Monday, January 16, 2012

Examples of How An Energy/Electricity Back Currency Would & Would Not Operate

This post continues the theme from the last post: how would an electricity or an energy backed currency operate? What are the benefits and what are the potential drawbacks of an electricity or an energy backed currency? In addition, this post will also point out examples of what to do and what not to do when prices of energy increase or decrease.

When I was describing how an energy/electricity backed currency would operate, you should notice that the Federal Reserve doesn't purchase energy, electricity, gasoline or natural gas with the money they print. Instead, when the Federal Reserve prints money, it lends it out to major banks and to the US government at a given interest rate. The Federal Reserve wouldn't use the money to purchase electricity, gasoline, natural gas, etc... and the reason why it wouldn't do this is simple. The goal of the Federal Reserve should simply be to maintain an average constant price for purchasing mechanical and electrical work. The goal is not to become an electric company or an oil/gas company. The goal is likewise not for the Federal Reserve to be a trading company like Enron. It shouldn't be guessing at which way prices of electricity/oil/gas will go in the future. The main goal of the Federal Reserve is simply to maintain price stability.

Forcing the Federal Reserve to maintain price stability will go a long way to providing dampening to the constant sources of price instability, such as oil price volatility, natural disasters, commodity bubbles, and runs on the banks. For example, if we had adopted an energy backed currency before 2007, it would not have been possible for Ben Bernanke to lower interest rates at a time when the average price of electrical and mechanical work was sky rocking. For example, the price of crude oil went from ~$70/bbl to ~$130/bbl from summer 2007 to summer 2008. Meanwhile, the Fed's interest rates decreased from 5.25%/yr to 2.0%/yr. Instead, the correct response to the increase in crude oil prices (along with increases in the price of natural gas and electricity) would have been to increase the Federal Reserve's interest rates. Why? If the real price of energy is increasing, then we are investing too much in luxuries and not enough on projects with real rates of return on work invested. Back in 2007, there were at least two effective ways that we could have tried to correct the problem of consuming too many luxuries and not investing enough into producing cheap oil/gas/electricity.

1) The Federal Reserve should have raised interest rates. This would have forced us to invest in technologies with higher rates of return on work invested. Higher interest rates would force us to consume less luxuries and invest more into energy companies.
2) We could have taxed luxuries. This too could have helped solve the problem of high energy prices by forcing us to invest more and consume less luxuries.

However, here's what we did instead: a) Ben Bernanke lowered interest rates so that federal interest rates were well below inflation rates. This was a recipe for contraction of the economy...and that's exactly what happened. The economy contracted between 2007 and 2009. By having interest rates below inflation, Ben Bernanke encouraged major banks to invest in projects with negative real rates of return on investment. You can't have a growing economy if banks are allowed to make money while investing in projects that only look profitably because of inflation.
b) The federal government was subsidizing expensive forms of energy (solar, wind, nuclear, ethanol), running large budget deficits, and fighting two wars overseas.
c) Environmental groups were calling for taxes on greenhouse gas emissions, which would have increased the price of energy.

This was a recipe for disaster and is a recipe for disaster if we continue to do this (as we still are doing today.) For example, the Federal Reserve's interest rates are still below the inflation rate. This means that we are continuing to allow major banks to profit on projects with negative real rates of return on investment. Though, it should be pointed out that the current state of the economy is nothing like 2007. The price of natural gas is plummeting; the price of gasoline is relatively flat; and it's possible that the price of electricity will decrease in the next couple of years as more natural gas power plants are built. This is a good thing, but this roller coaster ride could have been avoided if the Federal Reserve had simply followed the one very simple rule: maintain constant average prices for mechanical & electrical work.

This rule would clearly state to the public how much money the Federal Reserve is allowed to print if average prices of electrical/mechanical work decrease, and how much money the Federal Reserve is required to remove if the average prices of electrical/mechanical work increases. Also, if there was a strict rules to follow, then we wouldn't need to pay as many people to work at the Federal Reserve. Instead, they could working for oil/gas/electricity companies, perhaps working for companies that actually make a positive rate of return on work invested.

Price stability is pretty simple; it's easy to implement; and it can help dampen price shocks due to natural disasters, oil supply disruption, and commodity bubbles. Had the Federal Reserve implemented this policy back in 2007, then we would have seen investment into oil/gas/electricity much sooner than we did. Instead, the Federal Reserve helped take us on a roller coaster ride of oil/gas price inflation and deflation (crude oil at $70...$130...$30...$100 and natural gas at $6...$12...$5...$3.) There was no need for us to go through that roller coaster. And we shouldn't have to go through a similar roller coaster in the future.

We need to replace Ben Bernanke with somebody who can implement price stability into the Federal Reserve. Bernanke has shown multiples times in his short tenure that he is unwilling to maintain price stability. Example#1 was lowering interest rates in 2007. Example#2 is QE2, i.e. printing money in 2010 when oil prices were increasing from $30 to $100/bbl (the average price of electrical and mechanical work was increasing when Bernanke and the Federal Reserve decided to print money. While Bernanke supposedly values price stability and growth, his tenure as Fed Chairman has proved that he does not know how to implement price stability or how to achieve growth. But we don't need to replace Ben Bernanke with a superhero economist. We don't need an Einstein at the Federal Reserve. We just need to force the Federal Reserve to follow a strict rule on when to print or remove money from circulation. We don't need a single driver for the economy; the driver for the economy is all of us...each investing in projects with positive rates of return on investment. No one person can fix an economy, but it's possible for one person to mess up an economy by taking it through a roller coaster ride of price inflation and deflation.

In the years between 2008 and 2010, politicians were talking about fighting a potential financial meltdown. There is no need to talk about fighting off potential financial meltdowns if you simply follow the simple rule of stability in the price of energy (i.e. average price of electrical and mechanical work.) What we need is political candidates who are not going to try to scare us into thinking about there's an impending disaster (financial or environmental disaster.) We just need to follow some really simple rules so that we can return to growth.

But regardless of what happens at the national level, remember that you have control over what you do with your own time, energy & work. What I'm saying is: support candidates that will implement price stability for the Federal Reserve, but also focus on what you have control over: your time and your energy. If we all focus more time and energy on growing life (rather than worrying about peak oil, financial meltdowns, or political silliness), then we will all be better off.

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