Tuesday, February 15, 2011

The "Two-Tiered" Interest Rate, Part I: Defining Money

One of the most serious financial problems today is how we understand money and credit, and thus banking and finance. This has led to massive government deficits, and financing consumption through an ever-increasing burden of consumer debt. Fueled by the belief that it is impossible to finance new capital formation — or anything else — except by cutting consumption, accumulating money savings, then investing, the financial system and the economy as a whole have come to rely on inflation and State price control of an increasing array of goods and services in a failing effort to keep the economy running by undermining its foundation.

What is money? Money is anything that can be used in settlement of a debt. Period.

As for credit, according to Henry Dunning Macleod, credit is simply another form of money (The Theory of Credit, 1894). Unfortunately, at present most authorities define money very narrowly, as coin, banknotes, demand deposits ("checking accounts"), and some time deposits ("savings accounts").

This understanding of money is based on almost universal acceptance of the principles of the "British Currency School" of finance. That is, "money" is restricted to State-issued claims on the present value of existing inventories of marketable goods and services. "Credit" — the "supply of loanable funds" — is limited to what has been accumulated in the past in the form of money savings by cutting consumption. A "bank" is defined as a financial institution that takes deposits and makes loans.

In Currency School theory, the backing of the currency (considered the same as the money supply) is limited to gold and silver (uncommon these days), and government debt. This permits the government to manipulate the value of the currency to achieve political ends through induced inflation and deflation, with the private sector faced with period shortages or surpluses of loanable funds. This in turn results in manipulating the interest rate in order to encourage or discourage private sector investment.

In contrast, the Just Third Way is based on the principles of the "British Banking School" of finance. In this "school," "money" is defined as "anything that can be used in settlement of a debt."

This is the legal and accounting definition of money, and implies that all money is a contract, just as all contracts are money, regardless of the physical form the money takes; currency (coin, banknotes) and currency substitutes (demand deposits and time deposits) are only one form of money. The bulk of the money supply consists of privately issued "bills of exchange" that are either used directly as money by their issuers and holders in due course by discounting and rediscounting until redeemed at maturity ("merchant's acceptances"), or discounted or rediscounted at a commercial/mercantile bank and exchanged for currency or currency substitutes in the form of promissory notes issued by the commercial bank ("banker's acceptances") — a bank being defined as a financial institution that takes deposits, makes loans, and issues promissory notes.

The commercial bank may, in turn, rediscount such paper at the central bank, thereby spreading the risk of default and ensuring a uniform and stable currency backed directly by the present value of private sector hard assets. Because both existing and future inventories of marketable goods and services have present value, the "supply of loanable funds" is not limited to the present value of existing marketable goods and services, but to the present value of any financially feasible capital investment plus existing inventories.

Thus, financing is, in theory, available for any sound capital investment by discounting and rediscounting bills of exchange based on the properly vetted present value of the marketable goods and services to be produced once the capital has been formed. This precludes manipulation of the interest rate in order to encourage or discourage private sector investment. There is exactly enough money in the economy to provide financing for all feasible capital investment. For all capital investment financed by creating money by discounting and rediscounting bills of exchange, the interest rate becomes moot.


1 comment:

nail-in-the-wall said...

"What is Money?" so that even Homer Simpson can understand.


We the people's money, past present and future!

"People are hungering for property - for a secure, permanent and independent link with spaceship earth that ownership represents and which only ownership can create, protect or defend. It is humiliating to possess nothing, to own nothing, and hence to produce nothing and to count for nothing." --Louis O. Kelso and Patricia Hetter, (Washington Post, June 18, 1972)

"If you have not this, if this be not well secured to you, you may call yourself what you will, but you are a slave." -- William Cobbett (A History of the Protestant Reformation in England and Ireland, 1829, §456)

D'oh I think I get it.
"Own or be Owned"