## Sunday, January 29, 2012

### The Relationship between Energy "E(Δt)" and Currency "M0, M1, M2, M(Δt)"

Despite the technical title of this post, the theme of this post is relatively straightforward:  there is one-to-one correspondence between the different ways of measuring the amount of currency in circulation (i.e. M0, M1, M2, etc...) and the amount of work that can be generated within a certain time, E(Δt). This post builds off of the previous posts on electricity backed currency as well as the money supply.

The problem is to associate the correct type of currency (i.e. M0, M1, M2, etc...) with the correct value of E(Δt). In order to glimpse the important, but complex relationship between energy and currency, we need to first define E(Δt) and M(Δt).

Here, I am defining E(Δt) to be the maximum amount of electrical and mechanical work that can be generated in a country within a given time, 'Δt'.  For example, E(1 hr) for the US would be the maximum amount of electrical and mechanical work that the U.S. could generate within one hour of starting a hypothetical clock, i.e. E(1 hr) is the limit on the amount of electrical and mechanical work that can be purchased and consumed within one hr. (This excludes purchasing and reselling the electricity.) The question is: what is the relationship between the amount of electrical and mechanical work that can be generated in the US {E(Δt)} and the amount of currency [USD\$] in circulation {M(Δt)}?

I am defining M(Δt) to be the maximum amount of [USD\$] money that could be spent by owners of USD\$’s within time 'Δt'. For example, M(1 hr) would be the maximum amount of money that the U.S. could spend within one hour of starting a hypothetical clock, and once again it excludes spending money on items and then reselling them within that time period. As the value of Δt increases, so too does the value of M(Δt) increase. For example, I have access to more money because it takes time to access some of the money. Further, some of the money may incur a penalty if I withdraw the funds quickly, so this is one easy way of seeing that the amount of money that I have access to will increase as we increase the amount of time, Δt.

M(Δt) is pretty much how we define currency today, except for the fact that when we define M0, M1, M2, M3, we collectively forget about time, even though we known that the numbers 0, 1, 2, & 3 tell us something about how difficult it is to access the currency, and something about how long it might take to access the money to be able to spend it. [Note: I think a lot of this hiding of the variable ‘time’ goes back to when people were first formulating the principles of economics in the 1800s/1900s. Economics was historically rooted in the physics of the 1800s, i.e. equilibrium and classical dynamics...in which for simple systems, time can be eliminated as a variable. An example of hiding the variable of time is how most economists show supply and demand curves as Price/unit (y-axis) and # of units demanded (x-axis). The correct graph should be Price/unit (y-axis) and # of units demanded per unit time (x-axis). In the correct graph, the answer you get from where the supply and demand curves meet will have units of [\$/time], not [\$]. In the real world, we can't eliminate the variable of time from the equations of motion because the laws of physics are not deterministic (i.e. solvable in a way that eliminates the variable of time.) And it's really important that when we define a type of currency (M0, M1, M2, M3), we need to make sure that we are clear on the definition of 0,1,2,& 3, and to realize that the Δt for M0 is less than the Δt for M1, which is also less than the Δt for M1, etc...

When we use the variable M(Δt), we are forced into thinking about currency in a different way. It means that we need to be precise when we talk about currency. It's not that there's some magically fixed amount of currency in circulation. What we define to be the amount of currency in circulation depends on the amount of time that we allow people to access the money. Below is a quick summary of the present definitions of M0, M1, and M2, and you’ll notice that each definition of currency implies a longer time to access the funds.  (Also, note that, for some reason, the Federal Reserve stopped defining and measuring the amount of M3 currency during the last decade.)

Definitions:
M0 = Hard Currency (This is what the Federal Reserve has absolute and direct control over.)

M1 = M0 + checking accounts + traveler's checks  (The Federal Reserve has less direct control over the M1 currency supply, but it has some control over via M0 and the fractional reserve requirement)

M2 = M1 + small time deposits + savings deposits + money market accounts + overnight purchase agreements + similar short term deposits

M3 = M2 + all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets

The point in these definitions is that what we call currency depends on the ease at which we can access and spend the money. M0 (i.e. hard currency) is what we could spend with absolutely no problems. M1 (i.e. hard currency + checking/savings accounts) is what we could hypothetically spend with absolutely no problems (unless there’s a run on the bank.) M2 is all of the money (including M1) that we could hypothetically spend as a society with relative ease, though there might be some penalties for withdrawing early. We might also define a type of currency "M4" which might include all of the money we have in stocks/bonds, or an "M5" that also includes all of the money we have invested in our homes and our cars. This is money that can't be easily accessed because of the time it takes to sell the asset.

The important take-away here is that the amount of currency that we consider to be in circulation increases as we start including assets that require more time to access. The same is true for energy. What we call energy depends on the ease at which we can access it. If we only count the amount of work that can be generated over the next hour, then this number will be much less than the amount of work that we can generate over an entire day. In the U.S., we have some stored electrical and mechanical work in batteries, in flywheels, in turbine spinning reserves, and in the water immediately behind a hydroelectric dam. E(1 hr) would include most of this stored electrical and mechanical work, plus the amount of work from power plants that are already up and running can generate in one hour. E(1 day) would include E(1 hour), plus it would include all of the work from those power plants between 1 hour and 24 hours and include the amount of work that can be generated by turning on power plants that are currently idle, but that can be turned on within 1 day. E(1 week) > E(1 day) > E(1 hr).

What we mean by currency and what we mean by energy depends on the ease at which we can access the energy. For example, if I try to access and spend all of my money in a short amount of time, it will not have the purchasing power that it would have if I have an infinite amount of time to access it. (The faster I try to sell my car, then lower price I will be forced to take for it. And the faster I try to sell my stocks, the lower will be the sell price.) Energy is the same way. Let's say that I own 100 GJ of natural gas. If I try to obtain electrical work out of the fuel as quickly as possible, then I might end up having to send it to a low efficiency power plant that's already operating...I might only get 20 GJ of electrical work out of the fuel. However, if I can wait for a more efficient power plant to power up, then I might be able to get 50 GJ of electrical work out of the fuel. [This does not mean that we should do things slowly…it’s just a statement that if everybody in the US tried to use all of the money in their checking accounts to purchase electricity right now, then the amount of electricity they could purchase would be rather small because the price of electricity would increase rapidly. If they slowly spent the money in their checking accounts, then the amount of work they could purchase would be much greater than if everybody tried to spend it at the same time. This is one reason why I’m against the government setting price controls on energy and electricity, including feed-in tariffs. The price of electricity needs to be able to fluctuate at the minute/hour/day/week time scale. As I’ve mentioned before, it should be the role of the Federal Reserve to maintain a constant average price for the generation of electrical and mechanical work, but this is not the same as price controls. The price of electricity should be set by supply and demand…it’s only the amount of currency that the Federal Reserve has control over…not the price or quantity of energy delivery.

Money is the capability to do work, but the relationship between money and the capability to do work is not straightforward because there’s the issue of time. If we are interested in determining the relationship between the monthly or yearly average money and average work generated, then we can use a modified version of Fischer’s Equation to determine the relationship between money and the capability to do work. But if we look at the trees rather than the forest, there is no relationship between a specific amount of money and the capability to generate work. For example, for a given amount of money, you can normally purchase more electricity at night than you could during the day.

It’s only when you step back and look at the forest from the trees that you can see the average (or statistical) relationship between money and the capability to do work. On average, we don’t need all of the money that is stored in our checking and saving accounts. (If we did, then the banks would not be able to reinvest our money, which allows them to make money and for them to pay us interest…instead of us having to pay them to keep the money safe. If all of us required 100% of our money to be accessible 100% of the time, then there would be no such thing as investment. It would be like generating electricity and storing energy, but not letting the energy be reinvested into building new power plants. If you don’t reinvest energy into the building of new power plants, then eventually we run out of the capability to do work (once the power plant fails and the stored energy is consumed.) Fractional reserve banking is a sign of investment into the future. It also means that we should not expect to be able to access 100% of our money 100% of the time…because we’ve elected to reinvest that money (capability to do work) so that we can have more money (capability to do work) in the future.

As stated above, we’re smart enough to realize that we don’t want to spend all that capability to do work right now. This is what allows us to have fractional reserve banking. Fractional reserve banking is really a statement that we have energy reserves. Fractional reserve banking is analogous to the fact that the amount of electrical and mechanical work that could be generated in the future is much greater than the amount of electrical and mechanical work that can be generated in the near time. In order words, we have large energy reserves. Fractional reserve banking relies on energy reserves.

I think that part of the problem we face today is that people think that money in their checking/saving accounts could all be spent immediately. Even worse, in 2008, some people decided to take money out of their checking/savings account because they were afraid of their banks failing. (Sadly, I know a few people who did this.) This forces the banks to pull money from investments...and this could have the overall effect of slowing down the ability to generate more money (work) in the future if the Federal Reserve does not take action.

I don't think that runs on the bank shouldn’t effect the overall economy because it’s not like people are spending the money once they withdraw it from banks. (The velocity of money decreases when people pull their money from the banks.) It’s just sitting at home. Spending habits don’t change much when there are runs on the banks, and this means that there should be simple solutions for dealing with runs on the bank. The question is: what should the Federal Reserve do when there’s a run on the banks? Should the Federal Reserve print money and let people withdraw as much money as they have in their accounts? Or should the Federal Reserve do nothing and risk the banks pulling money from investments? I’m not in favor of the Federal Reserve sitting back and watching what happened in 1929 repeat itself. The question is: what is the appropriate action by the Federal Reserve?

I think that the appropriate action if there’s a run on the banks is for the Federal Reserve to print new money and make short term loans to the banks…but the Federal Reserve needs to closely watch the price of electricity, natural gas and gasoline. If the printing of money causes prices of electrical and mechanical work to increase, then the Federal Reserve will eventually have to remove some/all of the money that they printed once the ‘run on the banks’ has subsided. (I don’t particularly fault the Federal Reserve with their actions in 2008/2009. I fault them with the fact that they lowered interest rates in 2006/2007 when the price of gasoline/natural gas/electricity was increasing, and then they printed money in 2010/2011…i.e. QE2…also when the price of gasoline/natural gas/electricity was increasing.)

And now, I’d like to shift back to the relationship between E(Δt) and M(Δt), and to highlight why I favor a zero inflation currency over a currency that has positive inflation. To do this, I want you to think about the following question:

Should I be able to earn cash in 1980, have that cash sit in a box until 2010, and then expect that I could purchase the same amount of electrical and mechanical work in 2010 as it could purchase in 1980? In other words, should cash maintain its purchasing power over time? Or perhaps, should the purchasing power of hard currency decrease with time?

My answer is: Maybe, maybe not! If I earned (electricity) in 1980 and stored that electricity in a battery or flywheel, then the electricity would drain away in a few days. If I was paid in gasoline in 1980 and stored the gasoline until 2010, then I could generate nearly the same amount of work in 2010 as in 1980. The question is: should money be more like electricity in a battery or more like gasoline? Should it lose its purchasing power or should it maintain its purchasing power?

I can understand that having a currency with some small positive inflation rate would force us to invest our money into banks, which can then reinvest the money into projects that generate rates of return above the inflation rate. But in today’s electronic world, I just don’t think that we need to have positive inflation rates just to force us to place money in banks. Nobody likes carrying currency around any longer. And besides that, our society is becoming smart enough to figure out how to invest our money into objects that don’t lose their value with inflation. For example, to avoid inflation, I could put my money into a basket of energy products that don’t lose their energy value with time (natural gas, gasoline, crude oil, etc…). So, I don't think that the Federal Reserve should generate a positive inflation rate just to force us to place our money in banks.

My one policy recommendation here (besides my call to eliminate inflation) is for the Federal Reserve to work with banks to help people learn how to invest wisely. Right now, every time I walk into my bank, I’m surrounded by signs and fliers for taking out more loans. It’s all about buying stuff (like cars or houses) by taking out loans. Fancy cars and fancy homes don’t grow our economy…power plants with large values of ROI grow our economy. The best way to encourage people to invest rather than to spend money on more luxuries is to make sure that the Federal Reserve's interest rates are above the inflation rate. When it’s the other way around (like it’s been for the last ~4 years), then this encourages consuming larger houses and not investing. So, I see the Federal Reserve as one of the main causes of our lack of growth in the US between 2008 & 2011.

Luckily, it’s really easy to fix. The Federal Reserve can raise interest rates without causing the economy to collapse. In fact, it’s just the opposite. Raising interest rates causes us to buy smaller houses and to invest our money into projects with positive rates of return on investment…like natural gas power plants. Sure, there might be less people employed in the housing sector, but there will be more people employed in the power plant construction business and in the natural gas industry. Because power plants have a positive rate of return on work invested (and houses are net consumers of electrical and mechanical work), the net result of raising interest rates will be to grow the economy! There might be less luxuries today, but there will be the capability of making more in the future if we invest today.

So, now I’ll wrap up: We have to be really careful when we talk about currency and energy. I've tried (as best as I can) to emphasize this point by defining E(Δt) and M(Δt). What we mean by currency and what we mean by energy depends on the amount of time it takes to access the money or to generate the work from the energy reserves. In other words, not all money and not all energy are the same...it depends on the ease and the time that it takes to access the money/energy. Hard currency is similar to electricity stored in a battery...it's easy to access and can be consumed immediately. Money stored in stocks is more like gasoline energy reserves. It takes time to access the money/energy. The question is: Do you think that we should have a zero inflation currency or instead perhaps a positive inflation currency? My preference is for a zero inflation currency because currency should maintain its purchasing power just like stored gravitational or chemical potential energy.