Reason for a New Age

Posts Tagged ‘central bank’

Tying it All Together

Posted by publius2point0 on 2010/02/07


Having now discussed money, loans, stock, and all of these topics, we can formulate a simple miniature model of a free economy.

Before I do this, let me note again that economics started in philosophy. The goal was to figure out how man works and what rules he needs to live by to achieve happiness, while not impinging on others happiness. Understanding the basic idea of a free economy does not mean that an unrestricted, free market is the ideal. There are certain reasons why it has a tendency to produce good things, and understanding the apparatus by which this takes place allows one to, ideally, make decisions on how one is best to legislate. But all legislation is, at heart, a restriction of freedoms. The free market does generally work, but it does work better on paper than it does in the real world unless you use legislation to force people to act like their paper analogues. The free market is not a perfect solution for humanity, but it is the best one yet discovered. Possibly a better solution doesn’t exist. But there are certainly still ways in which it can be improved.

Our Model

In my blog titled “On Scarcity“, I introduced the “food unit”. 1 food unit is the amount of food that a person needs to eat a day to survive. In an traditional, subsistence farming civilization, a person would need to produce about 1 food unit, every day, for the entire year, just to live. Subsistence farmers rarely did much better than this, but we will say that we have a group who produce 1.2 units every day.

In a community of 100 individuals, we would then have 120 food units of wealth being produced each day.

Wealth and money are distinct terms in economics. An easy (and perhaps wrong) statement of the definition of “wealth” is that if you were to take away all money and commerce, whatever goods everyone is left with is their wealth. Unfortunately, this becomes tricky for one should class personal skills as a wealth, like medical knowledge or acting talent. Farming knowledge would count as a wealth as well, but we are going to ignore that fact for this discussion.

Personally, I think that the food unit is a good measurement of wealth. A person can live without shelter or skills or anything else, but he must have at least 1 food unit every day. As the only true necessity in life, everything you ever purchase that is not food, is diminishing your ability to purchase food. If you can safely afford to do that, you are already wealthy compared to nearly all of humanity since we evolved and all of the rest of the animal kingdom that ever has existed.

We will suppose that our community of 100 farmers is formed principally of specialists. Rather than each one trying to maintain a balanced diet within his own farm, one specializes in corn, another in raising livestock, yet another in fishing, and so on. Because of this, they have invented the concept of money. Our farmers get together periodically, selling most of their produce for money, and purchasing most of what they need from others with the money they have earned. Because of this, they each are able to get a balanced diet, and yet their personal amount of money never changes.

To make things easy, we will suppose that each of our farmers has $1.20. Each one might sell a dollar’s worth of his own produce, enriching him up to $2.20, but of course he then goes out and purchases $1 worth of produce from others, putting him back to holding just $1.20. In either case, the total wealth of the community (120 food units) equates exactly to the amount of money in the community ($120).

One of our farmers, who we will name Damon, comes up with the idea for a device that could double the production of all agrarian farmers. Since 80% of our farmers are of this type, Damon’s machine would increase the wealth of the community to 216 food units per day. The problem is that in order to invent his machine, Damon needs six months of R&D and production time. He can do all the labor himself, but he won’t be able to farm during this time.

With an excess production of 20 food units per day, the community can support Damon for as long as he needs. But, mankind has a particular quirk that if the same fellow shows up to beg for free goodies every day, pretty soon the charity runs dry and the people become antagonistic, telling the guy that he’s wasting his time and he should get back to farming if he wants to eat instead of fooling about with some wild-eyed project. Damon might be able to sell the community on the project to start with, but if he has to sell them on it again and again each day for six months, he will likely have to give up and go back to farming.

Damon would do much better to have a supply of cash ready, up-front, to pay his way through 180 days of labor. As a paying customer, no one can complain, since they are being enriched by his folly either way.

Selling off his excess 0.2 food units each day without buying back any excess, Damon could slowly build up a supply of money. Of course, to build up enough money, he would have to work for 900 days to earn $180. Since there is only $120 in the whole community, Damon and everyone else would have to accept trading with those who are in debt. Technically, this would be a fairly irrelevant thing since money is all a fiction to begin with, but people have a tendency to be wary of accepting $1 in credit from a person who has -$2. More importantly, by wasting 900 days, the whole community lost out on 720 days where they could have been producing 216 food units per day. Trying to do it in this way is less-than-optimal.

The community has the wealth to afford allowing Damon to do this, and he can sell them on the idea at least once, but cash-wise someone will have to go into debt. The answer to this problem that’s been found in modern day is the creation of a community bank (or central bank).

Damon goes to the bank, which might be overseen by some governing council that represents the community. He asks for $180 so that he can create his machine. Once he has his machine, he will be able to pay back his loan by selling it to others. The community bank accepts this, seeing that it is for the good of the community, and simply prints off $180. There is now $300 in our market.

Where does that money come from? The simple and non-philosophical answer is that the community bank is in debt, but since no one trades with the community bank and the village elders are saying, “No no, everything is fine! Just fine! Nothing to see here!”, no one much cares about this. A more philosophical answer would be to say that we suppose that Damon did work for 900 days and drive everyone else into debt. Knowing that he did/will do his part in saving up money, we deduct it all from his future self and put it into the present as a way to offset the debt that the community would have gone into as individuals. We raise the tide so that once Damon takes all their money, they still look and feel like they aren’t in debt–when in secret they have simply pushed that debt off onto the community bank.

Ultimately, how you choose to view it doesn’t much matter since it’s already being done and you’ve already lived with it being like that just fine. This is proof enough that people are happy enough to accept this method of operation.

For six months, thence following, Damon works on his project. Each day he trades for 1 food unit until he is left with his original $1.20. Everyone else in the community now has about $3.02. The central bank has -$180.

Damon knows that 80% of the people will want his machine and so he produced 80 machines to sell. Since this took $180, he spent $2.25 per machine. If he sells at that rate, he breaks even. Damon would much rather profit.

A farmer who will live for 40 more years, with Damon’s machine can make 34,176 food units. Without the machine, he can only produce 17,088 food units. If each farmer thinks to himself that $1 is equivalent to 1 food unit, Damon can charge $17,087 to buy one of his machines and a farmer would still eventually see a profit. Since he has no competition, Damon has no particular incentive to charge anything less than he can feasibly get away with. If he can make $17,087 * 79 people, he’ll not only never need to work again–at current prices–but he’ll also be able to see to the secure and easy futures of many of his descendants.

But of course, the farmers want to make as a great a profit as they can as well.

Let’s say that either group would be happy with 20% profit. Damon will charge no less than $2.70 and his fellow farmers will pay no more than $13,670.40. In this case, Damon would of course simply charge $13,670.40.

In the real world–and an item I realize that I forgot in Evolution, Instinct, and People, is that people are fairly short-sighted. Profit that can’t be attained for 30 years is something that most people wouldn’t really consider. Out on the edge of the bell-curve you might find one fellow who is willing to do this–the so-called early adopter–but to sell all 80 of his machines, Damon will need to lower his price. In fact, gradually lowering his price until all 80 units are sold is of course the route to the greatest profitability–though this takes longer and more finesse than simply charging whatever the lowest price is that can move all 80 machines.

Let’s say that the average price at which Damon sells comes out $100 per machine. Our entire market only has–at this moment–$300 in it. To buy Damon’s machine a further almost $8000 must be created. Our 80 farmers each end up going to the central bank and taking out loans for up to $100 each. Damon pays back his $120 quite quickly, but the market is still inflated to over $8000.

If you ask where inflation comes from, this is your answer. The central bank continues to go further and further into debt as people borrow against their futures.

An interesting thing, though, is where I supposed that $1 is equivalent to 1 food unit when the farmers do their mental math to decide whether to buy Damon’s machine, and how much to buy it for.

Back when Damon only had $1.20 and each of our farmers had $3.02, it’s fairly likely that the price of food would have increased. Everyone, knowing that everyone had $3.02 to spend, and being greedy, will charge more for their own produce. This all evens out so that no one ends up any richer–they just continue to stay at the same equivalent level of financial standing–but it means that the cost of food increases with inflation. Thus, when Damon considers how much he wants to charge, and when the farmers consider how much they want to spend, they will do this math, adjusting for inflation. Quite likely Damon will end up charging $200 per machine rather than $100, because the farmers would view the value of their future produce as being worth double what I said. This would mean our economy becomes worth over $16,000 instead of over $8000.

But then once our community is producing 216 food units per day, far more than is needed for 100 people even allowing for a desire for excess, some of our farmers will decide to become actors or to embark on similar ventures as Damon did and forgo farming. A full half of our community may stop being farmers. This means that half of our money will go towards watching plays or investing in new technologies or whatever, and only half to food. Instead of food commanding 100% of our market, it now only represents 50%. When our market value went from $120 to $300, the price of food matched that equally. When it goes up to $16120 (say), the price of food might only go up to $8060.

Remember, though, all of this is borrowed money. As our farmers farm, actors act, and so forth, some percentile of their earnings goes back to the central bank, until the central bank is back to zero debt.

When that happens, how much money does everyone have? Let’s work through what really happens, since everything still isn’t so simple as all that.

1) Our farmers each give Damon $200. putting the bank at -$16,180. The farmers maintain their $3.02 having borrowed everything they need from the bank.

2) Damon has $16,001.20. He pays back his loan to the bank, leaving himself with $15,821.20. The bank now has -$16,000 exact.

3) The farmers establish a market for select produce and a market for less-than-perfect produce. They charge $10 for 1 food unit of select produce and $2 for normal produce. Damon doesn’t work at all, he just spends money. Having the option to buy the best, he always does so, losing $10 each day for his food. This is only about 10 cents, divided out among all the farmers.

4) Since the farmers owe back their loan, as they chip away at Damon’s money, they maintain a level $3.02 apiece, gradually shrinking the total amount of money in the central bank. When Damon starts getting down to having $30 or however much, he stops buying the $10 produce, and so the price of select produce is lowered and lowered.

5) As Damon (or his son as may be) approaches only having $3.02 himself, there arises a distinction. While he only has as much money as everyone else, he is the only person in town who doesn’t owe money to the central bank. And so the distinction of select and normal produce remains. Damon still has greater purchasing power, while as the rest of everyone has to live cheap and send all profits that they make off of Damon or each other back to the bank.

6) Eventually, everyone has $1.20, including Damon, and the bank has zero debt. But, the value of produce will be only something like 60 cents per 1 food unit. The amount of money has equaled out, but the community still has more wealth than it did when this all began. Only half of their number work at producing food anymore, splitting the money pool.

The wealth of the community equals 216 food units as soon as Damon has sold all of his machines. They may only continue to produce 120 actual units of food, since that’s all they need, but the value of food has declined. People are willing to trade away food for other sorts of labor because they have plenty. The monetary value that they use at any given time is based on inflation, the imbalance of money distribution, and so on. But the important thing is the value of wealth and how it is distributed. Giving more money to one guy may make him feel like a king for a while, but everyone wins through in the end. The people at the bottom of money ownership might have less money, but the price of food and all other things decreases. They might have to take the bottom wring of food and acting and other products, but before there was no acting or other products besides food. With free time, people are able to study medicine and science and create products that become, in the eye of the consumer, as valuable as food itself like vaccines, houses, and cars. People consider profit that they can give back to the central bank to be the excess that comes after having attained a permanent residence, a car, baby vaccinations. This takes longer to pay back the central bank, but the world is better for it.

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