Sunday, 9 August 2015

Economic Problem Representation

Background

Over quite a period of time, I have been thinking about and reading about alternative economic models. This has included some reading of how the economic system developed including Graeber (2011) and Mellor (2010). This has led me to the writing of journal entries on economic issues and in particular “Money as a result of lack of trust” (Thompson 2015). Although I believe that blog lays out some of the issues, I have been thinking about how we might represent this development so that others have a much better understanding of the possible options. Vickers (2009) emphasises the importance of problem representation in the process of understanding and solving problems. If we want everybody to understand economic problems so they can make reasoned decisions about the importance to change certain structures (Jackson & Dyson 2012, Jackson 2013) then we need ways of representing the problem that drive home the importance of change.

Representing Economic System Development

The development of an economic system occurs over a long period of time but to some extent, the time line isn't what is important. What is important are the changes in the way people exchange goods and services, and begin to account for those exchanges. It is this focus that I want to look at in this blog. I am not going to argue for historical accuracy because I don't have the data to verify my views. This is my interpretation of things that I have read and what I see as the implication of these changes. If we take an evolutionary approach to the subject then we have to assume that at some point living beings (I don't want to rule out the possibility of other animals or species having an exchange system that we haven't understood) began to exchange items with or do things for each other. We can only speculate as to why this might have occurred but we know that it is this exchange of goods and services that dominates our economic system although we might ask what some of these exchanges are with some current economic activity but I am jumping ahead in the story.

Gift or free exchange

From my reading of Graeber (2011) and Mellor (2010), I understand that the first exchanges of goods and services were based on a free or gift exchange. Graeber does talk about an obligation to return a gift. I am going to represent this economy with the economic entities represented as circles and the arrows representing the exchanges. The size of the arrows is indicating possible imbalance in the exchanges but as there is no record keeping or value attached to the exchange, this initially didn't impact the system. However, we might guess that some felt that some benefitted from these exchanges more than others or maybe some where seen as taking more from these exchanges than they appeared to be giving.

As skills developed to keep a record of the exchanges, there may have been a simple accounting introduced based on the number of exchanges. This may initially have been a single individual accounting for what they have given and what they have received. At this point, there may still be no expectation of equal value in terms of numbers of exchanges but the individuals doing this accounting wanted to know whether they were receiving a fair deal (whatever that might mean in their interpretation). It is like me accounting for the hours that I work for my employer knowing that my employer isn't interested in how many hours I work provided I am seen to be doing the work expected of me.

The thing is that these exchanges continue despite any accounting for the exchanges that might be occurring and there are few disputes. We can still see this happening in some families or communities where money or accounting for exchanges hasn't become part of the family or communities operation.

Accounting for exchanges: IOU

The breakdown of the gift or free exchange economy begins when an individual begins to withhold their goods or services because they feel they are giving out more than they are receiving. When this starts happening others either have to pick up the shortfall in the meeting of needs or some people find their needs that used to be meet are no longer being meet.

Because this withdrawal of goods or services is impacting the community, an individual decides to introduce an IOU (I owe you) as a way of accounting for each exchange or possibly the value of the exchange. When they issue the IOU, the person may not have already produced the goods and services needed to clear the IOU but are simply making a promise to clear the debt at some later point in the exchanges. Others in the community may begin doing the same or they may use someone else's IOU to complete an exchange. Initially all of these IOUs may have had the same value (i.e. an exchange of a good or service). If a person has given out an IOU then they now have an obligation to clear that IOU or to obtain enough of another person's IOUs to be able to clear their IOU debt. The IOU process has the additional benefit that it isn't necessary to obtain an equal trade with any particular individual in the community.

The IOUs are cancelled when the IOUs are returned to the issuer or when two issuers agree to exchange each others IOUs as a way of clearing a mutual debt. However, potentially, IOUs could simply keep building up in the system until it is clear that an issuer can not meet the obligation of their issued IOUs. At this point, the IOUs are cancelled and the trading continues. Would this cancelling of IOUs caused the system to collapse? Probably not although there may be some individuals who are now questioning the value of some of the IOUs they still hold.

If we think about the starting point when the first IOU is issued, there is no certainty that there was any equality in the exchanges. Previously, there was no account to be cleared and no knowledge of whether the exchanges all balanced out. They simply occurred and people got on with their lives.

The introduction of the IOU changes the dynamic in the community. Initially, it may have been accepted that someone may issue more IOUs than others but as long as these facilitated trade amongst other members of the community, it wasn't a major issue. With so many IOUs in circulation, it may have been difficult to actually work out whether an individual had really cleared their IOU debt or maybe some IOUs were lost. Some may be holding IOUs in excess of those that they have issued. Does any of this make a difference? Some would argue that it does.

Centralising accounting

The issue with everyone issuing their own IOUs is that there is no control over the number in circulation and definitely no certainty about whether they will ever all be cancelled out. There is also no guarantee that one person's IOU is worth the same as another person's IOU. There is also no easy way of confirming how many of these IOUs are in circulation.

Possibly there were also signs of inequality occurring in the system as some people's IOUs were ignored in favour of others simply because it was observed that some people never seemed to clear their IOUs while others regularly meet their obligations. Maybe there was also an element of whose goods or services were more desirable so people wanted IOUs to give them more access to these desirable goods and services. This may have lead to debates about the relative value of IOUs. Are all IOUs of equal value?

If the accounting for IOUs was centralised within a community then maybe these dependencies could be managed. Rather than everyone issuing their own IOUs, a central organisation issues the IOUs. This ensures consistency in value of the IOUs but there are problems with centralised issuing and accounting.

In the original system, the number of IOUs outstanding that had been issued by an individual depended more on the difference between what the person needed and what they currently had produced and sold. The system of exchange may have meant that they were accumulating others IOUs rather than cancelling those that they had issued but through a bit of accounting, an individual could possibly work out whether their outstanding IOUs exceeded or was less than the IOUs that they held from others. As long as they felt comfortable with the deficit or surplus of IOUs, they would continue to trade. Some individuals may never have issued their own IOUs. Instead, they had received and trading using the IOUs of others.

The transition to centralised issuing and accounting may have occurred because one individual's IOUs were considered of more value than those of others. As a result, their IOUs became the dominant IOU used in trading. Recognising this, the individual may have begun to act as a bank issuing IOUs for others based on the perceived value of the trade (Vivian & Spearman, 2015). The issuer didn't need goods or services to back the issuing of the IOU because it was the value of another's transactions that supported the IOU. For the privilege of using their IOU, the issuer may have sought compensation since they were providing an accounting service for all of these IOUs and enabling the transactions to occur in society.

These issuers of IOUs would then settle transactions between themselves based on an agreed value of exchange for comparable IOUs. You could trade within your own community using the IOUs issued by your issuing authority and if you wanted to trade with another community then you could purchase the other community's IOUs through your issuer (bank).

Those most likely to be trusted as issuers of these common IOUs were likely to be the ruling classes (i.e. the sovereign) and they could use these to fund their own activities in the community and collect back at least some of the IOUs through a tax for the services that they supposedly provided for the community. There would be other advantages for the sovereign to issue IOUs as this would allow them to coerce others to serve in their armies or support their campaigns. The IOUs become an instrument for pursuing political objectives and fostering conformity within the community.

Nationalised money – Central Bank

With centralised accounting that is managed by one individual or the sovereign then that individual or the sovereign begins to determine what are valid transactions to be funded by the created IOUs. If it is a sovereign creating the money then who is able to control the sovereign's desire to go to war or for self aggrandisement? Shouldn't the sovereign be accountable to the people? Shouldn't the sovereign have to raise funds for their grand schemes in the same way as everyone else? Why should the issuer of the IOUs (currency because that is what the IOUs have become) have a special privilege over what really is a national resource?

There are also issues between local community IOUs and the exchanges between communities. Wouldn't it be a better option to have these IOUs managed from a central point and issued as needed to maintain the transactions of the community? Nationalising the supply of currency or money fulfilled this objective. The only currency in circulation could be that issued by the central bank. Those who distributed the currency (i.e. the original local issuers (banks)) could purchase IOUs (money) from the central bank and distribute them on to those who required currency.

The central bank has to decide how much currency to issue and to whom yet the local distributors (banks) are more in tune with the needs of their communities. As long as the local banks had to issue the national currency, their distribution activity would depend on what funding they could obtain from the central bank or from people who would ask them to account for their money (IOUs). Some of these local banks worked out that they they didn't need to hold all the money placed with them by depositors. Not everyone wanted their money at the same time so as long as you hand sufficient money to meet demands by those who wanted their money and to settle the exchanges with other local banks then you could lend out these saved funds to those who needed funds in the local community. The constraint was the overall balance of the money flow between what they distributed and what they collected in. As long as they were able to meet any deficit in this exchange that might occur, they were not constrained by the issuing of money (credit) by the central bank.

Although some trading is conduced in hard currency (centrally issued money). A lot of the trading is now by other forms of promises to pay (i.e. a cheque or values held on bank registers). If two customers of the same bank complete an exchange, the net impact to the bank is zero. They just transfer the numbers from one person's record to another's record without any physical or central bank money being involved. If they need to exchange with another bank then they either need physical money or central bank money. The end of this process is that for any local bank, there are two types of money involved. The money issued by the central bank which may be asked for by their customers and the money represented by numbers in their ledgers. The two do not need to be equal as long as the local bank can satisfy the demands for the real currency of exchange, the money issued by the central bank.

In this dialogue though I have also introduced a third type of money, central bank money as opposed to physical money. Why am I making a distinction between physical money and central bank money? Just as the local bank realises that it doesn't need to have physical money to back all the numbers in its ledgers, the central bank which holds an account for each local bank doesn't need to hold physical money to the equivalent of all the money that the local banks hold in their accounts.

The central bank acts as the bank to the bankers and as such settles the payments between banks. In order to achieve these payments, the central bank simply needs to transfer numbers between local bank accounts and not transfer physical money between accounts. The central bank can also now act as a lender of last resort by providing short term funding to balance the surpluses and deficits in the inter-bank exchanges. A local bank may have a short term liquidity problem (inability to cover the inter-bank transfer) but based on its transaction data feels it will be able to satisfy its obligations in a following day, it may seek a short-term loan from the central bank. The result is a tow tier monetary system, the base money (balances with the central bank) used for interbank transfers and the broad money (balances in the local banks) used by everyone else in the economy.

The nature of money or lending

If you followed this line of reasoning, you may have noticed that the local banks regained the ability to create money to enable lending activities to their clients. Not all of this lending activity is backed by physical currency or balances held at the central bank. Some argue that this is local banks creating money out of nothing (Jackson & Dyson, 2012, there are others who have also supported this view). This line of argument says that the banks don't require deposits in order to create loans hence they create money out of nothing.

There is a contrary view which to some extent is where I argued money or IOUs started. That is the IOU was issued to facilitate a transaction so the value of the transaction is what gives the loan its value and not the underlying currency or money (Vivian & Spearman, 2015). Without the loan or IOU, the transaction would not occur. If the system is too rigid in terms of creating loans and IOUs then the transactions slow down possibly leading to recessions. If the system is too flexible then there are few limits to the creation of loans and IOUs potentially leading to inflation (property bubbles). Controlling the rate of money creation through local bank loans is a key issue in managing an economy and inflation.

The creation of money out of nothing perspective (Jackson & Dyson, 2012) views the banks as intermediaries between depositors / lenders and borrowers. Since the bank doesn't need a deposit in order to make a loan then the bank must be creating money out of nothing. The money supply expands with loan creation and shrinks as loans are repaid. The banks control how much money is created and how that money is first used in the economy.

The alternative view of money creation (Vivian & Spearman, 2015) argues that the decision about the value of the loan is made in the exchange between a buyer and a seller. You could argue this is what the original IOU was except it was the buyer who accepted the debt and the seller who took the risks on payment. All the bank is doing is funding this transaction taking on the risk of the seller and managing the debt obligation of the buyer. As such the bank simply takes on a role of facilitating transactions through creating money to enable them to happen. It could be argued that the bank is less concerned about how much money to create and more concerned about managing the risk of purchases not meeting the IOU obligations. As such, they then decide on the level of risk of the transaction and not necessarily the necessity of the transaction.

Funding Required Transactions

Regardless of how you view local bank loan creation, what you do see is that the local bank is influencing what economic transactions will be funded. The statistical data suggests that this tends to be property transactions since if the borrower fails to meet their payment obligations, the bank can claim the property as a substitute for the money. This tends to inflate property prices.

It also has the negative impact that socially desirable projects are not funded. Banks don't want to take risks on projects that have no guaranteed return on the investment. Often these projects land up in the hands of local or central government. Just like any other economic unit in the economy, the government has to fund the deficit in its transactions by raising appropriate loans (IOUs). If the government has to do this through the banking system then it has to convince the banking system of the value of its social or infrastructure programmes and particularly for commercial banks or private investors what the rate of return on the governments programme is.

If the central bank is seen as the banker to the government then should it create funding for the government as needed just as the local / commercial banks fund create funding for private transactions? On what basis should it make these decisions? Should it apply the same risk management as private banks, the possible inflationary influence of the project, or on the necessity of the project to meet society needs? Is it possible that even this decision making is giving central bank bureaucrats too much control over government programmes?

In a needs based economy, if the government programme was satisfying a need then provided the resources where there to complete the programme, it would be carried out. There would be no accounting as to whether it was affordable or whether funding was there. The need and availability of resources to meet that need was the priority.

Even under a simple IOU system, the government would simply have issued its own IOUs to complete its programme. It may be that government IOUs (sovereign money) would have flooded the economy rather than those of any particular individual. If necessary, the government might write-off outstanding IOUs since it was recognised that these were what was required to complete government programmes. In effect the government deficit would simply be seen as what was necessary to maintain a healthy society. I am not saying economy because economy tends to move away from a need focus.

The problem, as I see it, is that under our existing system, the focus is on balancing the books and the central bank although being the banker to government, it is not the funder of government. As a consequence, it seeks funding from the wider community through mechanisms managed by the central bank. Government policy is dictated less by what the electorate desire or need (democracy) and more by what those providing funds to government require.

Conclusion

Regardless of whether I understand commercial banks as creating money out of nothing or funding transactions between buyers and sellers, we need a mechanism that funds the meeting of need rather than the wheels of an economy. When large percentages of the population can be driven into poverty because of economic requirements or the environment can be destroyed in order to promote profitability, the economic system needs to be questioned.

Would it be possible to return to a gift economy? Maybe not but we need to ask questions about why money restricts dealing with problems for which resources exist? We need to ask why government deficits shouldn't simply be funded by central banks rather than crippling economies by the demands of a banking system or corporate giants?

This blog is not intended to be an accurate history of the development of money. Rather it is intended to raise issues for thought and consideration. I partially expect it to be torn apart but I hope that my readers will ask the critical questions about the system that we have allowed to come into being and whether this system is meeting the planets needs.

References

Graeber, D. (2011). Debt: The first 5,000 years. New York: Melville House.

Jackson, A. (2013). Sovereign Money: Paving the way for a sustainable recovery. London: Positive Money. From: http://www.positivemoney.org/our-proposals/sovereign-money-creation/

Jackson, A., & Dyson, B. (2012). Modernising money: Why our monetary system is broken and how it can be fixed. London: Positive Money.

Mellor, M. (2010). The future of money: From financial crisis to public resource. London: Pluto Press.

Thompson, E (2015) Money as a result of a lack of trust. From: http://kiwi-et.blogspot.co.uk/2015/02/money-as-result-of-lack-of-trust.html

Vickers, P. (2009). How to think like a programmer: Program design solutions for the bewildered: Course Technology: Cengage Learning.

Vivian, R. W., & Spearman, N. (2015). Some clarity on banks as financial intermediaries and money 'creators'. Johannesburg, South Africa: School of Economic and Business Services, University of the Witwatersrand.