly and catastrophically as small reserves can be quickly depleted by a sudden need for liquidity.

Is this kind of money possible? Possible, yes. Sustainable, no. Eventually the money printing process will so deface the value of the currency that it must be revalued, or new currency introduced that is more valuable, and begin the cycle again. This is the current world standard due to the huge advantages it gives governments in the political process, but can only be maintained using violence.

Condition 5: Debt Money

This is the monetary system that is currently in use by the United States, and offers some significant value to the government over other types of fiat. Under most fiat systems, the government prints new money, then spends it on goods and services, increasing the money supply (I’ll leave dismantling the Keynesian argument of the benefits of this for another article). Under the debt system, all new money enters the economy as loans from the central bank (the Federal Reserve in the United States), which is owned by the government and has the power to print money. The government gets a great deal of its money, the money it would like to spend but taxpayers are unwilling to pay for directly, by issuing bonds. The vast majority of these are purchased by the central bank using newly created money. Money has been moved from one hand to the other, obscuring the inflation spending the government relies on to maintain its size. In this way, it is little different from a standard fiat system. The extra advantage (from the government’s perspective) comes from the fact that the central bank can also make artificially cheap loans to the banks and private parts of the economy. These entities also benefit from the lack of inflation that comes with being a first spender, and entices them to support the continuance of the debt system. Many of these loans actually have a negative real interest rate, meaning the value of money has gone down enough by the time they pay it back that they have made money just by taking out the loan. Eventually, the system can be expanded to include voters, who receive cheap home and auto debt, among other things. Here is what to expect, and some of the current conditions of the US economy:

Decreasing value of money- The value of money continues to go down as more debt is issued, but the value decreases fastest for the consumer, and the slowest for the government and banks, which are the first spenders of the new money.

Increasing prices- Prices generally increase, sometimes enough to entice consumers to purchase things with debt in anticipation of increased value. This was especially true of the housing boom of the 2000s. Prices increase slowest for the government and the banks, since they are first spenders.

Low interest rates- This is very beneficial for banks, who can acquire loans from the central bank for a very low price and invest the money accordingly. It is good for the government, since it has to spend little of tax revenue and new debt to service the interest on old debt. It may be good for people who acquire a home through debt, since debt will make a smaller amount of the cost of the home than it otherwise would if inflation were taken into account. It is, however, very bad for those who wish to save and invest. Since banks can acquire funds from the central bank very cheaply (often at far below inflationary rates), they have little incentive to offer savers the high interest rates that are necessary for them to maintain the value of their money. At the same time, more people are forced into banking to minimize their loss due to inflation, even willing to put up with rates far below inflation. Risky investments are very attractive as a means of maintaining the value of money.

Banking- Full reserve banking is non-existent. Partial reserve banking is the norm, with less and less held by the bank in reserve, since the money necessary to pay depositors can be acquired cheaply from the Federal Reserve. Almost all individuals must use banking systems or lose even more value on their money.

Is this kind of money possible? Yes, and the United States has been using it for decades. Lots of people get concerned about the national debt, but the number really just represents the amount of money that has been printed to finance the government. This amount of money will never be repaid. This, of course, amounts to a tax, since subjects lose the value of money they already have. The sustainability of the system is uncertain at best, but at some point the value of the currency will become so defaced that it will have to be re-valued to some degree.

Conclusion

There you have it! Over three thousand words of monetary theory, as clear as I can explain it. What system do I recommend? Free currency, of course! This allows the collective marketplace to make all relevant decisions at the point of sale. Metal, bitcoin, or other currencies all have their relative advantages, and the marketplace can decide how to use them. Bitcoin is cheap and transportable for online transactions, gold and gold certificate for in-person transactions. If one type of currency becomes unfavorable, there are many competitors to step in and be used instead, leading to true monetary stability, and above all, economic freedom.

Thank you so much for reading!

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