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Wednesday, November 9, 2016

Reading List: The Scandal of Money

Gilder, George. The Scandal of Money. Washington: Regnery Publishing, 2016. ISBN 978-1-62157-575-7.
There is something seriously wrong with the global economy and the financial system upon which it is founded. The nature of the problem may not be apparent to the average person (and indeed, many so-called “experts” fail to grasp what is going on), but the symptoms are obvious. Real (after inflation) income for the majority of working people has stagnated for decades. The economy is built upon a pyramid of debt: sovereign (government), corporate, and personal, which nobody really believes is ever going to be repaid. The young, who once worked their way through college in entry-level jobs, now graduate with crushing student debts which amount to indentured servitude for the most productive years of their lives. Financial markets, once a place where productive enterprises could raise capital for their businesses by selling shares in the company or interest-bearing debt, now seem to have become a vast global casino, where gambling on the relative values of paper money issued by various countries dwarfs genuine economic activity: in 2013, the Bank for International Settlements estimated these “foreign exchange” transactions to be around US$ 5.3 trillion per day, more than a third of U.S. annual Gross Domestic Product every twenty-four hours. Unlike a legitimate casino where gamblers must make good on their losses, the big banks engaged in this game have been declared “too big to fail”, with taxpayers' pockets picked when they suffer a big loss. If, despite stagnant earnings, rising prices, and confiscatory taxes, an individual or family manages to set some money aside, they find that the return from depositing it in a bank or placing it in a low-risk investment is less than the real rate of inflation, rendering saving a sucker's bet because interest rates have been artificially repressed by central banks to allow them to service the mountain of debt they are carrying.

It is easy to understand why the millions of ordinary people on the short end of this deal have come to believe “the system is rigged” and that “the rich are ripping us off”, and listen attentively to demagogues confirming these observations, even if the solutions they advocate are nostrums which have failed every time and place they have been tried.

What, then, is wrong? George Gilder, author of the classic Wealth and Poverty, the supply side Bible of the Reagan years, argues that what all of the dysfunctional aspects of the economy have in common is money, and that since 1971 we have been using a flawed definition of money which has led to all of the pathologies we observe today. We have come to denominate money in dollars, euros, yen, or other currencies which mean only what the central banks that issue them claim they mean, and whose relative value is set by trading in the foreign exchange markets and can fluctuate on a second-by-second basis. The author argues that the proper definition of money is as a unit of time: the time required for technological innovation and productivity increases to create real wealth. This wealth (or value) comes from information or knowledge. In chapter 1, he writes:

In an information economy, growth springs not from power but from knowledge. Crucial to the growth of knowledge is learning, conducted across an economy through the falsifiable testing of entrepreneurial ideas in companies that can fail. The economy is a test and measurement system, and it requires reliable learning guided by an accurate meter of monetary value.

Money, then, is the means by which information is transmitted within the economy. It allows comparing the value of completely disparate things: for example the services of a neurosurgeon and a ton of pork bellies, even though it is implausible anybody has ever bartered one for the other.

When money is stable (its supply is fixed or grows at a constant rate which is small compared to the existing money supply), it is possible for participants in the economy to evaluate various goods and services on offer and, more importantly, make long term plans to create new goods and services which will improve productivity. When money is manipulated by governments and their central banks, such planning becomes, in part, a speculation on the value of currency in the future. It's like you were operating a textile factory and sold your products by the metre, and every morning you had to pick up the Wall Street Journal to see how long a metre was today. Should you invest in a new weaving machine? Who knows how long the metre will be by the time it's installed and producing?

I'll illustrate the information theory of value in the following way. Compare the price of the pile of raw materials used in making a BMW (iron, copper, glass, aluminium, plastic, leather, etc.) with the finished automobile. The difference in price is the information embodied in the finished product—not just the transformation of the raw materials into the car, but the knowledge gained over the decades which contributed to that transformation and the features of the car which make it attractive to the customer. Now take that BMW and crash it into a bridge abutment on the autobahn at 200 km/h. How much is it worth now? Probably less than the raw materials (since it's harder to extract them from a jumbled-up wreck). Every atom which existed before the wreck is still there. What has been lost is the information (what electrical engineers call the “magic smoke”) which organised them into something people valued.

When the value of money is unpredictable, any investment is in part speculative, and it is inevitable that the most lucrative speculations will be those in money itself. This diverts investment from improving productivity into financial speculation on foreign exchange rates, interest rates, and financial derivatives based upon them: a completely unproductive zero-sum sector of the economy which didn't exist prior to the abandonment of fixed exchange rates in 1971.

What happened in 1971? On August 15th of that year, President Richard Nixon unilaterally suspended the convertibility of the U.S. dollar into gold, setting into motion a process which would ultimately destroy the Bretton Woods system of fixed exchange rates which had been created as a pillar of the world financial and trade system after World War II. Under Bretton Woods, the dollar was fixed to gold, with sovereign holders of dollar reserves (but not individuals) able to exchange dollars and gold in unlimited quantities at the fixed rate of US$ 35/troy ounce. Other currencies in the system maintained fixed exchange rates with the dollar, and were backed by reserves, which could be held in either dollars or gold.

Fixed exchange rates promoted international trade by eliminating currency risk in cross-border transactions. For example, a German manufacturer could import raw materials priced in British pounds, incorporate them into machine tools assembled by workers paid in German marks, and export the tools to the United States, being paid in dollars, all without the risk that a fluctuation by one or more of these currencies against another would wipe out the profit from the transaction. The fixed rates imposed discipline on the central banks issuing currencies and the governments to whom they were responsible. Running large trade deficits or surpluses, or accumulating too much public debt was deterred because doing so could force a costly official change in the exchange rate of the currency against the dollar. Currencies could, in extreme circumstances, be devalued or revalued upward, but this was painful to the issuer and rare.

With the collapse of Bretton Woods, no longer was there a link to gold, either direct or indirect through the dollar. Instead, the relative values of currencies against one another were set purely by the market: what traders were willing to pay to buy one with another. This pushed the currency risk back onto anybody engaged in international trade, and forced them to “hedge” the currency risk (by foreign exchange transactions with the big banks) or else bear the risk themselves. None of this contributed in any way to productivity, although it generated revenue for the banks engaged in the game.

At the time, the idea of freely floating currencies, with their exchange rates set by the marketplace, seemed like a free market alternative to the top-down government-imposed system of fixed exchange rates it supplanted, and it was supported by champions of free enterprise such as Milton Friedman. The author contends that, based upon almost half a century of experience with floating currencies and the consequent chaotic changes in exchange rates, bouts of inflation and deflation, monetary induced recessions, asset bubbles and crashes, and interest rates on low-risk investments which ranged from 20% to less than zero, this was one occasion Prof. Friedman got it wrong. Like the ever-changing metre in the fable of the textile factory, incessantly varying money makes long term planning difficult to impossible and sends the wrong signals to investors and businesses. In particular, when interest rates are forced to near zero, productive investment which creates new assets at a rate greater than the interest rate on the borrowed funds is neglected in favour of bidding up the price of existing assets, creating bubbles like those in real estate and stocks in recent memory. Further, since free money will not be allocated by the market, those who receive it are the privileged or connected who are first in line; this contributes to the justified perception of inequality in the financial system.

Having judged the system of paper money with floating exchange rates a failure, Gilder does not advocate a return to either the classical gold standard of the 19th century or the Bretton Woods system of fixed exchange rates with a dollar pegged to gold. Preferring to rely upon the innovation of entrepreneurs and the selection of the free market, he urges governments to remove all impediments to the introduction of multiple, competitive currencies. In particular, the capital gains tax would be abolished for purchases and sales regardless of the currency used. (For example, today you can obtain a credit card denominated in euros and use it freely in the U.S. to make purchases in dollars. Every time you use the card, the dollar amount is converted to euros and added to the balance on your bill. But, strictly speaking, you have sold euros and bought dollars, so you must report the transaction and any gain or loss from change in the dollar value of the euros in your account and the value of the ones you spent. This is so cumbersome it's a powerful deterrent to using any currency other than dollars in the U.S. Many people ignore the requirement to report such transactions, but they're breaking the law by doing so.)

With multiple currencies and no tax or transaction reporting requirements, all will be free to compete in the market, where we can expect the best solutions to prevail. Using whichever currency you wish will be as seamless as buying something with a debit or credit card denominated in a currency different than the one of the seller. Existing card payment systems have a transaction cost which is so high they are impractical for “micropayment” on the Internet or for fully replacing cash in everyday transactions. Gilder suggests that Bitcoin or other cryptocurrencies based on blockchain technology will probably be the means by which a successful currency backed 100% with physical gold or another hard asset will be used in transactions.

This is a thoughtful examination of the problems of the contemporary financial system from a perspective you'll rarely encounter in the legacy financial media. The root cause of our money problems is the money: we have allowed governments to inflict upon us a monopoly of government-managed money, which, unsurprisingly, works about as well as anything else provided by a government monopoly. Our experience with this flawed system over more than four decades makes its shortcomings apparent, once you cease accepting the heavy price we pay for them as the normal state of affairs and inevitable. As with any other monopoly, all that's needed is to break the monopoly and free the market to choose which, among a variety of competing forms of money, best meet the needs of those who use them.

Here is a Bookmonger interview with the author discussing the book.

Posted at November 9, 2016 22:24