19 June 2016 – I’m supposed to have some passing understanding of economics and accounting. I have, after all, a Master’s degree in Business Administration, for which I had to study Macroeconomics and Microeconomics, as well as Cost and Financial Accounting.
Howsomever, while trying to make sense of what folks call “Modern Monetary Theory” it dawned on me that, not only didn’t I have a clear concept of what money actually is, but the people babbling on about money and monetary policy aren’t any clearer on the concept than I am. A review of the differences between neoclassical economics based on Keynsian ideas and so-called Modern Monetary Theory reveals an incomplete understanding of money.
We all think we know what money is, and spout long winded and erudite-sounding loads of gobbledygook that only serve to prove, beyond a shadow of a doubt, that none of us have a clue what the stuff actually is!
I find that situation intolerable, and have set out to change it by trying real hard to come up with a theory that makes sense of all the stupid things we do with and say about money.
Now, I’m not a financial wizard, or a prize-winning economist, or even a whiz-bang developer of computer models of the global economy. I’m just some schmuck with some basic math ability, a little time on my hands, and the desire to make sense of something that it seems the “experts” haven’t wrapped their brains around, yet. So, I’ve thought about this problem a bit, and have a hint of an answer that I want to run up the flagpole to see if anyone salutes.
If this essay triggers something in the brain of somebody smart that sets him, her or it thinking in a new direction about money, I’ll count it time well spent.
So, here goes … .
In science, we try to make sense of anything we don’t fully comprehend by developing some kind of conceptual model that helps us predict what will happen in any given situation. The fact that we currently haven’t a clue what will actually happen when, for example, the Federal Government runs up huge deficits for a very long time, indicates that we’re very far from knowing what we’re talking about with regard to money.
I generally try to model things poorly understood through analogy with things that are well understood. I’ve developed a two-fluid model of money by analogy to certain ideas in classical physics. It seems to work decently for the situations I’ve applied it to.
Analogy with Momentum
Specifically, the model draws an analogy with Newtonian momentum, which is a conserved vector quantity – meaning that the total momentum in a closed system cannot be changed, and that the quantity involves both a magnitude and a spatial direction.
For our analogy to be useful, we need to also use the idea of generalized coordinates, which allow the idea of “direction” to extend beyond strictly cartesian spatial coordinates (motion in straight lines). For example, a bicycle drive chain wraps around two sprockets and has flexible spans linking them, so its motion certainly does not follow along a single cartesian coordinate, yet there is a well-defined path along which any two points on the chain follow each other, maintaining their separation (measured along the path). That allows us to measure motion along the path by a generalized coordinate.
In Newtonian mechanics, momentum is exchanged between objects, which are thought of as components of a system, through the action of forces. Mathematically, the magnitude and direction of the force equals the rate of flow of momentum between the objects.
Newton’s third law, which states that every force is paired with an equal and opposite reaction force, is just an expression of conservation of momentum in that every force (representing a transfer of momentum from one object to another) is paired with an equal and opposite transfer of momentum from the second object to the first. This takes care of maintaining conservation of momentum.
Take, for example, a person stepping off a boat onto a dock. At first, everything is (as seen from the perspective of the dock) stationary. The momentum of an object is defined as the object’s mass (amount of material) times its velocity (a vector combining speed and direction). Since both the person and the boat are stationary (meaning they both have a velocity of zero), the total momentum of the system of person + boat is zero.
Then, the person applies a force to the boat in a direction away from the dock. The Newton’s-third-law reaction force is a push by the boat on the person toward the dock. That’s how the person actually gets to the dock. The boat pushes him/her toward it!
The boat moves away from the dock. The person moves toward the dock. So, the directions of the two momenta are opposite. The speeds of the person and boat automatically (or maybe you’d like to say “magically”) adjust to keep the total momentum of the system equal to zero at all times. That is, at every instant the momentum of the person is equal and opposite to the momentum of the boat.
In the theory of money that I’m proposing, money itself is analogous to momentum. Altogether, it’s conserved. That is, it cannot be created or destroyed. There’s always the same amount of “money” – zero!
What we’re used to thinking of as “money” is only half the story, which is why there’s so much confusion over it. Borrowing from double-entry bookkeeping, we’ll call what we usually think of as money as credit. Everyone who understands double-entry bookkeeping knows that for every credit, there is an equal (and opposite) entry called a debit. For our purposes, we’ll shorten that word to something we’re all familiar with: debt.
Debt is the other side of the analogy, which we tend to ignore and that accounts for all the confusion.
We’re going to visualize credit and debt as fluids because they’re measured as continuous, as opposed to quantized, variables. That means that they’re representable by real numbers as opposed to integers. So, nobody has a problem with dividing seven dollars ($7) into two portions each containing three and a half dollars ($3.50). Current usage is to round everything to the nearest cent, or hundredth of a dollar, but that’s for convenience and not wanting to be bothered with truly small change.
At one time, we had half-penny ($0.005) coins, but we don’t do that anymore.
Okay, so “money” actually represents credit and debt in equal amounts, which consequently always add up to zero. Whenever money is created, it’s created as equal amounts of credit and debt.
Money creation always requires activity by two cooperating entities: a creditor and a debtor. Credit is created and transferred from the creditor to the debtor. An equal quantity of debt is created and flows from the debtor to the creditor. “Money” consists of these paired fluids, which flow through the economy via paired interactions between creditors and debtors. Money is created by an interaction that creates equal amounts of credit and debt, and the words “creditor” and “debtor” simply indicate the direction of flow.
Once created, the money flows around in the economy through paired transactions in which credit flows one way and debt the other.
This visualization allows us to separate the concepts of “money” and “wealth.” Wealth refers to tangible and intangible assets, such as commodities and intellectual property. Wealth is very definitely not conserved. When a contractor builds a house, he or she creates wealth from, essentially, nothing. The contractor then sells the house to the new owner in a binary transaction that transfers credit to the contractor and debt to the owner.
We’ll leave out discussion of what happens to the wealth represented by the house, since this essay is about money, and money is not wealth.
The owner previously got the credit through a transaction with a lender in which money was created as a transfer of credit to the owner and debt to the lender. The lender can then, for example, package the debt up into something called a “collateralized debt obligation,” and exchange it with somebody else for an equivalent amount of credit. The lender then transfers that credit to another prospective home owner in exchange for an equivalent amount of debt, and the merry-go-round keeps turning.
Unlike wealth, which was created from nothing, the total of credit minus debt in the system remains zero at all times.
It is interesting to note that wealth appears through the creation of a pattern in the physical universe. For example, bricks used by a contractor to build a house start out as a less-organized pile. The contractor creates wealth by arranging those bricks in a house-like pattern. The owner has no use for the disorganized pile of bricks, but has a use for them when arranged as a house. Similarly, the contractor had no use for the raw clay that went into the bricks until the brick manufacturer rearranged it into the pattern we call “bricks.”
Historically, folks’ fascination with the credit side of money has led them to confuse “money” with “wealth.” They’re entirely different things. One is a medium of exchange related to entries in a bookkeeper’s ledger, the other is a real thing related to patterns in the physical world.
I hope this essay manages to help make sense of the money nonsense!