Monetary supply: The role of borrowing in economic growth

Note: This article is concerned with a less important issue than my previous post. The question of monetary supply becomes simple if we first recognize the fundamental issue of whether, in the first place, we need banks.

In my previous article, Without banks: A proposal for a prosperous and stable economy, I discussed the role of banks in the money supply. I described how an economy with institutions that lend long and borrow short is inherently volatile and exposed to risk. I proposed that this volatility and risk could be avoided by phasing out the institutions that lend long and borrow short - eventually banning this business model altogether; requiring that all loans be covered by credit explicitly provided for the duration of the loan.

Towards the end of that article, I added a monetary proposal: shifting to a fixed, or predictable, volume of currency.

Central banks, with their ability to print limitless amount of money, currently exist for two purposes. One purpose is reasonable, if we are to have banks at all: central banks create money in times of crisis so that they can bail out depositors at failing banks. The other purpose is the subject of this article: creating money in normal times to 'stimulate' the economy. That is, to poke people with the stick of inflation, 'stimulating' them to deposit their money with banks.

I discussed how banks inflate the supply of money by a factor of about 10, and how the varying moods of the banking sector can lead to economic booms as well as busts. A 'boom' occurs when all the borrow-short/lend-long institutions lend freely, to the maximum amount they can. This increases the effective amount of money in the system vastly, and there's a lot of economic activity going on - much of which later turns out to be waste. A 'bust' occurs when it dawns on people that much of the economic activity during the 'boom' was waste. This means that lots of the loans that were made were bad loans that aren't going to be repaid. This threatens the lenders' capital reserves, which are already low because they've been lending as much as they could. So the only thing that they can do is decrease lending. I showed in my previous article how, if lending is decreased as a proportion of incoming deposits only by 10 percentage points, say from 90% to 80%, this eventually reduces the effective amount of money in the system by 50%.

When the effective amount of money in the system is decreasing, how are even those borrowers, whose loans might have seemed sensible before, going to repay their debt? Many of them aren't; there's insufficient money to go around. So now, as banks lend less, borrowers are increasingly going bankrupt, producing what is called the bust.

I argued that, in an economy with no lending long and borrowing short, and with a fixed supply of currency, there would be no boom and bust cycles, while sturdier bridges between prospective lenders and prospective borrowers would arise.

However, if the supply of currency was fixed, the role of borrowing in such an economy would be less.

The reason is that, in an economy where the supply of currency is constantly being inflated, everyone who holds currency has to lend it in order to just stand still. If you keep your money buried in a jar, its value is eroded over time because the amount of money in the economy is steadily increasing, compared to the amount of services and products. Whatever the economic growth, which would normally cause prices to slowly decrease due to increasing production - the money supply grows more. Holding bare currency is thus not an effective store of value.

In an economy where the monetary supply is fixed, the reverse is true. Holding bare currency does become an effective store of value. On the face of it, this sounds good. It may very well be. Banks, however, would have you believe that it isn't. The reason they would have you believe that is, in an economy where currency is a good store of value, their business would do much worse. If money is losing strength, people are forced to put their money into banks. It's common sense: put the money you don't need in a savings account, or else you're losing value.

Since banks are institutions that lend and borrow on a massive scale - a magnitude larger than even the amount of issued currency in the system - it is important for the health of their business that everyone believes that lending and borrowing is crucial to economic prosperity. Since everyone understands that lending and borrowing is not crucial for their day-to-day life, banks would have everyone believe that lending and borrowing is crucial for economic growth. The classic argument is, entrepreneurs need to be able to borrow money to create new products and services that we all need. But do they?

[Edit: removed an unnecessary argument that was probably defective.]

Does Intel need to borrow money in order to build a factory that will manufacture the next generation of faster processors? They do not. They have cash. Does Microsoft need to borrow money in order to build a new software product? They do not. They have cash.

I do not believe that all businesses can be bootstrapped. However, I do believe that investing is best when done by people who already have money - who have proved that they have the capacity to earn it and keep it; who do not need to borrow it from a bank. And the best way for such investors to be repaid is through an equity stake, i.e. by earning a proportion of future profits. If their investment succeeded, i.e. if it has increased production of a resource that is valuable to the economy, then their dividends will pay it back. This is not a zero-sum game, because everyone can be continuously investing in their businesses to improve production, and if all such investments are smart, then everyone will be paid back - not necessarily in a larger total amount of money, but with larger total purchasing ability, than if they chose not to invest.

I do not believe that bank-like loans are as crucial to economic growth as banks and other borrow-short/lend-long institutions would have us think. There is a case to be made for borrowing on a reasonable scale. However, the rampant lending on which our current economy is based, fuels boom and bust cycles, encourages a gambling culture of investment, and introduces a systemic risk.

In a fixed monetary supply economy, people would still borrow and lend, but more investment would be made by people investing directly into things they think are worth investing, acquiring equity stakes. It would be the reasonable way. It in fact already is; however, we now have short-borrowers/long-lenders who make it easy to 'invest' money with them. But it is not 'safe'; and it is not healthy for the well-being of the economy, because the people who might otherwise invest money directly into plans they think are worthy, instead pass on their money onto agents whose activities have more to do with gambling and where genuine production improvement is just one of the possible side effects.

And if it turns out that people in a fixed monetary supply economy do not invest or lend enough, and that growth suffers as a result - we can always cause the monetary supply to start to steadily increase, thus poking people to consider investing their savings. The economy might benefit if people used their minds and spent more time thinking about where to invest; rather than abdicate responsibility and do the default thing, putting their money into equivalents of banks.

Comments

boris_kolar said…
I don't think intentionally inflating currency is possible in a truly free market. After all, in free economy, many currencies may coexist. The market will demand currency that doesn't inflate (in fact they will demand a currency that slightly deflates) and someone will supply that demand. Banks supply that, but at a great cost.

The cost is that banks are backed by government, which can produce money out of thin air, effectively stealing from anyone who trusts official currency. Those banks consider themselves too big to fail and rely on government theft.

Instead of increasing supply of money, it would be better to decrease it by the exact quantity of production growth. A unit of money could then be seen as a share in all production. Banks would then merely have an obligation to store the currency, anything more would obviously have risks attached. And if production ever decreased, that would motivate people to replenish their wealth by producing more.
boris_kolar said…
Or to put it in simple terms:
1 currency unit = 1 trillionth of GDP
denis bider said…
boris: "I don't think intentionally inflating currency is possible in a truly free market. After all, in free economy, many currencies may coexist."

You are saying, inflating a currency does not work in an environment where everyone is free to choose their currency.

This does not appear to be currently the case anywhere in the developed world. Countries will go after you if you offer an alternative currency, and do not generally tolerate foreign currencies for domestic transactions. Obviously, this is because the countries' own currencies are inflationary and therefore unattractive, so people must be forced to use them.

It is a clever thought that a libertarian government might not need to mandate an official monetary supply at all.

The problem is, however, that an arbitrary currency chosen by the market would probably be good enough and stable enough in the short run, but inferior in the long run to a currency guaranteed to be of fixed supply by constitution. Gold, for example, is a point in fact.

However, we do live in ever more technologically advanced times, and perhaps it is time to let the markets experiment with currencies, and see after a while what the best one is that technology allows.

I have several ideas, of which the fixed monetary supply is just the simplest. I think we could do even better if we allowed the market to pick a currency, though.
denis bider said…
Oh, the GDP idea... it would kinda work if there was any way in which you could directly measure GDP.

But there is not.

It works the other way around. If you have a fixed supply currency, then a decrease in aggregate prices of things tells you what the GDP improvement is.

I don't see how it would be a good idea to switch things around, and base your currency on GDP, because then you're in a world of trouble trying to ensure you're measuring GDP correctly.

GDP is so frequently used that we have come to rely on it, and it is indicative in comparison, but what the initials really stand for is Grossly Padded Data. There's stuff in GDP measurements that is completely arbitrary, and totally subject to manipulation by people who would like things to appear in certain ways. Not at all, in my opinion, a good measurement on which to base the volume of your currency.
boris_kolar said…
A good point about GDP. Looking at definition of GDP (actually pretty well defined, proposed alternatives are much worse, such as "happiness index"), a simpler measure may be used to replace GDP and still provide accurate (I bet it would turn out to be more accurate) measurements about economy growth. Right now, without thinking about it much, it seems the sheer volume of trade would fit the bill nicely. In libertarian society, everything is a trade (even employment can be seen as trade of services between two companies, one of them being a single person company). And without measurement you can't have currency or market anyway (or both will fail when kept outside bounds of reality). So I hereby hypothesize volume of (official) trade in libertarian country is both easily and accurately measurable and more accurate than GDP. And another related hypothesis: if a there is more than negligible black market present, the country is not libertarian enough.
playadancer said…
I'm with you on the idea of fixed monetary supply. The banking industry has helped to create a situation that moved our economy from a currency based to a credit based system. They have removed currency out of the system increasing the need for credit. Common sense tells us this a credit based economy is inherently instable. The only problem with the fixed monetary supply is that population increase will require that the fixed amount be raised from time to time to accomodate more people.
denis bider said…
I agree that the whole credit card trend in the United States is weird. Plastic is a common form of payment in many countries, but in other places this tends to be used as a convenient method of payment, whereas in the U.S., people use it heavily to borrow. I don't get that. Borrow to buy a huge TV? Um... come again?

However, if you don't have a government that takes proactive legislative and enforcement steps to keep the economy from developing an equivalent to banks, it looks like this sort of thing is going to develop regardless of the monetary supply. A fixed monetary supply makes banks more vulnerable, but this didn't prevent the mortgage crisis of 1873. Note that this was before the Federal Reserve, and back when the U.S. was still on the gold standard, and yet the crisis was remarkably similar to today's.

The question that's bothering me now is, should the government take proactive steps to keep the economy from developing the equivalent of banks?

It certainly looks as though the abdication of responsibility, the disassociation from your investment that you commit when you put your money in a savings account, eventually leads to evil. The combination of agency problems and human herd mentality leads to huge trends of malinvestment.

But is this something that can be addressed at a systemic level, or will human nature undermine any attempt to counter this, and find new ways to jump into the abyss?

The whole point of libertarian philosophy is to have a small, well-defined state which does what it's supposed to, and doesn't babysit people. But what if people do need babysitting?

What if, if nobody babysits, people will just jump into the abyss?

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