Wednesday, December 6, 2017

Quadrupling Gross World Product -- the solution for Argentina / Afghanistan / etc.

by Karun Philip.

What in the world is 'money supply'? That is a question I asked myself at the age of 18, when I started reading business and economic newspapers and magazines. I read vast amounts of literature in the subsequent 16 years but still had no proper understanding of it in my mind. Then finally in the Year 2000, I found the answer while trying to understand the difference between the Austrian school of economics, and the Monetarist school of economics.

If you ask the Austrians, they will tell you the difference between the schools boils down to whether capital is 'homogeneous' or 'heterogeneous'. To my engineering mind, this is just more gobbledygook from the world's most dismal scientists, though there is a core of truth in that presentation. I now understand the answer in more simple terms. Mainstream economists look at money as something that exists and then is deposited in banks. The bank then has 'liabilities' on its balance sheet (i.e., it owes that money back to the depositor on demand), and they can create assets (loans to individuals and companies) on the other side of their balance sheet. They make money on the interest rate differential. The question that is begged in this model is where the original money came from in the first place. The truth is that money was created privately without the government in the first place. Governments took over a virtual monopoly on money creation only recently.

So how did money come to be created in the first place?

The answer is to look at credit (loans) first and deposits second, instead of the other way around. Credit creation is the manufacture of money. Our economies can continue to expand endlessly only because the total amount of credit created expands continually. Money supply is nothing but credit supply. Money supply expands when credit creation expands. Obviously, when credit expands, deposits expand by definition. But it is credit creation that comes first. A bank creates a deposit entry in the borrower's account when they issue a loan. The loan itself is not backed by other deposits (yet, in our new model) but simply backed by the collateral assets that the borrower pledged in order to obtain the loan. The money units in that account then represents the fractional recourse to the assets that were pledged. The bank notes issued from that account are not just pieces of paper -- they represent that fraction of the pledged assets. The reason why the bank needs to make sure it lends only to secure borrowers and good business plans and track records, is because if they did not, then people would stop honoring the checks and notes issued by the bank. The quality of the money is the quality of the credit created by that bank.

I can set up a bank even in a war-devastated poor country, where there is not yet any existing money or banks. All I need to do is decide what collateral asset I think is valuable, and tell someone "Okay, you got yourself a loan of $10,000 if you pledge Asset X to me." I then create a bank account in the borrower's name and write an entry saying that $10,000 is available to him. I give him a checkbook, which he can use to order me to transfer money to anyone else's account. If he needs cash withdrawals, I print out a piece of paper that has some fraud protection coding scheme to detect counterfeiting. In a competitive 'free banking' environment, each bank would print their own notes, which, apart from having the total number of 'dollars' (or whatever common word is used for the unit of money), would also have the bank name on it. Now, if other banks start thinking that I am not collecting good collateral or not making loans that are 100% collectible, they may start accepting my notes and checks only at a market-determined discount to the face value.

Over time, people stop thinking about the pledged assets at the bank and think of money as represented by the paper notes itself. In earlier times, banks developed a system of requiring other banks to purchase a certain amount of gold reserves in proportion to their deposits, and customers would be promised an amount of gold in exchange for any note. This served as a quick and easy way for banks to determine whether other banks' notes were worth accepting or not simply by checking their gold reserves, or being part of a consortium that enforces and oversees members gold reserve requirements. With this system, the accepting bank did not have to study the entire credit portfolio of the issuing bank in order to determine the worth of the note. It is important to note that the gold reserve requirement was only a fraction of the total deposits. This is because banks calculated that only a small amount was demanded in gold most of the time.

Now, it is worth taking the time here to understand what a 'run on the bank' is. Note that in a system structured as described above, the depositors are told they can withdraw money any time. Yet the loans are to be paid back only over time. What you have is a mismatch in the maturity of the deposits and the maturity of the loans. Now, imagine you are a banker. If, all of a sudden, some event makes people want to withdraw all their money and store gold instead, you will have a mismatch in the liquidity of your assets (loans) and liabilities (deposits). You told the depositor he could have his money any time he wanted, and promised him gold, but now in this crisis you are unable to pay. So you start calling in your loans and seize collateral assets and sell them in the market. If the event that caused this 'run' on deposits is one that affects all banks, then everyone tries to sell assets at the same time, with not enough buyers, and the whole banking system can collapse.

In modern times, we are still experimenting with alternatives to the gold reserve requirements. Now, governments have taken over the task of printing notes, and can print as much as they want in times when demand for liquidity surges. But they got themselves in great trouble when they, for political reasons, tried to print more money so that more credit could be created and the economy could expand faster. The problem with that approach is that when money supply started with credit rather than deposits, the bank had an incentive to ensure that only good credit was given. As long as credit only expands at a pace that the knowledge available to create new business expands, things are fine. But when the government tries to arbitrarily expand deposits first, creating a balance sheet necessity for the banks to lend, then the excess money supply -- the money created without enough new knowledge of productive businesses, without enough new goods and services -- manifests itself in increased prices of the existing goods and services. In other words, price inflation, caused by an artificial increase in deposits first, rather than good credit driving money supply expansion.

Milton Friedman said that inflation is always and everywhere a monetary phenomenon. What he misses is that accelerated money supply expansion (also called money supply inflation in classical economics, which causes some confusion in lay people who use the word inflation to mean price inflation) need not cause inflation. If the number of goods and services actually desired by the population and deliverable by entrepreneurs increased, then credit can expand at that rate without inflation. Inflation happens when the expansion of credit is faster than the expansion of entrepreneurial knowledge and consumer demand. The limit to inflation-free money supply expansion is in the limit to the expansion of productive knowledge in the heads of people.

Friedman's discoveries were valuable though, because it allowed a government-created money system to regulate itself by limiting money supply expansion if inflation seemed to be picking up. But it also hampers the rate of growth potentially possible. The true solution is to use our model of looking at collateral-backed credit that back the deposit liabilities. But instead of using fractional gold reserves, the Internet today allows us to require banks to publish their credit portfolio, including delinquency, default, and prepayment data. The notes issued by banks would then be bought and sold in the currency markets based on solid information about the credit portfolio, and Internet-based market data on their market price would be available to every shopkeeper and entrepreneur equipped with a Web terminal.

Now, it is interesting to note that the market is already moving toward such a structure. Not in the consumer deposit arena but the arcane world of bank-to-bank finance. Constrained by government-imposed restrictions on lending, banks devised a way to create loans and sell pools of loans directly to investors. People who manage money do not just leave it in a bank and rely on the bank to keep it safe. They find loans or pools of loans and buy little pieces of such pools. This process of pooling loans and selling off pieces directly to investors, bypassing the traditional deposit system completely, is called securitization. Securitization is how banks circumvented the strangling restrictions of government-regulated deposit-centered banking. Money supply increased far more in the last two decades, with little or no inflation, than Friedman's theory of inflation predicts.

But most of this money supply expansion, credit expansion, has happened through the device of securitization. Note that securitization removes the liquidity mismatch problem that causes bank runs. The investor in a pool of loans, or any pool of future income flows, agrees to take as much money as comes in. If there is a default, the investor takes the loss. A risk-averse investor can simply buy the first rights to any money coming in and accept a lower or even zero return. The investors who assume the last rights to any money coming in and the first position to take a hit if there is even a single default, would proportionately get a larger interest rate. Sophisticated investors like insurance companies tend to buy the first loss positions of thousands of deals, and so even if some of them default, the net return is high enough to compensate the insurance companies.

As securitization booms along -- it grew by $500 billion in 2001 and will accelerate further in the coming decade -- bank deposits are well on their way to becoming obsolete. Investors will choose the risk portfolio they want their savings to be invested in, and be responsible for the loss if the assets they chose default. Bank runs become obsolete. Instead of having fractional gold reserves, we will now have 100% asset backing on every such bond we buy. The currency used by a country that uses all or largely securitized credit will not be subject to the kind of volatility that countries like Argentina have witnesses. Indeed, by allowing banks to issue bank notes -- or even traveler's checks -- that are backed by specific assets that are disclosed on their web site and traded in the market, Argentina can solve its liquidity problem in one fell swoop.

The implications to poorer countries including war-torn Afghanistan are more profound, as I explain in my book Zen and the Art of Funk Capitalism. The key step here is the expansion of useful knowledge in people's heads. All we need to do is allow any number of adult training schools to enter the country, and mandate that they disclose data on their effectiveness at improving the income of their students. Student personal data may be kept confidential, even while disclosing effectiveness in various aggregated segments. With this data, banks and investors will be able to create loans to fund effective training. And as we discover more and more ways that work, credit can expand ever faster. Many schools may also offer a stipend to attract students, as long as they are confident that the training will provide the student with future income potential that will cover the stipend as well as the cost and profit of providing training. Or at least, there will be few enough defaults, that the interest on those who succeed will be sufficient to cover the defaults. With the increase in money supply going directly to students, anyone engaged in learning useful skills will have money. That in turn will spur spending, and create entrepreneurial opportunities. But the place to inject this money is not through huge government spending plans. Instead, an injection of credit in order to finance adult training will inject the money as well as provide the skills needed to use that money and knowledge to produce things that people want. This injection of credit will be money creation that is backed by the knowledge in the student's mind, and the purpose of the loan is to provide such knowledge. Market competition and intense monitoring by creditors will be the most efficient way of discovering all the opportunities in each region of the world and for each type of person. Over time, we will discover many new skills that are effective in producing income -- ideas collected by observing their success in the market, rather than trusting only our own imagination or the imagination of a government bureaucracy (!) to come up with the specific skill that will be useful to each specific type of person.

If needed and possible, governments or charities can offer to buy the first-loss position on pools of adult training loans. This would provide liquidity to the adult training loan market. But over time the system will surely discover through competition the things that work and those that do not. Who knows, those who buy that first loss position for pennies on the dollar may see windfall profits when that country becomes knowledgeable with relevant skills for the coming millennium. The time to try this out is now. Economic underdevelopment is causing fundamentalism's rise in various parts of the world. This poverty is only because of a misunderstanding of how credit and adult training work, and how they ought to be re-organized to be competitive and market driven.

If the world can come together and move us to a new world order of high and high quality skills training, I have no doubt whatsoever that Gross World Product will quadruple or more in the coming decade.

The author is Chairman of Tranquilmoney, Inc., a company that provides a software platform to manage securitization and structure finance deals. Here is the link to the Training Overview for Cortex.

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