Friday, February 27, 2015

Money Pays For Nothing

What most people still call "money" is just an IOU for me. It is not different in kind compared to any other IOU. IOUs are always created in the same way, and cash or deposits don't make an exception. They are not created "out of thin air", because they derive their value from the promise to pay and are thus backed by the credibility, or trustworthiness, of the debtor. This backing should not be confused with collateral, which is nearly always a Plan B -- an insurance. An IOU derives its ultimate value from the later payment in goods or services which is expected to take place.

"Money", or any other IOU, cannot pay for anything. To transfer an IOU to a seller is to transfer a promise to pay later. It can be the buyer's personal promise (that is, it is issued by the buyer) or someone else's promise (issued by a third party). In neither of these cases does it make any sense to talk about a payment in "money". Handing over an IOU constitutes a non-payment.

What makes picturing all the various debt/credit relations slightly complicated is that there's often at least one of two types of intermediaries* between the debtor and the ultimate creditor: a) a financial institution (for example, a commercial bank), or b) government. These two can be quite intertwined, so it is sometimes hard to keep track of private-private-private and, on the other hand, private-public-private -- remember, the government is us, the people, so the ultimate debtors and creditors can never be public institutions -- debt relations.
As I said, the value of "money", like of any other IOU, derives from a promise to pay later in goods or services. The value is not derived from people's beliefs -- for instance, from a baseless expectation of acceptance of "money" by others as a medium of exchange ("just because it has 'always' been accepted"). Whether people realize it or not, "money" ultimately serves as a medium-of-exchange and a store-of-value exactly because it's an IOU, and it has value just like any other (non-worthless) IOU has. Of course, both the actual and the perceived quality, or strength, of a promise to pay varies from one point in time to another, and it is issuer-dependant -- we are, after all, talking about credit. 

When the system is well governed these IOUs are widely trusted, and thus accepted, in the society. As a consequence of this wide acceptance, they work well as a liquid medium of exchange. Nevertheless, it is credit which enables this exchange, just like it enables nearly all trade. Eventually, "money" becomes so liquid and widely accepted that people forget that it is ultimately just an IOU and view it more like an article of faith.

We could think of this ultimate logic -- which goes unnoticed by most of us -- behind the value of "money" as a law of nature. We could compare it, say, to gravity. Thanks to the gravitational pull of Earth, people have been able to run fast for thousands of years without knowing that these gravitational forces existed. If we somehow managed to substantially lessen Earth's gravitational pull, we couldn't possibly expect people to run, and all kinds of machines to work, just as before. This much we know now, but we have not always known it. Way back in time, when we understood much less, we could have well imagined life to proceed as before even if the mass of Earth was greatly reduced.

To me, the Chicago Plan is about breaking the supporting law, or logic, behind "money". It's about removing its link to debt -- a link which ultimately gives it its value -- and hoping that people's mistaken beliefs about "money" remain intact. It doesn't make any sense to me. And I'm actually someone who mostly agrees with Michael Kumhof when it comes to the details of our monetary system and the grave problems we currently face due to the massive, global debt stock.

One could say I'm a dismal scientist. If, through theoretical reasoning, I cannot find any easy way out of our current mess, and I'm left with only bad options, I'm able to live with it. All I can do is hope I've got it all wrong and search even more intensively (this I have done), but I won't let myself be fooled to think that there must be an easy way out. Nothing tells me that there has to be one. Looking at all the easy answers our economists are trying to offer us -- "A depression reckons, unless you listen to me and follow these simple steps..." --, I must conclude that the dismal science is dead. But the ghosts of Adam Smith, David Ricardo and Thomas Malthus still live in me.

Epilogue, and a Prologue

Above I have explained how "money" works. George Friedrich Knapp (State Theory of Money, or Chartalism) and Alfred Mitchell-Innes (Credit Theory of Money) got the logic mostly right. But as far as I know, they didn't go on to develop a more comprehensive credit theory. They seemed quite happy to stay with monetary theory; to mainly explain how money is actually an IOU. I believe I have taken a leap forward by painfully unlearning "money". Forgetting "money" has allowed me to study a pure credit economy in a way Knut Wicksell could only have dreamt of. Our contemporary economy is of course in many ways different from the economy in Knapp's, Wicksell's and Mitchell-Innes's time. Without the unnecessary confusion that arised from the gold standard we can see much more clearly how we actually do live in a pure credit economy. In addition, the types of debt, and especially their respective shares of the total debt, are different today.

Here I have only scratched the surface of a General Theory of Credit, still concentrating on "money". Once we manage to forget "money", we can focus on how credit really works in the economy. We need to descend to the microeconomic level and study human psychology. Perhaps the most important concept there is what I call maturity transmutation.

* An "intermediary" refers here to an entity in-between the debtor and the ultimate creditor -- not someone who borrows or lends "money".

Thursday, February 5, 2015

Towards a General Theory of Credit

[What follows is plainly wrong. No debt is forgiven. Destroying these generally accepted IOUs does not reduce any debt burden because these IOUs cannot be directly linked to any debtor. Perhaps some sort of hubris got the better of me.]

Please watch this short video (for a 3-second summary, go to 0:45).

Now, does the Joker, by burning a huge pile of cash, confirm that he is a madman? If we look at the legal code of many countries (including the United States), we could think that burning "money" is, if not always a criminal, then at least a deplorable act.

For people familiar with macroeconomics this is a much more controversial question. Wikipedia says:

Burning money decreases the wealth of the owner without directly enriching any particular party. However, according to the quantity theory of money, because it reduces the supply of money it increases by the same amount the collective wealth of everyone else who holds money.

 After reading this, you might think the legal code is based more on superstition than reason.

I would like to do better than the Wikipedia article when it comes to the accuracy of the statement. Here is what I see on the video:

A creditor forgives a debt owed to him by the society.

The Joker does exactly what many people -- and even economists -- today suggest that rich creditors should do. He destroys a mountain of IOUs and so relieves many debtors of their debt to him.

Note: This is not a technicality or a "funny fact". It is not something that is "true, in a sense". It is an accurate description of the act ("money burning"), and it is based on a sound theory. The Joker is leading us towards a general theory of credit.

Do you think you can prove me wrong?

Monday, February 2, 2015

On Unpayable Interest, or: Confessions of a Monetary Crank

There is a fairly widespread misunderstanding -- if not among experts, then at least among laymen -- when it comes to "money creation" through bank lending and the need to pay interest on a loan. This misunderstanding has led many people to argue that there is a (logical) problem with interest payments. Their logic is this: Because the amount of money created equals only the principal of the loan, the interest payments are left uncovered and so we need to keep on creating more and more money through additional lending -- or else. You can find this kind of statements, for instance, here (500,000+ views) and here.

This is illogical.

Money circulates in the economy. Same money pays for many different things while it is in circulation. One of these things is interest. Money is only "destroyed" when it is used to repay -- partly or fully -- the principal.

 From a theoretical point of view, there is nothing that could keep us from paying the interest due on our loans even if the amount of money in circulation got decimated tomorrow. If, hypothetically, all debts were repaid, there would be no interest to pay. Well, then we wouldn't have any money left to pay for anything else either. But there's no need to fall in despair: We can always* create money if we really need it!

* This is a conditional statement, and refers now, specifically, to the purely hypothetical situation where all loans had been repaid -- a situation we will never face in the real world.

On Monetary Cranks

Learning how money is created through lending gives you a new perspective. I call it a "demigod perspective", as it can bring you a certain feeling of superiority. Think about it: 99,99 % of people just don't get it -- but you do! It gives you a chance to make fun of smart people who a) are academic economists, b) work at a commercial bank, or c) work at a central bank. They should naturally know better!

The problem with any demigod perspective is that it tempts you to think that even the experts (of the field in question) must be idiots. You might start calling them "experts" or even empty suits, to separate them from real experts like you. You might behave very much like Milton Friedman in some of his TV appearances, the only difference between you and him being that he knew much, much more about what he was talking about and behaved in a more civilized way. It is hard for you to hide your superiority, just like it sometimes was for Friedman.

Even very smart people might not realize that they must be wrong too -- and not only in thinking other smart people idiots. The latter is obvious. What is less obvious is how "monetary cranks" get money wrong.

Dennis Robertson, a Cambridge economist, wrote this in 1928 (via Naked Keynesianism):
"those who have Found the Light about Money take up their pens and write, with a conviction, a persistence and a devotion otherwise only found among the disciples of a new religion. It is easy to scoff at these productions: it is not so easy always to see exactly where they go wrong. It is natural that practical bankers, vaguely conscious that the projects of monetary cranks are dangerous to society, should cling in self-defence to the solid rock, or what they believe to be so, of tradition and accepted practice. But it is not open to the detached student of economics to take refuge from dangerous innovation in blind conservatism."

In 1928! It seems some of us are repeating the mistakes of our grandfathers. Well, we all do it from time to time, but most of our grandfathers were not monetary cranks. Think, for a second, what this must mean. Yes. Most of them had no freakin' clue about money creation by commercial banks.

A confession

I have been a monetary crank. I still am, some of the time, although I mostly keep it to myself, as I have always done (a-crank-in-a-closet). For all I know, this post could be just another sign of it! But I consider myself a bit wiser already. An idiot, for sure, but a wiser idiot. I don't think it's constructive to attack experts who don't know how "money" is created. Well, it might be suicidal to do more or less the opposite here -- to attack cranks like me. But on the whole, it could be constructive. I keep my fingers crossed.

A suggestion

If you have been an idiot like me, consider admitting it. It might make you feel better. But most importantly, it will make it more likely that other experts don't consider you a "monetary crank". Who knows -- they might even reply.

(To be clear: I often put money into scare quotes, because for me, money-as-a-medium-of-exchange doesn't really exist anymore. But I saved you from "money", this time.)