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Tuesday, August 3, 2010

Monetary system failings

I have read, and been thinking about money as a problem. A problem that all of society depend upon for functioning. In many aspects a good money system is more critical than fresh water, food, or even air. Without a good monetary system humans would literally not be able to evolve much further than everyone being farmers and hunters.

The function of money, as I previously discussed, has a basic issue. When work is done by a person A for Person B, Person B now has a debt. In effect Person B must provide the amount of work VALUE as person A to repay that debt.

The problem, writing a debt note, is rampant with corruption possibilities. The true nature of the corruption is the act of creating the debt note. A third person not involved in the transaction has no easy way to verify the debt note authenticity. Furthermore, a third person accepting the debt note has no way to ensure exchanging the note with anyone other than the person who wrote it.

So the true nature of money is a system to track the AUTHENTICITY of work being done. Also money has to have the ability to be UNIVERSALLY ACCEPTED. Finally, by limiting the power to create money to a few (such as a one entity, like a government), the risk of creating money for no work done (in effect, distorting the money) is greatly reduced.

The problem comes when the entity responsible for creating money succumbs to temptation of creating money without work done. When the central entity in effect doesn't uphold the standards of money creation, retaining it's value.

So therein lies the problem, you want money to be created as a debt note on a person-by-person basis. Creation of wealth is the ACT of doing work for another person, and that person then owes the same value of work back. But creating debt notes on a person-by-person basis is not trustworthy nor is it universally accepted. Therefore, a central agency such as a government creates money in a reasonable fashion to represent the work being generated by society within a reasonable range of accuracy.

Too few dollars created by central government
If the central authority creates money say at the rate of ZERO new dollars per year, the effect on society would be devastating. This can happen when money is based on precious metals such as gold. If a government can only produce X coins per year due to limited production capability, you starve the societies prosperity.

Too many dollars created by central government
If the central government produces too much money for work being done, the government in effect is committing fraud, akin to what would occur if individuals where allowed to make money. This results in currency devaluation, or even collapse. Some economists equate this to the word inflation. Inflation is a word I avoid, since it is used to describe too many different aspects of monetary valuation and policy. I prefer currency devaluation to be more accurate.

Creating dollars by central government AND banks
The US and most of the world use a money and credit creation system called Fractional Reserve Lending. When banks acquire new monetary assets, they can lend out MORE than they have in assets. The ratio of leverage is restricted by the government managing the monetary system. The level that is rational for maintaining low risk is of great debate. A ratio of 1:1 in effect means the bank can only lend out money they have in storage. A ratio of 2:1 in effect allows the banks to create credit at the rate of 2 dollars for every one they have.

Bear Sterns and others had ratio's of 30:1. THIRTY to ONE! That means if one of those loans goes completely south (cannot be paid back), the other 29 dollars have NO assets backing those loans. In effect Bear Sterns would have created money in the form of credit, in a fraudulent manner. Such high leverage by most (not everyone) is considered unsound. I am of the opinion leverage should be set between 1:1 to 4:1 in a Fractional Reserve Lending system.


The benefits of a Fractional Reserve Lending system is it allows money (in the form of credit, which in effect IS money) to be created by others, not just the government! This system comes closer to the ideal system where each person could create money when they do work for another person. By allowing others to create money than the central authority, money in theory can be more effectively created as demanded by the productivity of society.

In a pure precious metal monetary system, the ability to create debt notes for work done would be put into the hands of the very few. A Fractional Reserve Lending standard is in effect an extension of FIAT currencies, and therefore money is not backed by precious metals.

Unfortunately, Fractional Reserve Lending systems also fail because of two sources. First is, the government FIAT currency creation is done in an unsound manner. The banks are also empowered to do the same and can create massive fraud due to high ratio's. (in a 2:1, worst case is create 1 "fake" dollar for every dollar, for example) The higher ratios allow just by pure mathematics more fraudulent loans to be possible in relation to every true dollar saved.

Money Creation Tax
In the US based system, the US government cannot create debt notes without an attached "tax" to each dollar created. In my original money creation example of two farmers, when the farmer exchanges food to a shoe maker, it would be like attaching a interest rate to be paid to a third party for the privilege of the shoe maker writing a debt note. This unseen "tax" on every dollar created eats away at the wealth of society generated, and is a large reason for currency devaluation. The debt based system spirals out of control, eventually collapsing. In the US based system each dollar created by the US government must be first be backed by selling a bond. If the purpose of creating money is to capture work done, this interest rate is not required. Why should the US government have to pay banks to create money? Why do they have some sort of special rite to be the masters of money creation?

Money creation belongs to the people, those who create the work, those who are OWED work. Not the banks.

A better Monetary system
This post turned out to be pretty long. I'll create a new post of my thoughts of a better monetary system.

(thanks to John and Swan for proofreading)

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