Courtesy of Sandeep Jaitly @ Fekete research.com:
The aim of this paper is to show that the monetary/financial system that develops is a representation of some form of productive social interaction. The monetary system is the consequence, not the cause, of productive social interaction.
Money is defined as that substance which is the ultimate extinguisher of any debt. As a consequence the substance(s) used as money must have perceived value in and of itself. Menger described the iterative procedure by which a substance was promoted to money by the people themselves in ‘The Origin of Money (1892.)’
There is no record of the date at which humanity first gave value to gold and silver because the Sanskrit literature that first referred to them cannot itself be accurately dated. However, we can be sure about the mechanism that resulted in their promotion to the monetary metals courtesy of Menger.
The substance which is promoted to money will necessarily have very high inventory to primary production ratio (also known as stocks to flow ratio.) This arises from the fact that incremental additions to one’s personal holdings of this substance do not affect one’s personal terms of acceptance of this substance. This substance must exist, just as the largest number amongst a set of numbers must exist.
If one arranges all commodities on earth by the stocks to flow ratio, two metallic commodities stick out markedly: gold and silver. The extent by which these two metals differ from the next substance in terms of stock to flow is astounding and testimony to the exceptionally long period of time over which humanity has valued these two metals. There can be no other explanation.
With the monetary substance chosen, the evolution of the financial and payment system – merely a mirror of the natural ‘social interaction’ that arises from the fact of our own existence – can begin.
Economic activity is a base synonym for ‘social interaction:’ the farmer sending wheat to the miller who sends flour to the baker who makes bread for consumption. The crude extractor sending oil to the refiner who sends on refined petroleum distillate to the retail pumps. These are all examples of social interaction. Interaction that is not related per se to the medium used for money. Interaction that occurs by the very nature of our existence. Interaction that must recur for the maintenance of our existence.
A defined amount of the monetary substance is the unit of account of multiple aspects of this social interaction. An extended social procedure stretched over countless millennia itself gave birth to the monetary media, so it is quite clear to see that neither the monetary substance itself, nor the amount in existence, would influence that social interaction.
Social interaction occurs in different ‘forms’ and ‘frequencies.’ For example, the sale of bread by the baker is pretty much guaranteed whereas the sale of the new jet engine to the aircraft company is not. This is an example of differing forms of social interaction.
The construction of an airport takes a different period of time (usually) to the construction of a residential home. This would be an example of differing frequencies of social interaction.
Credit granted for the construction of a factory is extinguished, usually, by the sale of the produce of that factory. Credit granted for the sale of a ‘fast-moving’ good like carbonated drinks is extinguished by the sale of the drinks themselves.
Notice the difference in the form of the two credits: the credit for the former is not extinguished by the sale of the entity that the credit was used to create, whereas with the latter the obligation from the drinks seller is satisfied upon the sale of the drinks upon which the credit was granted.
Liquefying the Social Interaction
An often heard expression is that ‘banks create money.’ This is not true. To explain the origin of this misconception, one must examine the process of ‘higher order money’ creation. Higher order money is a misnomer, as the composite of higher order money is not strictly money, however this nomenclature will not be dropped. Money can only be created by the arduous extraction of gold and silver from the earth. The volume of money on earth has a monotonic increasing character. Gold and silver, once extracted from the earth, remain on the earth for all intents into perpetuity.
Imagine an endeavour that will increase the general standard of living. For example the construction of a warehouse for a village to store out-of-season perishable produce. This endeavour would alleviate the potential for famine. The enterprising villager who has insufficient access to the monetary resources to build the warehouse by himself must seek help. He approaches three other villagers who each promise 1/3 of the money required to build the warehouse. The three villagers all require the money to be returned no later than two years from present. The three villagers demand a tribute for the abstention of having the money themselves and a figure agreeable to all was fixed.
There are two facets to consider in this example: the length of time the three villagers were willing to give their money and the tribute required. If the money were required back at any shorter period, the length of time may be insufficient for the enterprising villager to build the warehouse. If the tribute required is too high, it may result in loss too severe for the enterprising villager to handle. There is a limit to the amount he can charge for the relatively simple task of warehousing produce. The former consideration represents temporal preferences, the latter spatial.
The acknowledgement of the debt by the enterprising villager to the three other villagers creates the first form of ‘higher order money.’ It is a trust between all parties concerned that debts will be honoured: credence is given to the relationship. That credence can be represented by (three) chits possessed by the three villagers. The total amount of money in the village would not change during the initial exchange or subsequent spending of proceeds.
However the acknowledgement of the three new chits will create the first form of ‘higher order money.’ These chits disappear once the credit originally given has been extinguished by the enterprising villager from the profit proceeds from his warehousing activities.
The continuance in the obligation between all parties gives value to the chit. The chit does not have value in and of itself. Higher order money does not have value in and of itself, as opposed to money. The chit can be sold if need be. It is not hard to imagine that other villagers may be willing to buy the chits, nor is it hard to imagine that different chits representing credit behind different productive endeavours and with different ‘maturities’ would also exist. The important thing to remember is that all chits eventually get extinguished and disappear once the credit that they represented gets discharged.
There is a class of chit in the village that is superior to all other classes in terms of demand from villagers: the chits that represent the credit behind the production and sale of items continually in demand by other villagers: bread; clothing; firewood etc. This class of chit is superior to the others as it only relies on the sale of a simple item for the credit behind it to be discharged, as opposed to the other chits that rely on the successful execution and running of an arduous endeavour. The chits and the ‘superior chits’ are analogies for the ‘bond’ and the ‘bill’ respectively.
The merchant bank is a synonym for a dealer in ‘chits’ or ‘bonds’ and the discount house for dealers in ‘superior chits’ or ‘bills.’ In our example, instead of the villager keeping the chit himself he could deposit it at the village’s merchant bank against the creation of a deposit: a deposit which turns into money upon the settlement of the original credit.
The system of merchant banks and discount houses arises as nothing more than the precipitation of social interaction. They are the consequence of social interaction not the cause. The balance sheets of these institutions represent nothing more than [part of] the aggregation of the representation of social interaction through bonds and bills. As society progresses with education, there is no limit to the potential for productive social interaction. Consequently, there is no physical limit to the size of the bond and bill market (i.e. higher order money in relation to money.)These institutions certainly did not create the bonds and bills that they hold…they merely liquefy (i.e. bring order to) that which would exist anyway.
Evidently, bills and bonds do not make sense without the monetary substance gold. The whole system of financial institutions is meaningless without the supreme measure of gold.
Perturbing the Natural Social Interaction
It is a mistake, as has been elaborated on above, to assume that merchant banks, discount houses and financial institutions in general dictate the level of social interaction (or economic activity.) In aggregate, they are merely a mirror of social interaction of various forms and frequencies. The only limit to the size of various frequencies of higher order money is the boundary of productive social interaction. This, naturally, is enhanced by a philosophy of education amongst the people.
Errors and pitfalls are a part of human nature. The system of money and higher order money is a mirror of the natural social interaction. Consequently, it is as sound as the interaction that it represents. Therefore the expectation of a monetary system that is absolutely perfect and free from any form of risk is a chimera. To expect them not to occur is as untenable as expecting humans not to make errors. But the damage on the monetary system caused by mistaken social interaction can be limited.
In our previous example, say two years has passed and the repayment of the chits to the three villagers from the enterprising villager is now due. The enterprising villager has saved insufficient money from his warehousing activities to pay off the credit initially given in full.
The three villagers tell the enterprising villager not to despair. They wish to endow a grammar school in the village and provide it with an income into perpetuity. The villagers tell the enterprising villager to change the old chits for a new chit that represents a fixed annual money sum into perpetuity. A rate agreed by all was haggled and an agreement forged. The newly founded grammar school held the new chit which proclaimed an eternal bond from the warehouse to the grammar school. The three villagers who founded the grammar school reasoned that the activity of the warehouse was likely to be perpetual in nature – just like that of the grammar school itself.
Problems involving money are not always settled as amicably as above. The sale of chits to parties other than those that created them could produce problems. If the chits are then possessed by people who have no link or comprehension of the enterprise which it represents – then problems could arise. The ultimate problem could be characterised by issuing chits with no intention of ever repaying them – the drawer merely hoping that someone else buys a new chit on expiry of the old one. These mechanically simple problems pass with verbose names in modern finance but the essence is no different to the examples.
This paper has shown that the monetary system is nothing more than a reflection of the natural social interaction. The monetary system will only be as virtuous as the interaction that it represents. Credit granted for the sake of alcohol consumption is not as noble – both from the perspective of the borrower and lender – as credit granted for the construction of a warehouse.
Sandeep Jaitly, 3rd November 2011 London.