The Invention of Debt and Inflation

Debt
In early society a debt was generally a moral or social obligation to repay someone for a good or service rendered.

Once money became the dominant form of exchange ( a commodity ), a debt came to refer to money owed by one party, the borrower or debtor, to a second party, the lender or creditor.
And these debts are commonly subject to contractual terms regarding the amount and timing of repayments of principal ( the amount borrowed ) and interest ( the extra money charged for making the loan ).

As the Rule of Law and the concept of Property Rights expanded, so did the idea of requesting a security over the money lent - a guarantee asset to be offered in place of the commodity money should there be a failure to repay all or part of the loan.

This securitisation of the debt shifted the idea of a loan away from the personal and short term - from having trust in the person or venture receiving the loan, from carrying some of the risk that the future status matched the planned outcome, to one that was both impersonal and low risk.

Debt became a business, and markets in Debt evolved.
The first step was to use the Rule of Law to allow the loan agreement, and its attached security, to be passed to another legal entity ( person or business ). Once this concept was established, loan agreements could be legislated as Bonds and these could be traded, and regarded as assets.

Dealing with individual loans and their securities was seen as inefficient and limited the scale of debt markets - so loans were pooled, sold to securitisation trusts, who bought them using Bonds ( Securities ) sold, in turn, into the Debt Markets.

## [ http://en.wikipedia.org/wiki/Debt ]

The critism of debt as a business is two-fold - firstly, that divorcing the lender from sharing the consequences of a future that does not match that envisaged on creation of the loan, unfairly pushes those consequences back onto the community and society that supports the borrower ( ie: can create public debt, environmental damage, social disruption ), and secondly, that as the Debt Market is a source of wealth creation, there is pressure to create levels of debt in excess of real and reasonable needs.

Inflation
Economists historically identify three factors that cause a rise in the price of goods and services:

• a change in the value or production costs of the goods, 
• a change in the price of money, which occurs when either the coins themselves are debased or an inflow of similar commodity dilutes the value ( eg: gold and silver flooding Europe from the Spanish invasions of South America ),
• or currency depreciation - an increased supply of currency, usually note printing.

## [http://en.wikipedia.org/wiki/Inflation ]

Basically each unit of currency buys fewer goods and services - a reduction in the purchasing power  per unit of money – a loss of real value. The measure of price inflation is the inflation rate, the percentage change in a price index, usually the consumer price index or similar basket of goods.

Negative effects of inflation include:

• an increase in the opportunity cost of holding money, making spending cash a priority,
• uncertainty over future inflation which may discourage investment and savings, and 
• if rapid inflation, shortages of goods as consumers both hoard out of concern that goods will disappear, and buy goods as inflation resistant assets or as barter items for future use.

Mild Inflation can have positive effects:

• it gives everyone an incentive to invest, as their money will be worth less in the future.
• it reduces the real burden of debt, but only if salary or income increases over time due to inflation, but outgoings or mortgage payments stay the same.
• it can keep nominal interest rates above zero, allowing central banks to reduce interest rates as a means to stimulate the economy.
• it can reduce unemployment by reducing the real value of wages, increases the demand for labor.

Historically high rates of inflation and hyperinflation have been due to excessive currency printing ( 1920s Germany), or floods of currency-like commodities (1500s Spain), or periods of failure of confidence in the government guaranteeing a note or bond based currency (1990s Yugoslavia ).

## [ http://en.wikipedia.org/wiki/Inflation ]

This is all historical information, and internally logical if simplistic. However, recent trends in country and global economies have not followed the expected patterns. Interest rates have been close to zero, wages growth is zero or negative, and in theory the increased money supply ( quantitative easing ) should have caused mild inflation and economic stimulation.

Investment in infrastructure, education, and preventative or primary health care can grow an economy in greater amounts than the investment spending. They act by reducing the cost of living, or increasing the apparent purchasing power of currency won through wages.

However, current government policy, in the face of slowing economies, is to reduce government spending, limit wages growth, and encourage private spending funded by increased debt.

One half of government is acting as if inflation was rising - using fiscal policy to reduce wages growth, and cut back on government spending on community; and the other half is using monetary policy, as if we are in recession - boosting public debt by transfers to private corporations.

Taxing The Use of Money

Summary: Modern developed economies now consist of three sectors - manufacture, service, and finance. Current tax regimes primarily collect from the first two sectors, leading to an impoverishment of both those sectors, and the government that uses that revenue. The proposed tax on the use of money would effectively and efficiently tax all three sectors. Such a tax is feasible due to the high level of computerisation of the banking system, and the decline in the use of cash in day to day transactions.

Background:
* Manufacture includes all the ways things are processed and transformed;
* Service includes activities that support manufacture and society itself;  and
Finance includes all the ways money is used as a commodity and a source of profit, rather than money being the lubricant to facilitate manufacture and service processes.
The tax system evolved along two principles - identify the processes that generate wealth, and find a way to efficiently collect a part of that wealth. This revenue was then used to finance processes that support the population as a whole ( according to the dominant social model for that time ).

Early taxation identified manufacture as the dominant source of wealth creation, and the goods created, excavated, or grown could be measured, valued and a tax collected on their transfer as property.

As society evolved, services grew, first as a part of manufacture - bookkeeping, goods handling and freight, machine servicing, labour support, etc. And these services were efficiently taxed by taxing the goods that they supported.

As ex-manufacture services grew - health, education, personal services - and as the previously internal services became outsourced, the concept of a GST developed to capture these less concrete sources of wealth. These taxes still relied on the practicality of taxing the transfer of goods, but the concept of an invoice enabled a form of virtual taxation that was equally effective and economical to collect.

Now it is estimated that Finance transactions are approximated 10% of the GDP ( and growing at around 3% pa ) and that these predominantly use money as the commodity of wealth generation - trade in money, debt, and securities being used to earn money.

This source of wealth is very poorly taxed - only declared profits being measured. Yet the impact on society ( and the environment ) of this use of money is a profound as strip mining or irrigation on the natural environment, or industrialisation on human society and towns.

This might sound an extreme analogy, but the use of money to generate money means that only those chosen to participate by the managers of those financial institutions, get any benefit, for the wealth generated by money debt today, comes by bringing future concrete wealth into the present, impoverishing those who did not gain ownership of that concrete wealth.

Proposal: Tax the Use of Money
Almost all financial and business transactions now involve a digital exchange. Most involve the deposit and withdrawal of a money amount in a legally defined and regulated financial organisation.
It would be relatively inexpensive to require all these financial organisations to modify their computer systems so that a percentage of these transactions are passed to a government account(s).

This source of revenue could replace all current taxes and levies, simplifying both the tax payment and the tax monitoring systems.

It would not have to be an exclusive tax - in fact, a gradual introduction, with concurrent reductions in other forms of taxation would ensure a smooth transition, and opportunities for industries and social organisations to monitor and adjust to the change.

The advantages of taxing the use of money would be:
government budgets would be easier to formulate from the smaller number of data inputs from financial organisations - much available in real time.
short term budget needs could be met with tiny increases and decreases in the transfer percentage.
the payment of tax would be daily or hourly ( or less ) in tiny amounts, so much easier to match to cash flow for business and individuals.
low-incomes could be supported by similar tiny frequent deposits from the government account(s)
over-seas purchases and transfers would be taxed as withdrawals in the local regime.
currency speculation and micro-trades would be taxed, and discouraged unless truly of value, leading to reduced volatility in the markets.

The disadvantages would include the taxing of investments, cash used to establish a business or venture, and research and development costs. But these could be treated as special investments in the common good, and supported by government grants.

The primary advantage would be that the tax burden would be more fairly shared across all three sectors of the economy, and the tax revenue would strengthen the sovereign government, and reduce the negative impacts of globalisation on society and the environment.

Structural Change in the Australian Economy

This employment graph is typically used to illustrate the change in the Australian economy over time.  But the services industries are very labour intensive, and there have been significant changes in the mix of services included in the data. The graph below shows the long term change in percentage contribution to GDP.  ( Note: Service and Distribution are grouped as Services in employment data )

The large growth in Services ( excluding Distribution ) reflects three trends.
Firstly - the growth of two income families has created demand for services that previously were conducted in the home - child care, pre-schooling, home maintenance and servicing, aged care, and cooking - and hence not previously included in the GDP data;
Secondly - there has been an increased demand for health, educational, recreational and financial services with increased incomes, and pressure for employment;
Thirdly - many activities that used to be run in-house in manufacturing, agriculture, mining, construction, and distribution, are now outsourced and re-classified as services.

So from a structural change view, the growth in services is not as dramatic as it first seems, but from a taxation or government finance point of view, it is a significant change with long term consequences.

Around 1900 - it made sense to tax goods as this collected the bulk of the financial activity in a format that made assessment easy and collection efficient.

Around 1950 ( and later ) - the growth in combined services encouraged the additional of a VAT or GST to both goods and services, as a practical way to tap into the increasing share of financial activity that was service based.

Around 2000 - it seemed appropriate to increase the VAT/GST rate, and/or extend it to include previously exempt services and goods - typically education, fresh food, and some health services.

However, Finance and Insurance currently contributes about 10% of GDP ( and is growing at around 3% ) and a VAT/GST typically fails to collect tax revenue from this activity. Part of the reason is the strong political lobbying from the industry in general, and the small number of powerful and wealthy individuals who benefit from the trading in finance. Part is also the difficulty in defining the service that should be taxed.

This problem has encouraged proposals for an alternative tax on the use of money - a tax that would replace all current taxes - VAT/GST, sales taxes, and levies - and be based entirely on the interface of money exchange. ie: levied at the point of deposit and withdrawal at financial institutions.

The argument is that this captures the true overall economic activity as based for taxation ( as revenue for government ) and is capable of responding to any future structural change in the economy.

There are also moral and environmental arguments for such a tax on the use of money, and these will be discussed in later posts.

The Mystery of Banking and Capital in the 21st Century

18 months between posts might seem excessive, but I have been reading books by some impressive economists - Murray Rothbard - The Mystery of Banking, and Thomas Piketty - Capital in the Twenty-First Century. Both authors come from Europe - Rothbard from Austria and Switzerland, and Piketty from France, and their european perspectives are enlightening.

Rothbard's focus is on how money and money supply works, and how the demand for loans led to the concept of Central Banking, and how this has become organisations ( Reserve Bank, Federal Reserve, etc. ) with their own commercial and political agendas that run counter to the aims and needs of the wider community and societies that they supposedly serve.

Piketty has collated and analyzed the records on property ownership, tax payments, deaths duties, and company shareholdings, from 20 countries, the oldest data from the 1700s in France and England, to build a model of how capital builds over time, and how it is used and distributed.

Piketty's key finding is that capital always tends to create returns in excess of the rate of economic growth, and that only in the immediate post WW2 period, did technology allow wage earners to match the earnings of capital ( itself temporarily reduced by the costs and damages of WW2 ).

Piketty expands his argument to include financial inequality ( income and wealth ) as a key factor in social unrest, and rebellion.  Critics have been quick to point to capitalism as the source of equality of opportunity, and of improved health, education and social equality, especially in developing countries.

However, Piketty has already pointed out that we are just leaving the "abnormal" post WW2 period, and that he is warning about returning to the long term trend line, where capital creates capital ( or wealth ), faster than wages can create capital.  And he notes that there is no clear correlation between increased capital and increased social equality, except in situations where improvement of the skills and health of the workforce generate productivity increases and so raises the return on the capital.

The key point that I take from these two books is the realisation that the actions of the expanded central banking system has both increased the growth in returns from capital, and through fractional reserve banking, decreased the ability for wage earners ( and governments that rely on them for tax revenue ) to build up capital.

This might not be a serious problem if the form of capital, and the uses made of it to generate returns, where similar that of the 1700-1900s.

Over this period, labour was a key component in the sources of returns on capital invested.
In the cases of using capital to invest in colonial trade and industries, the labour component was small, slavery was often part of the "capital" owned, and wages were tiny. But in most developed economies the return relied on skilled labour, whether in agricultural, industry, or mineral or timber extractions. So wages were a necessary "cost" and proportional to the nett return.

However, the last 60 years have seen a shift towards money being a commodity in its on right, rather than just the mechanism of exchange, or temporary store of value - the "oil in the cogs of the economy", or the "catalyst in the process of production".

The percentage that financial services contribute to the economy is also growing at around 5% per year - from a current 9% ( 2013/14 ABS ) - and half our overseas "trade" is transfers of money to related companies ( globalisation ).

The nett effect is that money is increasingly a form of capital ( rather than a measure of capital ), and one that can generate a return on itself with very little labour required.

Combine this with fractional reserve banking, and you have a system that shifts wealth to the more wealthy by diluting the existing wealth of the less wealthy, and reducing the capital creation ability of wage earners - an efficient source of the inequality that Thomas Piketty is concerned by.

Retirement Savings, Superannuation and Bank Deposits

The Australian Federal Government has set up the Murry enquiry to look at bank deposits, insurance, retirement savings and home loans, and the key issue seems to be the role of deposits versus other sources of funding.

Bank deposits have risen from around 40% in 2008 to 60% in light of the crash and slow thaw in wholesale money markets. Superannuation savings have grown to more than A$1.7 trillion and half of that has been invested in shares in the absence of a pathway into tax effective interest bearing deposits.

So curiously, we are at a stage where the banks themselves may lobby for a much larger real deposit backed lending process, drawing on the superannuation funds, and a move away from creating loans backed by the borrower's future access to wealth (- see the earlier blogs).

This would be a very good thing. In the short term the interest rate paid on deposits would fall or flat line due to the increase in funds available, but long term the depositors would start to demand better returns, and while this would raise the cost of borrowing, it would also raise the level of consumer demand for goods and services.

But more importantly, it would base investment on already generated wealth of the lender instead of mortgaging the future generation of wealth of the borrower.  And it would free to borrower from living up to the model of the future envisaged by the lending institution.

This may sound a little odd, but that is one problem with the current ability of banks to lend more than they hold in real deposits. That phantom money becomes real when you agree to borrow it because you are agreeing to give the bank your ability in the future to generate wealth, but the future you are signing up to is that that suits the bank - a future that they think will be favourable for them to make more money. This is why housing, property and development get such favourable rates, and ethical and sustainable projects struggle. The banks may not be especially mean over this, it is just that they can not model a green future, so they can not accept such an unknown future.

Mr. Soddy’s Ecological Economy

Frederick Soddy, born in 1877 in England, was a chemist with Ernest Rutherford when they jointly determined that radioactivity was atom decay and transformation. Back in Scotland, he described and named the concept of an isotope, and determined the changes in atomic number brought about by radioactivity. He received the 1921 Nobel laureate in Chemistry for his work on radioactive decay, and foresaw the energy potential of atomic fission.

He turned to economics, revolted by the mass chemical deaths of World War I, published four books from 1921 to 1934, and campaigned for a radical restructuring of global monetary relationships, but was dismissed as a crank.

He saw economics as a physical machine that must draw energy from outside itself.
The first and second laws of thermodynamics forbid perpetual motion - systems that create energy out of nothing or recycle it forever. He criticized the prevailing belief of the economy capable of generating infinite wealth.

Current economists model the economy as a living system. drawing from its environment valuable (or “low entropy”) matter and energy, ores, the raw materials provided by plants and animals. And like all life, an economy emits a high-entropy wake — it spews degraded matter and energy: waste heat, waste gases, toxic byproducts, apple cores, the molecules of iron lost to rust and abrasion. High entropy emissions include trash and pollution in all their forms, including yesterday’s newspaper, last year’s sneakers, last decade’s rusted automobile.

Matter taken up into the economy can be recycled, using energy; but energy, used once, is forever unavailable to us at that level again. The law of entropy commands a one-way flow downward from more to less useful forms. An animal can’t live perpetually on its own excreta. Neither can you fill the tank of your car by pushing it backwards. Thus, Georgescu-Roegen, paraphrasing the economist Alfred Marshall, said: “Biology, not mechanics, is our Mecca.”

Following Soddy, Georgescu-Roegen and other ecological economists argue that wealth is real and physical. It’s the stock of cars and computers and clothing, of furniture and French fries, that we buy with our dollars.

The dollars aren’t real wealth, but only symbols that represent the bearer’s claim on an economy’s ability to generate wealth.

Debt, for its part, is a claim on the economy’s ability to generate wealth in the future.

Soddy said that the ruling passion of the age, is to convert wealth into debt — to exchange a thing with present-day real value (a thing that could be stolen, or broken, or rust or rot before you can manage to use it) for something immutable and unchanging, a claim on wealth that has yet to be made.

Problems arise when wealth and debt are not kept in proper relation.

The amount of wealth that an economy can create is limited by the amount of low-entropy energy that it can sustainably suck from its environment — and by the amount of high-entropy effluent from an economy that the environment can sustainably absorb. Debt, being imaginary, has no such natural limit. It can grow infinitely, compounding at any rate we decide to accept.
Whenever an economy allows debt to grow faster than wealth can be created, that economy has a need for debt repudiation. Inflation can do the job, decreasing debt gradually by eroding the purchasing power, the claim on future wealth, that each of your saved dollars represents. But when there is no inflation, an economy with overgrown claims on future wealth will experience regular crises of debt repudiation — stock market crashes, bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets.

It’s like musical chairs — in the wake of some shock (say, the run-up of the price of gas to $4 a gallon), holders of abstract debt suddenly want to hold money or real wealth instead.

But not all of them can. One person’s loss causes another’s, and the whole system cascades into crisis. Each and every one of the crises that has beset the American economy in recent years has been, at heart, a crisis of debt repudiation. And we are unlikely to avoid more of them until we stop allowing claims on income to grow faster than income.

The problem isn’t simply greed, or ignorance, or a failure of regulatory diligence, but a systemic flaw in how our economy finances itself.  As long as growth in claims on wealth outstrips the economy’s capacity to increase its wealth, market capitalism creates a niche for entrepreneurs who are willing to invent instruments of debt that will someday need to be repudiated.

Soddy suggested five policy prescriptions - taken at the time as evidence that his theories were unworkable. And yet these four are now conventional practice:
abandon the gold standard,
let international exchange rates float,
use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and
establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort.

Soddy’s fifth proposal, was to stop banks from creating money (and debt) out of nothing.

Banks do this by lending out more than they physically hold of their depositors’ money at interest — creating debt ( a claim on real wealth in the future ) and creating apparent debit balances in the borrower’s demand deposit (checking) account, where it can be lent out again to create more debt and demand deposits, and so on, almost ad infinitum.

Herman Daly, an ecological economist, and many others have proposed a gradual, legislated move to 100-percent reserve requirement on demand deposits.

Banks could still support themselves by charging fees for safekeeping, check clearing and all the other legitimate financial services they provide. They could still make loans and still be able to lend at interest, but based on the real money of real depositors.  This would re-establish a one-to-one correspondence between the real wealth of the community and the claims on that real wealth.

The immediate response to this economic theory and its fifth proposal, is horror at the impact it would have on GDP, the share market, and economic activity.

But real debts do exist. These are mainly the real world matter and energy high entropy emissions and environmental impacts. The currently, un-costed, costs of removing CO2 from the atmosphere and oceans; of repairing degraded land and water supplies; of neutralising the toxins and organochlorides; and of redressing social inequity and poverty caused by the debt process.

And the problem is that these real debts have to be paid from current wealth generation.
They are not a claim on future real wealth. And they have physical priority over the interest created and charged from debt creation.

We are at a stage where real debts are increasing eroding our current wealth creation, making us all a little poorer each year, and throwing into doubt our ability to create wealth in the future, and so seriously weakening the claims by debt to that wealth.

This is both creating social and personal dissatisfaction and tension, and bringing forward the likelihood of financial crisis and collapse - debt repudiation.

It is increasingly likely that Soddy’s fifth proposal will also become conventional practice.

More on the Problem of Interest and Debt

Let us go back to when gold and silver was used to make coins.

These coins could not change in value or number, and the amount mined each year was very small, so if anyone charged interest on a loan then either the borrower ended up with less gold, or they had to take it from some-one else.

Neither of these improved society and it explained why both the Catholic Church and Islam condemned usury - the charging of interest.

The invention ( and public acceptance ) of the concept of paper money and bills partly solved this problem. It meant that the total supply of money in circulation could increase each year in an amount at least equal to the profits made from charging interest.

The Money Supply is the amount of money available for other to access and use. At its most narrow definition it is the money held in bank current deposits - liquid deposits.
The next broadest definition includes other deposits, short term deposits, and non-bank deposits.

It is not the amount of coin or notes in circulation - which is typically only equals 2-3% of the total money supply. The majority of the money supply is accounting notations that state that the depositor has ownership of the stated amount, and these are assumed to be real reserves, and that the owner agrees that these can be lent to others.

A government’s reserve bank or treasury can increase the money supply buy printing more notes and paying government employees and suppliers - this extra cash goes into the banking system and become 10 times that amount in liquid deposits as banks engage in fiat leading ( lending $100 for every $10 held in cash or real reserves ).
Governments can also issue bonds, or modify the definition of tax receipts, so that current deposits appear to increase. Too rapid an expansion of the money supply in this way typically leads to inflation, but in periods of recession, it can stimulate productive activity and improve the circulation of cash through the real economy.

The problem is that interest is charged each agreed time period. So it compounds and grows each year, and even if you gradually pay off your debt and reduce the interest you pay, your payments go back into the banking system, get lent to someone else, and the overall interest over the entire money supply continues to get charged, and paid for from real earnings.

The only way to match this is either inflation, the increase in the prices charged for things, or by making and doing a lot more of whatever generates the real earnings. Some of this might be from wages growth or improved productivity; some might be by the capital growth of the asset you took on debt for ( a future increase in real value to offset the loss due to interest charged now ).  But these are only accounting changes, they don’t alter the underlying dynamic of ongoing interest charged against real earnings.

Throughout history, every economy where interest is charged ends up with debt growing faster than the population’s ability to to pay. It can be masked for a while through apparent increases in property or capital value in currency ($) terms, and it can be eased briefly in periods of economic expansion ( eg; mining or resources booms ) but ultimately everyone becomes more impoverished and the environment more degraded.