One-Month Money: Why money ruins our economy - and how reinventing it could end unemployment and inflation forever

One-Month Money

Why money ruins our economy – and how reinventing it could end unemployment and inflation forever

Oliver Davies

with Ruggero Bozotti

To Aisling.

For giving me hope when there was none.

Contents

List of figures

About the Authors

A note on terms: what is neutral money?

Introduction

Part One

The Case for Change

Chapter 1

The Idylls of Adam Smith

A World to Aspire to

Savings, Interest Rates and Growth

The Invisible Hand

Chapter 2

Money

Enabling a Complex World

The Evolution of Money

Murmurs of Discontent

The Rotten Heart of Money

Chapter 3

Mr Keynes

Keynes’ Vision

When Money Leaks, the Wheel Creaks

More Than Just Fear

The Truth About Interest Rates

Chapter 4

Central Banks and Their Limits

The Broken Wrist of the Invisible Hand

Inflation

The Central Bank’s Plan

Affecting the Actual Rate

A Herculean Task

The Inevitability of Business Cycles

The Achilles Heel of the Central Bank

Chapter 5

Stimulus – Miracle Cure or Faustian Bargain?

The Best of the Worst

The Naysayers

Desperate Central Banks

Quantifying QE

Mind Games and Negative Reserve Rates

Beggar-thy-Neighbor

Best, Last, and Only

Chapter 6

The Rise of Secular Stagnation

Faust Forever?

Delving Deeper into the Ideal Rate

Demographic Scenario 1: Positive Ideal Interest Rate in Absence of Deficit Spending

Demographic Scenario 2: Negative Ideal Interest Rate in Absence of Deficit Spending

Empire of the Sinking Sun

On the Heels of Japan

Same Old Europe

Art, Not Science

The Risk of Inaction

Central Planning, Central Mess

Down the Hourglass

Part Two

Neutral Money

Chapter 7

The Monetary Violations

Monetary Violation I: Money as a Store of Value

Monetary Violation II: The Fractional Reserve Banking System

Monetary Violation III: Inflation

Monetary Violation IV: Foreign Exchange

Chapter 8

The Monetary Solution

Step one: 100% Reserved Money

Step 2: One-Month Money

Spent Money vs. Unspent Money

The Result

Personal Savings

Allowed Cash Balances

Physical Cash

Interest Rates

Foreign Exchange Rates

Allocating Expired Money

Following the Flow of Money

Chapter 9

The Benefits of Neutral Money

Chapter 10

Common Concerns

What happens if …

Chapter 11

Bubbles, Busts and Runaway Prices: Past Economic Hardships – But Under Neutral Money

U.S. Inflation of the late 1960s and 1970s

The Failure of Lehman Brothers, 2008

The Tech Bubble of the Late 1990s

Chapter 12

Alternative Proposals

Conclusion

Neutral Money in 15 Steps

Appendices

Appendix I: Intellectual Justifications of Neutral Money

Explaining Money Expiration

Why Not Three-Month Money?

Controlling the Money Supply

Appendix II: Closing a Loop Hole

Appendix III: The Transition

Appendix IV: Eliminating the Problem of International Aggregate Prices

Appendix V: Fixing the Euro

Publishing details

List of figures

Figure 1: Say’s Law of Markets

Figure 2: The Keynesian circular flow of income

Figure 3: Hoarding leads to a fall in sales

Figure 4: Fall in profits leads to cuts in production and a rise in unemployment

Figure 5: The economy is collapsing but has yet to reach equilibrium

Figure 6: The economy reaches equilibrium at a level of employment where savings equal borrowing

Figure 7: The central bank achieves its goal: the actual rate matches the ideal rate

Figure 8: The central bank causes inflation by setting actual rate too low

Figure 9: The central bank causes unemployment by setting actual rate too high

Figure 10: The government lifts the ideal rate into positive territory

Figure 11: Savings and its uses

Figure 12: Two demographic scenarios

Figure 13: Annual growth in Japan’s potential workforce, as predicted by demographic censuses

Figure 14: Annual growth in US potential workforce, as predicted by demographic censuses

Figure 15: Annual growth in German potential workforce, as predicted by demographic censuses

Figure 16: Banks under neutral money

Figure 17: The exchange banking system

Figure 18: The monthly cycle

Figure 19: The Keynesian circular flow under neutral money

Figure 20: Say’s redemption

Figure 21: Inflation in America

Figure 22: American workforce growth

Figure 23: The actual rate and unemployment

Figure 24: The US housing bubble and crash

Figure 25: The collapse in risky assets

Figure 26: US unemployment during the Great Recession

Figure 27: The production cycle

Figure 28: Production cycle with a buyer

Figure 29: The circular flow of income

Figure 30: Cheating expiration

Figure 31: Cheating expiration in the absence of corporation tax

Figure 32: Setting up the exchange banks

Figure 33: Activating the exchange bank system

Figure 34: The funding gap

Figure 35: Liquidating the legacy balance sheet

Figure 36: Foreign trade on Edison’s island

Figure 37: Edison swaps unspent money for jewels

Figure 38: Foreigner spends US dollars on Edison’s grain

Figure 39: Foreigner spends US dollars on meat

Figure 40: Meat farmer spends income on Edison’s grain

Figure 41: Foreigner swaps US dollars for wood with a foreigner from a third country

Figure 42: Second foreigner extends a US dollar loan to a third foreigner

Figure 43: Third foreigner spends US dollars on Edison’s grain

About the Authors

In 2007, Oliver Davies graduated from Yale University with a BA in Economics. After a brief spell as a research analyst at Orbis, a London fund manager, he founded his own asset management company, Huckleberry Investments. Since its inception in March 2011, Oliver has generated annualised returns of approximately 50%.

Ruggero Bozotti received a BA in English from Yale University and an MFA in Creative Writing from Brooklyn College. He was born in Milan, Italy and resides in New York City. He is currently working on his first novel.

A note on terms: what is neutral money?

The concept of ‘neutral money’ or ‘money neutrality’ has a long and somewhat confusing history. Professional economists may be familiar with other definitions than the one employed in this book. Here are the four definitions of neutral money, as given by An Encyclopedia of Macroeconomics.¹ One-Month Money uses the first:

1. The situation that money is a veil in the sense that the economy behaves as if it were a barter economy.

2. The situation of absence of disturbance from the monetary sphere, that is, maintenance of monetary equilibrium at all times.

3. Neutrality in a comparative static sense, that is, the quantity theory of money.

4. Superneutrality, that is the phenomenon that the ‘real’ economy is indifferent to the rate of inflation.

Introduction

Here is the world according to neoclassical economists. Everyone who wants a job can find one. The economy is a superb, self-correcting machine. This machine never breaks down. From time to time it may suffer terrible blows, but left to its own devices the free market will swiftly reallocate resources and find jobs for laid-off workers.

In this world, money is neutral. In other words, money is a veil over the real economy, never interfering with the production and exchange of goods and services. Money is simply a miracle technology that enables the complexities of modern commerce without incurring any negative effects. For neoclassical economists, our modern economies behave much like they did once upon a time under barter.

In this beautiful, barter-like world, inflation is always predictable, demand is always full, and there are no depressions. In this world, there is no need for government or central bank intervention because the free market will always heal its own wounds.

And now here is our world. US GDP plummeted at an annualised rate of 8.2% in the last quarter of 2008. A few months later, unemployment reached 10%. Despite gradual improvements in the headline rate, there are still over three million Americans who have been unemployed for more than 27 weeks.

In Europe, the situation is even grimmer. As of the first quarter of 2014, Spanish unemployment had reached 26%. For the youths of Spain, the divorce from the neoclassical vision was even more glaring – 54% of them were without jobs. Our world is one where 50 million Americans rely on food stamps. In our world we turn on the news and hear stories of Greeks turning furniture into firewood.

The economist John Maynard Keynes first confronted this discrepancy between neoclassical ideals and economic reality during the Great Depression of the 1930s. Keynes spent his entire career mocking and debunking the utopian world view of neoclassical economics, a world view that many mainstream economists still hold today. For Keynes, neoclassicists should be lauded only for their impressively-sustained forays into escapist fiction. Instead, Keynes and his followers (today known as Keynesians) prided themselves on being economists who dealt with the real world. And in the real world, the economy is not a self-correcting full-employment machine. Money is not merely a technology that greases the wheels of the real economy.

Keynes said that neoclassical economists suffered from what has been called the barter illusion. Once money is introduced, he said, the economy does not actually behave as though goods and services are traded under barter. Money cannot be ignored. Yes, barter economies are self-correcting, and everyone who desires a job can find one, but we don’t live in a barter economy. We live in a monetary economy. Money is not neutral – it doesn’t only boost productivity, it distorts the way an economy works. Money makes hoarding possible, for instance, which depresses demand and leads to unemployment.

To combat money’s ill-effects on the real economy, Keynes recommended that central banks and governments combine to keep the economy at full employment. There are times, he said, when the private sector alone is unable to provide a sufficient number of jobs. Governments should intervene until the private sector is strong enough to pick up the slack, and then gradually withdraw. To Keynes’ credit, the US did not recover from the Great Depression until it left the gold standard and implemented the New Deal. Even then, the recovery was not sufficient for a return to full employment. It was only with the massive deficit-spending of the second world war that the Great Depression truly ended.

Friedrich Hayek, an Austrian economist, never agreed with Keynes. He argued that Keynesian remedies come with costs, the most onerous of which is inflation. Since the government is unable to calibrate a perfect stimulus, it will inevitably begin competing with the private sector for resources, leading to higher prices. Furthermore, governments are prone to waste, mismanagement and corruption. So Hayek believed that removing government control of the money supply and limiting government spending was the only path to prosperity.

The US experience of the 1970s seemed to vindicate Hayek’s views. After a few decades of rigid adherence to Keynesian policies, inflation skyrocketed while unemployment remained high. To tame rampant prices, Federal Reserve Chairman Paul Volcker had to induce a severe recession in the early 1980s, during which unemployment rose beyond 10% and stayed high for over half a decade. The neoclassical school, which is the school that dominates classrooms today, seized this opportunity to end its flirtation with Keynes and move closer to Hayek’s views.

These two poles of the stimulus debate survive to this day, and, as with so much of our culture, have become increasingly politicised. For some, the plight of the unemployed is more serious than inefficient government spending or future inflation. These advocates, mostly on the political left, urge more stimulus. For those on the right, inflation and government debt are the main fears, and stimulus should be curtailed or abandoned entirely. Others believe that unemployment is structural (workers have the wrong skills, for instance) and that stimulus won’t affect unemployment at all, but bring only costs. Others still wonder how we can ever learn from our mistakes if we don’t purge our past binges with a curative dose of pain. The policy-paralysing debate is endless. In the meantime, unemployment continues to ravage countries the world over.

This book argues that both sides are right and both sides are wrong. Keynes was correct in demolishing the barter illusion of neoclassical economics. He was right in saying that economies are not inherently self-correcting. Money is not neutral – it interferes with the workings of the real economy. Keynes was a pragmatist; so instead he offered solutions that work for the real world, not the imaginary world of neoclassical economics.

And yet, there is no escaping the fact that these solutions are flawed and their track record patchy at best. During the 68 years since the end of the second world war, much of it under the sway of Keynesian economics, the US has endured no fewer than 12 recessions. Its unemployment rate has stayed above 6% for a cumulative 23 years. Around the world, there have been at least 13 financial crises.

Inflation has not fared much better. The golden period of Keynesian economics blew up in the inflation of the 70s. But even since the mid-80s, in a period economists actually point to as having ‘conquered’ price variability, inflation in the US has ranged from -2% to 6%. And who’s to say that the unconventional policies currently pursued by the Federal Reserve won’t result in rampant inflation that destroys our savings in the future?

It often seems that our best hope is for an economy that swings constantly from unemployment to inflation, with only a few lulls in between. But a grimmer possibility exists alongside this: that we forget the need for Keynesian policies altogether, and policymakers, by sitting on their hands, let us sink into another Great Depression.

As time passes and our economies become older and richer, the likelihood of this worst-case scenario will only increase. As we shall see in chapter 6, an ever-growing number of developed countries are entering a period of secular stagnation, where interest rates will remain permanently low and government deficit-spending will be the only way to avoid unconscionably high unemployment. Our current tools of monetary and fiscal policy, inadequate as they are today, will become even more so in the future.

This book proposes a better system. We need to recognise that money is merely a human creation, and since we created it, we can change it. We don’t have to let it disrupt the real economy. If money in its current form doesn’t work, we can design and implement a system of money that does, one where the full-employment machine of neoclassical economics can actually be realised. We can at long last unshackle Adam Smith’s invisible hand, and render central bank and government stimulus obsolete.

To achieve this neoclassical vision, we need to design and implement a system of genuinely neutral money. In a neutral monetary system, money does not interfere in our decisions to spend, save, borrow or produce – it is merely the grease on the wheels of the underlying barter economy. Neutral money is a vital technology that allows for the complex world of today, but without incurring any ill-effects.

In chapter 7, we will identify all the ways in which our current system violates the principle of money neutrality. These include money’s function as a store of value, inflation, fractional reserve banking and foreign exchange. Chapter 8 then proposes two relatively simple changes that will resolve these violations.

The first step is to introduce 100% reserve banking. This means that commercial banks must keep a dollar (or pound or euro, etc.) in reserve for every dollar current account² deposit they hold on behalf of their customers. If a customer wants to turn his or her current account deposit into cash, there will always be sufficient money to do so.

When the money supply needs to expand to accommodate growth and inflation, the central bank would inject new money directly into our accounts. Today, money creation occurs through loans issued by commercial banks, who channel this new money to a relatively narrow band of borrowers and profit handsomely by charging interest. In the new system, on the other hand, money creation would bypass the commercial banks entirely. Newly-created money would flow directly from the central bank to citizens at large, so that the benefits of growth accrue not just to those with a privileged access to credit, but to all of us. This system of money creation is much more equitable than our current version.

The second and more contentious step is to introduce one-month money. One-month money means that all money in the economy must be spent once every month or it expires.

While at first glance the notion of money expiration might seem unfair, or stressful, it doesn’t have to be. With the technological improvements of the last decades, such as debit cards and online brokerage accounts, decisions to spend and save have become increasingly simple. It’s also important to understand that one-month money does not mean that we are personally forced to spend all our income each month. We can still save, just as we do today, in savings accounts or other financial products, such as stocks, bonds, commodities and precious metals. The only difference from today is that we can’t save in cash and current accounts. In other words, we can’t hoard.

Taken together, these two changes entirely remove the adverse effects of money. Money no longer disrupts the workings of the real economy, as so often happens today, resulting in high unemployment and unpredictable prices. With neutral money, not only do we end hoarding and create the full-employment machine of neoclassical economics, but we also achieve stable inflation. By giving the central bank precise control of the money supply, we also give it precise control of inflation. And when inflation is stable and predictable, it no longer interferes with the real economy.

All is not well with the world. After decades of decent growth and low inflation, in 2008 we suffered a catastrophic financial panic that brought many economies to their knees. Today, even the best performing developed countries are unable to put all willing workers to work, while the worst are mired in full-blown depressions. What’s more, we can’t agree on clear policy solutions. Should we inject more stimulus? Or should the government recede and allow the free market to take the reins? Should we risk inflation, or should we stomach high unemployment? Over the course of this book, we shall see that by adopting a system of neutral money, such choices become irrelevant. Neutral money means we can achieve both full employment and perfect price stability without government or central bank stimulus. By implementing a neutral monetary system, we can create an economy where the beautiful, self-correcting world of neoclassical economists actually exists.

Part One

The Case for Change

Chapter 1

The Idylls of Adam Smith

A World to Aspire to

I f only we had more, people have cried since the dawn of paper money. Print more, and it will make everyone richer. But what if a group of survivors of a shipwreck were stranded on a deserted island with an unlimited pile of money at its centre? Would they consider themselves rich?

Perhaps. There would always be the hope that one day they could return home and exchange the money for goods and services. But if they were doomed to a life on the island, they would be among the poorest people in the world. When all hope of a rescue fades, their money would become meaningless paper, or more ironically, a puff of smoke as they sit around a campfire.

What matters to the islanders is the real economy. They care about food and shelter, about tools and clothes. The real economy is the place where people build houses, cut wood or mine for metal, where brewers swap beer for food and consultants swap their advice for cars. In the real economy, people club together to produce goods and services, and then trade them for the goods and services they desire.

And what a beautiful world it is. In a moneyless world, resources shift quickly from industry to industry. Unemployment is only temporary. All the scourges of our current system – recessions,