The more people are willing to consume goods and services, and provide something else of value in exchange, the more money should be available in the financial system in order to facilitate the required exchange. After the exchange takes place, money is no longer required until the next exchange takes place, thus the same money can circulate multiple times within the financial system. A good analogy is a car engine. When the engine is on, oil is used to lubricate its moving parts. When the engine stops or slows down, oil drips down to the oil pan and stays there till the engine starts or increases its speed again. If economic transactions are moving parts and money is oil, it takes money to execute economic transactions of value exchange. The bigger the engine (economy), the more oil is required to lubricate its parts. The faster the engine works, the bigger flow (velocity) is maintained. Money circulates infinitely because it accommodates an infinite number of economic transactions – the car engine oil that one never has to change.
If the exchange stops, the money won’t be needed (oil will stay in the pan of the car engine). This is a very unlikely scenario because of the continued growth of the world’s population and its respective demand. Nevertheless one should not forget that money is a delayed value (a promise to receive value at a future date) backed by faith in the financial system. Should the Federal Reserve choose to print a lot of money tomorrow and give it for free to everyone, money will lose a lot of its value immediately.
When an economy matures and there is no further growth potential (e.g. contribution and demand stay flat), the only fast way for it to grow is through an international expansion. When this happens, money plays an “entry key” function to uncap the value of local goods and services in order to make them available for the international users. This is commonly done through a letter of credit, where an international bank acknowledges a buyer’s capacity to pay, thus increasing its circulation in the local economic system, corresponding with the increased contribution and demand.
Profit, debt, securities, derivatives, houses, land, cars, water, gas, etc. are all values and are measured with money in the financial and accounting books and records, all based on the most recent exchange. In the USA the money’s name is U.S. Dollars, in Europe Euros, in Russia Rubles – every country has its own currency to keep their economies going. Let’s review the above mentioned values for their intricacies and interdependence.
Value-add = Profit = Inflation
Accounting profit is a positive difference between how much something was sold for (revenue) and how much it took to make it sellable (cost). Profits, revenue and costs (and other terms used in accounting lingo) are always measured with money, as required by accounting rules.
Imagine a small village of people with only $100 in its entire economic system. The villagers use all this money day in and day out to support the exchange of goods and services. The economic system doesn’t grow (i.e. contribution equals demand) and everyone works hard and exchanges all the goods and services they need with $100.
Before money was initially introduced, people gave their word to deliver something of value, and recorded such promise on a promissory note. Promissory notes were great, but they were time consuming to make. As more and more exchanges took place, villagers invented universal promissory notes – money – in order to accommodate the delay in the exchange of goods and services. This money was accepted by everyone. Money also seemed a better option because promissory notes had to be destroyed each time after being honored. Even though people started confirming their indebtedness with money instead of a word or a promissory note, it still remained a promise to receive value at a future date.
Should any part of the villagers’ economic system fail (e.g. the party that is responsible for the healthcare and general well-being of the villagers stops delivering value), a substitution would emerge quickly to provide the services needed. The reason why the villagers’ economic system functions well is because the contribution is matched with the demand and, as such, the economy is balanced. If someone doesn’t contribute, he or she doesn’t get paid, i.e. is not entitled to the products made by others.
No profits (accumulation of money) were recognized by the villagers, because the contribution matched the demand. As idealistic as it sounds, such a village and its economic system could exist in the real world if there were no such variables as new aspirations, inventions and opportunities on the one hand, and ego, moneymaking and envy on the other, all pertaining to the human nature. What happens to the economic system if new values are created and there is an increased demand?
Profit
A genius in the village comes up with an idea to build a dam, which would protect the village from the seasonal river floods in spring. Everyone in the village wants the dam because they see enormous value in it. The genius agrees to build it and approximates the construction cost to be $100. The villagers prepay all the money they have as a sign of their commitment to deliver goods and services to the genius in the future.
Some villagers work helping the genius build the dam and the genius pays these villagers $80. When the dam is finished, he realizes he has an extra $20. As an honest man, he wants to return the money, but he doesn’t know who to return the money to. An accountant tells the genius to record this money as profit – remuneration for his “value-add” – his talent to build something as remarkable as a dam. The genius likes the idea, especially as now he can enjoy a luxurious lifestyle he couldn’t afford before. This boosts his ego enormously. After the villagers learn about this fact and see the genius walking amongst them with a lot of money, they immediately switch their value priorities to moneymaking and profit maximization – the ultimate motivation of any business in our world today.
This is the first instance of both profit recognition and economic activity increase in the history of the village. The former is due to withdrawal of $20 from the economic system – the genius deposited $20 in the village’s central bank account in order to spend it at a later time. The latter is due to the expenditure of more labor by all villagers, including the genius, in order to build the dam. The villagers decide to measure their economic activity with a new metric and call it Gross Domestic Product (GDP) – amount of money times velocity over a given period of time.
Upon completion of the dam project, the villagers realized that $20 disappeared from the economic system’s daily circulation. They also realized that the only way “value-add” can materialize is when someone recognized it as a profit with money. When the excitement passed, they had to instruct the central bank to print more money, in order to maintain the exchange of goods and services at the previous level.
It is important to review the mechanism of how the central bank will infuse an extra $20 into the economic system. Since the central bank belongs to the villagers, they can instruct the bank to print an extra $20. The central bank cannot just give the money to people, because money has to be earned with labor, thus it makes an announcement that those who pave the road to the church will be paid $20. To keep things fair, the central bank organizes a lottery and the lucky villagers build the road and get paid $20 to do it. However, people have learned about moneymaking and profit maximization, and now everyone competes in every exchange transaction, trying to accumulate money at the expense of others. This is when the division in people occurs between rich and not so rich. Wealth Distribution chapter in Part II will talk more about this issue, followed by the geometry of how wealth is distributed in Part III.
The resulting monetary inflation of $20, or 20%, gradually finds its way to a Consumer Price Index (CPI) increase, as $20 is spent on the daily exchanges of goods and services, bringing liquidity back into the economic system. The latter is how the mechanism of inflation works: monetary inflation gradually transitions into CPI inflation due to spending of the value-add profit. The rate at which monetary inflation transitions into CPI varies, and depends on the appetite and demands of the profit makers.
After the genius spends all his profit mone
y, he will need to invent something of value again in order to get remunerated by the villagers in the form of yet another profit, and as such get his future share of goods and services, and the cycle continues.
Concluding this chapter, the amount of money in an economic system equals delayed value (a promise to receive value), expected to be produced and consumed in the future. Could we also make a conclusion that Profit = Value-add = Inflation? We sure can, but it gets more interesting when debt gets introduced.
Debt
Money is a universal confirmation of someone’s indebtedness (instead of a word, or a promissory note) to deliver value to the money holder at a future date – delayed value. Debt (bond), on the other hand, is a promissory note by a specific person or an entity that is indebted to the debt-holder. While money’s value is reflected with its denomination and is relative to the most recently consummated transaction, debt’s value is reflected with money’s denomination and is relative to an ability of a borrower to pay it back with money.
Money is usually earned for work performed; debt is taken on a promise to produce work at a future date. Money signifies past contribution to be honored in the future; debt signifies a future contribution to be honored in the future. Money creates debt when it’s taken or given to produce work at a future date. Finally, the same money can create multiple debts, all measured with money.
Debt has multiple applications in the modern economy. For example, debt can be used to increase consumption (business activity, GDP) by using money received from a party that doesn’t need it (or doesn’t know what to do with it, or even without their consent) because such money is not yet in economic circulation. For example, credit card debt, spent on goods and services, increases GDP.
Value received by a debt borrower today will not necessarily equal value produced by the borrower tomorrow. This is the reason why debt, while measured with money (and as such recorded in accounting with U.S. Dollars), cannot be immediately converted back to cash for the original face value, regardless of how “good” it is. An interesting fact – the secondary debt market always gives a discount to any outstanding principal amount to account for “interest” due at maturity. I didn’t introduce the definition of interest yet, but many of us know what it is. Why does this happen? Let’s review the mechanism of debt origination first.
Going back to the previous chapter’s example, there are two plausible scenarios for $20 received by the genius. First – if the technological progress of creating in-demand value-add inventions stops for a while, $20 will gradually find its way to the economic system and thus inflate CPI (because the genius will spend it on things he likes or needs to survive). Second – if the technological progress continues and thus more profits / value-adds are created, money supply will continue to increase through monetary inflation, but it will make villagers work harder for their love of the progress. These two scenarios interchange in the modern economy and cause the village’s economy to grow until a point when the contribution of human labor (including technology) can no longer increase (i.e. human capital will be fully used).
Debt represents a form of investing profit money, not immediately needed in the economy, in order to “make” more money. In our example, the genius could lend an extra $20 to another villager for his future work, rather than work done by him previously. Why would the genius do that? Two reasons: First – money has value, but it loses it due to inflation (if another genius charges profit for yet another potentially useful invention). Second – people tend to borrow if they think they are capable of creating new value, and sell it for a profit later.
While the purpose of debt is to “make” money for the debt holder by creating value-add, new business, etc., such undertakings take time and the end result is not guaranteed. By saying “not guaranteed” I mean that even if something can be built and function quite well, if others don’t see in it immediate value, they will not work harder in order to pay for it. In this case debt becomes worthless, because the contribution of the borrower does not equal or exceed the future demand.
On the other hand, if debt money is invested into something that other people will see of value regardless, and thus will work harder to pay for (e.g. houses, cars, clothes, food, etc.), demand will match the borrower’s contribution and debt will be returned with a premium. The premium (profit, value-add) will be provided by the central bank, because it will have to issue more money into economic circulation in order to maintain liquidity in the economy.
For example, debt money is spent to create a new technology, which makes watches – a nice accessory that people want to buy. Every time something new comes up, there is a shortage of money in the system (due to profit/value-add) and thus people need to work more to earn money in order to buy new things. This is how the cycle repeats itself over and over again.
A socialist might ask the question – why not just give the profit money to people and let them spend it in order to reinstate liquidity, or build something of value-add, but never claim it back? The problem here is that if people build something that is valuable, then the person “investing” money should get his/her share (ego) of the proceeds – money. Hence debt is also a “title” instrument, reflecting ego and moneymaking desires. Besides, it adds responsibility to the debt borrower to perform and deliver, and not just spend money without an obligation to pay it back.
Debt represents value that will either be increased or lost, depending on the future demand. This is the primary reason why debt-holders tend to secure the debt with something else of perceived value, in case the debt turns out to be worthless. It is called collateral. Collateral’s value has to be something of immediate value to everyone, but it doesn’t have to be a part of the daily exchange. This is why land (or any hard asset) is perfect collateral, because the debt-holder can put a lien on the borrower’s property and take his land if debt becomes worthless. In other words, debt’s lost monetary value is gained back by converting it into land value, not previously monetized. Thus debt is capable of recognizing value that was not previously exchanged, but it doesn’t require money exchange in order to do so.
International Expansion
Let’s assume that $20, after being deposited back into the central bank, is sitting there idle. The person running the central bank decides to “make” more money by lending $20 to a neighbor village. He agrees to the terms of 10% interest due in one year for $22 in total. The neighbor village takes $20 and uses it to buy goods from the central bank’s village.
Two things have happened. First, since the demand for goods and services increased and the supply stayed the same, the infusion of $20 into the economy automatically increased production, and as such there’s now $120 in circulation in the central bank’s village. Second, the neighbor village needs to give the central bank $22 dollars by selling something worth $22 by the end of the year.
When the central bank gave $20 to the neighbor village, it asked for its land as collateral, because it contained valuable natural resources, e.g. oil and gas. Given that the neighbor village doesn’t produce anything, but has land as its primary asset, the central bank’s village takes possession of the neighbor village’s land and its natural resources. The central bank then assigns value to the collateral of $22, which allows it to recognize a profit of $2 and cost of land at $20. And, of course, it prints an additional $2 to pay itself a profit.
When the genius returns to the bank at the end of the year to claim his $20, the central bank has to print yet another $20 (because the genius’s $20 is already spent in the local economy) and now has to convince the villagers that this is due to the fact that the central bank now owns land with natural resources, e.g. oil and gas.
The bank issues $21 back to the genius (because it previously agreed to pay him 5% annual deposit rate) thus reducing its own profit from $2 to $1.
In the aftermath, the neighbor village lost its land and had to move somewhere to allow the central bank’s village to grow its economy. The neighbor v
illage probably realized how deprived of the technology they are and will likely envy the central bank’s villagers. The central bank’s villagers started to exploit the natural resources of the neighbor village in order to support their increased economy. Finally, the central bank’s economy slows down, because the production volume is adjusted back to a previous level, but CPI is increased due to more money infused into the economic system.
As a result, there’s now $142 in the economic system of the central bank’s village ($21 of which is unspent by the genius), ownership of the neighbor village’s land plus monetary inflation of $42.
The Central Bank Dilemma
One of the qualities of debt is that it allows uncapping of value that wasn’t previously recognized, or monetized, by exchanging a recognized value.
The central bank decides that there is too little money in the pockets of its villagers and wants to make them wealthier by spurring economic growth. The central bank proclaims that not only the villagers’ recognized real estate is “undervalued”, but the village also needs more houses for those who couldn’t afford them previously (didn’t contribute in the past to earn them). The central bank prints $50 and gives loans with this money to those without houses and housing construction starts booming. New houses are built throughout the village.
Economical Equilibrium Page 2
