Sunday, May 20, 2012

Insight For A World Reserve Currency


Worried about their currency not being respected as much as before, some Americans have started to murmur about the value of the dollar and its role as a reserve currency for the world. Add to this the fact that the Euro seems to be going downhill nowadays and you can understand why there has been calls to return to the gold standard, a measure that some people believe will make of the dollar “sound money” again.

Unfortunately, the fundamental principles involved in this matter were barely mentioned if at all during those murmurs. But without developing an understanding of the principles involved, the full discussion of this subject – if and when it comes -- will be a waste of time. What follows is an attempt to elucidate the matter to the extent that it can be done, and thus get to the principles which are involved in giving a currency its value.

Let me start with an example. Twin brothers Peter and John who think alike marry twin sisters who also think alike. Each of the brothers inherits the same amount of money, and they launch the same sort of manufacturing business but do so at opposite ends of the city. Each of the sisters also starts her own architectural business away from each other. After a while, both brothers see the need for a bank loan to expand the business, and so they approach the neighborhood bankers who are not twins and do not think alike.

Peter's banker says to him draw up an inventory of the machinery and real estate you have then come back and we'll discuss how much we can lend to you. I have it right here, says Peter, and he shows the banker a list where the bottom line says one million dollars ($1,000,000). In this case, says the banker, we'll extend to you a line of credit in the amount of one million dollars. Peter goes to his wife and tells her what happened. Too bad, she says, because I have three talented architects in my own business but very little in terms of machinery or real estate. We generate of lot of sales, make a good profit, and I could do better if the bank would lend me enough money to do two things. I need to print an attractive sales kit showing all that we have accomplished up to now, and I need to hire and train a sales force that will go out and seek new customers. But from the looks of it, I have the feeling that the bank will not lend to me because I have little in terms of capital outlays.

At the other end of town, John's banker says to him draw up a balance sheet for the last full year of your business, then come back and we'll discuss how much we can lend to you. I have it right here, says John, and he shows the balance sheet to the banker where the top line says three million dollars ($3,000,000) in sales, and the bottom line says thirty thousand dollars ($30,000) in profit. Impressive sales but a small profit, says the banker, and I suppose you want to borrow money so as to improve on your productivity and thus generate a better return. Exactly, says John, and the banker says he will extend to him a line of credit in the amount of one and a half million dollars ($1,500,000). John goes to his wife and tells her what happened. She jumps for joy because she employs talented architects who generate a lot of sales and profit; and she knows she can do even better if she advertised. To know that the bank will lend her as much as half her yearly sales is to know she can expand the business to its full potential.

We see from these examples that there are at least two ways to evaluate a business. One way is to base the valuation on the amount of wealth that the business generates. The other is to valuate the business based on the amount of capital it has already accumulated. Which way is the better way? Well, in reality this is not a fair question because other variables come into play when valuing a business. There is, for example, the question as to where the economy stands at the time of valuation, what sector of the economy the business is in, how the sector is expected to perform in the future, what kind of management the company has and so on. But we assume for the purpose of this discussion that all of these factors have a negligible effect, and we ignore them.

We now examine a few other principles before we can resume the discussion on the currency. To this end, we imagine a spaceship full of human beings getting stranded on a planet that looks like earth in terms of the plant and animal life it contains. It is not inhabited by indigenous intelligent beings which makes it easy for the people from Earth to colonize it. The earthlings -- now calling themselves people of the planet -- understand they will be here for several generations without anyone from Earth knowing where they are or what happened to them. Thus, they decide to make the best of a bad situation by settling in and putting down the foundation for a whole new society to emerge and to evolve on this new home planet.

The first thing they do is establish a system of valuation for the goods they produce and the services they perform. They know they will soon be able to print money which they will use as a medium of exchange but until they do, they institute a system of barter that is based on the relative value of the goods and services they exchange with each other. Because the population is small, they do not rely on the marketplace to determine the value of each item. Instead, they consider the egg to be the unit value of the barter currency, and they price everything else accordingly. For example, when it comes to the proteins, a chicken is worth ten eggs; a lamb is worth ten chickens and a cow is worth ten lambs. As to the grains, legumes, fruits and vegetables, the people of the planet fabricate a basket, the content of which is given a value depending on what that content is. For example, a basket of apples is worth five eggs; a basket of wheat is worth seven eggs; a basket of mangoes is worth a chicken plus two eggs and so on. In the services, a haircut is worth half a dozen eggs and everything else is bargained for. The arrangement is not tailored to function like a commune or a system of free enterprise; it is something in-between.

Years later, the population has grown large enough for the people of the planet to move to the next stage. They print money, call it the Mighty Egg (ME) and use it as a medium of exchange. They also introduce elements of the free market economy where the forces of supply and demand are allowed to determine the relative price of each item. They elect a woman to operate the printing press, and call her the banker. But the economy is not yet a fully fledged one, and so the banker estimates how much goods and services will be produced each day, also estimates what the price of each item will be on that day, and does the math. She comes up with a figure and prints money in that amount.

The people of the planet muddle through for a time but after a while things start to go wrong, and everybody feels it. However, because the people are still nice to each other -- being in it together on this isolated planet -- they do not complain right away. With time, however, enough cracks accumulate in the system to create one big problem that has several sides to it. This is when the people decide to face up to the reality that they have a serious situation and that they must do something about it. They elect a number of individuals from among their ranks and delegate to them the power to go sit with the banker and discuss the situation on their behalf. The delegation meets with the banker who says she does the best she can to assess how much of each item the people of the planet will be producing during the day, and she prints the corresponding amount of money. But the members of the delegation reassure her that the mismatch between her assessment and the reality is so minor, it is not the problem they came to discuss. So then, what is the problem? she asks.

They say it is the way she distributes the money. To respond to them, she picks yesterday's example and explains what she did. She says she estimated that the planet will produce two hundred thousand (200,000) Mighty Eggs (MEs) worth of goods and services, and she printed this much to serve as money supply for that day. She divided 200,000 by the 20,000 inhabitants of the planet and got the number 10 which represented the number of MEs there was per capita. She distributed the money to each family according to its size. For example, a family of 4 received 40 MEs; a family of 7 received 70 MEs and so on. But this is precisely what is wrong, they say to her, because while the move may be laudable as an egalitarian gesture, it sets up a flawed situation whereby people are paid not for what they accomplish but for being there. They ask that the system be amended whereby each person will be paid according to merit based on what they have accomplished say, the day before.

We'll try that, says the banker, and she tells the people of the planet to get ready for a whole new social experiment, one that is based on meritocracy and not on egalitarian principles. To this end, she asks everyone who is of working age to pick ten people at random at the end of each day, and evaluate the work they did on that day. The people are to vote at the computer terminal she programed for the purpose when they come to pick up their salary at the end of the day. The thing everyone knows is that the computer is the one they had on the spaceship; it is so advanced it recognizes each person and will disallow anyone from voting for themselves.

Things went well on the first day of the experiment in that people got paid almost as much as before plus an allowance for the dependents they have. As a result, the price of goods and services remained more or less stable. But by the next day, and for every day after that, the pace of things picked up. What happened was that some people started to get paid evermore with each passing day. This meant that more money had to be printed, a move that resulted in prices inflating evermore with each passing day. It took little time for inflation to turn into hyperinflation, and the people whose salary did not keep up with the rising prices revolted. They asked that things be returned to what they were under the old regime; the banker agreed and so ordered. And she followed by appointing a commission to find out what went wrong.

After a thorough investigation it was revealed that a system of “you scratch my back and I scratch yours” got into the works and permeated the system. While it was true that people could not vote for themselves, they could form cabals and protection rackets whereby the members could vote for each other. This is what happened, in fact, as the people voted the highest grade for one another, a fraud that the computer did not detect. Those who got ahead as a result left behind those who were not adept at playing this sort of social games. In the end, it became clear that the system of meritocracy got corrupted by the fact that instead of true merit being attributed based on the work done by each individual, a false merit was attributed based on the political abilities of some individuals, on their ruthlessness and such other considerations as may go under the rubric of “beauty contest.” Moral degradation set in and played a big role in the collapse of the whole arrangement.

What to do now? asked the people of the planet. They discussed the matter and came up with the idea of having a full fledged free enterprise arrangement coupled with a monetary system that was based on the gold standard. From then on, the people who had a business would hire workers and pay them wages and salaries. To get going, the business owners were allowed to borrow from the banker an amount commensurate with the capital they had accumulated so far or the amount of sales they were doing on a daily basis.

An ounce of gold was fixed at the price of 35 Mighty Eggs, and every financial institution was required to keep in its vaults an amount of gold valued at no less than 10% what the institution normally loans to its clients. Things worked nicely for a while in that consumer prices were held steady. But what was not immediately apparent to most people was that pressure was beginning to build. The few wizards who knew what was going on, realized that an explosion was inevitable and that it would come sooner or later. The trouble they saw coming was two-pronged. The first prong was that wages had risen so much, it was costing almost 35 MEs to produce an ounce of gold; and this was forcing the gold mining companies to shut down. This in turn put an upward pressure on the price of gold that nevertheless was not allowed to rise in price by law. And this is why the gold miners were asking that the price of gold be liberated and allowed to move according to market forces.

The second prong of the problem was that the planet had gone from being a handful of hamlets to being a sizable city state. It now contained buildings, infrastructures and machines worth billions of MEs. These could be used as collateral by the businesses that wanted to borrow except that the lending institutions could not lend this much money because they did not have the gold reserves that the law required them to have. And this is why the business people and the financial institutions were asking that this provision of the law be dropped or that the price of gold be liberated and allowed to move according to market forces.

And this brings us back to the question: Which way is the better way to evaluate a business? Is it to base the valuation on the amount of wealth that the business generates? Or is it to valuate the business based on the amount of capital it has already accumulated? The answer is that it does not matter which way you do it because these are the two faces of the same coin. In fact, what we have here is not even a coin-like flat object; it is a multi-dimensional object with several faces, three of which are important to this discussion.

And this is how all this relates together. The level to which an economy has evolved is expressed by the permanent infrastructures underlying it. And these infrastructures could not exist were it not for the wealth that the economy generates on a daily basis. And so, these two aspects of the economy are so closely and naturally related, they must be thought of as one and the same phenomenon. For a bank manager to pick one or the other, and use that to assess the value of a business is purely a matter of personal preference. But whether it is one or the other, the cumulative effect of these choices by the lending institutions is what determines the size of the money supply in an economy. This, in turn determines the value of the currency.

What is not naturally related to that phenomenon is the value of gold. Given that the supply of the precious metal is finite, what comes into play here is the law of supply and demand. Whereas the daily output of an economy and the size of its infrastructures are determined by human activity, the supply of gold is largely determined by its availability in nature. Thus, to use gold as the only factor by which to give value to a currency is to take the wrong approach. What is needed, instead, is a system that will take into account other commodities as well. Added to the mix should be the level of development in the world as it is measured by the output of all the goods and services produced by the entire planet.

A currency that is real such as the dollar or the Yuan, or a currency that is virtual such as the Special Drawing Rights, can then be created based on that mix. It should also be made to vary and remain in step with the evolution of the planetary economy.