09 January 2011

Anchor/Base for Money Needed

The very first precondition for building a sustainable financial system is to have a stable basis for the amount of money being created, an anchor for money supply. In “good old times”, gold fulfilled this role – in some extent. The problem was that the economy grew faster than the amount of gold; thus, in 1971 the gold standard was abandoned. In the very same reason – namely that the supply of gold is not directly linked to the amount of money actually needed, gold is not suitable as an anchor also today.

So there is currently no limit to the amount of money being created by central banks. Furthermore, as we know from the basic principle of money creation, every dollar or euro created by central bank, results in a number of dollars or euros of total money supply. That’s why some, incl. for example well-known American investor, businessman and investor Robert Kiyosaki in his notes to the popular book “Conspiracy of the Rich: The 8 New Rules for Money”, call our money “funny money” or even “fake money”. Money supply is not directly anchored to anything.

Of course, central banks do have targets when regulating money supply, but there are several issues related to them, including but not limited to the following:
* The targets are not simple and transparent enough to be recognised by the many people; different central banks also set different targets
* These targets hardly enable to control credit growth or –contraction, and thus the creation of debt
* When targeting inflation, asset prices are being ignored
* In one or another way, the targets are linked to economic growth which in itself may not be sustainable (see my earlier post “The Way We Measure and Target Growth”)
Thus, current targets are not suitable for defining the amount of money in circulation.

Because of feedback loops and other characteristics of credit market, demand for credit is also subjective in terms of value being created. Economy grows faster if there is more credit, and households and companies demand more credit when economy grows faster. This sounds logical and ok at first. The problem is that this vigorous circle ultimately reverses itself and turns vicious as in fractional reserve system more and more money/debt needs to be created in order to serve the interest payments of increasing amounts of loans outstanding (see the post “Compound Interest and Loan Growth” for further explanation of this). At some point demand for new credit is replaced by the demand for refinancing and restructuring of existing debts, which doesn’t add anything to real economic growth. Thus borrowers start to default, credit supply squeezes and this only makes the matter worse.

To conclude the above, it should not be possible to create debt without creating money, and there has to be an effective anchor or base for the amount of money being created.  Let’s leave the first part for a separate discussion, and think a bit about the suitable anchor/base for money.

I think this anchor should ideally meet the following criteria:
* It should be objective in the extent that our subjective nature enables, i.e. not possible to manipulate
* It should be reasonably simple and transparent (but not too simple so that other objectives cannot be met)
* It should ensure that money supply conforms to the value created (and value created is not economic growth for every price; instead, it should reflect life quality of many people as well as considerations related to sustainable development), but also availability of resources for investing into projects that create value
* It should be recognised and approved
* It should be possible to validate if the actual amount of money conforms to the theoretical amount according to the anchor; the validation should be reasonably easy to do, and be based on independent assessments, calculations etc.

One more thing to consider is population growth / the total number of people. At least in theory, there should be enough money per person. One problem here may be population growth in itself – this should be included in the assessments to life quality, environment etc (if there are too many people compared to the Earth’s capacity, life quality starts declining).

So, what about replacing the equation of exchange in quantity theory of money, M*V=P*Q (where: M – the total amount of money in circulation, V – velocity of money, P – price level, Q – quantity of products and services), with the following rule or some modification of it:

This equation proposes the amount of money per person to be equal with a constant amount (Constant), which is adjusted by Life Quality Index. The Constant might be found e.g. as today’s total money supply divided by number of people living in the world (just to have a starting point). This way it reflects both: money needed for consumption and money for savings and investments. Life Quality Index is meant to be an index that summarises all important aspects which determine our life quality, including but not limited to our living standard, our health, the amount of time that we have for ourselves and for our loved ones, the quality of the environment where we live. It’s trickier to assess it but sure that better than nothing can be done – social scientists are performing lots of different studies that can be relied upon. The input from “sustainable developers” is needed too.

It’s time to stop criticising only because of criticising. It’s time to think about solutions.

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