The Economnic Crisis: Let's Go to Market

This essay has been written out of three fears: We are experiencing an economic crisis rather than a financial crisis in that the underlying problem is resource depletion; the crisis is world-wide rather than just an European one; And the crisis is much more serious than is generally admitted.

The ups and downs of economic activity have been a concern for a couple of centuries if not for several millennia This essay will try to use the formula from the quantity theory of money to evaluate where the economy is currently at, and then look at how money is created and propose an alternative way of creating money to facilitate the exchange of goods and services. This proposal is to extend local exchange trading systems into a national exchange trading system. It is also suggested we should move our economic structure closer to the perfect competition model.

The quantity theory of money suggests money supply has a direct, proportional relationship with the price level. I prefer to think of it as the connectivity formula because it connects the real economy and the financial economy. The connectivity formula states

MV=PQ

...where M is the quantity of money in circulation, V is the velocity or rate at which money circulates, P is the price level and Q is the quantity of goods and services produced and exchanged. I think it is important to note there are four variables and one should look at the factors which cause all four of them to move.

Generally we want P to remain stable. Inflation or deflation cause undesirable upsets in our lives and prices need to remain stable so that we can have faith in our money.. Changes in individual prices should be signals to change the mixture or quantities of goods and services we produce.

When I took my first economics course I remember the professor talking about scarce resources. However, since then many people appear to assume that the resource base is unlimited and that our economy will be able to continue to grow forever or at least the foreseeable future. I have not noticed much interest in the Q part of this formula.

Through most of the recorded history with which we are familiar there has been a long-term trend for Q to go up. This does not mean that it will continue or that the increase has been steady. It is quite likely there has been a fractal pattern to this trend and that these ups and downs have impacted the economy and our lives.

There are a number of things which could and probably have impacted on Q. Through the ages the most important has been improvements in agricultural productivity which has supported a larger population and released people for work in other fields. Technology has also played a major part in increasing Q through the years.

It is likely the discovery of resources and commodities and their depletion have also been fractal over short and long terms. This too would have impacted the formula.

Wars may also have had an impact. The demand for war materials would cause Q to go up during a war and may cause it to go down afterward as economies recover. Another possibility is a pent-up demand as was the case in North America following the second world war. While the Americans put a lot into the war, they still had tremendous commodity resources at the end of it. They also had the desire and developed the technology to exploit these resources.

Another possibility is changing values such as the work ethic.

Turmoil and volatility in the other side of the equation could cause production to decline. Ian Morris in his book Why the West Rules - for Now (McClelland & Stewart, 2010) identifies what he calls the five horsemen of the apocalypse - famine, epidemic, uncontrolled migration, state failure and climate change which "can turn into disastrous, centuries-long collapses and dark ages." (p 29) Any of these would also show up as declines of the Q in the formula.

All this is further complicated by the existence of seven billion people on this planet most of whom want a modern standard of living, good health care and families.

So what is currently happening to Q?

Too many of the headlines one sees on news articles are compatible with the fear that Q is on a major downturn. Here are three other major pieces of evidence.

Angus Maddison in his book Contours of the World Economy, 1-2030 (Oxford University Press, 2007) identifies five phases of growth since 1820 (Page 69) of which the years 1950 to 1973 he labels the golden age of prosperity. The years from 1973 until the time of publication (2007) were the second most prosperous of that time period. One would have to guess the down trend has continued since 2007.

The second piece of evidence comes from the World Wildlife fund which published the Living Planet Report late in 2010. The report claims we are using resources at a rate 150 percent of that which would be sustainable for the planet. If this is correct then there has to be economic turmoil. Even if the figure is exaggerated we should be taking it seriously. In the last year I have seen no discussion of the possible economic consequences.

The third piece of evidence is a United Nations report published in December, 2011 which claims 25 percent of the world's land is "highly degraded" and 44 percent is "moderately degraded," while only 10 percent was classified as "improving".

Even if these figures are an exaggeration we should treat this report with concern. No matter how many technical gadgets we have and no matter how much of our economy is based on services, if we can not produce enough food for everyone there will be serious economic and social problems. The less we consider this report and how to deal with its implications the more human suffering there will be.

Considering the number of factors which can influence the quantity of goods and services being produced both up and down, to maintain price stability it is important that the money supply can easily be varied.

These points along with most of the headlines I read every day lead me to think the world economy is into a major downturn. The horsemen of the Apocalypse are possibly riding again. Problems in the physical side of the economy are showing up as a financial crisis. This presents us with a policy dilemma. Austerity as is proposed by some people will inflict uneven suffering on too many people and stimulus as proposed by other people will consume even more resources and bring forward a major crash. If a chunk of the money supply should be lost as a result of a financial crisis, then the downturn will be even worse.

Now lets look at the financial side of the formula.

The study of anthropology shows humans do not need money in order to exchange goods and services and that relationships are important in exchanges where there is no money.. Money allows us to exchange with strangers and on a much larger scale. Therefore we should look upon money as a tool, or maybe even a lubricant, which makes it easier to exchange goods and services.. We probably should not be treating it as a commodity.

I want to look at three ways in which money can be created - the gold standard, fractional reserve money and LETS (local exchange trading system).

Through the years many commodities have been used to facilitate the exchange of goods and services. Being rare, beautiful and mostly useless gold has been a favorite. The metal itself can be used or receipts representing gold in storage can be used. The use of gold (or some other commodity) was probably an early step in the transition from an economy based on relationships.

The advantages of money based on gold are that it is easy to establish and it is easy for people to believe in it and have faith that they will continue to have something of value although even gold can change its value relative to things it can be used to purchase.

But gold has some serious disadvantages as money..The biggest is that the amount of gold is limited by what can be dug up or imported or stolen. Thus if there is too much gold in circulation there will be inflation which happened after the Spaniards started importing gold (and silver) from South America. On the other hand if there is not enough gold there will be deflation as happened when the Americans went back onto the gold standard following their civil war.

To some extent the quantity limitation of gold can be overcome by the use of fractional reserve money on top of gold base. The total money supply can be varied with changes in reserve requirements or in what else besides gold can be accepted as high-powered money. But on the gold standard people tend to be emotionally attached to the idea their money is backed by gold.

If there is anything that deserves to be called funny money, it is fractional reserve money. A couple of times I have asked loans officers how it feels to be able to create money, and they cannot believe that they are doing that. Money creation in our economy is just a little complex and it takes a little effort to understand how it works.

Money is created when banks make loans and uncreated when the loan is repaid.

Here is the classic explanation. Suppose $1,000 of money from outside is deposited in a bank in a closed economy of three or four banks where all transactions are by cheque (or these days bank card). This bank is required to hold reserves of 10 per cent (to make the arithmetic easy) and the bank manager now has $900 to loan to his customers. The customers spend the money and it ends up in another bank in this community. The second bank manager can now make a loan of $810. By the time the $1,000 of new money has worked through the system there has been $10,000 added to the money supply of this community. Isn't that incredible? No wonder loans officers won't believe they are creating money.

I've been trying to think up some advantages to creating money this way and the only thing I can think of is that it is what we are used to. Money is such an emotional thing that to suggest something else is seen as treasonous. Change can be threatening.

However, there are at least three disadvantages to fractional reserve money.

The first is that it gives tremendous power to bankers who get to determine which projects go ahead and by whom. They also have opportunities to take cuts for themselves and they get to charge interest on the money they have created. It is no wonder that the economic frustrations of people through the years have surfaced as protests against bankers.

The second problem is that the above model does not take into account that interest is charged on all those loans. Suppose the loans were all for a one year term at 10 per cent interest. On the one year anniversary the $10,000 of new money must be repaid with $11,000 even though no additional new money has been created. In the real world through most of the years fractional reserve money has been used the economy, the high-powered money and the money supply have all been growing so that interest has not been seen as a problem. This is beginning to sound like a variation on a Ponzi scheme.

A third problem is that this model does not look at what happens if something happens to the high-powered money upon which the $10,000 is based. The original $1,000 could be suddenly withdrawn or one of the banks could have to write off $1,000. Either way for the banks to maintain their 10 per cent reserve requirements they are going to have to reduce their loans by $10,000 and that will be $10,000 less money to facilitate the exchange of goods and services in the community. Unless the velocity of the remaining money can be increased either prices will come down or the economy will be forced into a recession as Q drops. The writing off of large amounts of debt and a reduction in high-powered money may be a part of what happened during the financial crisis of 2008. The current Euro crisis could be even worse.

Another problem with fractional reserve money is that the total money supply cannot easily be varied especially downward and deflation is probably more of a problem than inflation.

Through the years, as we saw earlier, there have been ups and downs in the quantity of goods and services the economy can produce. On top of that there are instabilities from the way in which we create money. There's a saying that complex systems fail in complex ways. If we really are going into an extended period of economic decline these financial instabilities and complexities are likely to make things much worse.

Sometimes the promoters of local exchange trading systems (LETS) try to sell it as a form of barter. However, I believe they are just using another form of money.

Rather than talking about creating money it might be more appropriate to talk about assigning credits and debits. Maybe this will help us get used to the idea that money should be considered a tool or lubricant rather than a commodity.

A group of people in a local area agree to trade among themselves. When two parties have agreed to a transaction they record the transaction with the organization. The seller gets a credit and the buyer gets a debit. They then go on to make further deals with others in the organization and over time everything works out. The exchange part of this is really not much different from using bank accounts to facilitate exchanges.

But doing it this way the problems with fractional reserve banking become positives. No interest is charged or received; therefore there is no need for the money supply to be continually increasing and there should be no inflation or deflation.

As money is assigned with each exchange the total amount varies automatically. If the members increase their economic activity the assigned money supply goes up and if some problems force a decline in their exchanges the assigned money supply automatically goes down without impacting prices.

A third advantage is that the velocity of money is variable. Once some money is assigned it can sit in the account until the owner is ready to use it. As money is a tool it can be used when needed. As there is no interest to be earned there is no pressure to do something with it.

There are two disadvantages to a LETS.

The first is that every transaction is recorded. On a national scale this would make social control much easier. One the other hand most of us have embraced debit cards with enthusiasm and give little thought that each transaction is recorded.

The second problem with LETS is that its usefulness is somewhat limited because people have to join and it is local. Most of us want to exchange goods and services on a much larger and wider scale.

Therefore I propose we expand the concept into a national exchange trading system (NETS).

Such a radical change in the way of assigning money would require a radical revision of our whole economic organization. It would also go against a lot of vested interests.

Here are some guidelines for establishing a new economic order.

First, I suggest the goal would be to get as close as possible to the perfect competition or market model.

Because many economists are close to big business or seen as being close a lot of people won't listen to anything from economics. Some of these people go on to propose an economy based on small business. What a shame they don't listen as the first requirement for perfect competition is that no participant in a market is so large as to be able to influence prices through purchasing or selling decisions. A lot of thought has gone into the economics of small business but it appears some people want to reinvent the wheel.

What I like most about the perfect competition model is its equality feature. As the competition is perfect there can be no profits other than wages, a return on investment and maybe something to compensate for risk. The challenge of the future is to organize our economy so that most people will be able to share the available resources. The closer we are to perfect competition the closer we will be to meeting this challenge. However, one has to recognize that not everyone is committed to equality.

As growth is not a part of this model, it is ideal for a steady or declining economy.

As it is important for economic efficiency that prices reflect the true costs of production, subsidies should be given to consumers rather than producers and there should be no protection from international trade. A country making this change should declare unilateral free trade. If other countries want to subsidize our living standards that is up to them.

We should try to limit political influence on economic issues as politicians tend to have goals that interfere with an efficient economy.

A second guiding principle should be that the money supply must be variable. However, we must also ensure there is neither too much or too little. We must take care that no individual or group allows the money supply to increase for their own profit. Prices in general need to remain stable although allowing individual prices to change will provide signals for changes in production activity. Probably the way to deal with controlling moneys supply would be to tie it to a general price index. If the index goes up then the money supply should go down and if the index goes down then money supply should go up.

For some time most of our money has been entries in the books or computers of the banking system. However many people still think of money as having its own value as in gold and it should therefore earn interest. To adopt a NETS system we are going to have to complete the psychological transition to thinking of money as a tool or lubricant that gets its usefulness from facilitating the exchange of goods and services.

NETS money would be based on debits and credits created when people exchange goods and services. Its backing would be the goods and services produced. As no interest is charged on this money velocity should be more variable and this should balance small fluctuations in the value of Q..

There would probably be a need for some currency for small transactions to preserve privacy and to keep police employed. (If there were no currency a lot of crime would be difficult or easily tracked.)

Currently a lot of money goes through government coffers in the form of transfer payments to individuals and subsidies to producers. I believe subsidies should go to consumers rather than producers therefore I propose that these be combined into some sort of universal income scheme to ensure that everyone has a minimum standard of living. This would involve making payments directly into the accounts of individuals probably on a monthly basis. It may be necessary to have some taxation to keep the money circulating.

A major effect of giving out universal subsistence payments would be to transfer power to individuals who would vote with what they chose to do with their money. The power to assign money would be with individuals rather than bankers.

Universal subsistence payments will be needed for the same reasons pensions, unemployment insurance and social assistance are needed - to help people get through those times in their lives when they are not capable of earning a living wage. It would also allow people to choose what they wanted to do with their time and their lives as current technology does not require everyone to work their whole lives. And when there is a probability of an economic downturn this program would ease the suffering from economic turmoil.

Most of the money supply would be assigned in the day-to-day transactions. However, some person or group of people would have to determine the amount of the universal subsistence payments. This amount should be determined so as to keep a price index steady. It would probably be best to keep politicians out of it although I can see giving presidents and prime ministers the right to make a limited special payment on the day before elections. We won't be able to stop this type of bribery so we might as well keep it controlled.

In trying to implement such radical changes it would probably be wise to reevaluate all government functions especially those related to economics.

Currently governments use their powers to pass legislation that restricts the operation of the market so that some people can make profits they would not make if full competition were allowed. This includes patent and copyright, licensing, trade restrictions and regulations. I would like to see governments reverse this role and support the basics of perfect competition. One thing they should definitely be doing is to require the publication of all knowledge relevant to the production and pricing of all goods and services. Producers need to have the knowledge to easily get into an industry and customers should have access to all the information they need to make decisions according to their values.

Another function of government should be to evaluate and publicize what is happening to the Q in the formula - the quantity of goods and services being produced.

Governments should also ensure the production of infrastructure, justice (rather than the rule of law) and education. Please note the word ensure. Governments could ensure the education of all children via a voucher system rather than through public schools.

People in government appear to enjoy spending money. Under NETS there are several ways in which government could be financed. The person or group responsible for managing the money supply could allocate funds to governments in the same way they would give out a universal subsistence allowance. Governments could impose taxes as they do now. Or there could some combination of the two. The more governments have to get money directly from their people the more accountability there will be. Governments should not be allowed to borrow.

The important thing is that the money supply be kept in balance with the other functions in the formula.

There would still be a need for financial inter-mediation to raise sums of capital for projects. In our economy this has been sold as savings and investment with a certain return. As returns have proven to be somewhat less than certain it might be more honest to encourage the industry to focus on risk equity.

As we are trying to focus on the perfect competition model firms would be allowed to fail. Their employees would be protected by the universal subsistence payments.

Foreign exchange would continue to happen as countries exchange goods and services with each other. Capital transfers should match physical transfers of goods and services for projects. Exchange rates would probably be closer to purchasing power parity.

Changes in exchange rates would reflect changes within individual economies and structural changes.

I believe economies are examples of fractals in that their graphs show a series of up and down trends and that within each trend there are trends within trends of ups and downs. One can calculate fractal dimension (2 - the Hurst exponent) and sometime the result can be used to identify turning points. But the ups and downs are so complex nothing can be certain.

Looking at the world economy we cannot be certain but there is a lot of evidence we have been through a major turning point and the major trend is likely to be down for some time to come. The return to growth which would be our salvation may be a long way off. To minimize human suffering we need to make some radical changes. In this essay we have looked at the connectivity formula from the quantity theory of money and noted the current economic crisis is probably a reflection of our unsustainable use of resources. We have also identified some problems with the way in which we create money and proposed extending the local exchange trading system into a national exchange trading system.