Monthly Archives: April 2013

BitcoinsThe free market is at work in attempting to come up with alternative solutions to government-controlled fiat money.  One interesting innovation is the development of “Bitcoins.”  A Bitcoin is simply a piece of information stored on a computer that is designed to be used as a medium of exchange and a store of value.  That is, Bitcoins represent a privately produced “money.”

The purpose of Bitcoins is stated as follows:

“Building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of using cryptography to control the creation and transfer of money, rather than relying on central authorities.”  (

We greatly applaud the founders of Bitcoin.  Creating a new “money” that eliminates the government and central bank’s monopoly on currency manufacturing is a significant move towards economic freedom and transparency.  However, there is a drawback to Bitcoins:  Like fiat money, Bitcoins are not backed by anything real.  One way to obtain a Bitcoin is to purchase it with government-created fiat currency.  The other way to get a Bitcoin is to generate it through a process of computer “mining.”  Either way, there is nothing of real value behind it.

 Of course, there is nothing of real value behind government-created fiat money either.  And at least Bitcoins are designed to be of fixed quantity.  In these days of across-the-globe money printing by governments and central banks, the promise of a fixed quantity of Bitcoins is precisely what is giving the new money some appeal in the marketplace.

Better than a Bitcoin would be a privately-created medium of exchange that is actually backed by something having real value.  The evolution should be toward a money that is traded electronically, and when it is exchanged it represents the transfer of ownership of a small sliver of the economy’s productive capital.  

We believe Bitcoins are unlikely to be widely accepted as a medium of exchange for the simple reason that the public is rightly suspicious of a money that is backed by nothing other than a promise to not create too much of it.  However, Bitcoins represent an important first step in the development of a private money that does have real value:  Capital as Money.

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Capital as Money CoverAn interesting review of Capital as Money was posted on Amazon on April 11, 2013:

I hate to give banks TOO much credit, but understanding how the world we live in works isn’t possible without understanding banking.

To understand banking, of course, you must understand money. And, further, to understand money you must especially wrestle with the concepts of fiat money and fractional reserve banking.

And, finally, to wrestle with those slippery concepts YOU SHOULD DEFINITELY read Capital as Money.

After you get the concepts of fiat money and fractional reserve credit creation pinned down, you’ll begin to understand more about why there is so much volatility and excess in our financial system. Then you’ll want to look for alternatives to the present system we all rely on, which is exactly what the authors of Capital as Money have done.

The idea of our money being connected to something other than `thin air’ has an instinctive appeal to people. The problem is that most times people latch on to the idea of gold as the substitute for thin air. My conviction is that `out of the ground’ is no better, really, then `out of thin air’ as a source of money.

Gold has the appeal of seeming to be “God’s Currency”. Problem is, though, that gold is not currency, God’s or ours, and using it as currency (or to back currency) is also problematic.

What you have in Capital as Money is a genuine alternative to `thin air’ or `God’s currency’. Rather than basing our money on `air’ or `gold’ let’s base it on the fruits of our labor, our productive capacity, our hard earned and long term capital, and our ability to create more of the same.

That’s the genius of capital as money. The securitized ownership of our biggest corporations (the public ownership of the stocks issued by our largest corporations) is extremely deep and liquid, and yet it rests on something real (not thin air) and growing (not hidden under the ground). The idea presented by McGrath and Dwayne of using this very real corporate capital as the primary method of backing our money system deserves very serious consideration.

Capital as Money makes a very significant contribution to a very important conversation about what our money system is going to be based on; not air, not gold, but something much better suited to the creation of money.

Read the book and join the conversation.

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Part II—Public Debt


7841152_sIt is a sad fact of human nature that many will observe the savings, wealth, or excess of production over consumption of others with greed and envy.

In our island example of private debt, let us now introduce government.  Government might be assumed be elected or imposed.  Suppose the individuals who comprise it look just like anyone else, except let us say that they have armbands with a pronounced “G” printed upon them.

What sets government apart is that these people, through legislation or regulation, have some very special privileges that allow them to violate the normal rules of the marketplace.  The market place, for example, operates under the rule of voluntary exchange and no stealing or taking of property.   The government can take property, income or wealth from others through a number of means that would be illegal for the rest of the population.  Their justification for doing so, of course, is that they employ this power only for “the greater good” of the island society—for example national defense, the general welfare, and various “public” goods which are thought to be inadequately provided by private markets.  The more cynical among us might be excused for believing that governments often exercise these powers instead to feather their own nests or to reward those who allow them to retain power.

How does government succeed in financing itself, in the taking of output or wealth from private individuals?  First, there is direct taxation.  The government can determine tax rates applied to income, returns to capital, trades, property etc.  It can make these tax rates specific to certain types of trades or activities that are either politically favored or disfavored.  Secondly, most governments have the power to exclusively control and issue the fiat currency that is used to accomplish trades in the private sector.  Since this currency is backed by nothing other than the faith of those who use it, this very valuable power can be thought of simply as the exclusive right to be the only legal “counterfeiter.”  A more ponderous power also exercised by government to interfere in the marketplace is the power of mandate.  That is, certain types of disfavored trades can be prohibited whereas other types of favored trades can be required.  Direct mandates tend to be controversial and not very covert.  Therefore, they are the last resort of shrewd politicians.  Finally, of course, governments can borrow.

In borrowing, a government which also has the power to issue fiat money as well as to control and regulate a private banking system holds almost all the cards.  In pernicious and extreme cases it can come to naturally view itself as the sole arbiter of the allocation of private savings.  Thus, it is not only greedy but, if we allow it, it is also in effective control.

How is that?  Let us first consider the advantages of the government as a borrower.  Whatever the required rate of return for private lenders is, the government can meet it.  Why?  Simply because the government has the theoretical power to raise whatever funds are needed for its debt and interest payments through taxes.  This simple fact assures lenders that the government need not default on its loans.  Thus, if lenders believe this, the government benefits from a lower risk-adjusted return required upon its debt and the broad perception of “no credit risk.”  Less attractive to borrowers, of course, the government also has the power to buy its previously issued debt or bonds with newly issued fiat currency.  It can thus “monetize” its previous debt.  By doing this it inflates the currency to the point where the real value of debt (that is, the value of the nominal government bonds in terms of output) is reduced to whatever level the government prefers.   The government can and does alter the supply of fiat currency to artificially manipulate the cost of borrowing in the loan market (that is, to achieve central bank interest rate targets).

Additionally by setting or changing the minimum proportion of vault reserves required within a fractional-reserve banking system, the government has control over the volume of private loans.  Worse, it controls the disposition of these loans through its regulation and licensing of private banks and through the legislative mandates it applies to them.  Put bluntly, an aggressive government can control how much is lent, by whom it is lent, to whom it goes, and at what price.  Clearly, that outcome is not a free market in lending.

It is any surprise that such a control and power over the allocation of aggregate private savings generates credit bubbles or gross distortions?  Our opinion is that such a top-heavy debt and lending system can explain virtually all of them.  Pushed to an extreme, the government’s own debt can become the biggest credit bubble of all.  If government spending growth dramatically exceeds the growth rate of the economy that bears it, an eventual collapse of the entire economy can be the logical result.  This happens.  For example, consider Greece.  Can such government aggressiveness explain the under-investment in capital that occurs in many economies?  Of course!  Not only does capital have to compete for savings on an un-level fiat money playing field, but private capital investment itself can be an officially “disfavored” use of savings.  How?  It is easy—simply raise capital gains rates, or raise corporate income taxes, or increase regulation.  Additionally, government can subsidize preferred types of capital investments and punish those that are out of favor.  Finally, when government abuses its power over private savings to an extreme, the general atmosphere prevailing in the market place discourages all types of private investment or allocation of saving.  Immediate consumption rules!

The bottom line is obvious.  It should come as no surprise that, as a government gets more aggressive in controlling private savings and its allocation, the efficient investment in productive capital may well be the first casualty.  It is no surprise (as we argue in our book Capital as Money) that the likely outcome of such an inefficient lending market is aggregate under-investment in new productive capital.  That is, the result is an economy that simply doesn’t have as much productive capital as it should have to maximize the wealth, economic growth, prosperity, and consumption of its citizens.

Of course, as in the case of private debt, the issue of a unit of public debt does not increase aggregate wealth.  Simplistically the asset value of a piece of government debt to its specific holder is exactly offset by the present value of the taxes required to pay its future stream of interest and principal payments—that is a liability all of us.  In fact, a critical observer may make the following inference:  Given the close historic relationship between public debt and fiat money issuance, issuance of public debt implies a corollary:  the inevitable future issuance of fiat money to monetize it.  This, in turn, implies an increase in the level and volatility of future inflation—tending to impair the wealth, prosperity and growth of the overall economy.  In fact, a good way to view the government’s monopoly of the money supply function is that it is precisely this power that affords governments the only “legal” loophole to effectively default on their debt.  It is exactly analogous to a counterfeiter paying off a loan obligation he has incurred by turning on his printing presses and printing up more bogus currency.  Wealth is destroyed, or at least stolen, by such behavior.

Considering public debt, total debt and its unfortunate de-stabilizing linkage to fiat money and monetary policy, it appears that our money is far too important to leave in the hands of government or central banks.  The supply of money and interest rates should not be gamed but instead should be market determined.  Money is not a public good!  We now have the tools and technology to allow us to choose a private money with a supply determined by private free market demand.  What is it?  Broad productive capital should be used as a unit of value and as a medium of exchange.  The solution is capital as money.

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Part I, Private Debt



This blog is intended to describe how private debt might look in a world that uses productive capital as its money, and is intended to answer questions we have received from several readers of the book.

When thinking about macroeconomics, abstracting to the simplest case is almost always profitable in aiding understanding.  Consider the example of debt in an economy that is devoid of fiat currency.  That is, contemplate debt in a world where we think of consumption and saving in terms of real goods and services, thereby not letting ourselves get confused by various illusions created by fiat money.

Suppose we start with an island consisting of perhaps 200 individuals.  They work singly or as groups (businesses) to produce different types of output and they trade freely with one another to obtain what they need or want.

At any particular time, some of these individuals accumulate more wealth or output than they wish to currently consume.  This excess of production over consumption represents their savings, and they must decide the most profitable way to place it.  In making this decision they must consider risk and potential return.  Of course, their goal is always maximizing their lifetime consumption at an appropriate level of risk.

Let’s start with the case where the only thing they can do with their excess of production over consumption is to invest it.  By “invest” we specifically mean they can create productive tools or knowledge enhancing their own future production, or the future production of other individuals or businesses upon the island.  In making this investment they therefore increase the island’s stock of productive capital available for future output production.  Clearly this is an important function for the future growth and prosperity of the island economy.  As a reward for accumulating capital the savers reap, on average, the marginal product of capital as the reward.  The marginal product of capital is the rate of return that a saver would expect to earn.  By saving, say, 100 bushels of seed corn, the saver might reasonably expect to have 103 bushels of corn the next period—a return of 3 percent.

Starting from that idyllic position, now let us suppose that individuals who enjoy an excess of output over their desired current consumption might do something else with their savings, which is to extend a loan to other individuals (or businesses) on the island.  The potential borrowers are those who would wish to currently consume more than is obtainable with their current production or income.

If borrowing is introduced into our island economy, then those who need more output than they currently produce can offer a price (an interest rate) to entice those with an excess of output to lend it to them.  How can they promise to pay an interest rate with any confidence?  The borrowers must have an expectation or guarantee that their future output or income is going to grow sufficiently over the future to enable the repayment of the interest and principal on their loan or debt.  Or, perhaps the consumption item desired is lumpy, large relative to current income, and infrequently purchased (for example, a house).  In any case, the terms and assurances of the loan is part of the negotiations between borrower and lender.  Moreover, to obtain their loan in a rational world, borrowers must be able to offer an attractive return and risk to the lender.  That is, a borrower must promise to pay the lender a higher risk-adjusted return than the lender might earn himself through his own direct investment in new productive capital.

Will a potential lender be willing to extend someone else a loan if the lender has an ability to use his savings in his own or another’s investment project? That is, if a saver can direct his savings toward accumulating capital (a fishing net, tractor, etc.) for himself, for example, why make a loan to someone else?  He will only offer his savings to a borrower if he can earn a risk-adjusted return which exceeds the expected return to capital.  In an economy that uses capital as the bedrock of value and exchange the return to capital will be viewed as the benchmark return—attainable by the default position of simply accumulating additional units of capital.

A default on a loan occurs when a borrower cannot or will not meet the demands for payment of principal and interest on a loan that was made to him.  Of course, loan defaults will sometimes occur.  Not all loans made will be wise or prudent on the part of the lender or the borrower.  In addition, things will happen—disasters, wars, accidents, and disease are always an unexpected part of human existence.

Where does the introduction of private debt leave us in our overall island economy?  On a macro-level, all loans either allow borrowers to invest or consume.  If all loans were made for purposes of investment, then the economy’s stock of productive capital will be larger than occurs if loans are made for purposes of financing consumption.

We are able to conclude that borrowing amongst individuals is not necessarily helpful in an economy that needs more productive capital.  When an island needs investment, extending loans to individuals for purposes of consumption simply keeps the economy undercapitalized.  Put simply, enabling lending in an economy that starts from a position of putting all of its available savings into investment of new capital cannot possibly result in a larger capital stock.  At most it will be equal and, in fact, probably less.  In any economy, even one that uses capital as money, no one say how much lending will occur in the aggregate or how much is “good.”  If individuals enjoy lending back and forth to one another, the total volume of loans might become huge.  If they primarily invest their excess of production over consumption, the total volume of private debt may be very small.  If loans are predominantly made to businesses which then invest them in new capital creation then the net effect of borrowing upon the creation of new capital may be almost the same as direct investment—although the ownership of the new capital is changed.  The important thing to realize is that, whatever its volume, the stock of private debt does not change our island’s aggregate economic wealth.  Each loan created between a borrower and a lender creates an asset to the lender and imposes an exactly off-setting liability upon the borrower.

Once loan contracts are made, then the ownership of the resultant notes or bonds may be secondarily traded in the marketplace.  One could even visualize private island “raters” who offer valuable and expert opinions as to the likely risk or quality of individual loans or pieces of island debt.  Thus, an islander who now finds themselves with an excess of production of desired current consumption can now invest it, make a new loan with it, or buy an existing loan or bond in the marketplace.

Suppose, for some reason a “lending frenzy” takes place upon our island which produces an enormous stock of aggregate private debt.  Is such an activity to be welcomed or abhorred?  Well, as we have discussed it has no necessary net implications upon the aggregate economy and its net level of consumption or investment.  Thus, we could say in the absence of loan defaults, all loans will be faithfully paid off and size of the total stock of private debt that occurs is irrelevant.

However, in the real world of uncertainty, the more loans that are made the higher is the probability of loan defaults—even if the loans are carefully underwritten.  Of course, the situation is worse if imprudent or poorly underwritten loans flourish.  The reason is that once loans start to default a “death spiral” of debt or bonds can proceed.  As loans default, the price willingly paid for them not surprisingly falls in the market place.  This in turn raises the interest rate required on new loans or the interest payments on loans already made but subject to adjustable interest charges.  In the limiting case a debt crisis or “implosion” can occur with new lending driven to zero.

However, we can place some confidence in the limiting mechanisms of a transparent, simple free loan market.  Although a debt explosion is theoretically possible, it could be argued that, in a rational private lending market, prudent, strong underwriting would be the norm and loan defaults would the exception rather than the rule.  When defaults did happen, they would be isolated and quickly addressed.   Moreover, loan defaults would naturally be immunized or quarantined with consequences largely limited to the individual lenders and borrowers who incurred them.  Secondly, the always present benchmark return to capital would make the occurrence of such a lending “frenzy” difficult to imagine.  To say the least, an always available, unimpaired return to capital would provide a strong, healthy natural brake on the scale of private lending activity.

So far debt seems pretty clear and simple.  What could go wrong with lending in our simple island economy?  The answer lies in governments, public debt, fiat money, taxation or mandates, and a government-regulated private banking system.  We will explore that next.

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