Tuesday, February 9, 2010

Ride the Pig, or, the Small Error that Leads to Huge Debt

Over the past several days world stock markets have been "plunging" (they never "decline" or "adjust" except in hindsight) in response to the discovery that a number of countries in the European Union have been spending more money than they have been earning. ("EU Searches for Way Out of Debt Crisis," AP, 02/09/10) In more normal times, this is called "Keynesian Fiscal and Monetary Policy." When the bill comes due, however (as it inevitably must), it is called a "crisis" — a manufactured and completely avoidable crisis, but a crisis nonetheless.

What no one seems to understand, however, is that such crises are built in to Keynesian economics, as well as an integral part of Monetarist and Austrian economics and every other system built on the shifting foundation of the tenets of the British Currency School. The bottom line is that virtually all systems of economic thought in the world today use the wrong definition of money.

That is bad enough. Rational thought requires that we define our terms before we can know what we're even talking about — and that these definitions reflect reality. It's all very well for policymakers and academics to insist that a "horse" is an animal with cloven hooves that squeals and yields bacon and ham, and even manage to get their definition inserted into law and the dictionaries. (Significantly, in his Treatise on Money, 1930, Keynes claimed that the State has the power to "re-edit the dictionary," that is, to change reality!)

The problem is that people engaged in real life outside of Wall Street and Beyond the Beltway are convinced that the animal so described is called a "pig." Using the "official definition" of horse is only going to get you into trouble when you attempt to hitch your Berkshire to your buckboard. It might do the job for a while, but sooner or later (usually sooner) the bad official definition is going to cause a problem or two . . . and pigs can get as mean and as vicious as their extremely high intelligence would suggest.

What's worse is that using the wrong definition of money — essentially a purchase order issued by the State or some entity to which the State has delegated the authority — can cause enormously more damage than even the angriest pig. It's not that the definition of money that Keynesians, Monetarists, Austrians and others use is wrong so much as incomplete.

Yes, money can be a purchase order issued by the State and backed by the ability of the State to collect taxes in the future. It's even true that an economy can keep going using this definition of money for quite some time without experiencing a financial meltdown — as long as the private sector manages to remain sufficiently productive to stay ahead of government-induced inflation and punitive fiscal policy that seems custom designed to destroy the ability of businesses to be productive.

The problem is twofold. One, claiming that money can only be a purchase order issued by the State unjustly infringes upon private property and subjects the economy to manipulation for political ends that often fail to address the real need of an economy for a stable medium of exchange and a source of financing for capital formation. Two, State purchase orders are, not to try and whitewash the matter, very bad money.

"Money" is anything that can be used in settlement of a debt, and consists of anything that two or more people freely agree to exchange between themselves. "Good money" is a promise on which the issuer can make good on demand, that is, deliver the wealth that backs the money. "Bad money" is a promise on which the issuer cannot make good on demand, either because he or she doesn't own the wealth that allegedly backs the money, or because he or she has to go collect that wealth from somebody else in order to make good on the promise.

In both of the latter cases, the issuer of the money is making promises that someone else has to keep. Ordinarily we would call that person a "thief." In all schools of modern economics, we call that person "the State."

If the countries of the European Union are serious about solving the debt crisis, they need look no further than the Capital Homesteading program proposed by the Center for Economic and Social Justice ("CESJ"). Detailed in the book of the same title, Capital Homesteading for Every Citizen (2004), Capital Homesteading is built on the common sense assumption that you can't spend what you don't have, and you won't have anything if you don't produce. Thus, if you want a country to have a tax base to support all the social programs, wage and price supports, State salaries and pensions that always look so good when you're voting somebody into office and not so good when it comes time to pay for them, you have to have a productive economy.

Even more than a productive economy, however, you need a productive economy in which all citizens can participate productively — and that means not just as sellers of labor, but as direct owners of the means of production, which has displaced human labor in modern technologically advanced economies as the primary source of marketable goods and services.

This, in turn, means that ordinary people have to have some source of financing to acquire productive capital — and that is where the correct definition of money comes in.

If we insist on defining money solely as a purchase order issued or authorized by the State, we cannot finance new capital from any source other than existing accumulations of savings. This restricts ownership of all new capital to those who already own the capital that is generating the income out of which only the rich can afford to save.

If, however, we use the right definition of money, that is, anything that can be used in settlement of a debt, then anybody can become an owner of capital. All anyone needs is a financially feasible capital project that will pay for itself within a reasonable period of time. Such projects have a "present value." Having value, they can be turned into "money."

This is what a commercial bank is designed to do. A prospective borrower brings a sound proposal with a positive present value to the bank. The bank examines the project and, if it agrees that the project has a present value of, say, $1 million, will allow the borrower to borrow up to that amount. (For simplicity's sake we're omitting the demand for collateral, which can be replaced by capital credit insurance and reinsurance in any event.)

The bank doesn't have $1 million in its vaults. Instead, it prints banknotes or creates demand deposits in the amount borrowed, and takes a lien on the capital project in the amount of the loan. The bank then hands over the cash or (more usually) a checkbook to the borrower. The banknotes or the demand deposit are not backed by cash, but by the lien on the capital project. (Again, for simplicity's sake, we will not get into a discussion on cash reserves, something that a central bank is designed to cover . . . if operated properly.)

The borrower takes this newly created money and invests it in the capital project. The project is completed, and begins producing marketable goods and services. The borrower sells these marketable goods and services, presumably adding on a margin to generate a just profit. Out of the revenues generated by the sale of marketable goods and services, the borrower gives the commercial bank back the money the commercial bank created, thereby buying back the lien on the capital asset held by the bank. The borrower also pays a fee to the bank for providing the service of creating money. The bank cancels the money used to repay the loan, and keeps the fee paid by the borrower as its profit.

The theory behind commercial banking is called the "real bills doctrine." The real bills doctrine is the basic tenet of the British Banking School. All economists who base their understanding of money on the tenets of the British Currency School reject the real bills doctrine. This is because the Currency School does not accept the principles of commercial banking and defines money differently. Thus, they conclude that the real bills doctrine, commercial banking, and central banking, all based on the Banking School, are all, essentially, frauds because they are not based on the Currency School. A pig is a fraud because it is not a horse.

If the financial and political powers-that-be, American, Asian, or even European, want a way out of the self-inflicted debt crisis, they should seriously investigate the claims of Capital Homesteading and the underlying theories of binary economics, and start using the world's financial institutions and systems as they were designed to operate in accordance with reality.

The alternative is to continue to try and saddle a pig. Maybe they can do it, but chances are they're not only in for a very short and very rough ride, they will fail in achieving anything other than being attacked by an enraged pig — and in getting a horse laugh from the sidelines.

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