Guest post: written by Jaco Schipper
Foreword
Last year I published what I consider my magnum opus: Towards a Trias Pecuniae. In this shorter article I want to provide an accessible summary.
When I published the original article, I intentionally made it heavy on philosophy because the economics curriculum has replaced all philosophy with complex mathematics that is then applied in a vacuum of ideas. Whereas all economic textbooks present economics to be a matter of linear or formative causality, it is my contention that in reality non-linear causality applies to phenomena of inflation, the emergence of systemic credit risks, and wealth disparities becoming ever larger. For professors who are populating the ivory towers of economic academia my blueprint for a dissertation was intended as a wake-up call: there is a fundamental shortcoming with student textbooks in the economics curriculum.
This summary is however a dressed down version doing without the problematic use of metaphysics in economic theories. This should make it more accessible for non-academics and non-economists. My thesis is simple and straightforward: the current international monetary and financial framework is based on a paradigm that requires elements of slavery to be adopted into law. This perspective is about your freedom. How to get it back? Nothing complex or complicated. All that is needed is codifying one utterly simple rule into Law: remove future income from eligible collateral in all credit arrangements.
Ex scientia pecuniae libertas. From knowledge of money, freedom is born.
Introduction
The perspective of a trias pecuniae is about applying Montesquieu’s trias politica to all wealth. A tripartite division of wealth powers consists of the fiscal power, the monetary power and the credit power and they are found with governments, central banks and all houses of credit. In conclusion, a simple solution to all monetary ills of inflation, financial excess and growing wealth disparities is put forward: by removing future income from the equation of eligible collateral, a tripartite division of wealth powers can be balanced in that all arrangements of credit necessarily become self-liquidating. This rule codifies the freedom of wealth into Law, and by adhering to it any society is able to prevent the system gaming the people.
To understand how this collateral requirement can accomplish what tons of financial regulations cannot, one needs to understand banking and the accounting principles that govern the creation of credit. With a detailed understanding of how exactly credit is created, one is able to grasp that the current financial framework cannot be changed drastically. It must continue operating like it does until it eventually breaks apart, and before it is politically deemed a necessity to create a new framework all together. The perspective of a trias pecuniae aims to help anyone understanding why the current financial system is going nowhere as well as it looks forward how a new financial framework can come into existence.
Theories on the nature of money and banking
For non-academic economists, it is a useful reminder that there are several schools of economic thought (i.e. Classical, Keynesian, Austrian, monetarism and the evolutionary approaches). For each of these schools, there is no prescribed combination of money and banking theories. This differs per author and differs within schools of thought. Notwithstanding, reading economic literature on money and banking, one can discern two theories of money and three theories of banking.
The two money theories are the commodity theory and the credit theory of money. All other money theories can be placed within this spectrum. Conventionally, the money literature presents the question of money as a choice between being private or public. In contrast, a trias pecuniae is about framing money to be impartial instead. Both the commodity and credit theories of money are connected to one of three theories of banking: full reserve banking, fractional reserve banking and free banking.
Banking theories
Full and fractional reserve banking assume deposits at banks are the basis for all loans. Both theories can be considered interloanable funds theory and most macro-economics textbooks assume fractional reserve banking to hold true. Theoretically, it is argued that money in deposits can only be multiplied by banks based on the reserve requirement so that in aggregate loans cannot exceed what reserves allow. Unless central banks intervene. With full reserve banking, loans are strictly limited to what has been deposited whereas fractional reserve banking allows fractional multiplication of loans as well as maturity transformation. The third theory – free banking – does not consider deposits to be the source of loans. Instead, credit is created by lengthening both sides of banks’ balance sheets without deposits or reserves being a constraint to the ability of extending credit.
In an especially enlightening manner, it was Richard Werner[1] who was able to empirically test which theory of banking is correct. By examining a bank’s accounting software, Werner was able to produce conclusive evidence: the credit theory of money is correct in so far it vindicates the theory of free banking. Banks extend credit by lengthening their balance sheets and taking a claim on its asset side and creating a credit facility on its liability side.
Seemingly, credit is thus created out of thin air this way. However, from an accounting perspective, this is technically untrue. Reading the credit theory, this point is almost never highlighted so that any student can easily miss this point[2], yet the following is so incredibly important: all credit is created based on collateral taken from the balance sheet of a borrower. Put differently: each credit facility requires two balance sheets to be lengthened, namely that of creditor and debtor.
Collateral requirement: no future income
From a bank’s perspective, any credit facility requires a borrower to pay for his/her loan from an income stream. From an accounting perspective however, there is a huge difference between extrapolating an income stream into a net present value, and a balance sheet item that is taken in as collateral.
Whereas a collateralized asset like a house for example, allows for an immediate liquidation of the asset and likewise the outstanding credit facility, an income stream cannot be liquidated at its face value. Why? It is a theoretical valuation of one’s profit & loss account, without necessarily accounting for instances of bad luck. As an automatic consequence of an inflated collateral valuation, credit risks build up to systemic risks, and lead to residual losses that can only be borne by either borrower, and more importantly unrelated third parties instead of being borne exclusively by those parties who entered into the arrangement of credit. Moreover, by method of debt-for-equity swaps, those parties are able to limit losses[3]. With legal protections however, creditors have incentives to escalate losses in different ways.
The fundamental problem with a credit facility that is based on a valuation of an income stream is that it lies much (much) higher than the assets that produce that income stream. Extending credit on this higher valuation requires asymmetric attribution of credit risks. It necessarily shifts off credit risks to unrelated third parties and this is exactly where monetary induced inflation comes into existence. If not in higher consumer prices, then in inflated asset price valuations, and more generally, in financial bubbles. Inflation is enclosed in each credit facility that is created on the basis of collateralizing future income.
Generic effects of collateralizing future income
The generic effects from collateralizing future income in arrangements of credit are manifold. Let it suffice here to give an overview in bullet points, and refer to the full article for a more elaborate exposition:
- Pro-cyclicality of credit booms is put on steroids due to [1] increased pool of borrowers and [2] dramatic increase in the amount of credit that can be extended this way;
- Once future income becomes the basis of credit there is no theoretical limit to the amount of debt that can be created. Hence, exponential growth in debt since 1971;
- Systemic mispricing of credit risks, build up of financial excess and systemic risks, as well as misallocation of real-economic resources;
- Adverse incentives and rewards for human resources;
- Short term profit taking by ramping up levels of debt at the expense of widely distributed positive equity and long-term economic and financial stability;
- Growing disparities in income and wealth, in part due to public guarantees;
- It introduces collateral discrimination especially for small and medium enterprises (SMEs).
One qualitative check?
Adhering to an utterly simple collateral requirement would balance a tripartite division of wealth powers in ways the current international monetary and financial system is incapable of doing.
Currently, institutions in the spheres of each of these wealth powers are abusing their ability to enter in arrangements of credit by means of collateralizing future income. Governments do so by issuing government bonds and rolling over accumulated sovereign debt, ad infinitum. All licensed credit creating institutions exploit the short-term upsides of seigniorage power by creating credit based on inflated collateral valuations. Doing so by lengthening their balance sheet at technically zero costs. And central banks of issuance are denying citizens freedom of wealth by pro-actively hoarding foreign exchange reserves so that they can only accumulate instead of being employed to enforce continuous international settlement through a floating price of gold[4].
Fiscal power
When the fiscal power collateralizes future tax proceeds when it issues sovereign bonds, it takes away the budget right from the people. In any democratic order, to have an especially autocratic power delegated to a people’s congress is preposterous because the electorate is disabled from putting forward any meaningful check to prevent fiscal profligacy. Any government administration is enabled to spend its way to popularity by collateralizing the future tax proceeds of unborn generations. Notwithstanding, a government can still issue a bond to finance infrastructure for example. So long future tax proceeds are excluded from the collateral this is non-inflationary. Without impairing citizens’ private budget right, it is in the public interest not to forbid the executive power to issue government bonds so long it is done on terms of mutual risk-bearing with creditors, yielding productive assets with a real-economic income model (i.e. roads, ports, telecommunications, health care, education, etc.).
Credit power
For the credit power most has been said, but two more points need to be made. Firstly, once future income is collateralized in arrangements of credit, the Law is required to make loan-sharking legally permissible. The Law must in some way account for the rights of creditors to keep debtors in positions of negative equity. In exactly these accounting terms it begs the question: how does someone with negative equity differ from being a slave? Secondly, the level playing field for all funds of positive equity is no longer. To quote from the original paper: “Banks’ ability to create credit out of nothing, on top off the liquidation values of collateralized assets, decreases the credit power of all other liquid funds. Available private funds, formed by the slow and gradual accumulation of positive equity, must compete with credit that can be created instantaneously, and technically, at no cost”[5]. A collateral requirement levels the playing field for all private wealth under management; hence the Credit power.
Monetary power
For the monetary power there is one thing to get right: account for any and all increases (as well as decreases) of base money in circulation by quoting a floating price of gold. A floating gold price accomplishes the following points (paraphrased from the original article): a central bank and private citizens have a social contract with each other[6]. In terms of purchasing power, this contract is made impartial and reciprocal only if the gold price floats. Said differently, a floating gold price takes away the seigniorage power from a central bank because the gold price effectively increases when the money stock is expanded. Under a classical gold standard, the gold price was fixed and formally, the Treasury was the mandated authority to approve a devaluation or a revaluation. The gold price was a political decree, not a free market price. When money is fixed as a weight of gold, then all gold owners are rendered price-takers. Essentially, it is a way to implement capital controls as it increases the exploitative privilege of seigniorage with legal impunity. With this understanding, one must acknowledge that a classical gold standard would reintroduce the very problem it tries to solve. As gold is nobody’s liability, it has historically served as an internal and external reference rate that allows any domestic or international imbalance to be dealt with: either voluntarily, by settling international balance of payments imbalances in a quantity of gold, or in the alternative, by accounting for a shortfall in real capital exports in terms of a higher price for gold. Why? Because accumulated foreign exchange reserves can always be used to buy gold outright, instead.
Conclusion
The future international monetary and financial framework is oftentimes said to become multi-polar, and as this may very well be, yet the foremost task for world leaders is to rid the current framework from its elementary failings. By removing future income from eligible collateral on basis of which each of these wealth powers are able to enter into arrangements of credit, this world levels the playing field for all wealth indiscriminately for all. Codifying freedom of wealth into Law is not only the right thing to do, for the greater good of all of humanity, but it would also bring about a new world order that promotes international peace in mutually beneficial terms. A truly catallactic[7] world order embraces a floating price of gold because it changes enemies into friends, it allows everyone to admit in the international community on equal terms, and it would bring about an international order of free exchanges, leveling the playing field for the management of all wealth in a bottom-up fashion.
Footnotes
[1] See: Werner, R. (2014), “Can banks individually create money out of nothing? — The theories and the empirical evidence”, in: International Review of Financial Analysis 36 (2014), pages 1–19. Permalink: https://doi.org/10.1016/j.irfa.2014.07.015
[2] The only author I am aware of who did make this point is Steffen Murau. See: Murau, S., (2018). “Offshore Dollar Creation and the Emergence of the post-2008 International, Monetary System”, IASS Discussion Paper, DOI: 10.2312/iass.2018.009, June 2018. Page 9; permalink: https://dx.doi.org/10.2139/ssrn.3191981
[3] See Zingales, L. (2008), “Plan B”. Permalink: http://faculty.chicagobooth.edu/luigi.zingales/papers/research/plan_b.pdf
[4] The body of thought that suggests a floating gold price is known on the internet as freegold. Although it has not yet been introduced in academia it is however useful to consider the source materials. See: https://fofoa.blogspot.com/; https://www.usagold.com/goldtrail/archives/another1.html
[5] See: Jakab, Z. & M. Kumhoff, (2015), “Banks are not intermediaries of loanable funds — and why this matters”. Bank of England, Working Paper No. 529. Permalink: https://www.bankofengland.co.uk/working-paper/2015/banks-are-not-intermediaries-of-loanable-funds-and-why-this-matters
Jakab & Kumhoff emphasize the instantaneous nature of credit creation, thereby highlighting that access to credit becomes discontinuous during busts.
[6] See: Duisenberg, W. (2002), “International Charlemagne Prize of Aachen for 2002 – the Acceptance speech by Dr. Willem F. Duisenberg, President of the European Central Bank, Aachen, 9 May 2002”. Permalink: https://www.ecb.europa.eu/press/key/date/2002/html/sp020509.en.html
[7] See: https://en.wikipedia.org/wiki/Catallactics
