Money Basics
Rev 2
Marc Gauvin Copyright ©
2011-05-19 All Rights Reserved
“The
study of money, above all other fields in economics, is one in which
complexity is used to disguise truth or to evade truth, not to reveal it.”
“The process
by which banks create money is so simple that the mind is repelled.”
John Kenneth Galbraith Money: Whence it came, where
it went – 1975, p29, p15
The goal of the following five
lessons is to provide exact technical knowledge that most anyone can
understand about the true nature of any financial system and thus provide the
individual with a truly authoritative understanding of the current
system. With this knowledge, it
will be possible for most to confidently define, independently of political,
religious or ethnic concerns, what exactly constitutes a stable currency
system, what does not and why.
To achieve this, we first demystify the current state of the art by
clearly separating in our minds the consequences of the present system’s design
alone from those due to human behaviour. In this regard, we take note of the
following axiom:
System design affects user behaviour but user
behaviour does not affect system design unless it expressly acts to alter or
replace it.
Thus just as in the game of
musical chairs, the design of the game itself can be the cause of the
inequity rather than the nature of the players, so too the design of our
currency system can be the cause of similar undesired outcomes independently
of the behaviour of individual players.
In this light, trying to
manipulate the behaviour of players to resolve a system design problem is as
absurd as expecting that in musical chairs, the missing chair will magically
appear on the basis of the way players dance about while the music is still
playing! This is where the
political class is entirely irrelevant as none of the proposals within the
left/right spectrum are wiling to address the system design. The political class without exception
confuses reform of the implementation of the design with reform of the design
itself.
The Why of Money
We all imagine that we understand
why money exists, but given that our understanding of money is coloured by
our social conditioning, it is worth revising, in a rigorous and rational
way, exactly why money exists.
If we think about it, we ought to
realise that money only performs one really practical and fundamental
function for us, which is to provide “liquidity”. That is to say, it allows us to represent divisions of the
value attributed to things. This
function of dividing value is the singular and most important reason for
inventing money, it is fundamental because without it, we would be unable to
trade a piece of our house for food. Also, without this divisibility function, we would
not be able to establish a standard means for measuring economic transactions
nor keep records of debts and positive accounts. Hence, the fundamental rationale for money is to provide a
measure of value so that we can represent value and its divisions.
It turns out that there are only
two requirements that need to be met in order to achieve this functionality:
1) Denominate a common unit of reference of constant value.
2) Maintain stable records of the inputs and outputs of the value
dividing process.
Therefore, having available any
wealth in the form of measurable goods and services and the need or desire to
trade that wealth, the statement “lack of funds” is an oxymoron that at best represents a conceptual error
resulting in lethally absurd consequences and at worst, given that economics
has come to be considered a science, scientific fraud.
Lesson 1 – Currency Unit “Creation”
When a bank finally concedes a
loan the following takes place:
1) First and foremost, the bank will require that something
of wealth that is free of any liens or previous debts be submitted as a
guarantee called collateral.
2) Through a process called asset evaluation, the submitted
collateral is assigned a fixed (bounded) value in currency units that is
maintained for the duration or term of the loan.
3) It
then adds a fixed (bounded) positive number equal to the principal amount of
the loan to the client’s current account. This number has a fixed (bounded)
ratio with the number attributed to the collateral guaranty established in
the previous step.
4) Simultaneously, the bank creates a special loan account associated
with the borrower to which it enters a negative number of the same magnitude
as that of the principal amount entered into the current account.
5) No
other accounts are subtracted from in order to realise the loan.
Now, because positive numbers in
current accounts can be used to:
a) Transfer units to any other account for any reason;
b) Obtain physical currency representing legal tender (bills
and coins);
c) Cancel negative numbers in loan accounts;
d) All
other things money can be used for.
Then, the creation of new positive
current account entries represents the creation of new money that is backed
in a fixed ratio to the wealth that has been provided as collateral. In fact, presently all currency in
circulation including currency bills, coins and legal tender, are put into
circulation only after first creating positive account entries backed by some
sort of borrowers’ pledge.
Conclusion: Money is simply a record of
value. Money is “created”
whenever a fixed amount of wealth is pledged unequivocally and irrevocably to
be represented by a fixed sum of units of money whatever the means by which
such is recorded.
Therefore, and as long as there exists wealth capable of being
pledged, new money can always be created. Money is only the representation of
divisions of wealth not the wealth itself.
Lesson
2 – Currency Unit “Destruction”
Whenever loan account entries are
cancelled, corresponding positive current account entries must also be
subtracted or deleted. Hence,
money is deleted from the system when principal debt is cancelled.
Conclusion: Since by design there is always a one to one ratio
of loan account entries to current account entries [1],
then when all loan accounts in the system are cancelled, all corresponding
current account entries will also have been deleted and thus ALL such
currency will have been removed from circulation. So, without loan account
entries there can be no money in circulation.
Lesson 3 –
Currency System Stability
In essence, currency or money is simply the abstract
medium by which “value” can be represented numerically by individuals in the
course of transacting the things to which such value is or can be attributed
to. Such processes of evaluating wealth as an input producing output sums
denominated in monetary units, constitute what are commonly called “money
systems”. These “systems” have
clear and precise rules that together constitute logical designs that can be
determined to be either stable or unstable by virtue of whether or not their
inputs and outputs are both bounded values i.e. whether or not they satisfy
the BIBO criteria for stability. Stability as defined in Control Systems
Engineering:
A
system [1] is stable if every bounded input produces a bounded
output. That is when the “Bounded Input Bounded Output (BIBO)” condition for
stability is satisfied.
This can be understood as saying that any
perturbation of the system will produce a response that will tend to revert
it back to its point of equilibrium.
If you push a ball up the inside of a bowl it will roll back down and
up the other side whereby friction will slow the motion down until the ball
is still. Such a system is a
stable system as the input (push of the ball) generates an output response
that has a bounded maximum value after which the ball tends to revert back to
its point of equilibrium.
Conversely, when the input produces outputs that increase over time,
requiring independent external forces to arrest the response, then the system
in question is considered unstable. A stable system is one that reaches
equilibrium by its own definition and inherent design. A Passive BIBO system is a BIBO
system where the output of which, apart from being bounded, is always equal
or less than the input.
In the most rigorous mathematical terms instability
is modelled by representing the output of a process in terms of time. If for
a given bounded input the output always increases over time then the output
is clearly never a fixed sum and therefore is unstable, while if the process
tends towards a fixed limit over time, then it is considered to be stable.
The way this is determined mathematically is by measuring the rate of change
known in math lingo as the derivative.
If the rate of change is always positive then the growth is always
increasing and the system is considered unstable. Conversely, if the rate of change is zero, then the system
is considered to be stable. A
process is considered unbounded when its rate of change is always positive
and bounded when its rate of change is zero.
Now and according to our Money Basics notes so far,
the system is indeed Passively BIBO stable because as long as we stay within
the bounds of just principal amounts, the system is stable because all inputs
and outputs are indeed bounded:
1. All real physical wealth pledged is bounded.
2. The principal sums entered into current accounts are
all bounded.
3. And all principal debts are bounded.
But, if we talk about the Total Debt due i.e. according
to the following simple interest formula [1]:
Total
Debt = P (1+ik)
Then the debt output no longer is bounded because it
grows as a function of interest i multiplied by the number of
periods k
measured in units of time, resulting in an unbounded or ever increasing
output making the system no longer BIBO and therefore unstable by
design. This simply tells us
that the simple interest function grows with respect to time as a straight
diagonal line with a constant slope.
This means that the rate of change is positive.
Since any loan account entry cancellation requires
an equal cancellation of corresponding current account entries, at ALL times
the magnitude of loan account entries is ALWAYS equal to the corresponding
number of current account entries, then any interest demands are at ALL TIMES
in addition to the available current account entries.
Now
and very importantly, instability is not identified by whether or not all
Principal and Interest demands can or cannot be satisfied, but rather
instability is identified by the fact that if, for whatever reason, either
are not satisfied, then the debt will continue to grow unboundedly.
Therefore and since it is absurd to expect the
outcome where 100% of both principal and interest are satisfied for 100% of
all scheduled payments at all times, then it can be accurately stated that
such a system, invariably produces residual unbounded Principal and Interest
debt that without issuance of new debt money units, remains un-payable
leading to a situation of perpetual debt. As we shall see in the next lesson,
if this debt is refinanced, then it necessarily becomes exponential in nature
exacerbating the aggregate system’s state of instability.
Lesson 4 – Linear
Vs Exponential
Consider a lake with a population of water lilies
that have the odd property of doubling their population every day. Depending on the size of the lake it
could take a very long time even a million years for half the lake to be
covered but following such a long period it will only take one more day for
the second half. Note also that
just weeks before reaching the millionth year, the lake would have much the
same appearance as it always had i.e. far from half of its surface being
covered. Thus, such growth is
far from being intuitive to the observer.
Mathematically, the process is simply the periodic
summing of previously summed values.
If one stacks cards by adding a card each period the stack will grow
in a linear fashion but if instead, one adds always as many cards as
previously were stacked, then the growth of the stack will be exponential,
growing much faster than the linear counterpart and much less intuitively.
So as we described in the previous lesson, if you pay
interest on interest then your stacking will be on the basis of previous
sums, leading to an exponential not linear result.
Lesson
5 – Systematic Inflation
As can be deduced from the previous lessons, from the
very first loan the system is predisposed to the creation of an arbitrary
debt “seed” that inevitably will be planted in the economy resulting in a
minimum amount of unbounded debt output. But the creation of perpetual
unbounded debt is just the very minimum result and not the only consequence
of this design.
The other even more spectacular consequence of the
root instability of interest debt growth is the fact that from the moment
that the growth begins, that growth is incorporated by users as a cost and
passed on down the value chain.
As it is passed on, it is subject to being refinanced over and over
again as it moves down stream from financing resource extraction, production,
distribution through to final consumption. Similarly the interest cost of capital assets increase
their cost in subsequent financing cycles. The result is a vast
multiplication and compounding of interest debt in the system, resulting in a
necessarily overall exponential output, where the rate of growth of debt is
no longer a straight line but a curve that approaches infinity more and more
quickly as time approaches infinity.
Like the first “lily” of our population that doubles
and doubles in time, so too, the excess debt seed and subsequent re-financing
of past interest debt will double and double in time. This rolling over of initial
and subsequent debt seeds has an important effect on the system as a whole,
particularly with regards to the relationship between the amount of money in
circulation (current account entries), wealth pledged and minimum prices.
Thus, from the onset and by system design alone,
excess debt i.e. without any previously stipulated wealth backing it nor any
corresponding current account entries, is perpetually generated every cycle
and as it is compounded, the system’s unbounded debt output ceases to be
linear but rather becomes exponential as the following system walkthrough
illustrates.
System walkthrough
Figure 4.1 Financial System
walkthrough [1]
1. Wealth is generated by ingenuity, human effort
and resources made available through past investment of wealth.
2.
Through the process of asset evaluation, a fixed amount of existing wealth is
attributed a fixed collateral value in the form of a sum of units of
currency.
3.
The fixed collateral sum is used as the basis for the creation of new
currency in the form of a second fixed value i.e. the principal sum of loans
issued into circulation through current account entries. Since both the
collateral and principal loan sums are fixed, they maintain a constant ratio
to the wealth pledged.
4.
Current account units are distributed back to wealth producers through
purchasing transactions or may be saved or stored (at a compounding interest
rate) or used to cancel debt thus reducing the total amount of money in
circulation.
5.
Total debt due is the principal sum entered as a negative number in a loan
account to which interest is added such that the debt grows as a function of
time.
6.
Because of the debt growth due to interest and the fact that not all payments
at all times will be made, exacerbated by the scarcity of money also due to
the interest, then it can be asserted that the system will inevitably produce
residual excess debt. If this
residual debt is refinanced then the debt will compound and the growth will
necessarily be exponential.
Further to this, is the fact that all interest amounts represent a
cost beyond the principal amount [1] that are past down-stream through cumulative
financing from resource extraction, production, distribution through to final
consumption. Similarly, the interest over capital asset loans will increase
costs in subsequent financing cycles. The result is an exponential aggregate
system debt output that leads to corresponding exponential increase in prices
(inflation) unless new wealth is produced in tandem with the aggregate debt
growth. Otherwise the system
collapses.
Conclusion
The system’s logical design is
inherently unstable because it does not satisfy the BIBO/Passivity criteria.
The cause of this instability is clearly the growth component of the total
debt output due to interest.
This growth creates a chronic deficit of currency units in the system
requiring that the system constantly produce more currency units irrespective
of whether or not new wealth is added.
But, if wealth is not increased and the unpaid past debt is added as a
cost to the value attributed to past collateral, the previous proportion of
wealth to currency is altered causing inflation. Every time this occurs debt is compounded and as the
interest cost is passed on down the value chain further compounding takes
place, multiplying inflation faster and faster over the lifecycle of an
economy. As the debt/inflation
accelerates the probability of generating new wealth to compensate decreases
but to avoid collapse, the system must continue to refinance past debt but
with less and less new real wealth. This can only culminate in a point of
debt saturation where virtually all the economy’s real wealth becomes
simultaneously caught in pledge (or withdrawn from circulation) so that
little or no wealth (collateral) remains available for the creation of new current
account entries. It is
precisely this that leads to uncontrollable run away inflation (continuous
debt money without real wealth) or other forms of system collapse.
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2011-09-25
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