Stable Money

The Global Financial Crisis has illustrated once again that the monetary system is unstable. In more normal times we see evidence of this with the so called business cycle where banks create loans and then restrict the supply of loans when too many are created.  We see evidence with asset bubbles where one or more particular asset class becomes overpriced.  We have seen it with houses, with the stock market and now we are seeing it with commodities.

The reason this happens is that the increase in the money supply is uncontrolled. Governments and Central Banks try to control the money supply but their method of control of regulation and varying interest rates fail to prevent endemic inflation and fail to stabilise the money supply.  The reason they fail is that the increase and decrease in the money supply is chaotic.

Chaotic systems are non deterministic because they have a random element within them.  If we could eliminate the randomness in the system then we would have a much better chance of predicting the behaviour of the system and hence controlling it.

The monetary system is non deterministic because for each loan made the number of monetary tokens created or destroyed is unpredictable.

Here is a simple example of a bank making a loan.  In one case the number of money tokens increase. In the other the number of money tokens remains the same. In another case the number of money tokens decrease. All fit within the banking rules and regulations.

The first column is the starting position.  50 in reserves, loans of 200 and deposits of 200.
A loan of 20 is made.
The second column is the end position where an extra 20 money tokens have been introduced.
The third column is the end position where no extra money tokens have been created.
The fourth column is the end position where money tokens have been destroyed.
We can have any variation in number of tokens created from -20 to 20
We do not know how many tokens will be created or destroyed on any particular loan.

Here is another example. In this case the amount of reserves that a bank decides to keep after each transaction is unknown but we have made some guesses.

As can be seen from these two examples the total amount of money in the system is indeterminant because how much money is created depends on the decision made by the bank each time any transaction takes place.

Economic theories and most descriptions of how the banking system work assume the system is deterministic.  Hence they are of little use in predicting what will happen in any situation.  The situation is even worse because predictions also influence how many tokens are created.  The tendency however is for the banks to make more loans than they should and to increase the number of money tokens. The reason that banks do this is because they make money if they make profitable loans and the more profitable loans they make the more profits they make.

This tendency causes the financial system to create more loans than are necessary. Once we get too many loans then the system collapses on itself as the loans are unwound so that real assets more closely match the number of loans. This makes loans less risky and hence more profitable.

We can reduce the randomness in the money supply by making the system so that banks tend to reduce the number of tokens in the system each time they make a loan.  If this happens then the number of money tokens in the system will move closer to the value of real assets in the system.

If we introduce more money tokens into the system in a way that is cheaper than regular loans then the variation in how many tokens will be introduced or lost on each loan will go away.  The reason is that banks will try not to make loans that cause them to increase the number of tokens in the system.  In fact they will try to make loans that decrease the number of tokens.

We can cause the banks to operate this way if we make enough interest free loans that create more new assets than is spent.  If we do this then the system will adjust itself so that banks will try to make loans that decrease the number of tokens because those tokens have interest attached and are more expensive than interest free tokens. The system will rapidly converge so that all banks will have 100% Reserve ratio which is the regulated limit.

The outcome will be a monetary system that will stabilise with zero inflation with a steady increase in productive assets.