10 July 2011

Sketching Sustainable Future for Finance (3/3)

We ended Part 2 of this series of articles with a promise to discuss moving from the current unsustainable financial system towards a sustainable one, the main elements of which we sketched last time. Just to remind these elements:
* Money that is not debt at the same time, and a suitable anchor for the total money supply (e.g. some kind of Life Quality Index)
* The new structure of financial system which most importantly would mean replacing the current banks with completely safe savings banks (narrow banks) and fund-type of financiers of various risk levels
* Replacing the current logic of interest rates with a price of money that is linked to the same anchor as the total money supply
* Understandable financial instruments the value of which could be assessed adequately
* Functions of monetary authorities that would be consistent with the other proposed changes in underlying systems
* General high quality financial literacy

How to move from here to there is a good question indeed. Whoever attempts to lead the transition immediately faces several serious challenges such as:
* Conceptual issues like the very principle of freeing money from being debt and linking it with a reliable and suitable anchor; taking local, regional or global view given the cultural and other differences on one hand and the interconnectedness of the economies on the other; the approach for dealing with the current imbalances; moving from one system to another without causing a real chaos
* Reaching an agreement about the vision of the future monetary and financial system among sufficiently many decision-makers given that most of them may even not see the problems of money being debt and what is worse, creating debt without creating money
* Strong resistance of those benefiting from the current flaws and asymmetries, or being just too comfortable for a change (as an illustration, just remember all the buzz around Volcker Rule and other similar proposals – and those are small changes compared to what we are discussing)
* The deep-seated practices of capitalistic society to measure everything, incl. how much a person is worth, in money terms and resulting urges to accumulate money (or assets that can be converted to money)
Thus it’s no wonder that until the current monetary and financial systems somehow work (no matter that on the expense of tax payers, and postponing and accumulating future problems) no alternatives are being considered seriously enough to be broadly accepted and implemented. Yet drifting towards a complete disorder (no matter if it’s triggered by Greece’s default, the downgrade of US rating, bursting of Chinese real estate bubble or declared bankruptcy of social security system) cannot be something we are happy about.

As follows we consider the matter from methodical/technical point of view and focus on the most crucial elements of the solution: detaching money from debt while being able to link the total money supply with a reliable anchor, and changing the structure of financial system accordingly. Our considerations right now are limited to Western economies (of course, others may join if they find the proposed approach suitable). In other words, we are not trying to solve everything once and forever, but rather get over the most basic flaws so that the new system could be built on a sound fundament. Of course, the improvements that can be made already now by the regulators, should be made already now – for example not allowing further issuance of flawed financial instruments or imposing stricter liquidity standards.

Who or what would be the best to lead the change? Well, I think it should be driven by a broad-based demand of well-informed and considerate customers. E.g. professional financial bloggers can fulfil the role of spreading information and encouraging discussions. Improving people’s financial literacy is definitely a key.

The very first step is to define the anchor for money. It’s obvious from the soaring gold price that without such an anchor major currencies are not trusted and ultimately their value will decline to zero. A gathering similar to Bretton Woods Conference in 1944 would be suitable to discuss the carefully elaborated proposals of various experts, and take the decision. Then the total currently outstanding debt has to be linked with the chosen anchor, which basically means a compromise between the defaults allowed to occur and the acceptable level of inflation.

Secondly, we face the choice: whether to radically restructure the existing banking sector, or to gradually wind down the existing (failed) banks and build the new system from scratch. On principle both approaches should be possible and perhaps a mixed approach would be most likely. For clarity reasons, we will base our further explanations to the option of starting from scratch.

The third thing is to solve the issue of bank ownership. With the fund-type of financiers it’s clear that investors (note that depositors are no longer depositors when allocating money means taking risks) are the owners too (in the extent of their investments). What concerns savings banks / narrow banks then these could be owned and operated by the state or on co-operative basis.

Fourth, the current guarantees for deposits in “old” banks (i.e. the banks that we have today) would be limited to the existing deposits. If customers withdraw their money and want to deposit it safely later on, they would have to place it into a newly established savings bank which will be 100% guaranteed in the new system. Alternatively, if customers are seeking returns on their money, they could choose between unguaranteed fund-type of financiers of various risk levels or invest directly into the securities of the non-financial companies.

Fifth, new lending based on the principle of simply writing equal amounts to the asset side and to the liability side of a banks’ balance sheet would no longer be allowed. Instead, new loans could be granted only from the real money that customers have placed into the fund-type of financiers. (In practice, in order to avoid shocks, this shift probably needs to be gradual.)

Sixth, as “old” loans are being repaid and the amount of “fiat money” contracts, the resulting contraction in money supply has to be replaced by the debt free money so that the total money supply would be consistent with the defined anchor (the anchor would serve as protection against unacceptable inflation). The debt free money could be injected into the economy e.g. in the form of compensating depositors for further bank failures, as repayments of government debts (which would also inject additional liquidity into the current banks) or (if there should be no government debts to repay and no failing banks to deal with) as government spending.

Seventh, the remaining loans in the “old” banks could be sold to the new ones according to the risk policies of the later; the remaining deposits could be transferred into the saving banks. Empty bodies can be liquidated.

Eighth, central bank (or some other suitable authority) ensures that the total money supply conforms to the chosen anchor for money, and regularly reports the value of the anchor as well as system's leverage (the measures such as the total debt relative to the total money supply and relative to the cash outside savings banks, and the total debt plus total equity relative to the total money supply and relative to the cash outside savings banks).

Basically that would be it about the structural changes. In result:
* Deposit guarantee is limited to the amounts in savings banks and essentially, given the 100% reserve requirement for savings banks, is not needed at all. There are no banks benefiting from government guarantees.
* Total money supply is by definition equal to cash (or its electronic equivalent) in circulation. The total amount of deposits cannot exceed the amount of cash in circulation (everything else is rightly defined as debt or equity shares). Thus, money supply is not affected by changes in lending. What are affected are the amount of debt obligations and the system's leverage.
* The money for paying interests is being created as additional value is created (thus, value added is divided between those who create value and those who put their money at risk for this purpose).
* As investors (both, those who buy securities of the non-financial companies directly and those who invest via the fund-type of financiers) bear all the investment risks and changes in the anchor for money as well as system's leverage are regularly reported, excessive lending is discouraged.
* Entrepreneurship is encouraged given the improved financial literacy and higher risks related to giving money to the others for use in the form of loans.

What I would further elaborate in some of my later posts is among others the way of how the fund-type of financiers could operate and maintain their targeted/communicated risk profile given changing systemic risk, as well as how the rate of return would change for their investors.

Finally I should express one of my main concerns regarding moving from the current unsustainable path towards a restructured monetary and financial system: there is simply so much excess (and unreported) debt outstanding already that attempts to anchor it with something and cover with the supply of debt free money would cause a huge inflation unless investors will have to take major losses. The problem is that among those investors are also pension funds and banks which have funded their risky activities with government sponsored deposits (i.e. deposits that are too cheap for banks "thanks to" the government guarantees). Yet further postponing of solutions means further accumulation of such uncovered debt.

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