Wednesday, 21 January 2009

Mining the Future

Many people will tell you that banks are a better investment than gold mines.  But what they won’t tell you is that banks are also mines.  The commodity that they mine though is far more abstract than mineral ores.  What they are mining is future value.  They are tunnelling into the future, extracting the value added to society by a certain person or company (the borrower), and bringing it into the present, where that value is represented by a fiat currency, added to the bank’s balance sheet, and lent to the borrower.

In a banking system where fractional reserve is not permitted, any lending activity must make use of current savings as the only source of funds.  This, by definition, restricts the supply of money for lending and therefore restricts economic growth.  But contrary to what you have been conditioned to believe, this is not necessarily a bad thing.  The economy may not leap forward in huge steps, but it is absolutely certain that the rate of development will be sustainable.  

With a fractional reserve system however, banks are able to give credit to a multiple of the cash they have on deposit.  In this way they are inflating the current money supply by issuing notes on deposits that don’t exist.  Or more specifically don’t exist YET.  The important thing to remember is that the loan is issued on the premise that it will be repaid from future earnings.  So in essence it is a loan, not of current money, but of future money.  In this way, the banks are reaching into the future and bringing back the projected earnings of a person, and allowing that person to use those earnings in the present.

People often say that in a fractional reserve system, money can be created from thin air.  That is not really true, it is just the understandable reaction of people who are concerned for the value of their own currency, who don’t understand the basis for the value of credit created in a fiat monetary system.  It is important to note that currency is never just indiscriminately printed and added to balance sheets; any money added to the money supply through fractional reserve banking is in the form of a loan to a debtor (borrower), and that loan is backed by the promise to repay the loan from the future earnings of the debtor.

There is potential here for feedback – either positive or negative, and this feedback is what makes banking magical.  If the borrowed money is used to finance productive capacity, it will increase the borrower’s future earning power, thus filling the future “value gap” created by mining the future, and even increasing the value present in the borrower’s future.  On the other hand, using the mined future value for pure consumption leaves the “value gap” in place, making the borrower poorer in his future.  If we apply the positive feedback scenario to all borrowings, the value of the future will increase exponentially.  This is what allows you to develop at the rate you have done.

I will not make a judgement on which is the best system, or which is the correct system.  My purpose is only to lay out in a simple way the mechanisms of value in each so that you may better judge the dangers of each, and make decisions with a better knowledge base.

The dangers of the 100% reserve system, or a gold standard, are only in the limits imposed on development.  Whether these limits are really dangers, or if they are safeguards is not known to me.  We cannot judge the future accurately – it may be that only technology can save the human race from a looming external threat, in which case fast development is preferred, or it may be that technology that develops faster than it can be fully considered and understood will create its own threat to the human race, or even the earth (I gather the possibility of “anthropogenic global warming” is the current fashionable threat; a case of technology – even such a primitive one - being implemented without full consideration and understanding of its effects).  Nevertheless, slow development must be considered a threat as much as fast development.

Fractional reserve banking, or “future mining”, has it own dangers – and here we finally get to the current global economic crisis.  As with any form of mining, there are skills involved – principally knowing where to find the richest seams of value and being able to assess the value of the seam, as well as its surrounding strata, to determine how much value can safely be extracted without the danger of a cave-in. This is the skill of a banker.  Being able to assess the borrower in terms of his understanding of the debt, the proposed use of the debt and its contribution to future value, his ability to repay the debt, his future prospects and his lifestyle.  All of these factors and more should be important to the banker, because his bank is acting as facilitator to the borrower, allowing him to borrow from his future by providing surety for the debt.  If the borrower defaults, the value gap in the future is never filled, it simply sits there on the bank’s balance sheet.  What has happened in the world economy is that there has been too much borrowing for pure consumption, which adds no value to the future, in conjunction with lending to people who have no hope of repaying the debt (sub-prime mortgages).  I also believe that third world state borrowing has a large part in this equation, because it is often used simply for consumption, and new loans are frequently used to service interest payments on old loans.  These factors have created a massive hole in the value of the future.  For a long time now, banks have simply been mining deeper and deeper into the future to fill the holes left open.  It has reached (or will soon reach) a point where banks can no longer mine any deeper into the future.  Beyond a certain time span – significantly less than a generation, there is no way of determining the ability of a person to repay a loan.  This is the depth limit of the future mines.  When this point is reached, we will have to simply wait until seams of future value collapse in on one another, creating a more homogenous mass to mine.  This is the financial meltdown.

How do you avoid this in the future?  It is simple, literally!  Just simplify.  Remember simplicity, teach simplicity, use simplicity.  By creating abstract complex financial instruments, and pyramiding one on top of another, by hiding bad debts in “black boxes”, by believing that complexity can overcome the basic principles of value, you have created a culture that allows, and even encourages, unwise banking practices.  It is not the system that is at fault, it is the people.

You will probably be saying, “we need stronger regulation”.  It is a natural reaction, but not necessarily the best.  This is a subject for another study.  In the meantime, best of luck to all of you all, and remember to simplify.

V


Tuesday, 13 January 2009

Inflation and Growth

A barter currency like gold is very useful in producing a stable financial system because the supply can’t easily be inflated.  There is a certain fixed amount (a definite mass) of the currency in circulation, which can’t be added to without mining more of the commodity.

You will note that I specified mass as the correct measure of the amount of currency in circulation - this is to illustrate the mechanism of inflation:

Consider your fortune in gold coins.  There are two ways to look at it: a certain number of coins or a certain weight of gold.  Then consider that (assuming the currency is standardised and established) when using the coins as a barter currency, the recipient will count their number, not weigh them.  If one was dishonest (as governments invariably are to some degree), one would then consider that one could expand one’s wealth by consolidating one’s gold coins into a single molten mess, then perhaps add a further 25% to the volume with a cheap metal of similar colour, then re-cast the coinage as before, or simply re-cast the coinage 25% slimmer, thus increasing the number of coins derived from the original gold.  In a stroke, you have increased your wealth.  Actually you have also increased the money supply, and an increasing money supply is the dominant factor driving inflation.

To understand the effect of money supply on price levels, you need to consider the simplest possible illustration of how prices are determined in the marketplace: 

Consider that there is a certain amount of currency in circulation in a society.  In that same society there are a certain number of goods and services available at any one time.  Essentially, people will have a need for goods, services and money for savings.  After subtracting the savings from the money supply, all the currency left over must be divided amongst all the goods and services available.  If the currency in circulation increases without a corresponding increase in things to spend it on, price levels will rise – and voila, inflation has been invented.  Many of you will say that this is a simplistic view, but it isn’t – it’s a simple illustration; all other factors that appear to make it complicated are simply noise and variations on the theme.  This background noise of complexity is what makes it so difficult for so many people to understand the mechanisms of finance.  Remember that the principles are all simple… just filter out the noise.

Once you understand this simple inflationary mechanism, you will understand the dangers of a fiat currency (a printing press is cheaper and easier to run than a mine, and certainly easier to disguise) - particularly if you can see that inflationary action takes time to filter through the economy. This is because the person who benefits initially from the inflated money supply (the one who shaved or supplemented his coins) is able to spend the money at its original value, with inflated money supply only influencing price levels as the new money filters through the society.  Effectively then, the inflating party is stealing value from the others in society.  Do you think that governments don’t know that?  If the government prints and spends money, the government benefits first and the society pays later through devaluation of their savings – a hidden tax.  Like they say, knowledge is power…

But a fiat currency is not necessarily all negative.  In fact, it can be an enormously powerful tool – a mine potentially deeper and far more productive than a gold or silver mine.  It is, in fact a future mine.  It mines the future.  I will elaborate on this very important point in the next edition, so as to allow you to ruminate upon and digest the dangers that a fiat currency poses to the value of people’s contributions to society.


V

Friday, 9 January 2009

The Fiat Currency

Last time we saw how gold and silver, being durable, divisible, valuable and portable, became commodities of exchange. You might think of them as "barter currencies" - exchanging one commodity for another (the barter currency), then exchanging the barter currency for other needed goods or services.

The value of the barter currency is interesting to contemplate. It is a somewhat slippery fish to get a hold on, chiefly because once a commodity is used as a universal medium of exchange, or currency, it develops a completely new demand curve. Its original value is based on its usefulness within the market, and as with all commodities, all people value it somewhat more or less than others. However, once it becomes widely accepted (because of its high value) as a currency, all people will value it more equally, and mostly higher than before. It then becomes more highly valued as money than as a commodity, and its value will rest to a significant degree in the fact that it is used as money. Therefore to an extent, its value depends on its use as a money, but its use as money depends on its value. A conundrum indeed.

Nevertheless, in times of uncertainty, the barter currency has its original value as a useful commodity to fall back on - it will always have a relatively high value; this is useful for the conservative financial system, but it is restrictive for growth (which we will examine in the next edition).

Fiat money evolved when the receipts for the barter commodity held on deposit had been used for a long time and had become separated in people's minds from the commodity itself. All it took was a legal separation of the commodity from the receipt; after all, the receipts were serving perfectly well in themselves as currency, without needing to touch the commodity itself at all.

What then is Fiat currency based on? Does it have value at all? The answer is that a fiat currency is essentially a certificate of contribution. It certifies that a person has made a contribution (through whatever work he/she/it does) to society, and places, through the market mechanism, a value on that contribution. A fiat currency simply removes the middle ground occupied by a barter currency or commodity such as gold. The fiat currency therefore has value in terms of the willingness of society to honour the value placed on a person's contribution to that society.

It should be obvious then that it seems in the best interests of society to maintain the value of the currency so as not to devalue each member's contribution to the society. Why then do we have inflation, and why is inflation connected to growth? This we will save for our next session.

In the meantime, it is a new year; I suggest a resolution to seek wisdom. I admit that wisdom is easier from a position of detachment. Nevertheless...

V

Thursday, 8 January 2009

The nature of money

Let’s start with Money. Money, they say, makes the world go around. In fact, I have come to see that this is a lie. There are, apparently, various laws of physics that make your world go around; my world is flat and doesn’t go around so much as forward through space on the back of a turtle, but there you are. Understanding money is, however, an essential part of having an opinion on monetary matters. If you get upset at the central bank raising interest rates, it’s important that you are able to justify your ire. You may be getting worked up for nothing, or your ire may be misdirected.

To illustrate money, we need to go to its origin. Money originated because barter is not really practical when it comes to exchanging a house for a few hundred thousand loaves of bread. It would be necessary for the builder to find a commodity that is valuable (to be worth exchanging for a house), divisible (to be able to buy a single loaf of bread at a time), portable (to carry enough for a loaf of bread to the bakery), durable (so he can still use it to buy bread when he’s hungry next year) and universally acceptable (in case he wants fish instead of bread). From these requirements, gold emerged as the logical commodity of exchange. Think of it as buying gold with whatever goods or services you produce, and then buying another good or service with your gold.

So there we have gold as a universal commodity of exchange. Gold is money. We will get to the question of gold’s value later, but for now it will suffice that at this stage of financial development, gold is money.

The next problem we encounter is that of portability and safe keeping. Gold is relatively heavy to carry around, but portable enough to be stolen, so people started to make use of goldsmiths to warehouse their savings. They would give the goldsmiths their gold to keep safe, and the goldsmiths would give them a receipt. Look at your bank notes: there is a phrase, “I promise to pay the bearer one Dollar”, or one Pound Sterling etc. This is a remnant of the receipts for gold or silver on deposit for safe keeping with goldsmiths, who later became bankers, at a time when a Dollar was a certain weight of gold and a Pound Sterling was, obviously, a pound of Sterling Silver. In time, the receipts for the gold and silver on deposit at the bank became a de facto currency, because they were in fact deeds of ownership to a certain amount of gold.

From this point there is a clear pathway of development to the modern bank note – a receipt for a certain amount of gold being held by a bank on behalf of the bearer of a receipt from that bank. There are some more steps to the modern day central bank note, but we will get there in the next session.

In the meantime, I have a Mime in the scorpion pit learning the error of his ways. I must check on him. So many lessons to teach, so little time.

V

Sunday, 21 December 2008

Introduction and Credit

Good morning, my name is Havelock Vetinari. I am a tyrant; many of you will be familiar with me. I would like to take this opportunity to thank Mr. Terry Pratchett whose fertile imagination and superb intellect gave me a pathway to this universe which is so different, yet so similar to my own.

It is interesting to me to compare our two worlds' forms of what you call democracy. The concept "one man, one vote" is very familiar to those in my city: I am the one man and I have the vote. I find it saves time and money.

Over the following weeks I hope to analyse the problems and strengths of our different systems, particularly in the light of current affairs. In the meantime, for some light background reading, I recommend the following books:

Going Postal
Night Watch
The Fifth Elephant
Making Money

All of the above by Terry Pratchett

Sicerely,
Havelock Vetinari