We know that Classical Economics is flawed, hence currency design (and consequently monetary policy), which stands in the middle of the subject, would have to be subject to many modifications. We also know that Behavioural Economics, with all its many flaws and imperfect solutions, is now the way of life in dealing with Economics, i.e. “eventually, I am hoping there will be no Economics left, except the “Behavioural” way” (Kahnemann).
Declaimer: This article was originally in November 2016, and some of the data points may be outdated
The 3 major roles of a currency are
So let’s look at Currency design through the prism of Behavioural Economics, to locate just where the King is walking naked. The 3 major roles of a currency are:
- As a medium of exchange, i.e. to denominate human behavior (i.e. services) or bundles of human behavior (i.e. products). If human behavior is really ‘sweat’, then we “exchange sweat” through currency, allowing a cobbler to repair the shoes of a stockbroker. Let’s call this “current” or “flowing” sweat.
- As a store of value, i.e. it (a currency) would set a ‘relative value’ between ‘accumulated sweat’ and ‘current sweat’. This relationship would be set by the current and expected inflation rate.
- A third, somewhat nebulous concept, would be as a measure to set ratios for ‘relative sweat’, which should move based on a combination of relative inflation and (relative) productivity. This would be used for setting the relative values of currencies, i.e. Fx rates.
Now let’s explain this with the “Robinson Crusoe island” 2-man economy, commonly used in Behavioural Economics. If there were only 2 people on an island, it would be the simplest form of economy, which would be self-sufficient with barter. So there was Crusoe and his Man Friday.
Now, how was Crusoe paying ‘wages’, and in return for what kind of labor? Crusoe would go fish and (let’s say) Friday would cook. If Crusoe got 2 fish on a fishing rod, he ‘paid’ Friday to cook, by giving him one fish. So the ‘value’ of Friday’s cooking was one fish, denominated (in case they had a currency) by Rs.100. So Crusoe got Rs.200 of fish, of which Rs.100 went out as ‘wages’.
The Higher relative sweat
Now, when Crusoe shifted to (fishing) nets, his ‘productivity’ went up, and he started to get, say, 10 fish, now worth Rs.1000. But Friday’s wages remained the same, because he remained on flint fires, and anyway, he had nobody else to sell to, hence no wage hikes. So now Crusoe has “higher relative sweat”, which translates into higher “relative income”. So he continues to earn this relative income, which translates into a huge hoard of ‘wealth’, that is now coveted by Friday.
After accumulating Rs.100,000, Crusoe tells Friday to both fish (with nets) and cook, and he will be paid, say, Rs.200 per day. There’s a relationship now between wealth and income.
Now Crusoe falls sick and Friday finds a herb that can cure Crusoe of the illness. Next thing you know, Friday has Rs.100,000 and Crusoe is back at the nets with roles reversed.
So far, we are talking about REAL sweat, real goods, and services that are being exchanged in this simple island economy. Suppose somebody comes and issues new notes into this economy, WITHOUT a concomitant increase in the actual sweat floating in the economy, First thing, the relative wealth is eroded, as the ratio of accumulated sweat to current sweat now deteriorates. And depending on who gets this new money, he becomes artificially (and unfairly) rich. Sounds familiar? Let’s call this new person Goldman Sachs.
Notice that Sachs has produced NOTHING of any value, except that he knows how to get his hands on new money, like being able to mine new gold, without any cost. If someone could figure out this part of the equation, i.e., when does Delta Money come from ZERO (Delta) sweat, then THAT part of the economy should be reduced to zero. In other words, a currency that tracks REAL sweat, both current and accumulated, would be the perfect currency.
Now accumulated sweat would be a nominal number, and REAL sweat is the total of REAL goods and services produced by the economy, i.e. the nominal economy MINUS the new money printed that produces nothing.
In the real world, one person would know this number, the Central Bank. And he can approximately calculate the amount of new money he printed that is producing nothing. This would be, however, a complicated process that would have to be corrected for the change in the velocity of money.
So now let’s shift back to our marooned island. If they were in a cashless economy (which they would be in the real world), the currency would be a means of accounting for the various transactions between them. This is now possible in today’s economy with smart cards/phones which can reference every transaction as real or virtual. In this world, you can introduce new money (QE) with the caveat that it will NOT be used to fund virtual transactions (i.e. Wall Street and non-lending banking transactions).
We’re not very far away from being able to do this. If money supply were to track the total of goods and services (sweat) floating around in the economy, we would be rid of both inflation and deflation simultaneously. While a pure Gold Standard currency would push the economy into deflation and hamper productivity growth, a pure Central Bank (fractional reserve) currency of the kind we have, will push inflation (in fits and starts) and destroy accumulated sweat, thus removing the motive for storing it in the first place. In trying to protect their accumulated sweat, savers tend to rush into gold, commodities, and real estate, thus affecting productive investment. In a gold economy, the return on cash would sometimes be higher than (the return on)productive investment.
the perfect sweet spot between inflation and deflation.
A virtual economy, which can track an accurate measure of the ‘sweat’ floating in it, would be the perfect sweet spot between inflation and deflation. Too much of either will result in pain, especially for the poor and the ignorant, i.e., the arms and legs of the economy. Both would result in a deterioration of the relative wage (as compared to the profits on capital). This is always generally true, but as we see in the current “1% problem” in the US, excessive QE skews the needle so far that it could lead to social tensions of the kind we see articulated in the Presidential Elections.
So now let’s set the prescription for an “all-knowing” currency, i.e., a ‘coin’ that knows where it has been, rather like the mythical drop of water that has been to the top of Mt. Everest and knows the journey down to the sea. That knowledge is pointless, but the knowledge a ‘coin’ collects as it changes various hands in the economy is useful, both individually and in the aggregate.
This knowledge could be sifted and sorted along various threads. Still, the one thread I am most interested in is how much of the hand-changing was for real goods and services, and how much for increasing the value of “accumulated sweat” (hence asset bubbles), price discovery, and holding inventory. In today’s world, QE money is funding derivative margins, which are being used to paper over the holes of 2008, holding up zombie banks and portfolios, that will collapse the moment money starts to find its correct value.
The assumption is quite simple, and not far away for India. A networked combination of the current Credit/Debit Card system plus the payment banks will take us to the point where we can do away with the need for cash. Thereafter, a Central Monetary Authority will track data in the Central Bank and set an automatic mechanism that issues new money based on an accurate measurement of the growth of the real economy. If everybody does the same, we have a “successful Euro”, which logically, removes the need for all but a single currency (ok, I think it is time to wake up).
The benefits far outweigh the costs. Yes, it takes away power from the worst of the Central Banks, but the better ones get what they are looking for anyway. All the countries that are not seeking to repress their savers, will shift to this mechanism, even if they don’t give up their administrative powers to issue currency. Along with all this complex tracking, they will be able to “follow the money” on terrorism, black money trails, and drugs/narcotics. And political wheeling-dealing, of course, but that is a problem.
Incidentally, some aspects of Bitcoin already have these embedded, and the rest can be incorporated. The general acceptability is already gaining momentum…