Monday, November 5, 2012

Let's Make a Deal, II: Bad Systems Design Principles

As we saw last week, a central bank is an economic and financial necessity if society is to advance economically. Consequently, prior to the Civil War the United States made three attempts to establish a central bank, all of which were terminated as a result of political pressure and a misunderstanding of what banks do.

Finally, in 1863, in response to an increasingly desperate need for a central bank, the National Bank system was established. Unfortunately, the architects of the system chose the wrong model: the British Bank Charter Act of 1844 that undermined the money and credit system of Great Britain, and accelerated the concentration of capital ownership in that country in fewer and fewer hands.

The fundamental problem with the National Bank system was that it was virtually custom-made to favor the already wealthy and concentrate ownership of the new industrial and commercial capital that began to be formed after the war at a tremendous rate. This capital was financed in large measure by the expansion of bank credit — by the currently wealthy issuing bills of exchange that were discounted and rediscounted by other capitalists and commercial banks. This left income from operations available for working capital and distribution in the form of dividends for consumption income — and reinvestment in additional new capital.

In other words, the already wealthy were able to create money at will for new capital investment and use current income to finance operations, consumption, and accelerated capital formation simply because they were wealthy. They had a lock on the formation of new capital because they had a virtual monopoly on the means of financing new capital: access to capital credit, limited only by the present value of the capital being financed, and possession of collateral to back up their creditworthiness. At the same time, farmers and small businessmen were limited to existing accumulations of savings for credit to finance operations and in many cases consumption as well — and there were some serious problems with that.

It is a basic fact of business life that if you can generate enough revenue to cover costs you will make a profit; "profit" is what is left after meeting capital depreciation (fixed) and operating (variable) costs. Capital, whether land or technology, is usually the single largest cost in an economy in which capital ownership is widespread and owners work for profits instead of being wage slaves driving up the cost of production. This is because owners take their consumption income out of profits; consumption income is not a cost of production.

In a wage system, of course, labor is usually the single highest cost in a business. This is because consumption income has been shifted to a cost of production, not a residual after production costs have been met.

Shifting from an ownership economy to a wage economy is a "double whammy." This is because a business (including a farm) can survive for a time if it meets all its variable costs (especially if the capital is fully paid for and the cost is the non-cash item of depreciation), but goes bankrupt when it cannot meet its variable costs.

Capital in the form of depreciation or immediate expensing of equipment is generally a fixed cost, i.e., it doesn't change in the short run. Labor is generally a variable cost, e.g., if you don't produce anything you generally don't have to pay workers who aren't there. A wage system economy thereby has a tendency to insolvency built-in by being oriented toward increasing costs, where an ownership system economy is oriented toward growth by being oriented toward increasing production.

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