Monday, October 6, 2008

Open System Economics

Think Value

Value is the beginning and end of everything economic and it exists only in the imagination of the mind. Value is the subatomic particle without mass upon which everything in economics is built. If there were no people on earth, nothing would have value. There is no such thing as intrinsic value. Science has yet to discover any properties peculiar to value in matter. The underlying problem of today's economic theories (everything from Austrian to Marxist) is that hidden, instinctive and automatic assumption that value is inherent in assets.

Things become assets when market participants ascribe value when trading. It doesn't matter whether it is a gold nugget found by someone in a mountain stream or a piece of paper featuring George Washington's image. Assets do not define value, but value defines assets. Assets are only carriers of value. What leads to "closed system" thinking is the notion that quantity of value is limited to the quantity of so-called "real" assets.

If value exists only in the imagination of mind, what are the limits? "Open system" recognizes that there are no limits except to the extent market participants want to ascribe value. Bring junk to the marketplace and there is no value ascribed, thus no increase in the national net worth. The genius of free market economy under the rule of law is the constant stream of new and varied products and services brought to the marketplace to which value is ascribed.

Free-market capitalism is unparalleled in its success. The common people enjoy a standard of living that in many ways is far superior to the rich of only a few centuries ago. Think of the easy availability of a large variety of cheap food, medical security from advanced medical science, easy mobility and communication, air-conditioning --- the list could go on and on.

But there is one sector of capitalism that is erratic and unstable. The Ponzi like financial scheme of fractional reserve banking. It is the historical swings of credit expansion and contraction. The control of monetary policy through fractional reserve banking is a historical tradition that multiplies money during credit expansion and annihilates money during credit contraction. There is no getting around the liquidity floods and droughts with fractional reserve banking. During the credit contraction phase both money and value disappears into thin air and leaves behind a lot of non-performing debt that can seriously threaten the financial system and subsequent economic performance.

Cheap debt capital inveigles financial gold rushes that always ends badly. And every time this happens, it gives the opportunity for big government political class to push regulations and governmental control of the private economy, and sundry folk excitedly proclaiming the end of capitalism.

The reliance of managing money supply with the archaic fractional reserve pyramid scheme is becoming unmanageable. It is the old Model T, unsuitable for high-speed, technologically advanced economies. The more that is discovered and invented, with the pool of knowledge growing exponentially, the potential of more discovery and invention rises in the parabolic curve; a reflexive feedback cycle. The development of science and technology combined with entrepreneurial energy (free trade included) produced productivity to the point that production of goods and services can quickly and easily exceed the propensity to consume.

When production exceeds propensity to consume, as it happens during economic retrenchment, the last thing we need to worry about is more production capacity. Supply-side economics was absolutely correct at the time of its application. In the 1970s the old industrial economy reached its apex, with structural economic sclerosis developing from rapid growth of government, expanding controls, regulations and high taxes. Any monetary stimulus only resulted in inflation because of disincentives for new production capacity. Supply-side economics solved that problem and free trade capitalism went global.

Free trade integrates the global economy with continued production efficiencies from more appropriate division of labor and resources. Supply side capacity grows even faster. Now, just look at China's large manufacturing base rapidly becoming idle. Trying to solve all our current problem with supply-side economics is uselessly fighting the old war --- even counterproductive to add more production capacity if the financial structure of underutilized capacity is exposed to debt leverage. This would add to the threat of deflationary debt deleveraging. One size economic policy doesn't fit every phase of economic cycle. There is a time to look at the demand-side problem.

The money from credit expansion due to technology and housing bubbles stimulated widespread global economic growth. But note this carefully: with very little inflation except at the very tail end --- and most of that was soaring energy prices. What this means is that a higher rate of stimulative economic policies is possible than previously assumed, but you can't do it by causing bubbles with the credit system.

Definition of money

You cannot differentiate quality of value because of the type of things that value is ascribed to in the marketplace. It is what it is. The value ascribed to a piece of paper featuring George Washington's image is exactly the same value ascribed to gold or a barrel of oil.

The true definition of money is that it is simply a notation of pure value.

John Maynard Keynes got one thing right when he called gold the barbaric relic. To be able to buy and sell instantaneously around the world in units of value unattached to anything tangible is a reflection of civilized advancements in rule of law and confidence in commercial institutions.

When we import from abroad we actually pay for imports with a manufactured assets to which the US has the exclusive right to produce. That's right, the US dollar. Again, that's because the value ascribed to gold is exactly the same value ascribed to the dollar. This is particularly true when a foreign country trades to acquire dollars for the old mercantilist instinct of hoarding money and building trade surpluses. No trade deficit there! But like any other asset, the dollar is subject to laws of supply and demand. Too many dollars exported abroad will cause the dollar value to fall.

If you are still uncomfortable with the idea of the dollar being equal to "real assets" like gold or silver, we could bury those dollars and recover them with ritualistic mining!

A brief history of the traditional and archaic fractional reserve banking

The accumulation of the commodities of gold and silver in a simple preindustrial bartering economy was often given to the moneychangers to collect interest. The moneychangers (incipient bankers) discovered they could expand money supply on base deposits with promissory notes because of confidence. Promissory notes tended to stay in circulation locally, serving as currency, without redemption. This system of fractional reserve banking builds an inverted pyramid of money supply starting with the equity base of the moneychanger plus deposits.

It is largely a Ponzi scheme. Recently, new financial instruments and derivatives are thought to spread the risk further around (as a kind of insurance) making it possible to expand the inverted pyramid even further on the base money supply. Lehman Brothers was allegedly leveraged 30 to 1 and the chickens came home to roost anyway.

Open system -- theoretical foundation

Viewing economics as a behavioral inquiry, let's establish a theoretical base on what seems to be a certain natural order of things. Starting with a simplified basic level of economic activity and defining a few principles.

Imagine a simple preindustrial agrarian community where everyone is known and trusted within the community. Trading at the village market, the farmer may make a trade with the craftsman by accepting an IOU in exchange ---- verbal or written.

Note what happens; a unit of money to facilitate trade is created out of thin air (IOU). It is something of real value but nothing tangible. This is the essence and definition of money, a notation of value. Using high value commodities such as gold and silver as money is a diversion into bartering.

The farmer may then use that IOU in another trade. (Confidence being sufficiently widespread).

The craftsman at the marketplace may create additional IOUs for trading that are accepted with confidence for future delivery upon the capacity to produce goods, (note and remember this) even though he may not have manufactured the goods. What is naturally happening here is the outright creation and use of money for additional demand upon the local economy, according to the economic capacity to produce. This increases economic activity and growth if the capacity is there to produce.

The differences between the two approaches of money supply.

The base money supply of historical fractional reserve banking was not tied to the production capacity of a given economy. Base money supply was dependent on the whims of nature and events in supply of gold and silver. In the 1600s the Spanish conquistadors flooded Spain with gold and silver, causing inflation even though it was "hard" currency. In modern times, with created money as base money supply, the credit cycles can still follow its own natural course regardless of balance with capacity of production. Too little money supply can cause deflationary environment or very slow growth. Too much money from speculative enthusiasm with supply side restrictions will certainly cause inflation. Then there is the possibility of hyperinflation, which is credit expansion gone bonkers --- everybody borrowing with the expectation of cheaper payback with greatly diminished value of currency.

Management of money supply with fiscal policy is to use specific structural deficits to inject money into the economy that targets actual economic capacity of production. It's possible to overshoot the target slightly, in a dynamic free-market economy, because an active, growing economy will readily invest in capital equipment that increases productivity. This in turn can negate the effects inflationary effects of the additional demand. Non-inflationary growth of 2 1/2 to 4% is achievable in mature, developed Western economy if the political environment is friendly to free-market capitalism and supply side economics.

The Austrian Problem

The Austrian economic thought certainly supports free trade capitalism. However, it has serious defects; one of which is politically fatal. The Austrian perspective is closed-system and uncritically accepts that mother-of-all Ponzi scheme; fractional reserve banking practice. The working assumption seems to be that this historical and archaic system of managing money supply is unchangeably fixed by the stars. Whether this system that builds an unstable inverted pyramid upon a small base of money supply is affiliated with a central bank scheme or not doesn't make much difference. It's still the same old Ponzi scheme. At the end of a credit supercycle, the inevitable credit bust takes place. Should economic conservatives allow full extent of economic destruction to occur (depressions are likely at the end of a credit supercycle)----- with soaring unemployment; the political party responsible would be almost completely turned out of office with the electorate now willing to elect avowed socialists. This would then deliver the dynamic, entrepreneurial American economy into the tar pits of Euro-sclerosis --- from which there seems to be no escape. This is the Austrian political dead end.

I consider myself a very committed economic and social conservative, but I don't accept the Austrian perspective as the last word for conservative economics.

The issue of managing money outside of fractional reserve credit system

You do it with created money----no you don't borrow it, you literally create it, and use it as part of the national budget. This does not add to the deficit and it's no different than if the US Treasury owned a mine with a shaft of solid gold --- accessing it to use as part of the national budget.

Management of liquidity should be shifted away from traditional monetary policy to fiscal policy--- and no, this will not cause inflation even though this greatly increases the base money supply. The fractional reserve banking system is correspondingly restricted in its ability to multiply money through credit expansion. Interest rates should be held in the upper level of historical range with increased reserve requirements for financial institutions.

Money is created when the federal Reserve credits the US Treasury's accounts for the purchase of treasury instruments. This is not creating real debt like as if the Fed borrowed money from somewhere else to purchase these bonds. This is simply the ritualistic process of creating money out of thin air ---- tapping the vast pool of value in the imagination of mind to replace the money that vanished into thin air from the collapse of the housing bubble.

The real benefit from this approach of increased cash flow through structural deficits into the economy would be to replace debt on balance sheets with equity. It would also greatly inhibit speculative activities because of the higher cost of debt capital. Additionally, it will relieve the private economy part of public sector burden. The private economy retains more money for investment and demand.

Tight money, loose fiscal policy and low taxes. (Reaganomics). During the 80s the calamity howlers constantly invoked Reagan's twin deficits with the dark consequences of economic chaos. Instead inflation came down; economy recovered, the dollar rose and the stock market boomed. So much for conventional wisdom based on "closed system" thinking.

And now the hardest part: money-management outside of monetary policy traditions

The actual administration of it must be kept away from politicians because they can't handle it.

I really don't have a very good answer for this. I could suggest an expanded charter for the Federal Reserve since Fed is able to track productive capacity of the economy. A financial model could become quite accurate over time in targeting the amount of actual money to create, and corresponding monetary policy. The structural deficit, specifically for the use of outright creation of money, belongs to the private sector in the form of lower taxes, not as revenues for politicians to spend. This is because the private sector has capacity to produce goods and services, as a balance to the supply of money, like the craftsman creating IOU money at the marketplace of pre-industrial village.

If the chairman of a sufficiently independent SuperFed gets the summons before a congressional committee to be harassed by political hacks for not producing enough money (jeopardizing their elections), he can calmly and forthrightly tell them where to go. The Fed chairman can tell them that excess taxation, regulations and hostile attitude towards free enterprise by the political establishment has reduced the growth of supply side capacity. This limits the amount of money that can be created and that they, the regulating, tax and spend politicians are the problem. That would be something to enjoy watching.

Also, if the output gap grows due to credit contraction or excess in production capacity as it sometimes happens, it is simple to keep up consumer spending by putting money into their pockets with tax rebates. There will be no inflation as long as there is not too much money chasing too few goods.

Dealing with Financial Crisis
The great depression was a first-class bungled up job. Everything was done wrong entirely due to "closed system" thinking. Even today, macroeconomic theory is of little help ----it's just that we learned from mistakes and have acquired operational experience in knowing what not to do.

Don't underestimate the amount of money it takes to counter deflation in a highly productive, modern, free enterprise economy. In the US, the 1930s deflationary environment did not really end until massive deficit spending of World War II. Actually, from an economic point of view it was a bit overdone. There was a surge of inflation when price controls were lifted after the war but it soon settled down.

Consider World War II from an economic viewpoint. It was a huge public works operation financed by unprecedented deficit spending. It commandeered the productive capacity of this country and then destroyed this production on the battlefield. Why didn't this bankrupt the country? Theoretically, an operation like that should have bankrupted the country like a "closed system" business operation would have been bankrupted.

One can only imagine the derision and criticism had anyone of stature, in the 30s, proposed such a program to end the depression economy. But there's no denying that World War II deficit spending did do it. Until one has a theoretical framework that can satisfactorily explain why World War II, not only did not bankrupt the country, but was the key factor in economic recovery --- all one can do is bewail the problem without offering any solutions that will work.

During deflation, when money supply is in a collapsing spiral due to debt deleveraging, the result is currency values soaring relative to other assets --- the marketplace is saying that there is a shortage of dollars. This is nothing more than an imbalance in the supply/demand equation, and it is just as important to create money for price stability as it is to stop printing money for inflation.

To counter rising currency values (relative to other assets), created money should be injected into the private economy through tax cuts and rebates ---- not increased government spending which worked only minimally in Japan's experience. Putting this money to work in the private economy is vastly more effective as a multiplier effect and allows the economy to go in the direction it naturally should.

After losses of over $12 trillion of value from the stock market and housing bubble collapse --- don't underestimate the amount of money that should be literally created to replace the money that has literally vanished into thin air due to debt deleveraging. A hundred billion here and a hundred billion there is chump change.

Now is the time for large, immediate tax cuts and rebates. This cash flow into the private economy would help support consumer demand. A lot of that cash flow would go into mortgage and debt payments, which would be just great. The banking system could use this cash flow --- reducing leverage exposure of banks. This additional route to bailout of the financial system will also greatly enhance private balance sheets. The idea is to keep pumping this cash flow into the private economy until housing prices start levitating. At this point those "toxic mortgages" will be suddenly priceable. This would end the crisis.

The single biggest argument for this approach is that large but temporary reduction in payroll taxes and rebates would eventually expire --- something we could certainly depend upon. Big government public sector stimulus spending will be extremely difficult, if not impossible, to stop its transformation into a permanent enlargement of government.

The second argument for such a program: to the degree that demand-side tax cuts and rebates is used to pay down debt means that the increase of public debt is offset by decreased in private debt. Thus no net increase of debt for the American economy; unlike public sector spending.

Third Reason: The equation for economic activity is: production and consumption. It's just that simple. You can't have economic activity without one or the other. And there are two sides to the financial system problem: the lender and the borrower. Both are in over their heads with leverage, which is historically normal at the end of a credit supercycle. (Nickolai Kondratieff still lives! -- Russian economist that documented the cycles of credit booms and busts of Western economies)

The degree of leverage by the financial system and the borrowers (currently probably a historical record), means all deficit spending should be focused on stabilizing the financial system, and supporting the economy in a way that allows repayment of debt. Most of the stimulus bill should have gone in this direction, considering that the consumer is the single most important source of demand; about 70% of the demand for the American economy.

If the private consumer is still overextended and struggling with debt load after all this public sector spending --- big government spending stimulus will fail as economic policy, which I consider to be quite likely, because it doesn't address the financial dysfunction (Japanese experience). And then of course, the big government political class will call for even more ineffective big government spending. This is how the US could experience its "lost decade."

The "closed system" idea that tax cuts/ rebates are liabilities to be paid off with future income is not valid when money is created to offset the money that is disappearing during debt deleveraging.

Note: open system applies only to national economies where government can create money. Money represents a substantial part of net asset value of an economy and is the premier asset. When there is a bankruptcy everybody wants cash --- not the other "real" assets. The other assets are to be sold as soon as possible for cash. During serious financial threats everybody rushes to cash.

To project personal, business or state economic experience onto the national economy is entirely erroneous. Yes, yes, national economies can indeed go broke but that relates more to the excessive size of public sector and the burdens it places on the private economy. The private sector locomotive can only pull so many public sector baggage cars.

This page is used as a reference page for full explanation, not so much as a regular blog. However, I do read the responses if you wish to post comment.


Ben Leet said...

I have read The Dollar Crisis by Richard Duncan, and half of Understanding Modern Money by L.Randall Wray. I think your argument may have some serious holes in it. It may amount to a simple transfer of wealth when you "rebate" your way out of a downturn. You are devaluing the dollars of those who have them and gifting dollars to those who don't have them. Your definition of "qualified recipient" also would be held in question. Perhaps that is a taxpayer or a household or an earner, or a sometime-earner. Foreign lenders would be discouraged by this plan, as they would not benefit but lose value. I think that applying a limitation on earnings, a earnings ratio among workforce participants, (see Good and Greed by Sam Pizzigati) and also a targeted national wealth distribution curve would be fairer. Fairer is purely subjective, but that is the nature of humans and democracy. I recommend those three books, the web page EconoSpeak, John Hussman, Ph.D. in economics, and my own blog,
Hope you keep posting. Ben Leet

Anonymous said...

I agree with many of the things you say about past economic theory being wrong. However, the "open system" you allude to seems to be a jumbling up of the notion of value.

>"Open system" recognizes that there are no limits except to the extent market participants want to ascribe value.

There is indeed no limit to the nominal value of anything priced in terms of money. But, the monetary price of something only gives it value in relation to all the other things which that money could buy. In this respect, there are no "open systems". Every system has a limited number of factors of production and each of those factors commands a price on the marketplace (assuming it is for sale).

>The true definition of money is that it is simply a notation of pure value.

You should expand on your idea of "pure value" if pure value is monetary value then this statement is circular.

>John Maynard Keynes got one thing right when he called gold the barbaric relic. To be able to buy and sell instantaneously around the world in units of value unattached to anything tangible is a reflection of civilized advancements in rule of law and confidence in commercial institutions.

This statement is amusing but irrelevant. Commodity backed money could be used just as easily in exchange. Witness that legal tender laws are required for people to ascribe value to fiat currencies.

>Note what happens; a unit of money to facilitate trade is created out of thin air (IOU). It is something of real value but nothing tangible. This is the essence and definition of money, a notation of value. Using high value commodities such as gold and silver as money is a diversion into bartering.

In this transaction where an IOU is 'created', no money or value is created. Say the farmer has agreed to give some of his wheat to the cobbler for some shoes, but he doesn't have the wheat on him, so he makes a promise. Nothing is created in this situation. The cobbler gives the farmer some shoes now in exchange for some wheat later. Furthermore, the "wheat promises" created are not causing an increase in demand. If the cobbler trades the wheat promises to somebody else, there is still just one unit of wheat promises attached to one unit of wheat.

Assuming the farmer doesn't actually have any wheat, he could in theory go around promising wheat to people and maybe increase "aggregate demand" for a time. But clearly this would distort the economy in favor of the things the farmer wanted (see Austrian theory of the business cycle and fractional reserve banking), plus he would eventually be found out (see 10,000 banks fold during the great depression; the collapse of the bank of Amsterdam in 1795).

>The "closed system" idea that tax cuts/ rebates are liabilities to be paid off with future income is not valid when money is created to offset the money that is disappearing during debt deleveraging.

The problem with this idea of money "dissapearing" is the essential problem you have of money = value. If all the banks collapsed in on themselves taking their borrowers with them. What 'value' would dissapear? Yest, the division of labor may be impaired for a while, but the actual factors of production: people, plant, and equipment are all still there. No money is needed to "cure" this ill, the only need is for ownership to be quickly reassigned to prudent savers who can buy those things at firesale prices and resume production.

Also, you talk a bunch about "injecting" money into the economy, but fail to notice that this is how we got where we are now in the first place. Get out of the mindset that there is a "market" out there which doesn't include actual market participants. By injecting money you will be giving money to some participants and not to others, you create winners and losers. If this IS what you want, then you should specify who you want to win and who you want to lose. The way I see it, people who borrow beyond their means deserve to lose their assets at firesale prices to people who were prudent. Prudence should be rewarded for once in this country.

Anonymous said...

I was intrigued to see a a non-Marxist criticism of the Austrian School on the WSJ forum regarding Peter Schiff's latest column. I think your theory makes some sense, though I doubt you've stumbled upon anything quite so unique as to warrant a distinct school of thought.


be more cohesive as you develop the meat of the essay; it's very hard to follow you and the layout of these ideas and how they relate to each other is very disjointed. Also, use advanced concepts by all means, but write for the layman in terms of language.

You have several good insights into the implications of banking as a pure Ponzi, and how the effectiveness of certain economic policies are contingent on the circumstances of time and place. I also agree that the Austrians are living in a different world of economics--the difference between the Austrian vision of sound economics and other schools is not one of policy, but entire systems.

The Austrians, have the habit common among theorists in general of taking what they think should be done and extrapolating the consequences in a resistance-less vacuum. The mostly polical conditions necessary for the success of Austrian policy are not likely to manifest anytime soon.

On the other hand, any opaquely written manifesto regardless of intent, reeks of what Hayek called the "Fatal Conceit". Public policy prescriptions and central plans implicitly assume flawless and inflexible implementation and follow-through--the more intricate the policy, the less margin for error. The Road to Serfdom was written mainly to ridicule this dangerous assumption and warn against making it.

Forget policies that will never mesh with the incentives of the State. There is no bad law or regulation that needs any tweaking other than to submit the issue to market forces of calculation.

There is no need for intricately planned reforms of the existing regime if all that needs happen is a real liberalization of money and banking. Market discipline can illuminate its participant's true preferences for mediums of exchange and account of whatever kind.

Thats subjective value--that's a market democracy. Down with our current economic dictatorship.

Joseph said...

Mr. Peachey:

Let me complement you on an intriguing and cogent critique of Mr. Melloan's essay in today's WSJ. The ideas you present are food for thought for my otherwise starved understanding of economics. I plan on reading more of your blog and what appear to be enlightened responses in the days to follow.

I wonder, however, if "fighting the last war" on inflation misses the real point of the article. The crisis that is developing is not so much a lack of confidence in values and pricing, as much as it is a crisis in the threat to the integrity of the "open system".

A Fed increasing money supply is not in itself a problem, particularly if the evidence is clear that the risks of inflation are outweighed by the need for liquidity. The problem is whether the Fed has lost its appearance as an objective intermediary.

The question that remains is whether the Fed will turn the spicket off when money supply exceeds money needs. A simple fix is what I suggest, which is a resolute communication to market participants that the Fed is not interested in the political ramifications of economic growth and is rather a cold, calculating arbiter of money flows.

It appears that you would agree that a centralized process of stimulating demand via politicians is likewise a threat to the "open system." A better approach would be to let citizens keep more of what they earn.

Anyways, great response today. Keep it coming.

Anonymous said...

When everything is coming your way, you are in the wrong lane.............................................

HYPERTlGER said...

"When we import from abroad we actually pay for imports with a manufactured assets to which the US has the exclusive right to produce."


There are just under 6000 commercial banking institutions in the USA with 10's of 1000's of branches.

Along with 1000's and 1000's of commercial banks outside of the USA with ultimately 100,000 of 1000's of branches combined.

The US dollar was a credit instrument in 1944 along with all the rest of the credit instruments of the world...or credit which is debt owed to someone else and ultimately back to the bank that created it.

In 1944 Bretton woods made the US credit instrument the global trade medium of exchange and fixed all the rest of the credit instruments of the world to the US dollar.

making all the rest of the credit instruments in the world a derivative of the US credit instrument.

The USA became the supply of inflation and the rest of the world the demand.

and from 1944 to 2008...the USA and world inflated up to maximum potential.

then the USA reached maximum potential inflation and began to deflate along with the rest of the world...

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