I've been trying to gather into crude shape my learning thus far on what money is and how systems which use it might work. I found myself drawing diagrams to clarify my position, and feel I have learned a little from the process. Here they are for comment and analysis. I'm only looking at fiat, not commodity-backed money, because I believe there's no real functional difference between them when pondering what money actually does in an economy. [With enormous thanks to my brother for pointing out my embarrassingly bad maths -- this blog has been edited since it first appeared!]
The simple world of this sequence, made up only of companies for illustrative purposes, is loaned 10bn by 1Bank to crank the system into life and get the game moving. Awkwardly, because of interest, World has to pay back to 1Bank 10.5bn. This is of course impossible, because only 1Bank is allowed to create money, and furthermore only creates money as an interest bearing loan at 5%. Even if 1Bank employs extra people to do hitherto unnecessary tasks, like polish its current employees' shoes, thereby returning money back into the economy, there is simply not enough money in the total money pool to cover the interest. The only way to sustain this simplistic system beyond round 1 is to loan the world more money to cover the outstanding interest. However, in this crude scenario and to illustrate a point about the necessity of lubrication, the amount of money in circulation slowly diminishes with each passing month and 1Bank extends no further credit. Companies that do best are able to make their repayments with their larger share of the available pool of money (profit), while companies that fare worse go quickly bust. Unemployment soars -- there is never enough money to pay workers -- as 1Bank inexorably retrieves from the economy the money it loaned World. When the debt is expunged it is game over, or system reset.
In this improved and fairly realistic scenario we have 1Bank loaning a total of 10bn to 5 commercial banks (CB1...CB5). Government, as a borrower, is hidden in World. The commercial banks have the right by law to loan out money (create new money) at the ratio of 10:1. This means that the injected 10bn can become 90bn in the economy. Again, since in Scenario 2, as in Scenario 1, all money is created as interest bearing debt, there can never be enough money in the economy to pay back to the lending institutions the loan plus the interest. In this total money pool we have 100bn in principal (to be expunged upon repayment), but owed to the banks is 107.7bn. The system is therefore 7.7bn short of necessary lubrication. For the banks to be able keep the system from collapse (only they can), accruing as they do 'real,' durable money from the economy (interest payments), they must pump back into the system their earnings (the interest). For any kind of balance to occur, the combined action of defaults, plus bank spending in the economy (via its employees and otherwise), plus new loans and rolled over debt, must keep the amount of money in the system equal to the task of lubricating the economy to some sufficient degree. Theoretically it must be more or less possible to keep this system going indefinitely, depending on what we mean by “to some sufficient degree.” In the philosophy of the people who favour this system, poverty is a necessary evil, as are defaults of course, both of which act as a spur to keep us working, to keep us motivated. Put simply, success is good, failure is bad. Here Smith's Invisible Hand can be faintly detected keeping the system tuned automatically. Look, no governmental interference needed!
Scenario 3 is a little like MMT (Modern Monetary Theory) as I have understood it. In this model Government has emerged from World as an institution that can also create money, but, in contradistinction to the banks, may do so as spending, which means no interest is charged. Government may choose to tax money out of the economy, or it may not, its decisions in this regard being guided by inflationary/deflationary pressures. (I include no arrow for taxation because the picture would have suffered in clarity.) In this theory we have a situation where defaults and financial ruin are not necessary parts of the system staying in some sort of balance. Government acts as a dynamic stabilizer, injecting and retracting money as the situation demands. Is this, potentially, monetary Nirvana? Seeing as there is no such thing as Nirvana, I very much doubt it.
So much for the theory. To please Bill Black (and myself) my final chart adds a little real world colour in the form of corruption.
Included in corruption are human imperfection, mistake making, fraud, crime and so on. Also, not represented is that systemically there is constant pressure towards corruption, simply because being rich is better than being poor. So at each place where corruption can occur, there is pressure to ensure it will occur. Such occurrences destabilize the system to some degree.
One of the features of money that so fascinates me is its logical bond with scarcity, and its ability to act as power-lever. Those who control it control the system's functioning. Money can, in my view, never be only a medium of exchange, the simple and pure lubricant of those systems which depend upon it. All diagrams, models, and theories which do not take this into consideration are therefore flawed as far as I can tell. At those points of the system where corruption can occur it will, and this compromises the system's long term integrity, before we even think about problems of inflation, trade, currency exchange etc.
In the circle representing World is a massive amount of detail no picture can convey, while the flow of money round and round represents, of course, only a tiny fraction of what really takes place in human civilization. However, as broad-stroke sketches, such images have some use in representing the simple maths of money creation, and the nature of the systems we might create that depend on money for their functioning. How important are the threats of poverty and default as systemic motivators? How beneficial/dangerous is full employment? How effective can government be at establishing the correct tax policy in a system prone to corruption? If we were to leave government out of it, how effectively could 'The Market' take care of corruption, or of roads, laws, education, the health of humans everywhere?
Finally, also not represented is change. Change is the only constant. The models I have sketched, which broadly represent the choices of monetary systems available to us -- at the functional level -- do not take technological unemployment into consideration, nor production-consumption at levels that threaten the health of the ecosystem which supports those money systems in the first place, nor technological advances which offer us abundance, nor the coming beginning of global population decline. In the final analysis, money is a tool which solves particular problems, but, as all solutions do, also brings new problems with it, such as corruption and entrenched societal divisions. And because scarcity is assumed as an eternal problem solved only with money, we have war as an inevitability too.
Is there really no other way?
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