Reducing the Cost of Credit by Reducing Uncertainty

The most common method of supplying credit reduces credit risk by moving the cost of credit to a cost of money tokens. While this may appear to reduce risk, it increases risk because it moves the credit cost from the real cost of credit to an artificial cost of money tokens.  Because there is no true value in creating money tokens participants in the system tend to create too many money tokens because money tokens cost nothing to produce and yet they are given a value.  If money tokens are given a value when created it inevitably leads to distortions in the money supply, to unstable capital markets, to a high risk of investment and to financial gambling through such mechanisms as high speed trading.

One solution to the problem is to change the accounting rules associated with repayment of credit to remove the time value of money.  This will take away the incentive for participants to create too many tokens and will enable both lenders and borrowers to concentrate on using credit to add value. It leads to a stable price of capital and to increased certainty of investment returns.

To illustrate consider the following scenario where capital is required to fund the construction of a dam to increase the average amount of water available for sale.  Let us assume that the cost of credit is 7% per annum.  Let us assume that the dam costs $100M and that it will increase the average amount of water available for sale by 10 gigalitres per year for the next 20 years.  Each gigalitre, at current prices, can be sold at $2,000,000 per gigalitre or, on average, there is $20M per year increase in sales due to the construction of the dam.  Unfortunately, while there is an average of 10 gigalitres extra water there may be no extra water available for 10 years at which time there will be 20 gigalitres extra water for the next 10 years.  Accounting methods that include the time value of money means that at the end of 20 years the water authority would have paid back $100M together with another $100M in interest yet still owe the capital providers $144 M. The cost of credit through the use of money tokens over the 20 years has been $244M.

If we remove the time value of money then after 20 years the water authority would have paid back the $100M, paid $91M in rent and have paid off the capital providers. The total cost of credit would be $91M.

If however all the increase in water supply occurred in the first 10 years then the current method of cost accounting, including the time value of money, means that after 20 years the total cost of credit would have been $27M.  If the new accounting rules were used the total cost of credit would be $21M.

The following graph illustrates the cost of credit where the time at which repayments starts is varied.
In all scenarios the risk of not getting the money back is exactly the same yet the cost of credit that includes the time value of money is a non linear function.  With the revised rules the cost of credit is a linear function and depends, as it should, on how long it takes for the money to be repaid.  Using credit through extra money tokens means it is very difficult to estimate the value of an investment because the measure of value is a non linear function depending on the rate at which credit is repaid.

While ever money is created through the fractional reserve banking system then the issuing of credit by increasing the money supply will always suffer from these distortions.

The macro economic effect of the extra cost of credit manifests itself as endemic inflation.

Socially this has resulted in modern societies where a high proportion of the GDP is consumed by the financial sector.  It is estimated that this cost burden can be reduced by an order of magnitude by changing the accounting rules on repayment of credit to remove the time value of money.

There are many ways to arrange credit to remove the time value of money.  In the case of a water authority it can be done through investors pre-paying for the supply of future water. While ever the pre payment is not used then the investor is given an increased amount of water to be supplied after all the pre paid water is supplied.  Investors can be protected from inflation by increasing the amount of water they get if the price of water drops below the rate of inflation.

A water authority can easily estimate whether any capital should be expended because it knows how much it is going to pay for the capital.  An investor knows exactly how much their return on investment will be and can make rational decisions without having to guess the rate at which funds will be returned.

Using this approach takes the financial guesswork out of investing and lets investors concentrate on the likelihood of the investment giving a real return in value.