Monthly Archives: February 2013

stock certificateThe last thing we need or want is some act of Congress or some other government mandate to move us to a “capital-as-money” economy.  If we’ve learned one thing it is that something as important as money should not be left to the government, a central bank, or the lending whims of a regulated banking system.  Money needs to be born as a natural outcome of free markets, free individuals, and voluntary behavior. 

Then how do we get there?  Just do it!

We are not so presumptuous as to try to offer the only roadmap to capital as money.  There are many alternative ways to skin this cat.  All can benefit from tapping into the superior natural genius and innovation of free markets and clever traders.  However, it might be worth our time to sketch one possible way movement to capital as money could happen.  

Imagine a group of individuals, businesses or entities that make frequent trades with one another.  Suppose they are interested in using broad capital index shares (i.e., equity index exchange traded funds) as a trading good and store of value.  For this purpose they could simply form a capital trading group or (heaven forbid!) trading bank.  The trading bank is not a bank in the sense of a current “fractional-reserve” bank, but rather more akin to the silver deposit bank originally envisioned in our island economy before Bob Jr. got hold of it (for more detail on that, read Capital as Money).  A capital trading bank might simply be a virtual accounting tool to keep track of cumulative trades and the resultant ownership of index ETFs.  How might this work?  Each individual in the group could make an initial “deposit” of a given number of index shares or simply prove to the satisfaction of the other members that they in fact own a number of index shares.  Then the trading of index shares for goods and services commences between the group’s members.  Of course, to avoid paying numerous brokerage fees and commissions associated with actually trading index shares, our group could simply use their own accounting mechanism to keep track of the changes in ownership without the shares actually being liquidated.  Periodically (perhaps quarterly or yearly or, in the limiting case, never, as the trading group members choose) an actual real broker trade could take place to square things up.    

Stretch your imagination, it’s not too hard to visualize such capital trading groups or capital trading “banks” forming and becoming pervasive in terms of goods and services traded and in the size of their membership.  If it happens, then our economy is effectively morphing into a capital-as-money economy.  And why not?  Especially when individuals see the advantage of using capital as a store of value.  Over time capital rewards its holders with a steadily increasing average value in terms of the goods and services for which it may be exchanged.  In a capital-as-money economy it is possible that fiat currency could still exist, but it would delightfully become less and less desired or relevant.  Given the innovation and adaptability of markets, as the process matures it is likely that the brokerage, custody, and trading functions would merge and blend with capital being traded directly for other goods and services and with a cost per transaction that was effectively zero.   

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“Hey Ed what’s happening?  You look a little down this morning.  Heck I hate to use the term ‘mangy’ but it even looks like you haven’t licked your fur for a week.  It’s sticking out in all directions and, if I may say so, you smell rank.”

“Yeah.  To tell you the truth Jill I’m just not feeling that good.  Two reasons:  First, I just heard that the coyote unemployment rate is sharply up this month and I’m part of it—your brother Jack just fired me.  I’m unemployed.  Second, I haven’t had a nice, fresh rabbit in a long time.  My stomach’s a little upset.  I shouldn’t have eaten that crushed road-kill magpie off the pavement—who knows how long it was there?”

“Ed, what are you talking about?  A coyote can’t be unemployed.  Just go catch a rabbit.  You and I have done it many times down at the dead-end dry gulch.  You chase ‘em in and I’ll rip their little throats out with my dainty sharp teeth!  Just like we always used to do!  What do you say?”

“Oh I don’t know Jill—it’s just not so simple any more.  I’m just not an ‘entrepreneur’ like your brother Jack.  He has everybody specializing at what they’re best at—some at chasing, some at catching, some at skinning and some at guarding the stash.  It’s quite a process now, but apparently I didn’t fit in anywhere, so here I am—fired.”

“Stop feeling sorry for yourself, Ed.  I don’t know what an ‘entrepreneur’ is.  It just sounds like some silly word to me.  Whatever they can do, we can do it too.  Just like we used to—let’s go to the gulch right now and get started.  A little fresh rabbit meat will perk you right up!”

“Jill, you’re still making it too simple.  Catching rabbits now involves bookwork.  President Bark now requires a license for any coyote enterprise that catches rabbits.”

“A license?”

“Yeah.  And that’s not all.  Now there are a lot regulations and paperwork involved.  Kills must be taken fairly and reported.  Part of the rabbits collected must go as taxes to the pack government.  ”


“Yeah, Jill.  Our pack leaders are too busy regulating us to hunt, so they need more rabbits from us. Rabbit taxes also pay for other things such as social security for coyotes in their old age and universal coyote healthcare.  Nowadays one in four rabbits goes to pay taxes.  My head is spinning just talking about it—that’s why I guess I’m not an entrepreneur like Jack.  That’s why I have to wait for someone to employ me.  I even think I’m supposed to get a quota of ‘unemployment’ rabbits, but I don’t see much coming my way.  I’m not holding my breath.”

“Are you kidding me, Ed?  We’re coyotes!  We don’t even have opposable thumbs.  We shouldn’t be worried about licenses and rules.  Forget all that stuff and let’s just go and catch our own rabbits down at the dry gulch.  All your talk has got me mad now.  It will be the worse for the rabbits.  I can taste their blood already when I rip their little throats out.  Just let someone try to stop me!”

“Jules, Bertha, and Tom might just do that Jill.  They could boycott us and picket our kill.  They’re the Concerned Vegan Coyote Committee for the Prevention of Cruelty to Rabbits (CVCCPCR).  They’ve singled out your very throat-tearing style to protest and have lobbied to make it illegal.  If they hear rabbit screams from the dry gulch, you can bet they’ll be there and on us like a shot.”

“Well just what are we supposed to do?  I’m starved!”

“So am I Jill.  The CVCCPCR says that we should learn to be vegan.  They recommend we raid farmer MacDonald’s garden patch and eat his fava beans and arugula.”

“Fava beans and arugula!?”

“It’s supposed to be very healthy.  Farmer MacDonald’s garden is certified organic!”

“I can’t do that Ed.  Where can we go?”

“Well, I understand you can still chase rabbits in Wyoming.”

“Let’s go to Wyoming.”

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DealConsider three individuals who are living on an island. Imaginatively let’s call them Gus, Carl, and Zeke. 

 Now, through a lot of risky hard work climbing trees and picking fruit, Gus has accumulated quite a stash of coconuts.  However, since Gus has been busy climbing trees, he has had no time to construct a hut in which to live.  In contrast, Carl has no coconuts but is known throughout the island to be a wizard at hut construction. 

 Gus and Carl realize gains from exchange are there for the taking, and they meet to negotiate a mutually agreeable contract.  Behaving as if they were free individuals, after some negotiation Carl agrees to build a hut for Gus in exchange for 7.25 coconuts per hour.  Of course, Gus and Carl are happy with their deal or they wouldn’t have agreed to it in the first place.

 Enter into the picture, Zeke.  Zeke is not a party to the trade and is really unaffected by Gus and Carl’s exchange.  However, Zeke is at heart nothing if not a frustrated bureaucrat and loves things like meetings, extensive discussions, “Robert’s Rules of Order,” and other such nonsense. Zeke is a weird bird who derives personal satisfaction from making and imposing rules upon others.   In particular, Zeke greatly enjoys ensuring that Gus and Carl adhere to his set of laws.  It is Gus and Carl’s unending misfortune that they are fated to share the island with Zeke.  (Apparently Zeke has a prison and monopolizes the island’s most sophisticated weaponry, which means Gus and Carl must take Zeke’s mandates quite seriously). 

 After overhearing the negotiations between Gus and Carl, Zeke decides that 7.25 coconuts per hour is not a “fair” wage, and that the compensation paid by Gus must be at least 9 coconuts per hour.  Also, glancing markedly at his weapons, Zeke reminds Gus and Carl that he is the law on the island.  He even goes so far as to suggest that the higher wage will stimulate the island’s economy, since Carl will be wealthier if he gets paid more coconuts.  Finally, Zeke gently reminds them that they must, of course, not forget the transaction tax to him of 1 coconut per hour—after all, regulation, enforcement and quality weapons don’t come for free!

 Evaluating his pile of fruit, Gus decides it just isn’t worth it.  He doesn’t want to pay 9 coconuts per hour, and calls off the transaction. Zeke has no problem with thwarting the exchange, his only concern was that no work gets performed at a wage he decides is “unfair.”  Carl is apparently hardest hit—he really wanted to eat.  After the deal is nixed, Carl is sometimes overheard grumbling that he wishes Zeke would get his nose out of his business.  Gus contents himself with quietly thumbing through weapons catalogs.

 (By the way, if you like island parables, you will enjoy Capital as Money.)

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money targetInsanity has often and aptly been described as

“…doing the same thing over and over again while expecting a different outcome.”

If this is, indeed, insanity then it is sadly too common in human behavior—especially in our convoluted system of money, credit and banking.

Depending upon what we read and to whom we listen, we are told that the Fed is following its monetary policy with the goal of stabilizing the broad price level, reducing unemployment, raising economic growth, dampening euphoric credit markets, reducing the impact of terrorism, stimulating bank lending activity, absorbing ballooning government debt, stabilizing foreign exchange rates, guarding the economic recovery, taming commodity prices, etc.

At the same time, looking at the private banking system we were told that the recent credit bubbles were due to excessive lending and poor underwriting of loans—too many mortgages to too many weak borrowers, too many unsecured personal loans, and too many loans to weak and speculative businesses.  Now we are told that banks are too reluctant to lend the unprecedented flood of liquidity from the Fed.  Like “deer in the headlights” they are simply accumulating and holding “excess reserves” while frustrated borrowers get little or nothing.  To our amazement, this last statement was actually validated by the recent observation that currency held by the public and within banks actually exceeded the so-called M1 money stock, total currency held by the non-bank public plus all checking accounts.  Clearly our current money and banking system is badly broken.

But, in truth, since its inception in 1913 it has never worked well.  It has always been racing around trying to put out spot fires largely due to its own previous policies.  Despite all the political pressure applied to the Fed and its Chairman, if you have but one policy variable, money growth, you can logically have only one target.  However, our monetary system is designed to fail. Irresistible political pressure always forces it to chase many and changing targets.  On top of this, the additional uncertainty of private bank lending, or the lack thereof, also works to ultimately determine the size of our money supply.  This makes it impossible for the Fed, even with the best intentions, to actually control monetary growth.

What should be the over-riding goal of money is to be a trusted store of real value—the very instrument of wealth we would prefer to hold over time.  As a benchmark of valuation and pricing of other goods, it should be simple, logical and understandable.  Its supply should be derived from the needs and desires of a private market and not the child of a policy intended to micro-manage the economy or generate a covert inflation tax to the government.  We need to break the cycle of insanity.  That is why we need productive capital as money.

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oil refinery

There are two critical related characteristics of the medium of exchange and store of value,  or “money.”  First is the adequacy of its supply, and who controls it.  Second is the issue of the safety and stability of its value as an asset to hold. 

How well any possible choice for “money” solves or addresses these two basic concerns says much about its desirabiilty to us as users and holders.

What are the possible candidates for money?  Broadly speaking they fall into three main types.

  1. Historically, gold and other commodity monies have been employed, including paper notes backed by commodities.
  2. Fiat monies controlled by governments and central banks are now the norm, because they serve the desires of governments—not necessarily the needs of their citizens.
  3. Alternative monies consist of our proposed productive capital as money as well as various schemes for pseudo-commodities, cyber-monies, and/or privately managed fiat currencies.

Let’s start with the worst choice and work toward the best.   Worst, we would say, is fiat money issued by governments.  Its scarcely disguised intention is to operate as a financing tool for government, monetizing government debt and saddling the populace with an inflation tax.  In either case it pulls real output away from the private sector and toward the government.  When it is combined with an opportunistic fractional-reserve banking system, its actual supply becomes dependent upon the whims of private bank lending behavior.  Moreover, how and to whom banks loan out your deposits is dictated by government regulations or political lending agendas applied to them as well as upon central bank issuing behavior.  Not surprisingly, this has historically caused excessive volatility for fiat money economies and the cost of severe fluctuations in employment, prosperity, and growth.   Thus, from the citizen’s point of view, supply control is poor.  Over time, fiat money has also proven a poor store of value.  The burger that cost $0.15 in 1945, would now cost over $3.00.

Somewhat better choices are commodity monies or possibly pseudo-commodity cyber-monies such as “bitcoin.”  The world, of course, has had a much longer experience with commodity money than with fiat money.  While sustained inflation is only possible with fiat money, fluctuating supply and demand in commodities, such as gold and silver can and has resulted in sharp, historical price volatility in commodity-money economies.  Since many scarce commodities have no underlying, stable productive value, their actual monetary value can be highly speculative and volatile.  This same characteristic would apply to cyber-monies with artificial scarcity which must be “mined” by breaking a puzzle or cryptographic code.   While, in theory, the supply of hypothetical cyber-commodity money could be more stable than that of natural commodities, there would always be concern that such a money was backed by nothing “real” and that there would be a strong temptation for it to be gamed by its originators for their own advantage.  After all, governments have been doing this for centuries.  Finally, if commodity monies are combined with a fractional-reserve banking system the potential for money, lending, and economic instability unfortunately multiply—witness the nineteenth and early twentieth centuries’ monetary history for the U.S.(see, for example, The Monetary History of the United States by Friedman and Schwartz).

Now consider broad productive capital.  Think for a moment of those exchange traded funds (ETFs) that you are likely accumulating in your retirement or investment accounts.  Why are you accumulating them?  Perhaps because you believe that they will generate a long-term return for risk better than anything else.  What if they became the asset in which all other goods and services were priced?  What if they became what was accepted for exchange in return for all other goods and services.  In short, what if they were used as money?  That would be a “capital-as-money” world.

 What’s so great about that?

  1. Money would be backed by the ownership of real productive capital not a mirage, faith, or an imaginary commodity.
  2. To those who accumulated and saved it, its value would actually be increasing over sustained periods of time—something fiat and commodity moneys cannot match.
  3. The use and accumulation of capital as money could deepen the economy’s stock of productive capital—raising output, consumption, wealth and prosperity and creating a “golden age” for the average citizen (read Capital as Money). 
  4. A private free-market monetary system would replace our current institutional money, banking and credit mess.
  5. Frivolous bank lending, government spending, and government borrowing would become disciplined and more transparent.
  6. The value of capital would become less volatile when it was not viewed through the veil of fiat money and central-bank manipulated interest rates.

With the possibility of instantaneous transfer of ownership of broad capital ETFs, capital best solves the two problems any money must face.  It has real increasing value in terms of consumption goods and services, which is to say it has an increasing value over time.  As a valuable real good itself, the amount of it used in trading (the “money” supply) would be simply market-determined by the desires and needs of its users, not by a government, central bank, or the lending whims of a private banking system.

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taxesOn January 24th we wrote a blog titled The Most Insidious Tax.  In the blog we criticized the wisdom, or lack thereof, in increasing the tax on capital gains from 15% to 20%.  We have decided to expand further on the topic of capital gains taxes, and to speculate on how the economy might change if we could move from fiat money to an economy that uses capital as money.

What is the historical long-term average rate of return to broad productive capital?  In terms of the S&P 500 Index, an index composed of the 500 largest U.S. companies, the average annualized total rate of return has been in the range of 9-10%.  This total return is composed of dividends and price appreciation.  Presently the average tax rate applied (capital gains and income tax on dividends) takes away 20% of this amount.  Thus, going forward we might reasonably expect an after-tax return of about 8%.

In addition to taxes, inflation also impacts returns.  Historically, the average U.S. inflation rate has been 3%, which has reduced the annual rate of return to capital when measured in real terms.  Using history as our guide, as a consequence of taxes and inflation the real, after-tax return to owners of capital in the U.S. is expected to be in the range of 4% to 5% per year.

If we move to a capital-as-money economy, the return to ownership of capital should initially surge. We will not have to pay inflation-induced capital gains taxes in an economy that uses capital as money.  As was stated in a previous blog, in a fiat-money economy a negative consequence of excessive money printing is inflation, resulting in price appreciation in real assets.  To the IRS price appreciation is a capital gain, even if the price appreciation is only a consequence of a higher overall price level.

By way of contrast, consider what happens when broad capital (the tools of production) is used as money.   When an index share is the “numeraire,” the index share would maintain a value of “one.”  In a fiat-money economy, capital gains taxes are collected on assets that change in value relative to the monetary good.  Printing more fiat money makes the prices of real capital assets rise, resulting in more tax revenue for Uncle Sam. This is a hideous disadvantage to capital ownership in an inflating fiat-money economy.   The elimination of this tax is a terrific advantage resulting from movement to a capital-as-money economy.  When capital is money, the return to capital will be reflected in the steadily decreasing prices of the other goods and services for which a unit of broad capital can be traded.   But, if capital is used as money, capital itself cannot experience a capital gain (just as presently it is impossible to have a capital gain on the ownership of a one dollar bill).

In a capital-as-money economy, reduced capital gains taxes and the absence of fiat-money inflation will make the ownership of capital more attractive.  Furthermore, our present system of fiat-money and fractional-reserve banking wastes valuable savings by directing loans to frivolous consumption, rather than towards worthwhile investment in the tools of production.  We need to move away from an inefficient system designed to meet voguish political agendas.  Doing so would cause investment in productive capital to naturally rise.

So, using capital as money would reduce taxes on capital and also eliminate the negative impact of inflation.  But there is still another advantage of using capital as money.  Stock ownership becomes less risky when capital is the numeraire. Presently the dramatic swings we see in the price of stocks is largely a consequence of the veil of fiat money fluctuations.  Stocks appear volatile because their prices are measured in fiat money.  Elimination of fiat money makes capital appear more stable, and capital’s ownership is more attractive.

For all these reasons, we believe the initial impact of movement to a capital-as-money economy would be a surge of investment in productive capital.  Ultimately the increasing capital-to-labor ratio would improve our standard of living.  However, the law of diminishing returns remains fully operational.  In competitive markets the marginal product of capital is also equal to capital’s rate of return.  As capital increases, diminishing returns works to reduce its marginal product, and its rate of return.  Ultimately, the neoclassical growth model suggests the increased investment in productive capital should persist until capital’s average real rate of return declines to 3% to 4%–equal to the average growth rate of the economy (see Capital as Money, and also our September blog titled On Equity Returns and Growth).

“So what?” you may be thinking.   “Why do I care if the capital-to-labor ratio increases?” The answer to this question is important.  An economy that is operating with less capital than it should have is an economy that is forgoing valuable output and prosperity for its people.   It is operating below the capital-per-worker level it should be at in order to maximize sustained consumption, called the “Golden-Rule” by economists (again, see Capital as Money).

Just as the opportunity cost of an “under-capitalized” economy is staggering, the prosperity bonus to the average American of moving to an optimally-capitalized economy would be equally huge.  Adequate investment in capital is so beneficial to all of us, that anything that interferes with it (inflation, capital taxes, and/or inefficient allocation of our society’s scarce savings) is to be abhorred.  Put simply, productive capital is the tools that are used to produce available output for the quality of life and welfare of our citizens.  If, as we believe, our economy doesn’t have as many productive tools as it should, then the gain resulting from employing capital as money looms large.  Capital as money could create increased wealth, consumption, jobs, wages and prosperity for all of us.  Capital is the very foundation of wealth, which is precisely why it should be used as our money.

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