Krugman and Money Bubbles

In a recent NYT piece, Krugman suggests that 'money is only a “social contrivance”. It’s a convention, which works as long as the future is like the past.' He then goes on to say later:

A final thought: the notion that there must be a “fundamental” source for money’s value, although it’s a right-wing trope, bears a strong family resemblance to the Marxist labor theory of value. In each case what people are missing is that value is an emergent property, not an essence: money, and actually everything, has a market value based on the role it plays in our economy — full stop.

Before reading the rest of the post, you should really read his full discussion, as this post will not make sense without you doing so. For me, the problem is his idea that there is no fundamental source for the value of money. It is wholly fantasy.

Here, for the sake of simplicity, I will treat the following as 'money'; base money (e.g. bits of green paper, and money created by the central bank through open market operations, and debt money (e.g. bonds, bank credit etc.). I know that we could debate the question of differences between these money types, what should be included in money etc. However, my purpose here is specific, and you will (I hope)understand why I characterise money in this way.

For me, the most important thing about money is not about the nature of the money, but about the demands that money might make on the economy. For example, each unit of money is a future demand for x value of product and services in a particular economic unit, typically but not always a country. The interesting thing about money is that it can very broadly be divided into 'now' money, and money in y period of time, or money in y period of time and z now etc. In other words, money units have a temporal dimension. This gives us something of an idea of how money can be seen to be founded in something. This is that the value of money is determined by the demands that might be made on the total value of output in the economic unit.

The important point about this is that, at given moments in time, there is a combination of credit money and base money in any economy. However, at any given moment, there is a total level of output of value in the economy. I use the word value here because what value might be is subjectively derived; for person A, they may value a new television over a Wedgewood tea set, even where the tea set has a higher price. However, regardless of what individuals value, there is a total output, however difficult that might be to measure accurately, but with relative prices making the best proxy that we have for perceptions of value. The point is that, with a given labour force, given technologies, given skill sets, and so forth, there is finite amount of value that can be created in an economy at any given moment.

You will notice here that I am treating an economy as if it is an economic island, which is false. Economies are not islands, and an economy's output is also contingent on the value creation in other economies. For example, if country B makes a product better/more cost effectively (I leave this loose here) than country A, then the country A output of value is questionable unless they do something to match the country B output of value. As such it possible to have potential for output of value that will not be realised, as there is a real world of competition. Therefore, the potential output of value of an economic unit is not its potential, but its potential in relation to other economic units. That potential is continually shifting, dictated by policy, individual and corporate endeavour etc.

The value of money is therefore contingent upon several factors; temporal, quantity, and the potential value of output of the economy which the money represents. For example, the bond market is driven by second guessing the relative influence of these factors, albeit that the second guessing is often crude and misdirected. The key point here is that each monetary unit, given these contingencies, at any given moment in time, represents one x percent of the total value of output in the economy. In other words, money is rooted in the total output of value in the economy, at a given moment in time. There can only be, as an economy is currently structured now, x amount of value of goods/services that can be purchased. I am being simplistic here, as some people simply hold the 'now' money, so that it ceases to be a demand on the economic unit, even though the money exists. In this circumstance, it makes no call on the output of value at that moment. It is another contingency on how money is valued, but by not making a call on the value in the economy now, it allows for a call on value tomorrow. For example, for a bond that has matured, might not be used as money now, but to buy more bonds with a view that this will allow an even greater capture of value in the future.

There are several things that are important when viewing money and value of output in the future. It is quite possible to issue more money now in the expectation that output of value will increase in the future to match the increase in money. Creating a greater supply of money, with the contingency that output of value will match the increase in supply is a risk. If output of value does not increase commensurate to the increase in money, then there is a problem. The value of output per unit of money has diminished. Most damaging of all, is when the demand for the value of output sits outside of the economic unit; if the demand is within the economic, it might represent a transfer, for example the liquidation of a mortgage debt.

However, even then, it is possible that the issuance of too much mortgage 'money' might be inflationary, and problematic. If the mount of money created for mortgages increases faster than the value of the value of the housing stock, this means that there is a specific and narrow price inflation, but also with a wider price inflation in the economy as a whole, as that mortgage money transfers into the economy. It just takes time. The housing bubble was this process in action. The rate of mortgage money creation increased faster than the value of housing stock, and also prompted bubble activity, such as building McMansions as a process of trying to soak up some of this new money creation. This brings me back to the problem of external credit, which is far worse, as it never represents an internal transfer.

The external funding of new money in the economy, such as mortgage debt, is a future external demand on the output of value in the economy. In all cases, it quite literally means that in the future, a demand will be made on the value of output in the economy such that some of that value output will no longer be available within the economic unit. The greater the value of the money created through external debt, the greater the demand on future output of value. This kind of demand can accumulate to the point where the external demands on the total output of value are so large, that an economy has no reasonable chance of servicing the value without having so many goods and services flow out of the economic unit that the actors in the unit will be reduced to penury. This is Greece now.

The curious part of the Greece story is that it is divorced from base money, and the problems are entirely created by creditors realising that the output of the Greek economy is not able to provide the value that they expected, or rather that Greece is unwilling to deliver that value as the loss of that value of output from within the economic unit of Greece is too hard to bear. The external debt of Greece is simply a massive demand on the value of the total output of value of the economic unit called Greece.

The idea that monetary units have no foundation, except in a social construction is simply not true. It is founded in the output of value in the economy for which a particular currency pertains. It may be complex, due to the contingencies that I describe. This is why all debt markets are so complex. However, there is one thing that is certain. If the aggregrate money supply increases faster than the value of output, the value of each unit of money will be diminished. We must also remember that the value of each economic unit is contingent upon the ability of each unit in each area of business, and that the aggregate of the ability will inherently effect the value of money, as this will impact upon the ability to realise potential output of value in an economy. Finally, externally created money is the highest risk, as it will absolutely make a demand on output of value in the future, and that value, if repaid will mean less output of value in the economic unit. Even if the economy does grow in an economic unit, a portion of that growth will no longer be available in the economic unit. The economic unit will have less output of value at the time that the demand is made for the output of value.

The final point is this; expanding money supply without an ability for increases in the output of value destroys the value of money. Borrow and spend is exactly this, and external borrowing is horrendously risky.

Note: This started as a short and quick and 'dirty' post, but did not turn out that way. I hope it all hangs together, and I have avoided some complexity that might have been added due to time constraints, and to keep the ideas as simple as possible. The nature of internally generated debt money is a case in point. Comments, as ever, welcomed. Feel free to be critical and pick holes. I published despite this despite being loose ideas with critiques in mind; I would like to refine these ideas, and critiques (constructive ones) and suggestions will help. In short, I have thrown the ideas 'into the ring' to see how they stand up to critical eyes. Regular readers will know that I have considered money before (sorry, no time to find the link, but it would help in supporting this post), and this is just some further thoughts/evolution/adaptation of the earlier longer and more detailed consideration.

Reforming Money - Fixed Fiat Currency

Introduction

I have long promised a discussion of a system of fixed fiat currency, and the discussion that follows is my first attempt at this। It is a very long discussion, and I hope that you will have the patience to plough through such volume (I guess that many will not). However, I do hope that it will prove to be an interesting potential system that might help prevent a repeat of the current economic crisis.


The fixed fiat currency system proposed here will not please any school of economics, as within the proposed system is something to cause consternation within each school. The discipline of macroeconomics is currently going through a period of turmoil as a result of the economic crisis that is engulfing the world. Leading economists such as Krugman are calling into question many of the foundations of macroeconomic theory, and debate is commencing on both the causes and solutions to the current economic crisis. The fixed fiat currency proposed here is an addition to that debate.

In order to understand the fixed fiat currency system there is a necessity to return to the basic question of what money actually is. Furthermore, once the nature of money is explained, it is apparent that any system of money must also include non-traditional forms of money, and that will mean that the proposed system must also take into account the financial system.

The proposed system is not perfect. It will not remove booms, it will not provide for social justice or any other ‘magic’ solution to the economic ills of the world. However, it offers greater stability, transparency and above all honesty and fairness. The latter notions are curiously absent from most macroeconomic discussion, which is puzzling as economics has a foundation in human endeavour.

The article is sparsely referenced, but includes ideas such as the value of labour which is rooted in the work of Karl Marx, critiques of fiat money which owe a debt to the many articles on the von Mises Institute website, and the overall theory and work of Adam Smith in the Wealth of Nations is an important overall inspiration.

There have, of course, been other sources, but none of these are specific such that they might be referenced. Overall, the majority of the considerations are the result of personal analysis and thought arrived at independently. This does not preclude the possibility of others already having come to similar conclusions or ideas, and I will apologise in advance if these ideas have been proposed by others.

Due to the relatively independent way in which this has been considered, robust but polite critiques are welcomed. It is, after all, the musings of an individual barely schooled in any economic theory.

The Nature of Money

The first point to make is that all economic activity is rooted in the value of labour. A commodity such as gold only has value once labour has dug it from the ground, and labour has moved it to the surface. Once it arrives at the surface it will be some form of labour that is utilised to move it to where it is next utilised.

For example, if a commodity is moved by truck, the truck represents a store of the value of labour of others, with the truck being a representation of a long chain of economic activity rooted in labour. From the commodities dug from the ground and being processed, the transportation, sale and processing of the commodities, the purchase by component manufacturers of the commodities and the final assembly of the truck, each step of the manufacture of components is rooted in the labour of individuals.

At the heart of all economic activity is human labour, and economics is the process of exchange of value of labour between individuals, organisations and other economic units.

Within this system of exchange of value of labour, the underlying purpose of money is very clear. It should only act as a medium through which the value of labour might be accounted, and is always representative of a store of value of labour, with an underlying contract that it might, at some future point in time, be exchanged for the value of labour of others.

Any system of money should seek to represent the value of labour in a way that is both fair and stable, such that the underlying contract is met regardless of elapsed time. Such a system implies that the value of money should be a neutral token to be used in the exchange of value of labour, such that it offers a fair exchange as determined by how individuals and organisations value the labour of each other. The purpose here is not to discuss the rights and wrongs of how one person’s labour might be valued against another, which is a debate about social justice, but rather to identify that all economic activity is the exchange of value of labour.

If we view what might constitute money as it is defined here, it is possible to see that there are two forms of money that operate within an economy. The first form of money is the issuance by government of fiat currency, which might be called ‘traditional money’ for the sake of ease of expression. This is the money that is currently created by central banks in the form of banknotes and coins, as well as by entries in the balance sheets of banks. At present, the issuance of such money is controlled by central banks according to their understanding of the underlying state of the economy, and historically has seen a progressive and continual expansion of the money supply wherever the system has been enacted.

The other form of money is IOU money. To illustrate the principle of IOU money, a simple illustration might serve to explain how it is created, and from where the value in IOU money is derived. This will also aid in understanding of the value of traditional money, as the two types of money interact throughout an economy, and traditional money is just a particular form of IOU money.

If we think of an individual (we will call him Fred) in a small town who is short of traditional money, he might visit his local pub and talk with his associates in the pub about exchanging his labour in return for pints of beer. In return for the pints of beer, Fred might promise the individuals who are buying the beer for him that he will mow their lawns which will take one hour of his labour in their garden. This means that one pint of beer = one mowed lawn, which represents one hour of labour for each pint of beer that has been purchased for him. As he is drinking beer, he is worried he will forget to whom he has offered his services, and will therefore provide a slip of paper offering one mowed lawn to be undertaken next week.

Fred, being a heavy drinker, starts to issue many IOUs and Henry has exchanged pints of beer for two IOUs. However, on reflection, Henry decides that he only needs one mowing of his lawn next week, and wonders what he might do with the IOU. He then sees a friend with a sandwich and offers the IOU to the friend, in exchange for half the sandwich. The friend accepts the IOU and provides half a sandwich.

What we are seeing is the creation of money. Fred, in offering a future commitment of his labour, is creating IOU money. It serves as money, as the IOU notes have become a recognised unit of exchange. When the person exchanged the sandwich for the IOU, he was exchanging the sandwich on the basis that the value of labour stored in the sandwich would be exchanged in the future for the value of Fred’s labour. In so doing an exchange of labour has taken place, and an underlying contract has been created. The IOU also acts as a measure/account of value of labour, as we are starting to see that one hour of labour in a garden = one pint or half a sandwich.

At the moment, Fred’s IOU money is ‘good’ money. Everybody in the pub accepts Fred’s IOUs as money, and Fred continues to drink beer in exchange for the IOU money. At the end of the first day, rather drunk, he staggers out of the pub having exchanged 15 IOUs for pints. He returns to the pub the next day and, being a heavy drinker, does the same thing. On the third day that he returns to the pub, he tries once again to make the exchange of IOUs for beer. However, as he enters the pub, he meets a cold reception.

Fred now owes 30 hours of gardening for next week. An individual in the pub has pointed out that Fred is already employed by a gardening firm, and that his ordinary working hours are 40 hours per week. This will mean that next week, Fred will need to undertake 70 hours of labour. There are doubts in the pub that he is this hard working and, just before he came into the pub, one of his IOUs was therefore hurriedly exchanged for a packet of peanuts, which are half the price of half a sandwich in traditional money. Confidence in the money being issued by Fred has fallen. The currency has devalued due to lack of confidence in Fred meeting the contract in his IOUs.

Fred is thirsty and alarmed at the lack of confidence in his IOUs. He therefore decides to take measures to restore the value of his IOU money. He explains to everyone in the pub that, if he does not meet his gardening commitments, he will instead provide the holders of the IOUs with some of his gardening tools. Whilst many people do not want the gardening tools, having the IOUs backed by the tools means that, at least, if all else fails, they might sell the tools in lieu of the labour owed. Fred’s IOU money is now backed by assets, and Fred is now able to continue exchanging IOUs for beer.

Within this scenario, it is possible to see how the value of money is created and maintained. In all cases the money is backed by, or representative of, the value of labour. Even when Fred backs his IOU money with his tools, the tools represent a store of value of labour of others. In all cases, the money is an IOU of value of labour, and the value of money is determined by the confidence in Fred’s ability to deliver that value next week.

In the case of traditional money, the same thing occurs. It is accepted on the basis that it will, at a future point in time, represent a contract for the exchange of labour. It is identical to what Fred has done, but is different in that it represents a wider pool of labour, and is abstracted away from being a single variant of value of labour. Whilst Fred’s money uses units of one hour of gardening as the base unit of measure, traditional money has no single base unit to measure against. This is different to, for example, a gold standard currency, in which the commodity becomes the base unit of measure.

We can also see in the case of Fred how money holds value when supported by an asset. If we look at a commodity standard, or the issuance of asset backed securities, we can see that asset backed money simply offers a substitute of stored value of labour in place of the future commitment of labour.

However, there is a problem with asset backed money. If we imagine that Fred is very lazy, and fails to meet his future commitment of the value of his labour, he will have to offer a large number of his tools in lieu of his labour. Many of the recipients of the tools will want to sell them, and the result will be a flood of tools being offered for sale in the local classified section of the local newspaper. However, there is no reason why there might be a sudden demand for so many tools within the town, and therefore many of the tools cannot be sold. The holders of the tools are faced with holding on to the tools in hope of later demand for the tools, or selling them at a steep discount. They believed that the tools were a substitute for the hour of gardening labour, but find out that they are not.

This point is the underlying problem with any asset backed form of money. Whilst, in the case of Fred, he has offered an assurance over and above his promise to deliver, the value of that underlying assurance does not necessarily represent the actual value of labour that is contracted in the money that he is issuing. The same point may be made for any money secured by an asset, such as gold backed currency. The value of the underlying asset is subject to fluctuation, such that it may advantage or disadvantage the holder of the money, with no reference to any labour undertaken by the holder. The same might be said for any commodity currency, such as gold coins or silver, which might be subject to variations such that each unit changes value in relation to the value of labour.

What is apparent from the example of Fred’s money is that the only real value of money resides in the meeting of the underlying contract of provision of value of labour. In other words, the only way to achieve the full value of Fred’s IOU money is for Fred to actually do the hour of gardening work promised in the IOU, which means one mowed lawn. In practical terms, therefore, any good money system should not be based in assets but in firm commitments for the fair exchange of the value of labour at a future point in time.

Current Fiat Currency Systems

In the current fiat currency system, it is apparent that the currency is neither fixed against an asset, and is not fixed against any value of labour in the economy. The issuance of the money is not referenced to the potential output of value of labour in the economy, and the supply of money is continually inflated. It is like Fred offering ever more IOUs regardless of whether he might meet the contract for each unit offered. The issue of each unit of currency does not represent the actual value of labour in the economy, and is issued independently of this.

An interesting comparison with current fiat systems is the issuance of currency in the online world of Second Life. It is a currency issued by the owners of the Second Life world, is utilised for exchange within the world and can be converted into $US through a currency exchange. Both currencies are as arbitrary as one another, as neither currency is rooted in anything. People are now earning a living in Second Life, and use the currency exchange to allow them to convert their online value of labour into ‘real world’ money.

As an example of the problem of un-rooted currency, if we were to imagine the economy has a total daily output of 100 units of labour, and Joe provides one unit of that labour, the value of Joe’s labour is worth 1% of the total value of labour in the economy. If today we have 100 units of money in circulation, Joe will be given 1 unit of money as a result of his labour, and Joe would hope to be able to exchange his money for 1% of the total value of labour the next day. However, if the units of money are increased by ten units the next day, then Joe’s 1 unit can no longer be used in exchange for the 1% of the total value of labour.

The problem arises as to where that value of Joe’s labour has gone? He undertook the labour, stored his labour in the unit of money, and some of it has now disappeared. He might reasonably think that this is unfair and unjust. He might reasonably ask where that value has gone.

The value has, of course, been transferred to the newly issued money। They have, in effect, taken some of the value of Joe’s labour from him. Whoever issued the money, they are now in a position to utilise that value of labour that has taken from Joe to exchange with the value of labour of others. In so doing, they have expropriated some of the value of Joe’s labour. Any such system is inherently unfair and unjust. The new holders of the value of Joe’s labour have not actually done anything which might justify their expropriation of his labour. If Joe’s labour was building a brick wall, and his payment was made for this task, it is not clear how someone who made no efforts or contribution to the building of the brick wall might have a portion of the value of that labour of building the brick wall.

An interesting point to note is that, once a central bank creates money, as is pointed out by the Austrian economists, the first recipients of the newly created money are banks. The earlier the money is utilised, the greater the value of the money that is retained, as it takes a while before the newly created money creates inflation in the economy. The issuance of new currency is therefore beneficial to the banks that receive it.

The problems extend beyond this. Such a system also undermines the utility of the money as a neutral account of the value of labour. If the supply of money is variable, it is not possible to calculate the relative value of labour now with the value of labour in the future with the money. How is it possible to exchange the money today at ‘x’ units of value of labour, if we do not know that we will, in the future have ‘x’ units returned to us. It makes the value of money arbitrary, and inherently unstable.

Furthermore, in the current world trading system, it is apparent that it is possible to manipulate currency issuance in order to pursue quasi-mercantilist policies. It is also possible for governments to impoverish sections of their society in order to meet state goals, and to hide fiscal imprudence through the manipulation of currency. These points will be discussed later.

Fixed Fiat Currency System

The only way that a system of money might offer both stability and fairness is to instigate a system of money that represents each individual’s actual input of value of labour into the wider economy that is utilising the money. The only way to do this is to fix the currency against the actual value of labour in the economy. This means that each unit of money becomes a token that represents ‘x’ percent of the total value of labour in the economy. In order that the token always represents such a percentage, the number of tokens must be invariant.

There are several advantages in such a system, which will be addressed later, as follows:

1. A fairer system of money, that allows more individual freedom of choice
2. Greater stability of the financial system, with a tendency towards consistent and steady price deflation
3. A system in which asset and other bubbles might be more evident, providing an early warning of the formation of bubbles
4. A more transparent world trading system that has self-balancing characteristics, and which will provide a fiscal discipline upon government
5. Allowance for a more transparent banking regulation system, and the removal of most current banking regulation.

The Problem of Currency Units

One of the potential arguments that might be provided against a fixed fiat system is that it provides for a system that will trend towards deflation (discussed later). In a situation of continual deflation, there is a potential problem with the utility of currency units. This is best illustrated with an extreme example. If we were to imagine that the Normans has instigated a fixed fiat currency in England in 1066, and there were 100,000 units of currency, each unit today would hold a value of labour that would make such units impractical for day to day usage.

As such, it would be necessary to break such units up into smaller units, to allow for the multitude of small exchanges that are necessary within an economy. The way that this might be accomplished without the inflation of the money supply is to view each unit of currency as if it were, for example, a loaf of bread. If the loaf is cut into smaller slices to share it out, the loaf of bread remains but in the form of many slices. It is still just one loaf of bread that is being shared out.

In the same way, as each individual currency unit becomes less useful, the currency would then be subdivided into smaller units, with the subdivision meaning that there is no actual change in the overall value of the original unit, just that the value is split amongst the new units. In practical terms, if we issue 100 pence in coins, we must destroy the £1 note that was divided.

Steady Deflation

One of the great advantages of a fixed fiat currency system is that it provides for a system which will achieve steady and consistent inflation. The assertion that this is advantageous might horrify many economists, and therefore requires some explanation. In particular, there appears to be a widespread belief that deflation is a ‘bad thing’. There is no evidence that this is the case, but rather there is plenty of evidence that a change in the rate of inflation or deflation, or a move from inflation to deflation is damaging.

However, before moving to the effects of change, it is worthwhile destroying some myths about deflation. The first myth is that deflation prevents individuals from making purchases, whilst they wait for better prices. In the following examples, it will be shown that the reality is that people do not delay purchases in the expectation of lower prices.

Example 1 – Fast Moving Consumer Goods

If a shampoo manufacturers were to improve their output by 5% through a manufacturing innovation each year, their output of shampoo would increase, and this would reflect in a decrease in the price of shampoo. In other words, there will be a steady and continued deflation in the price of shampoo. According to the idea that consumers will delay purchases in an environment of deflation, in such a situation, consumers would choose to walk around with greasy hair, never buying shampoo in the expectation of further price decreases. Such a proposition is fatuous.

Example 2 – Hedonic Goods

Over the last few years countries such as the UK have seen the emergence of many discount airlines, such as Easyjet. The emergence of these kinds of airlines, and the increase in competition within the sector, has seen the price of air travel deflating. Much of the utilisation of these airlines has been by consumers using the discount airlines to have cheap foreign holidays, and this can be described as a hedonic good. It is an entirely discretionary expenditure as there is no necessity to go on holiday to another country. Despite the continual deflation, there have been many years of continual expansion in the discount air travel market. The deflation has not prevented consumers from taking flights to go on holiday, but rather has had the opposite effect.

Example 3 – Computers

Personal computers (PCs) are an interesting case, as they have year on year improved performance and year on year seen deflation of actual prices. It is also an example that includes both business purchases and consumer purchases. Despite the ongoing deflation in the prices, the market for PCs has had a long period of explosive growth throughout this deflationary period. It seems that the steady deflation in prices has had no impact through the postponement of purchases.

Example 4 – Special Cases

Remaining with the example of PCs, it is possible to construct a hypothetical example of how consumers might indeed delay their purchase in expectation of deflation. If one of the large computer manufacturers were to announce that they would be introducing a new type of computer in the coming year, and that the computer was to offer twice the performance at half the cost, it is quite likely, assuming their claim were credible, that consumers might delay their purchase of computers in expectation of this future deflation.

If the thinking of those who argue against deflation is considered, such a deflation is a ‘bad thing’ as consumers withhold their money in expectation of lower prices. If this logic is followed, then the new and more effective design of computer is not a good thing for the economy, as it has created a deflation in the price of computers, and has caused a delay in the purchasing of computers. However, once the computer is introduced, it will make more computing power available to more people. How this might be a ‘bad thing’ is not entirely clear. Everyone who purchases a computer sees their wealth increase, as they are able to enjoy relatively more computing power in relation to their income. They are quite literally wealthier.

Debt and Deflation

There is an argument that suggests that deflation causes problems with the servicing of debt, as the value of the debt sees relative increases through the deflation. This is a scenario that appears to be very plausible, and can be backed by some solid calculations and formulae. However, what is missed in such arguments is that it is not deflation that is problematic, but the move from inflation to deflation. It is not the change in the value of money that is problematic, but the change in inflation/deflation from the original inflation/deflation position from the time of the issuance of the loan.

A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.

If we think of this example and think of a change in the rate of inflation from 5% to 2%, and compare this with a change from 2% inflation to deflation of 1%, we can see that there is the same process taking place. In both cases we are seeing the relative burden of debt in relation to income moving in exactly the same way. In the inflation and deflation environment, interest rates will move to reflect the underlying changes in the value of money, and debt burdens will be locked into repayments that are based upon an out of date criterion.

In other words, it is not inflation or deflation that is problematic, but rather it is the change in inflation/deflation that alters the burden of the debt. As such, any monetary system should aim to achieve either stable inflation or stable deflation.

Fixed Fiat and Deflation

A fixed fiat system does not guarantee stability of deflation, but does have features which will inherently stabilise the rate of deflation. If it remembered that a fixed fiat currency is tied to the total value of labour in the economy that is issuing the currency, it is apparent why this is the case.

If output of value of labour in an economy increases, the value of labour per unit of currency will also see a commensurate increase. This is the deflationary effect of a fixed fiat currency. However, there is no guarantee of an increase in output of value of labour. For example, if there were no technological or process improvements over a period of time (unlikely), then there would be no inflation or deflation. Equally, if for example there were a natural disaster that destroyed infrastructure, then the output from the economy would fall, creating inflation.

External inflation such as an increase in commodity prices might also create inflation, though these inputs might reasonably be isolated from the overall measure of inflation/deflation in the economy. These are factors that can not be changed from within an economy, as they are resultant from both internal factors and external factors that are beyond any action in any individual country. For example, if there is a poor worldwide harvest of wheat, this might see food price inflation across the world.

No monetary policy or manipulation of the money supply will alter the amount of available wheat in the world. As such, any shift in prices of commodities might cause a temporary shift in inflation/deflation, but there is no monetary policy that might influence this. The only thing to do with such changes is monitor their effects, and try to strip out their effects from the trend of inflation and deflation.

In most cases, deflation will follow the gradual and progressive level of increased efficiency resultant from step-by-step innovations in process and technologies. However, if there were a major innovation, such as the introduction of new highly efficient technology, there might be a resultant period of relatively high deflation, as output increases rapidly such that the value of each unit of currency rapidly increases.

Real cases in history that might cause rapid deflation in a fixed fiat system would be the introduction of electricity into manufacturing, or the introduction of railways. In both cases, the introduction of the technologies resulted in higher output per unit of labour, such that there was a widespread overall increase in the value of labour across the economy. This is a positive form of deflation, as the overall output of value of labour has increased without an increase in the volume of available labour. The economy has simply become wealthier. This is best represented in the earlier argument about the introduction of a far better PC. We should wish for this kind of dramatic deflation.

Hoarding of Money in Deflation

It is possible to read in accounts of deflation the use of the word ‘hoarding’. Before discussing why people might invest in a deflationary environment, it is worth addressing the word ‘hoarding’. It is a word with particular connotations, such as the idea of a dragon hoarding gold. Within such connotations it is possible to perceive that there is an emotive meaning in that the word implies selfishness and greed. The use of such an emotive word should therefore start to ring alarm bells, as it is a rhetorical device rather than a reasoned argument.

However, there is an underlying concern that, in an environment of deflation, people will simply use cash as their method of saving, rather than using their money to invest in new productive activities. This appears to be a plausible argument.

Nevertheless, it is not as plausible as it seems. The underlying argument is that, if there is deflation, the value of cash is in any case going to increase over time, so why would an individual risk making an investment if they can just ‘sit on’ their cash and see a positive return.

The problem with this argument is that it does not account for the variable levels of risk that individuals are willing to take in order to see a return on their money. For example, in the environment pre-economic crisis, there were a range of investment opportunities, each with a relatively different level of risk. An individual in the UK might have placed their money in government bonds at a low rate of return but with very low perceived risk, or they might have invested their money in a perceived high risk and potential high reward emerging market tracker fund. We know that people invested their money in both of these investments, and this clearly demonstrates that different individuals at different points in their lives will be willing to take varying risks with their accumulated store of the value of their labour.

In a situation of steady deflation, the behaviour of individuals will not change. Some individuals will ‘sit on’ their money, and others will seek to gain a return on their money that is greater than the return provided by the deflation. The key difference in the system is that the necessity of investment is taken away, such that no individual is forced to risk their capital. If we think of an individual approaching retirement, due to continual inflation, they must risk the value of their labour stored throughout their life, if they are to retain the full value of the store. In doing so, they also risk the loss of that capital with the result that they might live through an impoverished retirement. There seems to be no reasonable justification to force such a risk on any individual.

Within a fixed fiat system of steady deflation, it is apparent that some individuals will utilise their store of labour value to invest in order to gain a return, and others will enjoy the benefits of retaining the value of their store in relative security. Whilst there are no guarantees that sitting on cash will preserve the purchasing power of that cash (e.g. the natural disaster example), the holder of the cash has the assurance that he/she will remain as wealthy relative to others under all circumstances.

Interest Rates and Investment in a Fixed Fiat System

In a period of steady deflation, how will investment actually work? It is an interesting question that is far simpler than it might first appear. If we were to imagine a steady rate of deflation of 2%, how might interest rates be determined?

As has been outlined, it is possible to ‘sit on’ cash, and that cash will then yield an annual return of 2%. In order to persuade an individual to invest, it is necessary to offer a higher yield relative to the perceived risk in the investment. In looking at the problem this way, it is apparent that investment decisions are no different to the choice that was outlined in the example of an inflationary environment. If inflation is running at a rate of 3%, an individual might seek a real return on their investment of 5%. As such, they will direct their investment to an area where they will expect a total return on their investment of 8%. If the rate of deflation is 2% they will, using the same calculation, seek an investment with a return of 3%. In both cases they are aiming for the same real return, and will make the same risk/reward calculation. There is absolutely no difference except that the individual has a choice on whether they might invest their money at all.

What if the rate of deflation was very high? The first point to understand is that a high rate of deflation means that the economy is actually very successful. It simply means that the output of the overall value of labour has seen a significant increase. In real terms, the economy is wealthier overall.

However, should the deflation reach a very high level, for example an extreme deflation of 10%, there will be a problem in presenting investments that might attract individuals to take risks. The rate of return on the investment would have to be very high, as few people would be willing to take risks when they can earn a 10% return by ‘sitting on’ their cash. The result would be that the flow of money for investment would diminish, and the speed of the growth in the output of the economy would be constrained. The question here is whether this might be a good or a bad outcome.

If the output of the economy is expanding at such a rapid rate, it is quite possible that there will be a period in which there will be ‘irrational exuberance’. The history of the many examples of how individuals might become carried away with a particular class of investment needs no retelling, from the South Sea bubble, to the more recent housing bubble.

However, there have also been other bubbles which have been resultant from the introductions of new technologies, such as the telecoms or Internet bubbles. In both cases, there were significant innovations which had potential to increase output in the economy, and in both cases early investment yielded strong returns. However, in both cases the early returns led to manias, and those manias saw significant overinvestment in the sectors, so that overinvestment took place with a resultant misallocation of resources.

In a fixed fiat currency system, the deflation that would result from the expansion in the economy would present a natural stabiliser on investment during technological innovation. It might be argued that the high deflation would ‘starve’ the new technology of capital for expansion, but the opposite view is that each innovation might be ‘digested’ before any manias developed. This is not to say that a fixed fiat system would guarantee no manias, as people will always have the potential for ‘irrational exuberance’ under any system. However, if an innovation creates dramatic deflation, the deflation might cause far greater caution in further investments, and therefore act as an automatic stabiliser.

As the drop in investment takes place, the growth in the output of the economy will start to moderate, and the economy should stabilise back towards a steadier rate of deflation. Whilst giving the extreme example of 10%, it is unlikely that there might be such extremes, as the stabilising effect is progressive and self correcting. One of the underlying strengths of the fixed fiat system is the inherent self-stabilising effect, such that investment and borrowing should be taking place in a steady rate of deflation, thereby ensuring that lending and borrowing do not see volatility such as the alterations in the costs of servicing debt burdens.

Stability of the Financial System

At the start of the discussion, it was identified that there are two types of money in an economy, broadly characterised as traditional money and IOU money. Up to this point IOU money has not been discussed, despite the important part that it plays in the system of money overall.

Whilst the fixed fiat money system might create a steady deflationary tendency, it does not account for the rise and fall in the supply of IOU money. This raises the question of how IOU money might be regulated such that there are no booms or busts due to overexpansion or contraction of this money supply. As has already been identified, there is a natural stabiliser which should ameliorate bubble forming investments and activities, but this does not fully account for expansion of IOU money. For example, if deflation is very high, it might be that one company will less willing to extend credit to another company. This is a natural circuit breaker on the economy in which fast expansion will see a commensurate contraction in credit.

However, one of the main sources of IOU money is the banking and financial system, and any stability in the monetary system must therefore ensure some stability in the creation of IOU money in the banking system. The temptation here is to introduce a system of complex regulation, and enforce various measures upon the banks. However, the use of a fixed fiat system, alongside provision of particular information, offers a simpler and more effective method of managing the banking system.

The first point is that the fixed fiat system allows individuals to hold cash at very low risk to their stored value of labour. This extremely low risk allows for the creation of what might be called ‘deposit banks’. These are banks which literally, for a small fee, will store the money of an individual, with the entire holdings of deposited money always available for return. This is so essential to the system that, if no private institution were established to offer this service, the government would need to offer such a service. The function of the deposit banks is simply to store the money, facilitate transfers and transactions, and a fee would be needed to pay for the services.

The reason for the necessity of these banks is that each individual must have a clear and available choice of a bank which does not does not risk their stored value of labour. In having this choice, individuals have real choice in the way that they risk their money.

The second element of the financial system is ‘speculative banks’, which are any banks or financial institutions which might not, on any given day, be able to return all of the deposits that they have taken. These are any financial institution that takes depositors money and uses it for any kind of investment. In all such banks, at least proportions of the deposits that are held are at risk of loss, and can not be returned on demand. The name of this type of bank is explicitly given to remind any depositors of money into the bank that they are speculating, and the banks would be regulated such that they would need to include the name speculative bank in their name.

However, the most important element of the regulation of these banks is not their name, but something more fundamental. It is essential that depositors into the speculative banks are aware of how much of their deposit is subject to risk at any particular period in time. For the sake of pragmatism, this information should be available on a daily basis, and would need to be published daily in all branches of the bank, and on the bank’s website homepage (in a specified format). In particular, each bank would need to give an exact percentage of their deposits available for withdrawal as cash on the previous day, as well as a rolling trend for the percentage. This information will ensure that every depositor is fully aware of the amount of their deposited money that is at risk. The penalties for the provision of false information would need to be severe.

The third element of the system is the provision of information about the nature of the risks being taken by the speculative banks. At present, there is no regulation that prevents the banks from paying for external assessment of their level of risk. The conflict of interest in such a system is apparent, and has been made more apparent as a result of the financial crisis. One of the problems in assessment of risk is considered to be the asymmetry of information, and it therefore necessary to ensure a system where there is well financed external assessment of the risks in individual banks. The only way of ensuring this is to regulate the usage of the information provided by external assessment agencies to ensure that each individual who uses the services of the agency is restricted to using the information for their own personal use. For example, newspapers could not report the assessment of agency ‘x’ of bank ‘y’ without the explicit permission of the agency.

The regulation would ensure that there was the available finance for an effective system of external and independent assessment of the banking system, and individual banks within the system. Even within such an independent system, errors will still be made, and any assessment would need to make a statutory declaration in a regulated format advising the recipient of this fact.

The purpose of the provision of information about the banks, and the development of deposit banks, is to provide individuals with the information about the risks that they are taking, and to make informed choices as to whether they take risk. No form of regulation can remove the risk taken in any form of investment, and the only solution to this problem is to make risk a choice, and make the nature of the risk as transparent as possible. When individuals are presented with information and choice, any guarantee of the deposits by the government no longer becomes necessary, and the financial system can be largely left to operate as the market demands.

The last element of the regulation relates to the one remaining problem that might arise in the banking system. This is the notion of the ‘too big to fail’ bank. It is apparent that, if institutions become large enough, their collapse might lead to severe problems in the economy. The existence of banks of this size is therefore a danger to the stability of the economy. It goes beyond the scope of this discussion to go into detail of how banks might be broken up and regulated in order to remove this risk, but regulation of size of banks would be a necessity.

So far, a radical system of regulation and deregulation has been presented. It is apparent that a fixed fiat system is necessary to allow the deposit banks to play their role in the system. However, this does not explain how stability in the provision of IOU money might be achieved.

In order to understand this, it is necessary to think of individuals making choice according to their own circumstance and their individual appetite for risk at various points in their life. Pension and life insurance markets give a clue to how these decisions are presented and made, and it is apparent that in aggregate the total level of risk individuals will take will remain relatively stable over time. Under the current system, any deposit into the banking system is undertaken without any heed to the levels of risk in an individual bank (excepting during the recent bank runs). The assurance of government guarantees of the banking system, and deposit guarantee schemes, means that banks are able to operate with levels of risk of which the depositors are unaware.

In the system proposed, in which levels of risk are more transparent, individuals will be confronted with clear information about the levels of risk that they are undertaking. If there is an aggregate steady level of acceptance of risk, the banking system will adapt to the informed choices of individuals, and will provide a range of options that will meet the aggregate demand for risk. As that aggregate demand will normally not see abrupt changes, any change in issuance of IOU money by the banks will be dampened to reflect the aggregate risk demand in the market. Once again, there is nothing in the system to prevent manias, although the deflationary nature of the system will ameliorate the manias. As a result, in normal time, the issuance of IOU money from financial institutions should remain relatively stable and constant.

This entire system can only be achieved in a system of a fixed fiat currency, which provides the foundation of the reformed system of banking and finance.

Government Issue of IOU Money

Another potential source of issuance of IOU money is government, typically in the form of government bonds. The purchase of these bonds can be broadly divided into domestic and overseas purchases, and each has a different impact and considerations in the consideration of financial stability.

A government issued bond, as with any form of money, is a promise to return a value of labour in the future. The key difference between a government bond and other forms of IOU money is that the government can utilise the law and tax system to force individuals to provide a proportion of their value of labour in servicing the obligations of the bond. It makes them a relatively sound form of money, as they can in principle make (within some boundaries) large claims on the value of labour in an economy.

The starting point in the consideration of the issue of bonds is the purchase of the instruments by overseas buyers. This has most curious effects on the economy that receives the bonds, and upon the perception of the state of the recipient economy. Before going on to these points, it is worth reiterating that the bonds that are issued are no different from the IOUs for gardening provided by Fred in the explanation of money, with the exception that the bonds might force Fred to work the necessary hours for repayment. Just as Fred uses the bond to allow him to consume beer, a stored value of labour, a UK bond purchased by a Japanese investor allows the UK government to consume the stored value of labour of Japanese workers.

A good way of thinking about this is to imagine that the purchase of the bond by a Japanese investor is being used to build a hospital. For the sake of simplicity, we will imagine that the bond is for the building of the hospital alone, and is only purchased by Japanese institutions. As part of the purchase, Japanese currency will arrive in the UK, and that might be used to exchange for other currencies to purchase material, services and equipment, or purchase these directly from Japan. In addition to this, some of the money will be used to pay UK contractors and suppliers. In all cases the payment is being made from the stored value of labour of Japan.

If we imagine the purchase of a piece of medical equipment from Japan, at some point in the future, the promise of the bond is that value labour of a good or service slightly greater than that purchased will be returned to Japan or whoever holds the bond. When the device is shipped to the UK from Japan, it will also generate significant activity in the economy, with an importer handling the import, a logistics company moving it to the hospital, and the contractors who install it into the hospital. At each stage of the process, the value of labour being utilised is a consumption of the Japanese value of labour that was provided in the currency exchanged for the bond. However, the impact upon the economy extends beyond these discrete actions.

For example, each of the individuals or organisations that have been paid through the issue of the bond will go on to spend the IOU money provided by the bond in the wider economy. For example, a contractor may save enough money to purchase a UK built car with cash, thereby increasing output of cars in the UK economy by one car. However, whilst he is paying for the car in what appears to traditional money, he is in fact spending the IOU money from the bond. If we think of the myriad of ways in which the bond IOU money will increase output in the economy, it is apparent that the IOU money has an effect on output far greater than the headline figure. The money from the bond becomes tied up with the traditional money in the economy, and separation of the IOU money from traditional money becomes impossible.

The issue of bonds then needs to be placed in a wider context, if we are to understand the implications and effects of the bond. If an economy is running a current account deficit, then the economy overall is being provided with goods and services over and above the output of the economy. If governments are issuing bonds and these are purchased by overseas investors, the money that then flows into the economy represents an aggregate consumption of the value of labour of the creditor country. The problem that then arises is how we might actually measure the output of the economy. As has been illustrated in the case of the hospital bond, the value of Japanese labour entering the economy becomes inextricably entwined with the economic output as a whole. It generates considerable activity throughout the economy.

If we then consider that GDP measures are a consideration of the activity within an economy, it is possible to see that the GDP figure is measuring the output of Japanese value of labour output as if it were UK value of labour output. Furthermore, the greater the issuance of bonds, the greater the activity in the economy, and the higher apparent GDP will be. Issuance of IOU money in the form of bonds will increase activity in the economy, giving an illusion of growth in the economy. This becomes particularly problematic if the sustainability of bond issuance is being measured as a percentage of GDP, as that figure will include the impact of previous bond issuance, and is not representative of the output of the UK, but is representative of the output of the UK economy and the imported value of labour of Japan (to return to the earlier example).

The GDP measure of the economy does not actually represent the output of the economy, but the measure of debt to GDP allows government to continue the issuance of more IOU money than might be sustainable.

It is here that we come to the question of how a fixed fiat system might prevent such problems. The first point is to say that a fixed fiat system will not be able to prevent governments from the issue of bonds, which is of itself a dubious practice in ordinary circumstances (though the reason for this will be left aside for this discussion). However, if a country is running an overall current account deficit, under the fixed fiat system, the country will find that money is flowing out of the country, and that there is a process of deflation taking place. This deflation will make the purchasing power of the currency increase, and will therefore make the goods and services of the country more attractive, as the currency will provide more goods and services per unit. This will mean that a current account imbalance, as soon as it appears, will start to correct itself.

However, if a government is issuing IOU money to overseas investors during a period of a current account deficit, it is immediately apparent that the government is seeking to artificially maintain the current account deficit. They are seeking to prop up consumption within the economy, and in doing so are building an unsustainable economic structure. In so doing, they are issuing money against a level of output that is already unable to service the current exchanges in value of labour between the bond issuing country and its trading partners. Without the endless confusions being caused in targeting variable interest rates, different volumes of money, such reckless behaviour will be very apparent.

In other words governments will not be able to hide irresponsible policy behind a wall of monetary policy. The current account balance between countries will become main the determinant of the relationship between their currencies. In terms of exchange rates, they will become transparent, and will alter according to trading relations, not with monetary policy. Our Japanese investor will see clearly that fiscal expansion during a current account deficit is a policy that can not be sustained, and the future repayment of the bonds must see a devaluation of the currency. No overseas investor would invest into such a poor currency.

A fixed fiat system prevents governments from borrowing more money than might be supported by the actual output of value of labour in the economy. It creates transparency and clarity about the state of the economy in relation to trading partners.

With regards to the issuance of IOU money, where the purchase is made by individuals or organisations from within the issuing economy, this is more problematic. However, there is an indicative measure of whether the government is indulging in fiscal irresponsibility which is that, within a fixed fiat system, inflation should only take place in few limited circumstances, and those circumstances can be reasonably isolated from the general trend within the economy.

Barring the impact of these circumstances, in the event of inflation, it is apparent that the government is issuing more IOU money than can be supported by the output of value of labour within the economy. Any inflation within the economy can be seen as a warning sign, and it is then a matter for the electorate to discipline the government for causing the inflation. This moves beyond economics, and is the question of how a mature democracy might function, and is therefore beyond the remit of this discussion. How or when a government might be disciplined is firmly within the realm of the relationship between governance and the democratic system.

Overall, the fixed fiat system provides clarity about the actual state of the economy, and also provides some mechanism of stabilisation of trade between countries. It is a system which should, in most situations, offer considerable stability and ensure that an economy grows in a sustainable way.

The Problem with a Fixed Fiat System

There is a problem with a fixed fiat system in a world in which the current fiat system holds sway. In particular, there is the problem that a fixed fiat currency would be very attractive to investors who have their domestic currency operating in a conventional fiat system. In particular, they will know that the value of the currency will never be eroded through the issuance of greater volume of the currency. As such, over the long term, it will appear to be a stable and secure form of money into which a person’s value of labour might be stored.

The problem that this stability represents is that it will encourage a situation in which the stability of the fixed fiat currency will be undermined by the apparent stability of the currency. It is a contradiction that requires some explanation.

If, for example, the UK switched to a fixed fiat currency, and Japan remained on a standard fiat system, then Japanese individuals would likely want to place their stored value of labour in the UK. The result of this would be to see lots of Japanese investors seeking places to put their money in the UK. For example, government bonds would appear to be attractive, offering considerable security. However, as has been detailed, the issuance of government bonds is in fact the issuance of money. As such, if the government, or other recipients, of Japanese investments accept the flood of Japanese money, the money supply will have increased, which is inflationary.

The problems that this might cause are best illustrated with the carry trade from Japan. The carry trade was resultant from the policy of quantitative easing in Japan in conjunction with low interest rates in Japan. The result of the policy was that, as fast as new traditional money was added to the Japanese money supply, money flooded out of Japan seeking higher interest rates in other countries. In so doing, the increase in the money supply helped create the asset and credit bubbles in countries such as the UK. Furthermore, the money that was being created was earning a rate of interest that helped counteract any loss of value of the Yen that should have resulted from the increased issuance. The investment of the money flowing out of Japan contributed to the positive current account balance of Japan, thereby strengthening the Yen.

In other words the targeting of interest rates and quantitative easing was a contributory factor in the development of imbalances in the world economy. It illustrates the danger in conventional fiat money systems, and these kinds of imbalances would appear in any economy with a fixed fiat system.

The only solution to this problem is that all currencies should move to a fixed fiat system. Under such a system, there would be no targeting of interest rates, as the money supply could not be manipulated, and also there would be no possibility of quantitative easing. In a world built around a fixed fiat system, the world economy would look very different. For example, if we imagine our Japanese investor, his choices will look very different.

In determining where to place his money, he will no longer be looking at the relative prospects for any individual currency in terms of monetary policy of the country, but will be looking at the fiscal policy of the country, and the output of the value of labour in the country. The interest rate in the country will no longer be set by the control of issuance of money, but by the conditions of the market in the country.

The only way such a system might be enacted would be through international agreement. For example, if the G20 were to agree to the system, and made trade with any country conditional on implementation of the system, then it would become the world currency system. The problem that arises is that the system would run counter to the quasi-mercantilist currency policies undertaken by countries like China. It would also present a constraint on governments borrowing from overseas sources, and this would force them to have to confront the underlying economic difficulties within their countries. Whether there could be any agreement in these circumstances is questionable.

Conclusion

So what is the key, the underlying principle behind the fixed fiat currency system? With a little reflection, it is apparent that the underlying driver behind the many benefits is the shift to something that becomes a representation of the actuality of the economy. It creates transparency, and thereby creates systems that are inherently stable. It removes power from the regulators, the central banks, the government and the financial system, and transfers and distributes that power into the wider economy. It is essentially a democratic reform.

Even if this reform of money were to found to be a sound and coherent approach to the management of money in the economy, it is unlikely that it would ever be enacted. It hurts too many interests, and those interests would fight any implementation of the system. However, if the system is workable, this paper is written and published on the basis that it is better to have an alternative system ‘out there’ in the world, rather than locked away in the thoughts of one individual.

I therefore conclude the article with two points. The first is that I am profoundly pessimistic about the prospects of any change which might remove the privilege and power of the banks, and even more pessimistic about the prospects of government accepting such reform. The second point is to reiterate the point at the start of the article. This is the musing of an individual without any schooling in economic theory. As such, thoughts, comments and critiques (hopefully polite) will be welcomed.



Notes:

Note 1: I am not sure how many might reach the end of the article, but I hope at least a few will find it worth the effort. For those who do get this far, I would like to thank you for your patience.

Note 2: I use Japan as an example on several occasions for illustration and examples. This is not to single out Japan as a particular source of problems, but rather the country is used for ease and consistency.

Note 3: A couple of the examples I have used for the deflation argument have been used elsewhere (I forget where), but I also used these examples in an article a long while ago, so I have not referenced the article.

Note 4: The Austrians will object to the fixed fiat system, as they believe all currency should originate in the 'market'. I see no reason for this, and would be happy to see a commodity currency compete with the fixed fiat. I am confident about which might win over as the chosen currency used by most people. It is also noteworthy that in reality, for a commodity currency, they are actually discussing gold and silver, both of which have considerable variation in value over time. This is an inherently unstable currency. I also had a brief debate on the subject of a fixed fiat currency system on the von Mises website. They suggested any fiat currency would be subject to debasement. My pointing out that commodity currencies have been debased throughout history fell on deaf ears.

Note 5: Suggestions and further ideas are welcomed. This is, after all, the first attempt to outline this system.

Inflation, Deflation and Money

The post that follows is a slight change of direction. I started one post (see below) and found the question of money was nagging at me. In particular, there were some interesting comments on the subject of money after my last post.

The first point I would like to consider is output and money. The measure of output is a bit of a tricky problem when looking at an economy. In particular, if the measure is made in currency x then, if there is inflation of currency x, it appears that output is actually increasing by this measure.

If we imagine that factory x produces 100 units a day, and there is £100 available to purchase these units, we have 1 unit = £1. If we increase the supply of money without increasing output, then we will have more money chasing the output but still no more output. This is inflation. If we then record output in £, we will measure an increase in output. However, this is not the whole story....

MattinShanghai, a regular commentator, has raised the issue of inflation and money supply as follows:

You've talked a lot about the dangers of hyperinflation resulting from the uncontrolled printing of money by central governments. I have to admit that I'm quite confused about the whole subject, and reading numerous opinions published both by "experts" and amateurs, does not help. On the one hand, there are voices saying that we are on the road to Wiemar-style hyper inflation. Others say that the destruction of paper wealth in real estate and the stock markets, collapse of the markets for securities which underwrote many of issued loans, bankruptcy of financial institutions etc. have "shrunk" the money supply so much, that no amount of central bank money printing can fill the "black hole" and avert deflation.

I suppose that my natural reaction in the face of this is simply to suspend judgment and adopt a "wait and see" position. But I also do seem to have some fundamental problems with supposedly "uncontroversial" aspects (at least in mainstream economics) of money theory. I wonder if you or any of your readers can enlighten me on the subject and point out where I'm wrong.

Matt goes on to offer a critique of mainstream economic formulae, and highlights the absurdity of the fudge factors in the formulae. I find myself in agreement with his critiques.

I have previously discussed at some length the nature of money. In particular, I have argued that money is what 'we' collectively believe it to be. Although Matt has suggested that he disagrees with me on what money might be, I find that he hits the nail on the head in the following point:

But it gets worse. Take the money supply 'M'. What is it? Is it just the sum of notes and coins in circulation? What about money stored in jars buried in gardens? Does this count? How about credit card limits? Savings accounts? Private debts? Cheques "in the post"? Questions and more questions...

What I have argued is that money is 'money' when we believe it to be money. When a shop accepts a credit card, and a person generates a debt on the card, the shop is accepting the payment as real money. They believe that the credit card will provide them with x number of electronic currency units that they will be able to exchange for goods and services in the future.

If I am a worker, and I am short of cash, I might exchange my labour to mow your lawn at some future point in time in exchange for your buying me a beer. I might write an IOU note, promising that I will, within a week, spend an hour mowing your lawn. In turn, you might transfer that IOU to another person in exchange for some cakes that they have baked, and I will have to mow that person's lawn for one hour instead.

The critical part of these two very different transactions is that they must be based upon a belief that the currency in question will be repaid in goods or services in the future. If I am actually lazy and unreliable, and therefore unlikely to meet my promise of lawn mowing, then it is unlikely that my IOU would get very far as a currency for exchange. Quite simply, people will not believe that they will be paid.

I have previously given another example; the famine currency. If we are in a situation of famine, and there is a limited supply of food still available, then the idea of what money is will shift. If I offer my services to you in return for payment, and I am on the point of starvation, I will want to be paid in food. You might offer me piles of gold bullion but, if that gold bullion can not be exchanged for food, then I will reject that as a currency, and only accept the food. Gold can not buy what I need, and therefore ceases to have meaning as a currency. The same might be said of any medium of exchange that might be offered to me, if it ceases to allow me to buy food.

Money is therefore a matter of perception. In a previous example, I have pointed to the lines outside of Northern Rock. The people in those lines wanted bits of paper with the head of the queen printed on them, not IOUs provided by Northern Rock. Northern Rock held large numbers of IOUs, but individuals refused to believe in them. They no longer believed that the IOUs would do the equivalent of purchasing one hour of lawn mowing.

It is when we see money in these simple terms that the arguments about deflation make sense, but it is also possible to see how they do not finally add up.

Banks have been passing on the savings of people (value of their labour) to provide credit in return for IOUs. Those people who have provided the IOUs have promised to apportion part of their future labour in return for the money. The trouble is that there was so much money pouring into countries like the UK from overseas, that prices of assets such as houses rose. As such, there was a boom in the issuance of IOUs which started to exceed the ability to repay the IOUs, or at least impossible without a significant fall in consumption of those issuing the IOUs.

In real terms, a Japanese worker has provided a car to a UK consumer. The UK consumer has promised to repay the labour of the Japanese labour with an equivalent value of labour. For the moment we will leave aside the difficult question of how labour might be valued. In our lawn mowing example it was a beer for an hour of lawn mowing, but it might equally have been an hour of building a shed. The important part is that there is an expectation that the returned labour will have a value that is worthwhile to the recipient.

The problem that has arisen is that the Japanese labour has been exchanging their labour for IOUs, but the labour in receipt of the IOUs is unwilling to return an equivalent value of goods or services. The credit crisis is simply a recognition of this fact.

In other words, huge amount of the IOUs are no longer recognised as money, or at best are seen as debased money.

At first blush, this appears to support the deflationary argument. It appears that the money supply in the countries that were recipients of the labour of countries like Japan, now have less money. After all, individual IOUs have ceased to be an accepted unit of money. There is a lack of belief that the individuals can repay in an appropriate value of goods or services.

However, instead of issuing credit to individuals, the new method is to extend ever more credit to governments. As such, instead of lots of individual IOUs being generated, there is a single huge IOU being developed as a replacement. Just as with the individual IOUs, there is an implicit promise to return the value of the labour at some future date. In other words, even as one form of money is being destroyed, more money is being created as a replacement. Of even greater concern is that the previous money that was supposed to have been destroyed, has not in fact been destroyed. It is being converted into the new form of money - government IOUs (of course, government debt was expanding even before the credit crisis, but I hope that you understand the point).

Now, if we return to the beer and lawn mowing example, one of the key features of the transaction is that I have consumed the beer. Now if we imagine that I am not just issuing the IOU to you, but making similar deals all around the town, I am getting extremely drunk, and having a very good time this week. However, all the time I am drinking, I am in a situation where I am promising greater and greater amounts of labour to people all over the town. In fact, I am promising that next week I will undertake 100 hours of lawn mowing. In other words, for the consumption of this moment in time, I am going to have to have a very tough week next week. In addition, even if I do all 100 hours of mowing, I will have to use all of that labour for repayment, and will not be able to exchange my labour for beer during that week.

I wake up on Monday morning with an almighty hangover, and can not face the job of the mowing. As you would expect, the creditors of my beer drinking binge are none too happy when I fail to show up for work. The problem they face is that the beer has now been consumed, and there is no way to get it back.

Unlike in the analogy that I have provided, there is another important consideration. In the real world, governments are now borrowing more, and promising to repay the debts that were accumulated during the binge. As a result of this, the creditors are willing to continue to extend credit. The important point about government is that they can, through the taxation system, enforce less consumption upon people, and indirectly force them to work more. In other words, they are in a position where they can allow me to drink more beer now, but make me work the necessary 100 hours next week. It is on this basis that creditors continue to lend.

As such, as the situation exists, there is more money flooding into the economy, and ever more IOUs being issued in return. In other words, the money supply continues to increase, and the form of money is IOUs.

Now if we were just to imagine that Japan was the only creditor, then we can see that we have a growing debt of labour to Japan. That debt translates into a future commitment to provide goods and services of 'x' value to Japan. If we then think of this in practical terms, each gilt (for example) that is issued is a call on the output of the UK economy. If we then see no increase in the output of the economy, we can see a greater amount of labour owed per unit of labour. If each unit of labour is producing one unit, but we keep issuing ever more IOUs against that one unit, then it becomes less and less possible for that labour to service the debt. What you have is more and more IOUs making demands on the one unit of output. That is inflation.

In addition to this, we have the confounding factor of what I would call 'traditional' money. This is the units of £GB, and I call this traditional on the basis that this is what the people who lined up at Northern Rock believed to be money.

As regular readers will be aware, the Bank of England is creating more of this traditional money, but is doing so without any commensurate increase in output from the economy. This means that, in addition to more IOU money being issued, there is more traditional money being issued. This is, in effect, a double whammy. Both the issuance of traditional money and the issuance of IOUs represent a commitment of future labour in return for the credit now. They are both being expanded at a time when the output from labour is not expanding.

The one factor I have not included in the example of the real world is time. In the case of the lawn mowing, I specified 'next week'. As many are aware, government debt is issued over a range of time periods, such that in different periods, different quantities of debt are due for repayment. I have not included time, as there is currently no proposed time frame for government to start repaying the overall burden of debt. Rolling over existing debt, whilst accumulating more debt, means that the time frames are moot points.

The only solution to these problems are as follows:

1. There is a massive reduction in consumption, and an expansion in working hours. This would allow an increase in output available for repayment of debt. This is deemed as politically unacceptable.
   
2. The government takes the credit offered, and later repays it with less value than was implicit in the original bargain. This is the process of inflation, in which the government allows ever more issue of money whilst not demanding that labour reduces consumption and increases hours to the necessary level for repayment. Under these circumstances, more money will be chasing the existing output, such that the value of all UK money is debased. Inflation.
3. The government, by magic, engineers a productivity miracle such that output exceeds the increase in the amount of money.

The current policy is item number two, but with number 3 as the excuse for greater borrowing.

If we think of money in the terms that I have discussed, it becomes apparent that the reality of money is contingent on the belief that it will have a future value in goods or services. In issuing IOUs, governments are increasing the money supply, as they are increasing the promise of future goods and services. The problem that arises is that they are being dishonest, as there is no way that they intend to repay the IOUs in full.

They are like me drinking too much beer, refusing to work the 100 hours I have promised, and only accepting that I will do 39 hours of lawn mowing. Not only do I refuse to do the 100 hours, I also insist that many of the 39 hours I undertake is used to purchase more beer. In other words, I am cheating my creditors. My currency of IOUs is debased, and is inflated.

When I have discussed money on previous occasions it has always been highly contentious. I fully expect that there will be further debate on this post, and will try to find time to address any of the points. In the meantime, I would like to just highlight the key points of the arguments.

1. Money is a belief in anything that is seen as a medium of exchange for the future value of labour (i.e. goods and services). Money is only money so long as people believe that it might be exchanged for goods and services that they need/want.
   
2. The value of money is determined by the total supply of money, measured as a division of labour output divided by the units of money in supply, over time in which the money might be utilised. e.g. the timescale of IOUs is a factor in the value of money, as in the case of the lawn mowing. Time and value is contingent on the amount of money calling upon labour output in a given period.
   

The last point is complex, and I hope it makes sense (I had to re-read it myself and I'm still not certain). However, the principles I am outlining are my best explanation of money, and why there must be inflation.

This leaves the timing of inflation in relation to the two points above. The money supply, according to my understanding of money, is increasing. The question that remains is how that increase might eventually translate into demand for the value of labour, at what time. This is a question that is, quite frankly, beyond me. However, I hope that, from this explanation, it is apparent why inflation might be delayed for some time. My suspicion is that inflation will be prompted through a collapse in belief in UK issued money, rather than a progressive increase in inflation as debt falls due.

Of one thing I am certain. More money is being issued than can be supported by output. Short of a miracle in productivity, I see no prospects for anything other than hyper-inflation.

Below is the original article that I was going to write. Somehow, thinking about the points below led me into the discussion of money. The post below may make more sense in light of the discussion of money.

More Green Shoots.....

There has been yet more talk recently of economic recovery in the UK, and the £GB has strengthened as a result. This is a perfect illustration of the point that I made in my recent TFR article - that any good or bad news will see wild swings in markets.

In this case, the good news has been provided by an economic think tank, the National Institute of Economic and Social Research (NIESR). The Telegraph reports their findings:

The NIESR figures were the latest sign that parts of the economy have been staging a modest recovery, and coincided with data from the Office for National Statistics, which showed that UK manufacturing output increased by 0.2pc in March.

It was slightly better than economists expected and represented the second monthly rise in a row after the ONS revised up March's figure from a fall of 0.1pc to an increase of 0.2pc.

There has long been talk of a restocking of inventory, and it is likely that this is the process in action (assuming the figures are accurate). However, there is something faintly absurd in such figures, and this is illustrated in the following quote:

Meanwhile, governments across the world have seen their budget deficits explode as they seek to cushion their economies from the crisis. In the US and the UK, the fiscal deterioration is especially severe - with deficits this year around 12pc of GDP each and no credible medium term plans for balancing their budgets.

What we have here are two figures that simply do not add up to anything. On the one hand we have an explosion of fiscal deficits to around 12pc of GDP, and on the other hand we have a minuscule uptick in a couple of indices. In other words, the situation is so dire that the monstrous pouring of money by the government is still leaving the economy in a situation where it is barely into positive territory on a couple of indicators. The real question here is to ask what this indicators would be showing if the debt spigot were to shut down.

It is at that point that we would start to see the underlying output of wealth creation, in contrast to debt fuelled activity.

It is a long time since I discussed the essential reality of government borrowing, and borrowing in general. For every £1 of borrowing now for consumption there will be £1 less to be spent on consumption in the future. If I have a credit card and I spend £25 on a meal today, next month I will have £25 less (+ interest) to spend on a meal next month. The only way that this may not be the case is if my earnings in the future outstrip the debt, in which case I might still have £25 to spend on a meal, instead of £25 + my increased earnings. Even in this case, my consumption now is restricting my future consumption.

In the case of government, if they borrow to spend money on a nurse this year, there will in the future be the same amount unavailable for spending in the future. In other words, one nurse now, costs one nurse (+interest) in the future. Again, the same provisos apply as with the credit card debt.

The question that then arises is to ask how earnings might increase such that they outstrip borrowing. The only way that this can happen is if there is significant investment in the productive parts of the economy, such that productivity rises. This applies to directly to the example of personal debt, and indirectly to government debt. As a worker, I need to achieve greater increases in my income if I am to be able to continue to spend at the same level as I am now, and these increases can only be sustained through greater output in my area of work. If not, at some point in the future, my spending must decline. In the case of government, it is possible to continue with the same spending only if I tax more from the economy, but this is replacement of private spending with government spending. This is neutral for the economy overall in terms of total consumption.

This discussion does not consider an ongoing increase in borrowing, which appears to be the current solution. In this case, all that is happening is that there is the build-up of a larger future contraction in consumption.

Within this scenario is a deep problem. If the government and individuals continue to borrow for consumption now, then there is less money available for investment into productive output. If the government borrows £40,000 today to pay for a nurse (figure guessed at for illustration), then there is exactly £40,000 less for investment into future increases in output of new wealth (i.e. there is less money available for investment into business). The situation is, of course, complicated by the problem that finance is global, such that an individual economy might have finance for both consumption and investment, but the problem in aggregate remains accross the world economy. Bearing in mind the explosion in government borrowing accross the OECD this presents a problem.

What we are looking at is a situation in which there must be a significant future increase in output per person, a massive growth in productivity, if there is not to be a future contraction. However, there is no prospect or indication of such a productivity miracle on the horizon. Whilst it is impossible to deny that such a miracle is possible, it currently looks improbable. In the meantime, governments are competing for finite capital that might make such a growth in productivity possible, thereby making it less probable.

Returning to the slight uptick in output reported in the Telegraph, what we are seeing is the fruits of debt fuelled consumption, not increases in output that might be sustained in the medium term. This is a best case scenario, but it is just as likely that there will be a tail off in the output once inventories are rebuilt.

At this point I was going to discuss inflation, and at this point I moved to the other article. The point I was trying to explain is that it is quite possible that inflation will offer the illusion of increased output. I suspect that, it is quite possible we will start to see inflationary effects appearing in the economy, and that these might be mistaken for recovery.

As such, I am increasingly concerned that there will be a relaxation of governments as a result of thinking that they have solved the crisis. The problem is that, instead of solving the crisis, they are simply deepening the crisis.



Note 1: The discussion of the Austrian school proved to be very interesting. I am happy to see that I could find some common ground with Lord Keynes on the point that commodity currencies are as subject to debasement by government as fiat currencies.

One of the interesting points in the discussion was the role of ideology in forming views on economics. Regular readers may have noted that I pick 'n mix from various sources, wherever I see a point of interest. As such, I value the Austrian school's critique of Keynesian solutions, but disagree with their approach on many points. I am endlessly impressed with Adam Smith, but still believe that trade can be a zero sum game and so forth. In other words, I do not subscribe to a particular ideology, and am not bound by any particular school of thought.

Whilst having a libertarian streak, in that I mistrust government, I still see a role for government in many areas, such as healthcare, or ensuring legal frameworks operate fairly. I simply believe that power should, as far as possible, not be concentrated. As such, wherever possible government should be minimised and powers dispersed.

However, I would hope that the balance of my personal approach is best expressed in the articles on reform. I am not sure that the ideas would fit neatly into any ideology.

Note 2: A long post, but I hope that it proves to be interesting.