Money Basics 

Rev 3 (22/12/2013)

Marc Gauvin Copyright © 2011-05-19 All Rights Reserved

 

“The study of money, above all other fields in economics,

is one in which complexity is used to disguise truth

or to evade truth, not to reveal it.”

 

 “The process by which banks create money

is so simple that the mind is repelled.”

 

John Kenneth Galbraith Money: Whence it came, where it went – 1975, p29, p15

 

The goal of the following five lessons is to provide exact technical knowledge that most anyone can understand about the true nature of our current financial system and thus provide the individual with a truly authoritative understanding of any currnency/money system. With this knowledge, it will be possible for most to confidently define, independently of political, religious or ethnic concerns, what exactly constitutes a "stable currency system", what does not and why. To achieve this, we first demystify the current state of the art by clearly separating in our minds the consequences of the present system’s design alone from those due to human behaviour. In this regard, we take note of the following axiom:

System design affects user behaviour but user behaviour does not affect system design unless it expressly acts to alter or replace it.

Thus and just as in the game of musical chairs, the design of the game itself can be the cause of the inequity rather than the nature of the players, so too the design of our currency system can be the cause of similar undesired outcomes independently of the behaviour of individual players.

In this light, trying to manipulate the behaviour of players to resolve a system design problem is as absurd as expecting that in musical chairs, the missing chair will magically appear on the basis of the way players dance about while the music is still playing! This is where the political class is entirely irrelevant as none of the proposals within the left/right spectrum are wiling to address the system design issue. The political class without exception, confuses reform of the implementation of the design with reform of the design itself.

The Why of Money

We all imagine that we understand why money exists, but given that our understanding of money is coloured by our social conditioning, it is worth revising, in a rigorous and rational way, exactly why money exists.

If we think about it, we ought to realise that money only performs one really practical and fundamental function for us, which is to provide “liquidity”. That is to say, it allows us to represent divisions of the value attributed to things. This function of dividing value is the singular and most important reason for inventing money, it is fundamental because without it, we would be unable to trade a piece of our house for food.   Also, without this divisibility function, we would not be able to establish a standard means for measuring economic transactions nor keep records of debts and positive accounts. Hence, the fundamental rationale for money is to provide a measure of value so that we can represent value and its divisions.

It turns out, there are only two requirements that need to be met in order to achieve this functionality:

  1. Denominate a common unit of reference of constant value.
  2. Maintain stable records of the inputs and outputs of the value dividing process.

Therefore, having available any wealth in the form of measurable goods and services and the need or desire to trade that wealth, the statement “lack of funds” is an oxymoron that at best represents a conceptual error resulting in lethally absurd consequences and at worst, given that economics has come to be considered a science, scientific fraud.

Lesson 1 – Currency Unit “Creation”

When a bank finally concedes a loan the following takes place:

  1. First and foremost, the bank will require that something of wealth that is free of any liens or previous debts be submitted as a guarantee called collateral.
  2. Through a process called asset evaluation, the submitted collateral is assigned a fixed (bounded) value in currency units that is maintained for the duration or term of the loan.
  3. It then adds a fixed (bounded) positive number equal to the principal amount of the loan to the client’s current account. This number has a fixed (bounded) ratio with the number attributed to the collateral guaranty established in the previous step.
  4. Simultaneously, the bank creates a special loan account associated with the borrower to which it enters a negative number of the same magnitude as that of the principal amount entered into the current account.
  5. No other accounts are subtracted from in order to realise the loan.

Now, because positive numbers in current accounts can be used to:

    1. To emulate a transfer of units to any other account for any reason;
    2. Obtain physical currency representing legal tender (bills and coins);
    3. Cancel negative numbers in loan accounts;
    4. All other things money can be used for.

Then, the annotation of new positive current account entries represents the "creation" of new money that is backed in a fixed ratio to the wealth that has been provided as collateral. In fact, presently all currency including currency bills, coins and legal tender, are only annotated as positive account entries backed by some sort of borrowers’ pledge.

Conclusion: Money is simply a record of value. Money is “created” (annotated) whenever a fixed amount of wealth is pledged unequivocally and irrevocably to be represented by a fixed sum of units of money whatever the means by which such is recorded.   Therefore, and as long as there exists wealth capable of being pledged, new money can always be created. Money is only the representation of divisions of wealth not the wealth itself.

Lesson 2 – Currency Unit “Destruction”

Whenever loan account entries are cancelled, corresponding positive current account entries must also be subtracted or deleted. Hence, money is deleted from the system when principal debt is cancelled.

Conclusion: Since by design there is always a one to one ratio of loan account entries to current account entries, then when all loan accounts in the system are cancelled, all corresponding current account entries will also have been deleted and thus ALL such currency will have been removed from circulation.  So, without loan account entries there can be no positive account entries.

Lesson 3 – Currency System Stability

In essence, currency or money is simply the abstract medium by which “value” can be represented numerically by individuals in the course of transacting the things to which such value is or can be attributed to.  Such processes of evaluating wealth as an input producing output sums, denominated in monetary units, constitute what are commonly called “money systems”. These “systems” have clear and precise rules that together constitute logical designs that can be determined to be either stable or unstable by virtue of whether or not their inputs and outputs are both bounded values i.e. whether or not they satisfy the BIBO criteria for stability. Stability as defined in Control Systems Engineering:

A system is stable if every bounded input produces a bounded output. That is when the “Bounded Input Bounded Output (BIBO)” condition for stability is satisfied.

This can be understood as saying that any perturbation of the system will produce a response that will tend to revert it back to its point of equilibrium. If you push a ball up the inside of a bowl it will roll back down and up the other side whereby friction will slow the motion down until the ball is still. Such a system is a stable system as the input (push of the ball) generates an output response that has a bounded maximum value after which the ball tends to revert back to its point of equilibrium. Conversely, when the input produces outputs that increase over time, requiring independent external forces to arrest the response, then the system in question is considered unstable. A stable system is one that reaches equilibrium by its own definition and inherent design. A Passive BIBO system is a BIBO system where the output, apart from being bounded, is also always equal or less than the input.

In the most rigorous mathematical terms, instability is modelled by representing the output of a process in terms of time.  If for a given bounded input the output always increases over time then the output is clearly never a fixed sum and therefore is unstable, while if the process tends towards a fixed limit over time, then it is considered to be stable. The way this is determined mathematically is by measuring the rate of change known in math lingo as the derivative. If the rate of change is always positive then the growth is always increasing and the system is considered unstable. Conversely, if the rate of change is zero, then the system is considered to be stable. A process is considered unbounded when its rate of change is always positive and bounded when its rate of change is zero.

Now and according to our Money Basics notes so far, the system is indeed Passive BIBO stable because as long as we stay within the bounds of just principal amounts, the system is stable because all inputs and outputs are indeed bounded:

  1. All real physical wealth pledged is bounded.
  2. The principal sums entered into current accounts are all bounded.
  3. And all principal debts are bounded.

But, if we talk about the Total Debt due i.e. according to the following simple interest formula:

Total Debt = P (1+ik)

Then the debt output no longer is bounded because it grows as a function of interest i multiplied by the number of periods k measured in units of time, resulting in an unbounded or ever increasing output making the system no longer BIBO and therefore unstable by design. This simply tells us that the simple interest function grows with respect to time as a straight diagonal line with a constant positive slope. This means that the rate of change is positive.

Since any loan account entry cancellation requires an equal cancellation of corresponding current account entries, at ALL times the magnitude of loan account entries is ALWAYS equal to the corresponding number of current account entries, then any interest demands are at ALL TIMES in addition to the available current account entries.

Now and very importantly, instability is not identified by whether or not all Principal and Interest demands can or cannot be satisfied, but rather instability is identified by the fact that if, for whatever reason, either are not satisfied, then the debt will continue to grow unboundedly.

Therefore and since it is absurd to expect the outcome where 100% of both principal and interest are satisfied for 100% of all scheduled payments at all times, then it can be accurately stated that such a system, invariably produces residual unbounded Principal and Interest debt that without issuance of new debt money units, remains un-payable leading to a situation of perpetual debt. As we shall see in the next lesson, if this debt is refinanced, then it necessarily becomes exponential in nature exacerbating the aggregate system’s state of instability.

Lesson 4 – Linear Vs Exponential

Consider a lake with a population of water lilies that have the odd property of doubling their population every day. Depending on the size of the lake, it could take a very long time even a million years for half the lake to be covered but following such a long period it will only take one more day for the second half. Note also that just weeks before reaching the millionth year, the lake would have much the same appearance as it always had i.e. far from half of its surface being covered. Thus, such growth is far from being intuitive to the observer.

Mathematically, the process is simply the periodic summing of previously summed values. If one stacks cards by adding a card each period the stack will grow in a linear fashion but if instead, one adds always as many cards as previously stacked, then the growth of the stack will be exponential, growing much faster than the linear counterpart and much less intuitively.

So as we described in the previous lesson, if you pay interest on interest then your stacking will be on the basis of previous sums, leading to an exponential not linear result.

Lesson 5 – Systematic Inflation

As can be deduced from the previous lessons, from the very first loan the system is predisposed to the creation of an arbitrary debt “seed” that inevitably will be planted in the economy resulting in a minimum amount of unbounded debt output. But the creation of perpetual unbounded debt is just the very minimum result and not the only consequence of this design.

The other even more spectacular consequence of the root instability of interest debt growth, is the fact that from the moment that the growth begins, that growth is incorporated by users as a cost and passed on down the value chain. As it is passed on, it is subject to being refinanced over and over again as it moves down stream from financing resource extraction, production, distribution through to final consumption. Similarly the interest cost of capital assets increase their cost in subsequent financing cycles. The result is a vast multiplication and compounding of interest debt in the system, resulting in a necessarily overall exponential output, where the rate of growth of debt is no longer a straight line but a curve that approaches infinity more and more quickly as time approaches infinity.

Like the first “lily” of our population that doubles and doubles in time, so too, the excess debt seed and subsequent re-financing of past interest debt will double and double in time.   This rolling over of initial and subsequent debt seeds has an important effect on the system as a whole, particularly with regards to the relationship between the amount of money in circulation (current account entries), wealth pledged and minimum prices.

Thus, from the onset and by system design alone, excess debt i.e. without any previously stipulated wealth backing, it nor any corresponding current account entries, is perpetually generated every cycle and as it is compounded, the system’s unbounded debt output ceases to be linear but rather becomes exponential as the following system walk-through illustrates.

 

System walk-through

 

System Walkthrough

 

Figure 4.1 Financial System walkthrough [red indicates chronic imbalances]

 

  1. Wealth is generated by ingenuity, human effort and resources made available through past investment of wealth.
  2. Through the process of asset evaluation, a fixed amount of existing wealth is attributed a fixed collateral value in the form of a sum of units of currency.
  3. The fixed collateral sum is used as the basis for the creation (annotation) of new currency in the form of a second fixed value i.e. the principal sum of loans issued into circulation through current account entries. Since both the collateral and principal loan sums are fixed, they maintain a constant ratio to the wealth pledged.
  4. Current account units are distributed back to wealth producers through purchasing transactions or may be saved or stored (at a compounding interest rate) or used to cancel debt thus reducing the total amount of money units available at any point in time.
  5. Total debt due is the principal sum entered as a negative number in a loan account to which interest is added such that the debt grows as a function of time.
  6. Because of the debt growth due to interest and the fact that not all payments at all times will be made, exacerbated by the scarcity of money also due to the interest, then it can be asserted that the system will inevitably produce residual excess debt. If this residual debt is refinanced then the debt will compound and the growth will necessarily be exponential. Further to this, is the fact that all interest amounts represent a cost beyond the principal amount that are past down-stream through cumulative financing from resource extraction, production, distribution through to final consumption. Similarly, the interest over capital asset loans will increase costs in subsequent financing cycles. The result is an exponential aggregate system debt output that leads to corresponding exponential increase in prices (inflation) unless new wealth is produced in tandem with the aggregate debt growth. Otherwise the system collapses.


Conclusion

 

The current system’s logical design is inherently unstable because it does not satisfy the BIBO/Passivity criteria for transactions. The cause of this instability is clearly the growth component of the total debt output due to interest. This growth creates a chronic deficit of currency units in the system requiring that the system constantly produce more currency units irrespective of whether or not new wealth is added.  But, if wealth is not increased and the unpaid past debt is added as a cost to the value attributed to past collateral, the previous proportion of wealth to currency is altered causing inflation. Every time this occurs debt is compounded and as the interest cost is passed on down the value chain further compounding takes place, multiplying inflation faster and faster over the lifecycle of an economy. As the debt/inflation accelerates the probability of generating new wealth to compensate decreases but to avoid collapse, the system must continue to refinance past debt but with less and less new real wealth.  This can only culminate in a point of debt saturation where virtually all the economy’s real wealth becomes simultaneously caught in pledge (or withdrawn from circulation) so that little or no wealth (collateral) remains available for the creation of new current account entries. It is precisely this, that leads to uncontrollable run away inflation (continuous debt money without real wealth) or other forms of system collapse.

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