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Part 2: Money Theory

Why you don't understand economics ... and nor do they!

Preamble

Here is the common view of how the Australian economic system functions.

Check it out and see how much you agree and disagree with the points being made.

At least half of the above is pure rubbish. How much did you detect?

Terminology

I think the most common problem in economics comes about through the casual use of common terms, and these terms can carry implications and be imprecise, and they lead the reader off on a tangent. This imprecision involved in words within economics is hidden by the fact that their tomes are full of figures, and we instinctively feel that figures convey precision.

Measurements and numbers epitomise precision to most of us -- and precision means that the information provided is probably the result of a scientific approach. For this reason I suggest, Economists with egos believe that they are the experts in a "social science". This belief is reinforced because their published papers are generally loaded with dollar figures.

Part of our lifetime's conditioning is to read pages of information about a range of subjects we only partly understand. And if If we are educated and involved, we unconsciously accept that since these pages are loaded down with numbers, they must deal with objective facts rather than opinions. We tend to accept such analysis on trust, assuming that they are more then personal opinions or lobbyist's influence. But in economics, the words and numbers are often just the results of bad analysis.

Economics therefore appears to neophytes as some form of statistical science, dealing specifically with money. And the pseudo-precision of these numbers reinforces this illusion.
 
If you measure length using an elastic-band tape measure, you can record precise figures without knowing anything much about the actual length. The same problem exists with money; it's purchasing power shrinks by the week.

I guess it is natural for us to think that money is the dominant factor. But it isn't.  

Economics is the study of the way we produce, distribute and consume useful goods and services.

Of course you all knew that ... as we all do. But within two minutes of accepting and agreeing with this truism, almost everyone will automatically resume thinking that an economist's expertise is with money. In fact, this automatic fixation on the monetary side of the economy is more closely aligned with a priestly adherence to religious transcendental ideas. Like priests and gurus, economists also have bibles, cults, and factions at variance with each other: and they also hold their treasured beliefs with the same sort of absolute certainty.

This exposes probably the most consistent cause of confused thinking in anyone studying economics.

• "Money" is seen as a single, simple unit: whereas "the economy" refers to thousand of quite different items varying in importance between "necessities" and "frivolous" or even "destructive".

• These items are both real (i.e. "goods") and semi-abstract (i.e. services).

• Different items have different 'values' to us over an extraordinarily wide range. Utility value is obviously important, but some items are bought for status, style, or amusement.

• For this and other reasons (scarcity, difficulty of creation, etc) the items are set by the vendors at different prices. These prices bear almost no relationship with the ranking of the purchase between "essential" to "frivolous".

• We assume that because money represents purchasing value to us as individuals or households, that it has the same intrinsic value to governments and official public-service bodies. It doesn't.

As a consequence of all this complexity ... in the study of economics,
we are forced to use monetary values as a PROXY for estimating market realities.

We must develop the habit of regarding most dollar figures in economic discussions as
PROXY terms for what is important -- the actual goods or services.

My position on the present economic ideologies is ...

• Most economic experts are often little more than knowledgeable accountants who believe with reasonable certainty that they are right ... while, at best, most of them are half-right. Economists can't escape the tinge of politics of the lure of industry funding, no matter how much they pretend.

• Economists tend to concentrate at opposite ends of a left-right spectrum of orthodoxy, with the older followers of John Maynard Keynes on the political left, and Friedrich Hayek and Milton Friedman on the right.

• Probably most economists would now agree that the upgraded version of Keynesian viewpoint are more correct than the Hayekian neo-liberals (aka the "Austrian School", neoliberals, or "Libertarians") These theories have now been largely discredited and abandoned, but many right-wing businessmen cling to them.

• However the "neo-Keynesian" form which is common in current economics still has the vestiges of their old problems in treating money as is it were somehow 'real', and consequently holding a position that the government is within the circulatory system in the economy. They cling to beliefs that governments need taxation to fund their programs, staff salaries and new projects.

• The Chicago School of Monetarists were a neoliberal offshoot which exaggerated the importance of money in the free-market, and they generally believed that government's mainly had disruptive effects. Milton Friedman was their main guru: his theories are generally discredited now. He blamed government for inflation, and promoted mass privatisation.

• The Australian wave of New Monetary Theorists have created a view of economics which is a vast improvement on all these more traditional views. However I believe that they also make some fundamental errors, mainly in ascribing the creation of money only to the Federal Government.

Neo-Keynesian Economics is now the flavour of the month.

The older Keynesian theories of economics have returned, but in a modified form. While I still maintain some objections to this approach because I believe it still had many of the misleading concepts I've identified here; mainly because they seem to assume that money is real. In that, they pander to the public view about the primary importance of money.

These New Monetary Theory (NMT) ideas have begun to permeate widely, and they have a distinct ecological-sustainable flavour. There these concepts were co-developed by Emeritus Professor Bill Mitchell at University of Newcastle (NSW), and Richard Denniss at the Australian Institute. Many of these ideas have been incorporated here.

This web-site is a composite of thirty years of reading and analysing, with some interpretative concepts that I believe I can bring to the subject. I generally believe that the constant arguments between these ideologies, and the influence of politics and popularism, has constructed an academic edifice with more fixes, patches and structural repairs than the subject justifies.

Experts tend to create complexity. They often become rigid advocates for selected viewpoints.

You may think that I've gone too far back to the basics in these first sections, and that I'm spend too much time nit-picking definitions. But my defence would be to claim that:

1. Economics is only about half as complex as it seems.

2. Economists, like all experts, have vested interests in maintaining complexity.

3. If you get the basics right, some of the confusion quickly disappears.

The problems of terminology 'inexactitude'.

If you accepted in that statement above that the dollar is a "standard unit of wealth measurement", then you've succumbed to a classic logical trap, which is the imprecise definition of words. Without tight definitions, people draw different inferences from many important statements, whether or not these are correct and based on fact.

It's my opinion that the study discipline of academic economics:
    •   Uses a lot of undefined terms, which can carry different implications. This leads to confusion.
    •   Lacks necessary terms and labels to simplify many of their most important concepts.
    •   Tends not to match the discipline's usage of terms with what is common usage. This creates popular misunderstandings.

Money and Currency:

At one time they had some important distinctions: currencies were 'physical objects' made of paper or metals, and money was the 'valued' entitlement that was attached to the currency. This appears to be a fairly trivial distinction, but confusion of these two has some substantial consequences in the way we generally think about the way the economy functions.

We still have our childhood fairy-tale cartoon depictions of kings with vaults of taxed gold coins (currencies). The king would dole out a bags full of cash to his lackies to pay for the army or for some other project. This idea perpetuates the false concept that money is something real, and that it cycles back through taxation to the governing authorities, who then dole it out to fund their various projects.

You've probably never even thought of this distinction, and yet 'entitlements' (money) and a 'authentication' (the role of currency) are the key to understanding how governments fund their projects. The free-market, of course, is in the business of generating real goods and services, and of exchanging these between all citizens using the "entitlements" of money. You wouldn't accept Calithumpian Zeno banknote entitlements as payment for your car because you have no way of authenticating that they are acceptable to your bank, or to anyone else you may wish to purchase goods from.

Entitlements: The main point to note is that anyone can create entitlements. I can tell you that I will give you a cake on your birthday, and within the bounds of our friendship I have created an entitlement. You can anticipate that this will be honoured by virtue of our relationship: you know how much I can be trusted.

So the 'entitlement' will always be trusted only to the degree it can be 'authenticated'. And for transfer of an entitlement in any sort of national economy, it must be accompanied by a universally-recognised and accepted authentication. And in Australia, for general day-by-day purchases, that means the State and Federal Governments. At one time each Australian colony had its own money, and that money was only valid within the State.

If I were to create a more substantial entitlement today, say to the occupancy of a house or building I claim to own, you might feel it necessary that I put the grant of that entitlement in writing. You will want me to provide details that you can authenticate (ie. proving that I own the house) and you'd want me to sign a formal rental agreement. This process then becomes a contract, provided only that it is made out to a specific person, company, entity, etc.

It will usually have conditions such as the provision that you agree to pay the weekly rent and keep the place clean. This form of entitlement has good legal standing, and you will want this form of security -- and therefore you need to trust our agreement enough to use the rented premises as headquarters for your business.

However, what is not quite so clear (legally) is when the entitlement documentation has been made out vaguely "To the Occupier" (rather than a specific entity or person). Money is like this because the entitlement is awarded to "The Holder."

If the rental agreement had been made out vaguely to the occupancy of the premises, it then becomes tradable. But note that neither the issuer or the recipient of the entitlement necessarily know each other. In these circumstances, each potential occupier will need to be sure that the original source of the entitlement can be trusted to actually own the property, so now the authentication process become crucial.

The authentication of entitlement now needs to be traceable back to someone (or some entity) universally trusted. At this point in this analogy, we have something in the lease document that is very similar to currency -- with the abstract entitlement being a transferable rented space.

So the components that make money useful for our everyday exchanges are:
    •   The entitlement (the money component) must be spelled out clearly in unit form.
    •   A traceable pathway must exist, back to some universally trusted entity (State or Federal governments).
Money and the physical form of currency have both of these.

Brief history of money

There are historically four different phases in the evolution of our money supply, and I've experienced the latest three in my lifetime.

1. Money was made out of precious metals (mainly gold) by the Romans, and the practice continued up to about the time of the Norman Conquest of Britain (1066). Gold only had 'utility value' as jewellery because it didn't tarnish, and it was rare and associated therefore only with aristocrats and others with excessive wealth.

   This introduces a couple of important ideas:

   • Pretzel logic: which is the art of twisting an argument back on itself.
     People think of gold as intrinsically 'valuable'. But to the peasant, gold only had value [??] because it was used in coins ... otherwise it was worthless from any utilitarian viewpoint. We often view ideas from Left-to-right, when they can equally be viewed Right-to-Left.
      
   • Benchmarking: The only real value of gold coins to 12thC peasants was that the rare metal discs established "benchmarks" for making some purchasing judgements. In a barter-economy, every judgement is simply made from the viewpoints of the pair involved: the buyer and the seller. Money created a wide-spread "benchmark" for comparison.

     This was important guidance in the middle ages, and to a degree it is still important today.   Benchmarking is how we make most of our purchasing decisions, by judging the object's 'worth' to us as individuals, partly on the sale price, but also on the basis of previous experience.

   I'll return to Benchmarking later: it is a term we apply to a "slightly-vague judgement". And we use benchmarking today in most of our purchasing decisions because, with the purchasing-power changes in each dollar, constantly changing prices, and tens of thousands of similar products, we need to rely more on these vague memories and benchmark indicators.

2. After the Norman Conquest most coins were made from lower quality metals like copper and silver. So it wasn't any actual value of the metal that made them useful in commercial exchanges -- it was just the abstract entitlement that money represented.
       Both the authentication evidence and the units of entitlement were carried by the numbers and profiles impressed on the sides of the coins.
       Coins were difficult to make without specific dies and stockpiles of the standard metals, so this rarity of materials and the difficulty in machining the tools required provided most of the authentication factor: it wasn't worth the effort. And, with coins, the abstract money-entitlement and the physical authentication factors were inextricably linked.
    
3. Banknotes were an idea that Marco Polo brought back to Europe from China. With this change, they effectively divorced the 'entitlement' units from the 'authentication' because banknotes were really nothing other than a piece of printed paper. The authentication lay in the difficulty of duplicating the paper of a certain quality, with hidden identifiers such as special fibres in the paper-making. They also hanged counterfeiters in those days, which tended to discourage people from making their own until colour photocopiers became readily available. Today they use a special form of polymer.
    
4. Electronics: The Bankcard was introduced into Australia in 1964 when the private banks created a common electronic system. This was ten years before Whitlam's Trade Practices Act of 1974 made it illegal for companies to collude in setting prices or carving up exclusive rights to territory. The Australian Bankcard people then did a deal with the international credit-card operators, Visa and MasterCard.

   Of course the sum of your entitlements in Australian dollar units still exist as numbers held in the private memory location of your bank's computer database. But the old authentication role of the physical currency has now been superseded by bank controls and auditing, and by the fact that the two accounts involved in the money exchange can be instantly compared to ensure that the reduction in dollar amounts in one, exactly matches the increase in dollar amounts in the other.

So why do we bother still making the distinction between entitlement and authentication?

The key value of retaining the concept of these two distinct entities, is that these together create the base-line units for our whole system of monetary exchange.
    If you don't understand this, then you are like a carpenter or builder who doesn't understand the difference between the old imperial yards/feet and inches, and the metric system of metres/centimetres and millimetres.

What's more, the importance of this distinction extends to pricking the bubble of confusion that has led people to invest in that Ponzi scheme called BitCoin and other crypto-currencies. It also help explain those incorrect ideas about money circulating (supposedly) endlessly through our governments and the wider economy.

Sovereign Authority

The founder of modern economics, Adam Smith, lived about the time Australia was first being colonised. But economics has developed over the years since those days ... and the world has seen adherents to extreme political and economic ideologies fighting for control, resulting in enormous confusion. We've had all those political years of global turmoil involving Communistic and Socialistic uprisings, with nationalisation of ex-government enterprises ... followed by the Liberal-Conservative privatisations of just about everything.

Yet this has left us with huge terminological gaps in our vocabulary. What's more there's been a blending of political ideologies and economic theories. For the lack of simple terms to cover a simple concepts, thousands of erudite academic papers have been written which profoundly explaining some fallacies and some realities ... which are often as plain as the nose on your face.

So I can only apologise for adding marginally to this maelstrom of confusion, by reviving some terms that have gone out of fashion.

• One of these is "Sovereign Authority". This is nothing more than a simple term referencing the functions of all governments -- as granted to them all by "the people". In any democracy, the people are the Sovereign Authority, and we have both State and Federal governments represent our interests. We are jointly the Sovereign Authority: while they are elected to do the spade work.

  In bygone days we used to call this abstract entity "The Crown" and pretend that all power and authority governing the Australian nation emanated from some male or female wearing some gilded metal object held somewhere in Balmoral Castle in the UK. But let's get real!

  We can categorise the economy into two quite distinct, major sectors:
    (A) this government authority with a focus on fairness and the common good. This is the sector which is elected in order to serve the 'common good' in every way, from our defence, to cleaning public toilets.

  (B) the free-market with its emphasis on the individual and his/her household.
    This is where businesses run, salaries are paid, farms grow things, factories operate to produce real goods and services.

  The term 'Sovereign Authority' refers to the functions which allow our communities and free-markets to operate collectively for the common good.
    It this abstract entity has the benefits of specialisation in administration, and it provides the society with an organised system of exchange.

• However, be clear, the term does not refer to the people or the politicians or bureaucrats. THE SOVEREIGN AUTHORITY is US (collectively).

There are three levels of government in Australia: Federal, State and Local Council

And the term Sovereign Authority extends to cover the role of all three -- and we give all three levels the right to demand taxes (including rates, etc.). They are not independent entities even though they are elected as quite separate units:

1. The Federal Government has very substantial influence over the states and territorial governments. It awards pensions, pays for education and health care, etc. It also collects the Goods and Services Tax (GST), on most things sold (except essentials) nationwide, and it has power over the Commonwealth Grants Commission (CGC) which has many intriguing formulae for determining which states get what share of the $90 billion dollars collected each year.

2. The State Governments are in control of most of the infrastructure being built, especially at the level of utilities and housing. They also run these services and charge such fees as water-rates, almost as if this were a government business enterprise. Australia has 500+ local councils which are almost subsidiary agencies of the State Governments, especially in such matters as allocation of land and the development of housing.

3. Of course, our Local Councils tax us at the level of rates. But it is a mistake to think of these as business enterprises. It is impossible to form any judgement on the basis of "price for service" because so many of the important "public good" operations are not readily noticed or measurable. How would you price sewerage disposal for instance?

At this level of discussion we can get away with thinking of State and Federal Governments as the only two levels that matter.

However, the distance of each of these three tiers from the daily routine of human existence, is also an important factor. There's no doubt about the importance of the Federal Government during war ... but there's also no doubt about the consequences of local councils allowing construction of new housing estates to take place on flood plains.

I am increasingly drawn to the idea that all full-time politicians elected to all three levels of government should be paid at the same (slightly generous) rate, since we want the best possible candidates at all levels. We'll discuss this idea later in Benchmarking proposal as a way to reduce inflation.

In our democracy we elect officials and award them the responsibility of encouraging enterprise ('greater productivity') but primarily of distributing this national bounty in an EQUITABLE (fair) way.

We need this term 'Sovereign Authority' to be quite clear that we are talking about the functions of government in supervising, assisting, and maintaining the environment in which the free-market can operate to the best (and fairest) of its abilities. It should make very little difference which political party is in power.

We also need to be quite clear that no one suggests that everyone should share the goods and services produced in the nation EQUALLY. We do however expect that the bulk of all individual benefits should flow in a reasonably balanced manner to (a)Those who produce things of benefit to the whole society (b) Those disabled by age, disability, etc. whether they have a history of production or not.

We have had very little public discussion as to the rights of the aged to hand down their legacies to their offspring, given that these people may never have contributed anything.

Until the recent discussion into establishing a Well-being Index we have left it entirely up to the free-market, modified by partisan politics, to determine what we think is "fair", and this, perhaps is the greatest failure in Australia's economic milieu.

For the time being, we need to be sure that we are clearly distinguishing between:
        - the current political parties in power; the parliaments; the ministers and their departments, and
        - the role these people all play collectively at the Federal, State and Local Council levels.

The term Sovereign Authority refers to the roles only. We give these organisations collectively the rights to demand taxations of many kinds, to build some roads and charge tolls for drivers to use them, and others to have good old roads without tolls. We also expect them to run our "common good" organisations like schools and hospitals ... and a thousand other functions, including defence on a "not for profit" basis.

The Sovereign Authority has the right to resume your land, conscript you to serve in the army, and to jail you for non-compliance with their laws.

More appropriately to this discussion, we award the Sovereign Authority (collectively), the right to create money. They do this specifically to provide the free-market with basic mediation-units called dollars. This serves only one purpose: it is a flexible way to lubricate the exchange of goods and services in the free market.

We also give the Sovereign Authority absolute control over the fair distribution of the products we produce and the services we provide, on the understanding that they will ensure division of these national spoils in an equitable basis.

The key emphasis here is on the fair distribution of the nation's spoils, and this of course involves subjective judgements of fairness. This, supposedly, is what politics does.

For exactly the same reason, governments acting as the Sovereign Authority have also been given the right to extract and destroy circulating money by way of taxation, tolls, fines and whatever.

Fallacy of Composition:

These distinctions between the individual in the free-market and the government functions of the Sovereign Authority are important because you must have a clear understanding why the rules and incentives that govern the functions of governments, are not the same as those that govern individual and companies operating in the free-market space.

• We also tend to think of governments as just large corporations with a CEO as prime minister, and with similar motives.
This is the cause of most general confusion.

• This common confusion is caused by most people thinking of the abstract and the physical representatives as the same.
This is the same as the token/currency and abstract/money-value confusion. Parliamentarians aren't board members on behalf of the company or the political party, they are representatives of us ("the customers?")

• Partly, this is created by us being plagued nightly by politicians and bureaucrats on our television sets. They are representatives of the Sovereign Authority -- but they are not the Authority itself.
This is not an obtuse distinction, because this confusion leads us into a maze.

You can also look this up in Wikipedia, where you'll find both trivial and more complex explanations. For this reason I have written a seperate explanatory piece on these fallacies because understanding some of the consequences is important in economics. See either a short piece, Composition Fallacies, or a much more general and detailed examination of the complexities 'Fallacies of Compositions' on an adjacent website.

Government Parallels:

  We tend to think of the Federal Government in the same fallacious way as simply representing an entity requiring a greater amount of money, than that of an individual or household. We fallaciously see it's role in our monetary system from the viewpoint of an individual, rather than from an Australian national management and improvement perspective.

[They have both a wider picture, and one which has an entirely different focus.]

For instance we generally look on the Cabinet as a distinct organism, but with functions similar to those of a corporate board.

These are the money-concept traps that even the best economists fall into when they try to write casually for the general public in the newspaper. I doubt the economic writer of the above piece really believes there are "government coffers" or shortages of tax moneys: this is just his short-hand way of avoiding a contentious discussion.

But this mental image of the government as being little more than a large corporation, is rarely examined and largely assumed. It lies deeply embedded in our brains, and leads us to imagine that any deficit in the Federal or State government's budget exposes a serious mis-management problem.

We then assume that the deficit is probably due to rash spending. And since politics is so partisan and so divided by economic class, we may also readily accept that deficits are maybe caused by politicians conferring favours on their friends. We constantly find them awarding million-dollar contracts to some of their supporting companies to provide trivial consultative services. This is one of our problems in distinguishing what is economic, and what is political.

Inquiries into some of these expenditures do happen, and probably much more frequently than you'd like to believe. They often don't get exposed in the press and on the broadcast media. But when there are large government deficits, it is wrong to automatically assume that the governing party in power is irresponsible or corrupt in its business dealings.

Governments will end any financial period with a deficit -- usually the smaller ones are just covered up. But deficits more likely to arise from them taking action to reduce adverse economic conditions. It is wrong to fear that deficits might accumulate until the Federal Government goes broke.

This is a Fallacy of Composition.
There's not a chance in the world that our governments can go broke.
Deficits are merely the gap between prediction and reality in government's project spending.

Governments undertake massive infrastructure projects which often take many years to complete, often face serious unforseen consequences, and are no more able to predict climate of international strife that any of us.

I will discuss this further in a section on Fallacies, because the Fallacy of Composition is a mistaken error of thinking that lies largely hidden behind many of our misconceptions about the economy.

In fact, if you think about it ... it is part of the reason why academic economists divide their discipline into "Macro-Economics" (dealing with national-level concepts) and "Micro-Economics" (that of businesses and individuals). And its also why our run-of-the-mill commonsense concepts about government activities are so often wrong.