Money and Economics

Money and Economics

Modern human culture arrived and swept all before it from 100,000 to 30,000 years ago.  It has a lot of features, including symbolic communication (also known as "language"). Developing at that time, was the symbolic representation of wealth: the right to access resources. This was an essential part of the major evolution of modern humans that allows us to live in large groups, instead of in the small groups where everyone knew everyone else.

Money

Cowrie shells of a narrow range of sizes were one of the early forms of money. This is because it took a significant and fairly constant amount of effort to find them. This is the "proof of work" theory of money, which led to the invention of cryptocurrencies such as bitcoin. Gold and silver mining came to dominate money creation, even though the amount of work involved is more variable, leading to inflation events such as when Spain received a lot of South American gold, or when the Emperor of Mali took the Hajj pilgrimage in 1324 (seriously).

From the beginning, money has tried to do two jobs that are not perfectly compatible: one is to act as a medium of exchange, and the other is to act as a store of value. We are psychologically confused about this, with a strong expectation that it should act as a store of value. A common error is to assume that when money fails to act as a store of value then that is because of government printed paper money, and that would not be a problem with a "proof of work" money system such as gold. The assumption is that the money should retain a value equal to the work that went into it, but that is false because the work happened in the past and can't be undone, and the value is set by current events, as I'll describe later.

Bitcoin is a perfect example of money as a medium of exchange. Its use is primarily this: the buyer first exchanges some of his local currency for bitcoin; then they use that bitcoin to buy on the internet; then the seller takes the received bitcoin and exchanges it for her local currency. This is certain to correctly reflect the exchange rate between the buyer's and seller's currencies, because if it didn't there would be money to be easily made by looping some money through the FX (foreign exchange) and bitcoin routes. For this use of bitcoin as a medium of exchange, it doesn't matter what the current value of bitcoin is, as long as it doesn't go up or down too fast. And indeed we've seen big swings in the price of bitcoin, but usage has continued. 

Another example of a medium of exchange that is never held for long is a paper currency that is experiencing significant inflation. In this case, as with bitcoin, the value of the currency is dictated by the amount of use it is getting. For bitcoin, where there is limited production, the value can go either way, but since it depends on decisions by many people, it is inherently unpredictable. However some people keep a significant bitcoin holding, as if it was a store of value, and the existence of these stores means there is always a risk that the market will be flooded by people trying to cash them in.

Value

When the economy is functioning correctly, it continuously produces things of value at the highest possible rate, giving something close to full employment. The things of value that it produces are services. A car or a train provides transportation services. A house provides shelter and accommodation services. Owning a house provides a security of shelter service.

To produce services you need assets: houses, cars, people with skills and time, and much more. What services an economy can produce depends on what assets it has. What services an economy does produce depends on who has the economic power to decide. In a pure market economy that power is precisely money. In our society governments and banks have substantial additional power.

If value consists of services continuously produced, then what is a "store of value"? Non monetary stores of value are just assets that can be put to use producing services in the future (whether or not they are currently used): houses, machinery, stores of non-perishable raw materials, and much more. The relative value of these things changes, so the concept of a store of value is a fuzzy one. Can money be a store of value?

Gold acts as a form of money. It has industrial uses, but the amount of gold stored vastly exceeds any such requirements. Also the price of gold is artificially high because of all the storage. We have to deduce that gold only acts as a store of value because people expect that it will, and that expectation is no different from the previous expectation that cowrie shells would retain their value.

Suppose that, for some form of money, the value of the money (what it will buy) is steady or going up (deflation). Then people are inclined to save it for the proverbial rainy day. If the currency has limited production, such as gold or bitcoin, then the fact that money is being taken out of circulation means there is less money chasing the same amount of goods, so prices must fall. Which is the same as saying that the value of the currency is going up. This further increases the inclination of people to save because if you can defer a purchase you pay less. But the "rainy days" that people are saving for are not always uncorrelated. When a pandemic or a weather disaster comes along, then that money comes out chasing a supply of goods that can't quickly increase, causing instant inflation. We see that saving money is not the correct way for society as a whole to prepare for an emergency, and that money with limited supply can mislead people into thinking it is a store of value.

A real store of value must be linked to future production of services, because that is the real economy when you strip away the veneer of money. Later we'll consider how to do that.

Currencies

Currencies should be optimized for the role of being a medium of exchange. And indeed that is what modern Reserve Banks try to do, and largely succeed.

Though the currency is a medium of exchange, still the participants in the economy want to keep a buffer of money. They don't want to have to liquidate an asset whenever they need to buy something. But as we've seen, it is unhelpful if there is any incentive for people to hold large quantities of the currency, because then the authorities lose control of this vital part of the economy. The Reserve Banks have found that 2 to 3 percent inflation is ideal. People can hold plenty of currency for exchange purposes without significant loss, but everyone has a big incentive to buy or invest to avoid their wealth melting away over the longer term. So the money keeps going around at a moderately constant rate.

If there is excessive inflation then the Reserve Bank can soak up money by borrowing money (selling bonds) which raises the interest rate. This actually presents itself as raising the interest rate. Presumably it is easier to work out how to counteract a particular amount of inflation by specifying a particular interest rate and borrowing enough to hit that target.

If inflation is too low, or there is deflation then the Reserve Bank can counter that by lowering the interest rate by buying bonds to put more money into circulation. There are minor and major problems with this. A minor problem is that there may not be enough bonds to buy back, which has been solved by buying other organizations' bonds. The major problem is that if money isn't circulating, which is what happens in recessions, then adding more doesn't help much and makes the situation less stable. I should admit that I don't understand the detail of how Reserve Banks function, but I think this is close enough.

Using interest rates to control the economy is fundamentally wrong since it has random effects on many people who need to live off a risk free investment. Currently interest rates are close to zero, forcing Reserve Banks to move to what they call quantitative easing. Buying non-bank bonds gives wealthy debtors free money, aggravating the rising inequality in our society.

For a stable economic system we want the interest on safe investment to be fairly steady. Historically it looks like inflation plus 3 percent might be the right number. This allows people to save for retirement expecting that they can expand their capital at the rate of inflation and also have income to live off. To achieve this we need an alternative to low interest rates to inject money into the economy.

I propose that there be a "tax on low inflation". When there is deflation or low inflation, the Reserve Bank will create money and pay it to the tax office. The legislation for this tax will require that it be spent almost immediately, and that any that cannot be so spent should be sent immediately to the general population, as the Australian Labor government did in the GFC. 

Another way the government can spend the low inflation tax is to buy something from another country, as long as the money can be spent immediately. How does that work? The government buying foreign currency lowers the country's exchange rate. That makes it easier for local industry to sell for export. It also causes immediate inflation by raising the price of imported goods.

While the tax on low inflation will be a big improvement in normal times, it does leave the situation where a lot of money is in private hands and can, in certain circumstances, flood the economy.

A Value Store Currency

We increasingly deal with money through computer software. That makes it easy for us to deal with multiple currencies. We have seen the difficulty of a single currency being both a medium of exchange and a store of value. It is natural to ask if we can separate out a 2nd currency that is a store of value. I have a proposal.

Value is services, provided by assets. A store of value consists of assets that will contribute to providing services at some future time. But such assets have variable lifespans, and they vary in their relative value over time. What we want for our value-storing currency is for it to represent a right to part of a collection of assets, that is maintained in a way that preserves its value. Explicitly:

We'll call our value-store currency "doubloons". People can interchange doubloons and dollars at any time at the current rate. The intention is that the exchange rate changes will be identical to inflation (for some reasonable definition thereof), so that the purchasing power of doubloons will be constant.

The government keeps non perishable assets whose value matches that of the outstanding doubloons. When people cash in their doubloons, so that there are then less outstanding, then the government sells some assets to keep the store level correct. When people buy more doubloons, then the government uses the dollars it gets to expand the store.

When the value of the assets held rises faster than inflation, then the government can sell some and pocket the money. However if the value doesn't rise fast enough then the government commits to expanding the store using tax money.

The government has an obligation to keep stores of things to prepare for an emergency. PPE (personal protective equipment) and oil have been in the news lately. It is intended that this value-store be used for this purpose, though the government has to make up any costs from storing perishable items that need to be constantly refreshed (such as food). When an emergency does strike then the government should replace the assets it then needs with others.

The store should not be an arbitrary collection of assets, but rather cover a wide range in the right proportion, so that the country can continue to operate during periods when it is cut off from suppliers for any reason.

Since there are costs associated with supporting this, it is envisaged that it will be for citizens and local organizations only. All they are allowed to do is convert the currency to or fro. It still makes sense to have loans and other financial operations denominated in doubloons, but when the time comes to do the actual financial transfer it is actually done in dollars calculated at the current rate.

Foreign Currency Exchange

We see the breathless news item "there is a current account deficit/surplus". What does that mean? When there was fixed exchange rates then a current account deficit meant that more people wanted to sell the local currency than there were people who wanted to buy it. So the government was forced to sell its foreign currency or gold holding to preserve the fixed rate, and this couldn't continue indefinitely. It was an urgent situation. Eventually the government would be forced to reduce the price of the local currency, changing to a new fixed exchange rate. Investors who guessed this would happen made a fortune.

Now that we have floating exchange rates, running a current account deficit is neither positive nor negative. It has a different meaning. A current account deficit means that more goods and services are coming into the country than are going out. And yet the currency has an equal number of buyers and sellers. How can that be?

The answer is that the extra buyers of the local currency are buying things in the country which they then don't take out of the country. This might be real estate, or equity in a business or it might be a loan. So one way to look at it is that a current account deficit represents foreigners investing in the country. Another way is to say that there is net borrowing from overseas. There is no way to distinguish between these.

On the other side, a current account surplus sounds like a great thing, but it might just mean that foreigners are disinvesting in the country.

When countries share a currency, such as the European Euro, then that is taking fixed exchange rates to extremes, since countries don't have the option to modify their rate. This was a big problem in the Eurozone, with poorer countries teetering on bankruptcy. This is potentially a problem in federal countries like the USA and Australia, which have states with substantial economic independence. In those countries the solution is for the central government to arrange wealth transfer from richer to poorer states. It seems that the Eurozone has now recognised the need to do this, with the European Central Bank buying government bonds of the poorer states at low interest rates.

Reality versus Finance

When I was a kid in the mid-1950s, the milkman delivered milk to our door. With cream on top, but I digress. He just had to run between the vehicle and the doorsteps because the vehicle advanced by itself using natural intelligence. Yes it was horse drawn. Sixty five years later and artificial intelligence hasn't caught up. But by the 50s horses were already rare.

What caused the Great Depression of the 1930s? In our assets plus services economic model, what happens if you suddenly lose a lot of assets? Obviously the total ability of society to produce services is reduced. It is the job of government and the finance sector to figure out what to do about that to produce services at the rate needed for full employment.

The 1920s and 30s was a period of transition. People were moving from the country to the city. In the country they had tremendous skills for dealing with horses and other animals. Even in the city horse skills were very valuable. The move to mechanization threw those skills in the bin. At a moment in time when there was a tremendous need for new skills, the market was flooded with labour that was unskilled in the new context.

Governments could have handled this better. Yes it would have been good to get the unemployed people to work building infrastructure such as roads. Pouring money into the economy and blowing some huge asset bubbles would have helped, and that's what we would do today. But really the right answer was to identify the training needs and make that happen.

That would have been hard then, but maybe we can leverage the Internet to do it now. Which brings us to the next section.

Pandemic Economics

In the pandemic there are many services, recreational and optional, that are much less used. But there is also less employment so it balances out. Except that the unemployment is not evenly distributed. So the government is paying the unemployed in various ways. This maintains the consumption of essential services like food, so that essential services are not also reduced by lack of demand, as happened tragically in the Great Depression of the 1930s.

If we think about services, the first question is what extra services could be provided while restrictions are in place. Most of the people who are underemployed have skills that are not currently useful. So extra work would have to be relatively unskilled, and shovel-ready. This is hard, though it does seem that in Australia some unemployed people could be employed doing fuel reduction to reduce the impact of bushfires.

We can also try to prepare by considering what services will be wanted when the pandemic is under control. A lot of people will want a holiday, including people who usually go overseas but will now stay closer to home. A lot of people will be keen to save, having blown their savings, or because they are behind on their mortgage. This will create unemployment unless the government steps in with community wide services. There is plenty that needs to be done.

Most of all we need to give unemployed people the ability and incentive to learn new skills.