Challenging the time value of money

Why is it that we expect our savings to ‘grow’ all by themselves? What would happen if our savings diminished over time instead?

Let’s first have a look at the historical coincidences that led to the absolute acceptance that the future should be discounted. Before any banking system existed, to save you must store your valuables, whether it be precious metals, grains or other food, somewhere where they can be preserved. To save them for the future, you must invest MORE in the present, in the form of preserving food, building defensible stores, and if there was enough gold in there, possibly paying for protection, to have LESS in the future. Thus prior to banking , the future was valued MORE than the present.

The logic behind this is simple. The future is risky, and to maintain your wealth for future times of uncertainty, you must invest in the present to protect it.

So where did the idea of earning a return on savings originate?

It must have been some time ago when the idea of lending money with interest first came into being – it even gets a mention in religious texts. I imagine that the ancient Greeks and Romans were the first to consider the problem I am considering today.

I guess there were two interrelated issues that led to money lending at interest – the advent of central banking in the form of paying goldsmiths to store and protect your gold, and the advent of international ‘trade’. I use the term trade loosely because much of the trade was involuntary in ancient times – by that I mean that that trade was achieved by waging war. But the point is that through trade increased wealth could be achieved easily, which could then be used to pay interest.

To get back to the questions I raised at the beginning of the blog, I would suggest that the reason we expect our savings to grow is because that is how it has been for a long time. Most of the time we can generate a small positive return on savings if there is a little growth in production.

But what if we have reached some resource limits, and growth is now a little more difficult to achieve. How can we lend money with interest in an environment of negative growth? On a national scale, how can we generate the wealth necessary to pay the interest? In short, we can't.

Maybe some readers have already noticed a major problem with negative interest rates (or a deteriorating money supply, or a reversal of the principle of the time value of money). Those who hold wealth will have a much more difficult time preserving its value. Challenging this one basic principle raises questions of the validity of land ownership and rents, and how it may be possible to own any income producing asset, let alone value it? Imagine capitalising an asset at 0.00001% - any income producing asset would be almost infinitely valuable. Where would be the motivation to invest in any capital equipment?

Where does this leave us? To be honest, the more I think about it, the more I see the importance of maintaining economic growth. A sustained period of negative growth would destroy the system – the money supply, capital values, rents – but what would it be replaced with? I am yet to think of a reasonable alternative, but I am sure there must be one.

Stimulating paradox

I read an intriguing article yesterday about the fundamental paradox that underlies the global phenomenon that is currently known as an ‘economic stimulus package’. The basic gist is that to justify spending billions of dollars the government has to scare the crap out of everyone to justify it. In doing so, they radically increase the chances that people will want to save instead of spend. They could have alternatively just said everything was fine, downplayed the situation as a media beat-up, and done nothing. At the moment, doing nothing is exactly what I think is the best thing for governments.

But let’s take a moment to look at the theoretical arguments surrounding the stimulus. I am going to raise quite a few economic theories that have been subject to debate a long time, so please do a little research if anything interests you.

Keynesian theory suggests that recession is caused by a wave of pessimism that flows through society, impacting on business decisions. It has some merit. One business sees another buckling down for tough times ahead, so they do the same, and so on until everyone has reduced production, but no one knows why. Real herd mentality in action. The economists’ prescription for getting out of a Keynesian style recession (Yes that there are different types of recession that require different policy responses. For example one caused by a ‘supply shock’ to a key resource.) is for government to intervene in markets to maintain demand and employment, in addition to ‘talking up’ the economy to raise business confidence. It seems that the current policy response forgot to mention that things will be fine, and went for the big spend – the exact problem raised in the paradox article.

But there is more. The opposition raised a very interesting point about the merit of giving people cash to spend, when the principle economic theories of consumption suggest that only a very small proportion will be spent. Milton Friedman’s Permanent Income Hypothesis (PIH) explains how people choose how much to spend based on their long-term expectations of income. Thus it would be expected that a one off payment will be diluted amongst household spending over a long period.

The opposition has a few more economic theories up their sleeve as well. One of the main maco-economic models, the IS LM BP model, that links together interest rates and output of the economy taking into account international trade and foreign exchange, makes clear that in a country with a floating exchange rate, fiscal policy (government spending) will be rendered completely ineffective.

Further, the Barro-Ricardian equivalence hypothesis (which doesn’t gain much acceptance anymore, but makes a very good point) also suggests that fiscal stimulus will be ineffective, whether financed through debt or taxes. Since any money the government has is raised through taxes, and any debt they incur must be paid by future taxes along with interest, people will realise that this round of debt funded spending is actually equivalent to RAISING TAXES. And what kind of stimulus would that be.

My final point is about the continual decline in interest rate, and the possibility of a liquidity trap. In short, a liquidity trap occurs when lowering interest rates does not increase the supply of money. Banks are already reluctant to lend, and since their real returns are minimal once the nominal interest rate approaches the inflation rate, they fail to approve more loans even though the interest rate is lower. I would suggest that there may be a little of this occurring, especially if the current interest rates drops are perceived as temporary measures.

In any case, we will never know if the fiscal (and the Reserve Bank's monetary) stimulus did anyone any good, because we have no basis from which to measure the success of failure of the policy. Maybe we could have given the money to just half the states and done a bit of a real life experiment. The political claims will be obvious - Rudd Bank will claim success no matter what the outcome, because 'it saved us from the worst of it', while the opposition will blame the stimulus for any further deterioration of economic output. Neither of them are right. We are subject to the whims of international markets, and no policy of ours have a noticeable impact.

Before I go I just want to let you know that I am more of a subsriber to the theory of creative destruction. This theory suggests that recessions are a necessary part of development. A recession is simply a process of 'destroying' outdated and outmoded production systems to enable the 'creation' of production chains for new goods and services. Followers of this theory would see a recession as a sign of development, and not something to be avoided.

Unfortunately governments have a hard time persuading people that some short term pain is worth the long term gain.

That’s all for now folks.

A monetary system for a sustainable society – the BIG question.

I spent a couple of hours this evening watching Chris Martenson’s Crash Course. For those interested in financial or environmental matters, and believe there is any connection between the recent ‘financial crisis’ and the peak of oil production it is very interesting. For others, it is probably still quite interesting.

I won’t give it all away, but the lecture series gives a thorough overview of money supply, speculative bubbles (a must see section), debt, growth and all things financial. It concludes that we are in for some tough times due to the coincidence of peak oil, retiring baby-boomers, and the collapse of a speculative bubble in housing.

These intriguing lectures got me thinking about another issue. Why is it that concerned individuals spend so much time looking at the problem, and telling others about the problem, but are rarely discussing potential solutions. And I mean real solutions – the mechanics of it all – not just ‘be nicer’, ‘do your part’. What is nice anyway? And what is the part I should do, and will it work? These are the questions that need answers if change is to happen.

I know I may have fallen into this trap a little in some of my blogs. But I’m in good company. Al Gore’s Inconvenient Truth spent hours on environmental problems, but only flashed up a few dot points on what we as individuals could do, and given my recent research, most of them are a waste of time.

All of this must be leading somewhere. It is. Given the intrinsic relationship between economic growth and environmental decay, and consumption of natural resources, we must reject growth as a long-term proposition. However, if we accept that society will be forced to exist within limits, and that any growth period will be counteracted with periods of degrowth or ungrowth, how will the financial system operate?

By the time you have watched the Crash Course, you will know that for money to stay in existence growth is an absolute necessity. So how can we have a currency that performs the basic functions of money – a store of value, a medium of exchange, and a unit of account – when the quantity of goods produced in the economy may fall for long periods of time? How can interest be charged on loans if there is no extra increase in production with which to pay the interest?

This question has perplexed me for a long time. We need a monetary system that has the flexibility to adjust the quantity of money when the quantity of goods produced changes, but one that will not be prone to periodic episodes of high or negative inflation. If we have a fixed amount of currency, maybe used gold for example, when output increases prices would decline, and then rise again when output decreases. How can money act as a store of value in this case? If you lent money in period of price deflation, no one would be able pay the interest, as the loan would be continuously getting larger in real terms. This is one of the main concerns about the current financial crisis. If deflation sets in, it will become self-reinforcing, and lending will cease altogether, stifling investment of all forms.

Anyway, for now I hope this has raised your interest in the matter of money, and I will endeavour to examine some options in the next blog.

Down the rabbit hole

I thought it might be nice to put up on the front page a recent comment by Chris. He states:

I can't quite get my intuition around this counter-intuitive concept. I'd like to try to develop some points that still bamboozle me:

1. Equating dollars to energy: For the purposes of example let's make up an economy, let's call it Moldova, which is powered 100% by coal-fired power plants. Say Moldova is a pretty dodgy place and the coal-fired power plants are running break even: so it costs the same amount of Mol-dollars to produce the energy as what they sell it for. Intuitively we would expect that this system could work; that the Moldovians, however poor they may be, would have electricity. However if we substitute the words coal-fired power plant with solar panels it becomes impossible. In both examples the cost of production equals the price of their product. It's easy to understand that if in the process of creating the solar panel we require the same amount of electricity than it produces over it's lifetime we gain nothing since we can easily equate apples with apples. However when we equate dollars with energy, one dollar spent on buying a solar panel (e.g. $1 = 1Wh) only produces 1Wh back again we gain nothing from the process. Thinking this way, equating $ with Wh, how can our poor Moldovians still use their electric milking machines?

2. I'm trying hard not to believe that we gain nothing from buying solar panels. Assuming they cost (like in Moldova) the same as the value of the energy they produce. We spend a dollar on a solar panel: this dollar in infinitely divided as it swims upstream through peoples wallets, and through this process looses it's identity as my 'green' dollar and comes out representing the total resource inputs of our economy, probably more a brownish sludgy colour now. So it doesn't matter if I temporarily green wash my dollar or spend it to create a burning petrol feature-fountain in my front yard: it's all the same. However I reckon by buying a solar panel I change the resource inputs of our economy: so my dollar swims up a slightly altered stream, it still arrives a brownish sludgy dollar, but a slightly greener one.
However after my solar panel is online, the total resource pool of the economy increases, energy becomes cheaper and consumption increases to fill in the space my green dollar bought: so total polluting is not reduced. Arrghh! I thought I was arguing for solar panels!! damn. BUT.. if the federal government wants to stimulate the economy they should spend it on solar panels? Since they would be growing the economy without increasing pollution. I've lost my point. Anyway what do you think?

Cheers
Chris.

My response:

Chris. You have some very neat logical arguments here. And there is no real answer to the first one. I have been pondering this problem for about a year. I get the feeling we are getting very close to the bottom of the rabbit hole, with only one remaining theoretical explanation. Chaos! (complex adaptive systems to be more precise)

While I have given the impression that tracing resource inputs to the economy up the tree can be envisaged much like a never ending family tree, there are interactions along the way that make it a complex system, and the capacity to learn and change also makes it adaptive. There are two major problems with such systems; (1) an action cannot be isolated from the rest of the system (thus one product cannot be isolated as good or bad), and (2) the way to change the whole system is uncertain, given the complexity of actions in response to change within the system.

Further, there are major problems in my theoretical argument against solar panels due to time and technology. For starters, the energy we used to construct the power plant was from half a century ago, which came from power plants and oil wells built a century ago, which were constructed from… well you get the picture (maybe read my Hunger, humans or happiness blog). Without this previous energy use, we would not have current energy production. Thus we could arguably trace back infinitely through time the energy requirements of producing a given product, which may be a sum total of all energy use in history!

In light of these and other issues that arose in lunchroom economics discussions, I developed a ‘Theory of Private Property’, which suggests that somehow economic growth (but not human welfare) is fundamentally linked to the creation of private property. How to develop this into a comprehensive and useful theory presently escapes me, but I am yet to find contrary evidence to dispute the relationship. The point of such a theory would be to suggest that solar power cannot contribute to growth because it doesn’t involve the use of land (whereas fossil fuelled energy can due to the continued consumption of land in the form of coal or oil). If we could attach a right to the sunshine, it may help. The solar energy producers would pay rents on the rights to the sunshine.

Anyway, while that was not a short answer, it does begin to raise some important points that one might consider before proclaiming a specific behaviour as good or bad.

Banking is a Ponzi scheme

I mentioned in my last blog that I would comment on the similarities between Bernard Madoff's Ponzi scheme and the tradition of fractional reserve banking. However, many other, and probably more eloquent, writers have had similar thoughts and done the hard work for me. In a break from tradition, this blog simply directs you elsewhere to pursue this astounding, and concerning idea.

The Wall Street Ponzi Scheme called Fractional Reserve Banking: Borrowing from Peter to Pay Paul, by Ellen Brown

Ponzi Schemes in Russia, Colombia and the US: from Mavrodi to Murcia to Madoff (MMM), by Kaufmann

The bright side - a simple solution.

Many of my blogs have been perceived as a little pessimistic. This final blog of the year is intended to provide some optimism.

The positive message is this - Humans are infinitely adaptable, and can change very quickly when required.

Often I see graphs of exponentially growing resource consumption and environmental destruction, accompanied by the saying – this can’t go on. And that is absolutely right. It can’t go on forever. No matter what happens, we will adjust. We can’t defy physical limits. In times of crisis it amazes me how people can quickly make tough decisions, and devote their energies to the greater good. It appears that for most people then, there is no environmental crisis just yet, but I am certain when reality bites, actions will follow.

Now to the more specific task of reducing carbon emissions. I have made the point many times that we need to take a supply side approach, which means focussing on the actual source of pollution. Therefore pollution/emission limits are the only way to go. More importantly, this limit must consider all parties involved. For carbon emissions, we require global cooperation. Otherwise, there will always be incentive for those exempt from the limit to take advantage of the situation.

To explain why this is the case, consider the classic common pool resource problem (aka the tragedy of the commons). A common pool resource is non-excludable (you can’t stop anyone using it) and rivalrous (when someone uses it, others cannot). A park bench exhibits these features. Anyone can use it, but when someone is, others cannot. The atmosphere has similar characteristics. If one party uses the atmosphere to dispose of carbon, others cannot use it for providing a steady climate. The incentive in this situation is for the polluter to use as much of the resource as possible, as they receive all the benefits, while everyone else shares the costs. Water resources have, until recently, been much the same.

This issue has been historically solved by rituals, traditions, religion, and other enforceable means the limit use. The classic example is the summer meadows in alpine areas. Anyone can graze their farm animals there, but when there are too many other animals, there will not be enough grass for yours. To solve this problems of competing demands, one must enforce grazing limits (or some kind of rationing system) on all people involved. It is not enough that one person decide to do their bit and limit their herd, as it allows others to increase the size of their herd. Even if all but one farmer exercises self-control and limits their herd, the last farmer will take advantage of this and graze all remaining fodder.

In climate change lingo, the slack taken up by other countries is known as the displacement hypothesis. Tight pollution controls in developed countries stimulate the relocation of polluting industries to countries without environmental controls. This is the reason some countries appear to have been successfully reducing their carbon emissions.

Clearly then, we need enforceable limits on pollution at the relevant scale. For carbon emissions, this means global cooperation (this appears to be getting closer each day). For water management, whole catchment areas must be involved. It is a simple recipe for halting environmental degradation. As we have seen recently with the Murray-Darling Basin Authority, when we reach the point of ‘crisis’ effective actions follow swiftly.

Finally, to keep you give you a taste of what is in store for next year, some topics that are swirling around in my mind right now include:
- the similarity between Bernard Madoff’s pyramid scheme and the banking system
- the welfare benefits of piracy
- and the parallels between cap and trade regulations and land conservation.
- problems and solutions to degrowth

Merry Christmas.

Carbon tax V Cap and trade

This blog is to help those interested in understanding why there is a debate between these two alternative policy options for reducing greenhouse gas emissions. While at first a cap and trade scheme and a carbon tax appear to be different versions of the same thing, there are important differences. These differences explain the push from big business for a carbon tax.

First, we must recognise that a tax is simply a reallocation of funds between economic agents – from individuals and companies, to the government. Thus a carbon tax, a cigarette tax, an alcohol tax and a GST all generate government revenue. We know from my previous blogs that all consumption is equal (in resource terms). If governments do not spend this extra tax revenue, they will reduce other taxes, but the total economic production will be the same afterwards, as will the total consumption by all economic agents. Therefore a carbon tax will not reduce carbon emissions.

One quite interesting discussion I had earlier this year with ECOS magazine editor James Porteous led me to a paper by Barney Foran, entitled Powerful choices: Options for Australia’s transition to a low-carbon economy. Foran suggests that revenues raised from a carbon tax can be allocated to a future fund, which is basically an offshore investment vehicle. I think he fails to understand that this investment itself has serious carbon implications (This translates as “let’s stop climate change by taxing Aussies and investing in Chinese production”).

A cap and trade scheme on the other hand is actually a restriction on the amount of emissions – a ban on emissions once they hit a given level. This will guarantee emissions reductions (at least within Australia). Unfortunately, we know that to be effective, environmental policy must come at an economic cost – and this scheme will limit Australia’s total production, and limit its international competitiveness.

Without getting too political, the 5% target recently announced for the cap and trade scheme to be adopted in Australia in 2010 is infinitely greater than any carbon tax that could have been proposed to seek wide public approval. Intriguingly, I would suggest that the current governments popularity with green groups would increase with the proposal of a "large" carbon tax, even though it would be less effective at reducing emissions.

Some clarification on the solar riddle

My last blog was too brief, I suspect, for the challenging idea it presented. So I will elaborate a little further.

The key point I want to make is that a dollars worth of any consumption good or service, due to the infinite interdependency of economic production, requires an equal amount of resources for its production. A dollar spent on a pair of shoes requires an equal amount of coal, oil, minerals and other natural resource inputs, as a dollar spent on an apple, a hybrid car, a haircut, electricity, motor fuel, a solar panel, and every other good currently being produced. A dollar spent on any good also stakes a claim on an equal amount of pollution.

How can all goods be equal? Surely spending a dollar on a massage is better for the environment than a dollar on fuel or electricity?

But let us run through the flow on interactions in each of these cases. You buy a massage. You mistakenly believe that the environmental cost is negligible because there are no material inputs. What happens to the money then? The masseur then spends that money on whatever they choose – food, fuel, furniture, and any other items. Then what happens at each of these purchases/transactions? The dollar divides further to pay for the labour costs, and the upstream material inputs and so on ad infinitum.

The dollar spent on electricity can be traced in a similar way. The wholesale costs as well as the labour and rents of the electricity retailer are paid for. Then these upstream intermediate industries use this revenue to pay for all of their inputs. Any profits made along they way get spent on other consumption items. This single dollar continues to divide and change hands until it is diluted amongst all natural resources that supply our modern economy.

If a dollar represents a claim on a proportion of the resource inputs into the economy, this paints a different picture for environmentalists. There are no ‘green’ alternatives. Which brings me to the solar panels.

A $20,000 solar panel will generate less than $20,000 worth of electricity over its lifetime. If all consumption requires an equal amount of resources, then it takes more coal to make the solar panel than is required to generate the electricity it is intended to replace. In energy terms then, the solar panel is also likely not to produce more energy than is required to manufacture it in the first place.

But then again there is no harm in going solar – you will just have less money to spend on other things (oh, and they aren’t much good for the environment either).

Solve the solar riddle

My recent blog on the Ehrlich-Simon wager aimed to raise 'the principle of the indivisibility of economic productivity'. Briefly, this means that when you improve the efficiency use (aka productivity) of one resource through improved technology, you actually improve the productivity of other resources. So for example improved energy efficiency, will also improve the efficiency of use of other resources - minerals for example (due to reduced extraction costs).

The point of this blog is to take an extra step. I may have previously raised the possibility that all consumption is equally environmentally degrading. Spent a dollar on an apple, and that has equal environmental footprint to a dollar spent of motor fuel - somewhat of a shocking thought. But since the economy is infinitely interdependent this is the case. Costanza raised this issue back in 1980. He found that a dollars worth of any commodity has almost equal energy intensity.

Now to the solar riddle. If a dollars worth of any commodity has equal energy intensity, then a dollars worth of a solar panel will require an equal amount of energy to produce as a dollars worth of electricity. If this is the case, a solar panel that costs more than buying the electricity it produces  from another source, than it cannot be said to produce more energy than is required to produce it in the first place. Since the coal fired electricity that it replaces is cheaper over the panel lifetime, traditional grid sourced electricity must be the less energy intensive alternative, taking all the economic interdependencies into consideration.

In the end, although it is a difficult concept for many to accept, your income is the sole determinent of your environmental footprint. You can't just choose to spend that income in a particular way or another. But by reducing your income, and hence reducing your contribution to economic production and its associated externalities, you can make a difference.

In fact that was not the end. Because if you weren't heading off to work each day to earn a crust, someone else might be able to expand their work instead. So there can be no blaming or finger-pointing in the environmental game. We live in a complex system, of which component parts are inseparable. Maybe we should instead attack externalities at their source by enacting effective regulations to prevent them.

A comment on Fixing the Floor in the ETS

Dr Richard Denniss recently published a research paper for The Australia Institute. Despite its promising title, there is no solution for fixing the ‘floor’ in the ETS to be found in this document. In fact, it takes tentative steps towards teasing out the mechanisms through which the economy and environment interact, but in the face of reality, jumps back on the feel good, greenwash, drive a hybrid, hold hands and be nice to each other bandwagon.

Let me explain.

The story woven by Denniss is that energy and emissions conservation efforts by households will be rendered ineffective due to the proposed emissions trading scheme (ETS). For example, if households reduce their electricity demand through efforts to conserve, the electricity producer now needs to produce less electricity, and can then sell some of their emissions permits to other polluters. Hence the ETS provides a floor on emissions that cannot be passed, as permits can always be traded to other potential polluters.

However, the fundamental assumption in the paper is that households can reduce their greenhouse gas emissions by simply changing their purchasing behaviour and embracing energy efficiency. If you have read my previous blogs you would know that this is an ineffective strategy.

While the paper provides an interesting insight for many, the major flaw is that Denniss acknowledges the flow-on effects from the ‘after ETS’ scenario, without any reference to flow-on effects in the ‘before ETS’ scenario. As an Associate Professor in economics, Denniss should know that these type of flow-on effects would appear without the ETS due the price mechanism. Taking the above example in the 'before ETS' scenario, a reduction in electricity demand should reduce the price of electricity, and subsequently increase electricity demand by others (because of the Law of Demand - lower the price, the more we buy). Therefore, the actions that are supposed to be rendered ineffective by the ETS are already ineffective.

Blake Alcott has a very interesting paper that debunks conservation as an effective way to reduce energy consumption and subsequent greenhouse gas emissions.

In short, as I have mentioned many times in this blog, to truly reduce resource consumption you must restrict the supply. In the case of greenhouse gas emissions, the ETS does exactly that. Individuals actions mentioned in the paper are presently ineffective, and will remain so under the ETS. However, there will now be the opportunity to buy emissions permits, restricting their supply to polluters if you wish to invest in behaviour that reduces emissions.

If the only pressure on emissions production is upwards, then the existence of a floor is clearly not an issue, as long as it also acts as a ceiling. If you think about is, most restrictive regulations that provide limits also act as floors with little criticism. Safety standards, town planning restrictions, and many other regulations provide no incentive to ‘outperform’. That is not their purpose.

It is time to stop the feel good ramblings and the government blame game and accept reality for a change.