Through the past three posts of the “how money works” series I have talked about my proposition for a new monetary system and how this idea could replace our current system with a means of exchange which is organically created as society’s needs of exchange increase. The system works on a credit/debit basis with the total sum of debits and credits at any given time totaling zero, a system which has no debt and has no intrinsic limit besides the true needs of exchange. However one of the big questions people have had about this system is, how does this system allow to replace a loan based economy? How can a person start a business or acquire an expensive good (like a house) under this system? On today’s post I will explain how this system allows people to do these things in a much more organic way than the current economic system.
Let us remember that in this system “money” is simply going to act as a means of exchange and NOT as a means for the accumulation of wealth. All transactions have a given living time (probably one year would be the most convenient length) and if the credit is not spent the transaction is reversed. Money is therefore destroyed inevitably preventing the accumulation of exchange credit within the system by any single party. How do you accumulate wealth then? Well you can certainly accumulate wealth by buying goods which are TRUE stores of value (this is the only sound way to accumulate wealth). So for example you would buy gold, silver or other valuable commodities with your credit if you wish to accumulate value for later purchases.
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However this system wouldn’t be a realistic replacement for the current one if people aren’t able to buy houses and start businesses in the same or at least a similar way to which they do now. In this system there are various solutions to the problem of replacing a “loan based economy”. We first need to remember that there is no interest or debt in this system and since the debit potential of people is limited to their credit earning history there is simply no way to go into what we know today as “loans”. Since money acts as a mere means of exchange and NOT as a store of value the idea of loaning money loses meaning.
Let us suppose Peter has just turned 25, married Jane and wants to buy a new house. Under the new system there is simply no such thing as a “mortgage” so things must work out a little differently. The person who built the house can offer Peter and Jane the possibility to live in their house on a rent/purchase mode in which they pay a given amount of rent every month which also purchases a small percentage of the house. Peter and Jane are purchasing their house little by little every month (as in a mortgage) but without getting into any bank loans. Large purchases of any property type can be carried out in this way. The percentage of the house owned by Peter and Jane increases with time until they own the house. In the end the builder of the house has made the money he or she wanted and the same exchange was carried out without the payment of interest to ANY lender.
The problem of business starting is a little bit more complicated since businesses need to have some sort of liquidity to be able to get started. There are mainly a couple of viable solutions to this problem. The best one is the creation of business starting corporations which will have X members who will put credit towards someone’s business in exchange for ownership of part of it (think something like stocks) giving the owner the possibility to “buy out” the investors at a later date at the new value of the company (or to keep them as passive partners as in stocks). Note here that all investors are taking a potential risk when they invest in this business, something which will decrease the amount of started businesses in the economy. When you consider that more than 95% of all started business ventures fail it is important to wonder why this is the case. The system definitely needs more stringent conditions for business startup and this model provides this filter as the people who invest on the business are interested on its success. It eliminates the start of businesses with shaky grounds.
Of course this system doesn’t allow for “loans of money” as money is no store of value but there is nothing on the system that prevents the loaning of means of wealth accumulation (there can be “commodity debt”). A person can therefore loan another one 1kg of gold and the other person promises to pay 0.1 additional grams of gold for everyday they keep the gold. The person can now go to the market, sell the gold for credit and use the credit to do whatever they want. The person later on needs to work for enough credit to buy the gold necessary to pay for the commodity debt but since the money supply is not limited the person can always generate enough credit to pay for this interest provided that they can work to earn the necessary means of exchange (credit). The interesting thing here is to consider that this type of commodity debt can work with ANY commodity and the person later needs to return this same commodity and NOT money. The means of exchange are completely separated from the means of wealth accumulation.
Of course it is evident that there is a natural limit to the commodity debt as the amount of commodities available is limited and competition for commodities becomes larger if people desire to take commodity loans or accumulate wealth. This is an interesting consequence of the system because it limits the accumulation of wealth to what is naturally possible, there can be no accumulation of wealth above the existence of means of true value. However there is no limitation on the means of exchange as this is the function of money and NOT of commodities. The economy can continue to function perfectly but restricts the amount of wealth anyone can accumulate or loan to whatever stores of value are available.
Let us suppose Peter works as a carpenter and wins 1000 credit units each month (his customers get debits for purchases and he gets credits for them). He then spends this credit buying groceries, paying his wood suppliers, paint suppliers, varnish suppliers, tool suppliers and the utility company. In the end of the month he has 200 credit units which he can spend however he wants to. He can now buy things he wants such as services (go out to dinner or an amusement park) or he can get things with this credit (like a new netbook, some hobby supplies, a new carpet, etc). If he wants to save this money for a larger purchase he can do so for a year (if he keeps it anymore it will extinguish (with its matching debit) as there can be no substantial accumulation of the means of exchange) or he can go and buy a true store of value (he decides to buy platinum). After this platinum is bought he can then sell it later on to get credit again (at whatever the price of platinum is).
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If everyone bought platinum it would become more and more expensive unless people start to sell it (supply and demand) and therefore the accumulation of wealth using platinum is limited to its supply. This is a natural consequence of the system which makes the economy sustainable, wealth accumulation in commodities is limited to the availability of valuable commodities. However other means of wealth accumulation such as the investment of credit into a business (stocks) would still apply. If metals are too expensive Peter can use his credit to buy a part of an existing business or to contribute to the creation of a new one (business startup corporation). As you see if valuable metals are in short availability the potential for exchange does NOT diminish (as it would on a gold based economy) as money is created dynamically as it is needed. Again, the success of this system would lie in the separation of the means of exchange and the means to store value. No one can control the money supply as it is controlled by the needs of exchange :o)
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Daniel,
Very good post. You directly addressed all of the questions I had yesterday and now I have a much better picture of how the system would work in practice.
One issue I think the housing system has is that the house being payed off in small installments to the company who built it would likely cause some cash flow problems for the company because once they have built a house they will need to start building more. But if they are not getting lots of money in quickly (like they do from the banks who pay the property developers and give the homeowner a loan in our current loan based system) then they may not have enough capital to build more property. And if they are running out of money, would they not be able to repossess and sell people’s houses because they will have a majority share in it? Also, there will inevitably be people who will default on their payments (due to a job loss or something), then it might end up just as bad as the current system, but possibly worse because there will be lots of fairly small property developers with part ownership in houses that people are defaulting on instead of powerful banks. This could end up with a catastrophic situation with the housing market like in 2007-9.
Also, in this system because people are putting money into commodities, of which there is only a finite supply, wouldn’t this probably mean that the price of gold for example would just keep going up which would be unsustainable (much like the bullish housing market pre-2007) and would, at some point, have to crash like the current economy inevitably does every so often. This could mean that there is nowhere really safe to store wealth which would send everyone into a blind panic probably causing the markets to go crazy.
Regards,
Mike
Hi Mike,
Thank you for your comments :o) Ok, definitely some things need a better explanation! (reason why I’m thinking a book might be needed to explain this whole idea). Let me try to answer your questions.
The first problem you pose which deals with defaults is a logical problem of any financial system, someone will fail to pay on their obligations. If this happens then the consequence is pretty simple, the person gets out of the house and the property owner pays the share which has been covered with previous payments. However the way in which this protects you from a “housing crash” is that the deal is not done through a bank but it is done directly between the owner of the house and the person who wants to buy it, this means that the person who is selling the house will have a natural tendency to ensure that the person who is getting into the house will not default on debt. The housing market will therefore have a very small sub-prime component as few home builders would be willing to take the risk of relying on a person who would default since they would need to take the burden of the default. The 2007-09 crisis was caused by an excess of sub-prime lending because loans were repackaged and sold such that the original lender passed the burden to someone else and therefore had no interest in whether or not the loans would get paid. This generates moral hazard which does NOT EXIST when you deal directly between the buyer and the seller. The person here who gets the house does the deal directly with the buyer and therefore the builder has a primordial interest in the buyer’s financial condition.
The problem of liquidity is also addressed quite easily. If liquidity is a problem then the housing companies can demand a down payment of a certain proportion of the house, such that they will ensure that they have the necessary liquidity to continue building new homes. Bear in mind that this system puts a halt on excessive growth as it stabilizes economic growth to what is actually possible with the resources at hand. There will be no home-building bubbles as home building will be limited to available resources as the accumulation of wealth by the population and their ability to pay is never out of control. A home builder builds a house and sells it to someone they know has the financial ability to pay, since most people will fill these obligations they will be able to build new houses. However there will not be an artificially large amount of wealth (created from thin air) caused by sub-prime loans given on the incentive of short term profits derived from the repackaging of these loans as derivatives.
Regarding wealth accumulation in commodities and a “crash”, you’re ignoring the dynamics of supply and demand. Let us suppose that everyone wants to buy commodities to accumulate wealth. If the commodity is hoarded and it is not resold then prices increase and demand starts to go down, at some point the people who initially bought the commodity see profit and start selling it and as the price starts to drop people start to buy it again (seen as a bargain). You see the classic cycles of supply and demand. However these cycles will not be “huge bubbles” that cause crashes because you’re limiting speculation (no leverage to buy commodities) and commodities are not tied to the value of money (as the system is not inflationary in nature). Yes, commodities will go up and down but they will not have exponential rallies with huge crashes because the growth on the system will be effectively limited as you cannot create money out of thin air (money supply is limited to the necessity of exchange). An unleveraged trading system were physical goods are exchanged practically eliminates extreme market cycles, although the cycles will work on a healthy market basis. The fact that money doesn’t have intrinsic value but acts merely as a means of exchange is also of great importance here :o)
Dramatic bull runs and crashes are a result of leveraged speculation, moral hazard and the need for exponential growth to sustain a system were all money is created as debt (while the interest needed to pay that debt is not). Overall this system guarantees the absence of extreme market cycles and limits resources to what is available. The system limits wealth accumulation to the availability of commodities and production (think when using stocks) and completely avoids these “crash and burn” scenarios. Feel free to post anymore questions you may have :o) Thanks again for commenting,
Best Regards,
Daniel
Hi Daniel,
Thanks again for answering my questions, particularly with such a substantial and easy to understand answer. I am, at the moment, an amateur with economics and definitely need to improve my knowledge (which you are helping me greatly with by the way). I’m only 16 and am going to start studying economics next year in the hope of doing an economics degree in a few years time. I am very interested in what you do and if you wouldn’t mind would you be able to give me a quick explanation of what Forex and mechanical/automated trading is and what you do.
Regards,
Mike
P.S. I think this would be a very good subject for a book.
Hi Daniel,
the system you describe will remain utopia. No one can be obliged to take part. If you are very desperate and someone shows you the last ray of hope involving a usurious interest, you will grasp it. If you are very demanding and not satisfied what your current situation is giving you, you will be willing to take some risk even if it is not inline with the official moral.
Greed is inherent to humans. Regardless how you design a system, most participants have to be loosers. Equality and fraternity can’t be guaranteed by design, but the opposite can. I don’t want to live in a system where the government knows best what is good for me and all man are equal. I like an unfair world as long as one has a chance to cope with it, at least to a bearable degree. I like bubbles and crashes because they are able to create new rules. If you didn’t succeed in a previous environment, you get a new chance after the crash. The worst thing you can produce is a system where is no hope. It does not matter where this hope comes from.
Best regards,
Fd
Hi Fd,
Thank you for your post :o) What you say is true, greed is inherent to human nature and almost any system can guarantee the success of the “intelligent-greedy” by design. However I believe that the majority of us hope to live in a world where everyone has – although not the same success – at least the same opportunities to achieve them. My proposed system does not equalize everyone, nor does it remove the hope of achieving more wealth than the rest, the system merely guarantees that wealth accumulation is directly tied to production and resources meaning that you just cannot build your success upon abusing others, robbing them of their wealth. I believe that we all want a system that offers us a chance to succeed but a chance in which we all have the same initial opportunities, a world where the people who produce wealth are those who work hard and produce real value for society. Why does a banker make billions while those who produce the true value of society go broke? I believe we can and wish to do better than that as a society! At least I know I do. Thanks again for your comment!
Best Regards,
Daniel
It is not that unrealistic, this system. It will do the main role of the money we need,- to exhange and still we will be able to accumulate the wealth using the TRUE stores of value. It is simple and clear.
A problem I see is that we will not be able to speculate on the valutas market, thought the comodities will still be there and probably there would creat itself bubles stronger then ever in these markets. Also we will need this system changed in the hole world at same time or else it will isolate such a country from the rest of the world.But everithing is posible.
Hi Daniel,
As I discovered recently, similar electronic money systems already exist, however they are interconnected with the traditional national currencies. Their aim is to speed up money circulation for small and medium businesses and they pay no interest.
One of the oldest systems is the Swiss WIR, which was founded in 1934.
A more recently applied system – which is based on an open-source infrastructure – is C3 which was introduced in more Latin American countries.
Bernard Lietaer’s idea is that big, monolithic systems will fail over time, and this is the case with monetary systems too. Like in biology, diversity is the key, money has to work at different levels of the economies with different functions and they has to be interconnected. Here’s a video about his thoughts: TEDxBerlin – Bernard Lietaer