Friday, February 24, 2012

Review of the DeKo and Specific Details of How an Electricity Backed Currency Would Work

This post is devoted to going into the details of how an electricity backed currency would work, and in particular, I review & analyze a similar idea for an electricity-backed currency,' as presented by Nick Gogerty and Joseph Zitoli. Before I get into the details of their idea, I'm going to start this post off with my conclusions. I'll also restate them at the end after reviewing the paper by Gogerty and Zitoli.

Concrete Plan of Action on How to Fix the Federal Reserve
1) Allow the Federal Reserve to purchase bond funds of power producers, such as utilities and independent power producers, as well as government bonds.
2) Slowly  (i.e. over the span of a few years), the Federal Reserve should sell its mortgage-backed securities and purchase bonds from power producers. It should also sell all of its gold assets and purchase a portfolio of bonds from power producers. A goal of 50% gov't bonds and 50% bonds from power producers would be a good goal to set by 2020.
3) Maintain a constant average price of electrical and mechanical work  (perhaps a running-three month average). This means that the price of electricity and gasoline can fluctuate minute-to-minute, day-to-day, and week-to-week, but the Federal Reserve would either print or remove currency from circulation in order to maintain a constant average price.

4) The money in the Federal Reserve should be separated between private funds and public funds. The profit from private funds should go to the banks. The profits from the newly printed money should go to the US government. There should be a clear demarcation between how much of the money in the US Federal Reserve is private and how much is public money (i.e.  tax payer's money.)

 So, now let's get into the details of the paper by Nick Gogerty, Joseph Zitoli.  While I agree with most of what they argue for later in the paper, their paper unfortunately gets off on a bad footing.

"All currencies are belief systems."

This is post-modernism philosophy in a nut-shell. It just goes to show you that the field of economics is in deep trouble. If you can start an essay with "All different forms of X are just imaginary and subject to different people's beliefs", then there's no point in trying to make an argument. Why? Because: Who cares?  It's all just a matter of belief, right?  Perhaps I believe that currency should be free to everybody. Or perhaps somebody believes that the best currency is a deflating currency. Instead, I would have phrased it as follows:  "The strength of a currency of exchange reflects the strength of the people who use that currency for exchange."

Economics is not a belief system. There are hard truths to economics because economics is a measurable subject. The main unit of measure is the [kWh]. The amount of currency should not be arbitrarily left to the belief system of the Chairman of Federal Reserve. Instead, there should be set rules on how much hard currency there should be in circulation, and this should be a function of some measurable quantities, such as the price of electrical & mechanical work and the amount of electrical & mechanical work being generated.

While I disagree with the authors on the phrasing of this first point, I do agree with the authors that a gold-backed currency is a form a belief system because gold has virtually no real value. The authors explain as follows:

"Many desiring gold backed currencies are merely articulating a desire for a stable independent central bank issued currency with a fixed reserve ratio. In this guise, gold is the fiscal and physical expression of a rational economic desire for price and monetary stability. 

I agree with the authors. I think that most people arguing for a return to a gold-backed currency simply want price stability. Unfortunately, gold-back currency only gives you price stability with one item: gold. And gold has very little value in itself. There's no energy content. You can't eat it. You can only do a few things with it. And worse, having a gold-backed currency will drive up the price of jewelry. When I hear people like Ron Paul calling for a return to a gold-standard, all I hear is: things were better 100 years ago, so let's go back to what worked back then. The problem is that it didn't work back then. That's why we created the Federal Reserve. The problem now is that the Federal Reserve Board is living in a fantasy world. So, let's end the fantasy world of lending money at interest rates below inflation rates. But let's also end the fantasy that the gold standard worked in the past. In a gold-backed currency, you could trade in gold for a set amount of currency. This means that, if we find a bunch of new gold mines, then we could all get rich mining gold...which stays in the vaults of Fort Knox. This doesn't help our economy...a gold-backed currency is a joke...and a gold-backed currency was the cause of many of the depressions prior to 1913. Gold doesn't drive our economy. In a gold-backed currency, we could hypothetically all become gold miners, which if taken to its logical conclusion is absurd.

"Consumers as holders of a currency bear the ultimate risk of a currency in exchange for its usefulness as a store of value and unit of exchange. The more stable the currency, the longer the period consumers may hold or “bear” the currency using it for trade or as a store of value. This faith in a currencies purchasing power and unit of account allows for longer term planning and investment."

Where the Federal Reserve loans money and at what interest rate tells us a lot about who we are as a people, and it tells us about our capability for growth. Does it purchase government debt? Or does it purchase bonds from electricity utilities? Does it hope to maintain zero growth and zero interest rates? Or does it hope for real growth in the capability to do work? I'll leave these as hypothetical questions for you to answer, and shift over the main point of the paper by Gogerty & Zitoli.

"The DeKo based currency issuer holds a portfolio of electricity delivering assets."

If I understand the authors correctly, they are stating that the Federal Reserve should change its portfolio. Right now, the Federal Reserve owns a lot of government debt (and since 2008 now owns a lot of mortgage-backed securities.) They own very little gold (and that's a good thing.) The authors suggest that the Federal Reserve should start purchasing more energy assets, but not coal/oil/natural gas. They suggest purchasing a portfolio of electricity generating assets. 

If this means purchasing bonds from utilities and independent power producers, I completely agree with the authors. In fact, I think that this is a wonderful suggestion. I agree with the authors that the Federal Reserve should not purchase coal/oil/natural gas, just to have it sit around. The Federal Reserve should try to make as much money as possible. The part of the profits derived from private funds should go to the banks. The profits from the newly printed money should go to the US government. So, the Federal Reserve should never want to loan money out at interest rates below inflation (as it is now) and it shouldn't want to purchase items whose energy value doesn't increase in value over time (such as coal/oil/natural gas...though, with that having been said...coal/oil/gas's capability to do work could increase with time as power plant technology develops.) But either way, the Federal Reserve shouldn't be in the business of directly owning energy assets, and instead, it should purchase bonds that are issued by utilities and independent power producers. This way, the Federal Reserve doesn't actually own the power plant; they own the bond, and in fact, they should probably own a portfolio of bonds from power producers in order to avoid the appearance of favoritism and corruption. It would be like a mutual fund of bond investments in electricity generating power plants.

The authors actually argue for a mix of government bonds and electricity bonds. The question is: what should be the inflation rate at which the Federal Reserve loans out money? While the author's don't particularly answer this question, it appears that they are favor of maintain overall prices at an overall inflation level of 0-2%/yr.

"The desire for fixed value currency runs counter to some macroeconomic theory that advocates a 1-2% stable annualized inflation target rate as optimal for optimizing long-term economic growth. This 1-2% inflation rate is effectively a wealth tax on currency holders but not necessarily asset holders."

It seems that the authors favor an inflation level of inflation between 0%/yr and 2%/yr.

Here are some analogies between energy and currency, which might help to explain the difference between inflating and deflating currencies: 
1)  There are energy assets like coal/oil whose chemical potential does not change with time. Owning coal/oil would be like holding on to a zero percent inflation currency.
2) There are energy assets like electricity in batteries whose chemical potential decreases rapidly with time.  The analogy here is to holding on to a currency that inflates with time, i.e. its purchasing power decreases with time. Clearly, storing electricity in a battery would be a horrible way of backing a currency!!! It would cause inflation rates of ~1%/day. (Don't get me wrong here, I'm not saying that we don't need more electricity storage in our electricity grid. All I'm saying is that the Federal Reserve shouldn't directly purchase stored electricity in flywheels or batteries as a means of backing our currency, and this is something that everybody can agree on. Electricity storage should be purchased on a case-by-case basis by utilities & independent power companies who think that buying more electricity storage can yield a positive rate of return on investment through a type short-term of energy arbitrage.)
3) There are energy assets like power plants. For successful power plants, there's a positive rate of return on investment. The analogy here is to a currency that deflates with time, i.e. its purchasing power increases with time. A deflating currency implies that the Federal Reserve is investing in some really good businesses and is reinvesting that money back into more businesses.

The question is:  what type of currency should we have?  Should its purchasing power increase, stay constant or decrease with time? The answer to this question should not be at the whim of a Chairman of the Federal Reserve and the Reserve Board Members. No one man, and no one board, should have all that power.

Let's all agree to a certain inflation rate and stick too it. Let's all vote on a inflation rate, and 
then let's average the votes to come up with a fixed inflation rate on which we can all agree. Some people might like deflation and some might like inflation. I vote for zero-inflation. (But I'm only one vote.)

Part of the reason why I think that a zero percent inflation currency is a good thing is that it helps people do long-range business planning. This is especially important because all power plants (even natural gas power plants) are long-term investments, and since power plants are the driving force for our economy, it makes sense to have long-term price stability.

What's worse is that (instead of maintaining a fixed level of inflation) the Federal Reserve Board has agreed to fixed levels of interest rates (i.e. zero interest rates) no matter what effect this has on inflation. This is mind boggling!  The Federal Reserve is living in a fantasy world in which they think that the economy will grow with zero percent interest rates. There's a huge difference between having a zero percent inflation currency, and one in which you let the currency inflate or deflate while maintaining constant interest rates. How can you fix interest rates for the next few years? (The answer is: you want a steady-state, non-growing economy.) So, when you hear the Federal Reserve talking about zero-interest rates for years to come, this is a buzz word for a "non-growth, steady-state economy."  So, I hope that you are all aware of this so that we can fight against the idea of a steady-state economy. A growing economy needs interest rates well above inflation rates.
So, now I'd like to turn my attention away from the paper discussed above, and spend some time discussing the details of how an electricity backed currency would operate in practice.

If the Federal Reserve decided to also purchase bonds from power producers, they could raise interest rates while growing the economy. And in order to maintain price stability, the Federal Reserve should print money when electricity prices decrease, and they should remove money from circulation.

What I'm saying is that it's more important to control inflation than it is to set interest rates. Interest rates depend on supply and demand. I think that it's absurd that the Federal Reserve sets interest rates at zero. In a free market, the interest rates should be allowed to vary depending on real-world facts.

Let's think this through completely. And to do so, I'm going to go into the details of what would happen to interest rates in an electricity backed currency. Let's start by restating clearly what would be the role of the Federal Reserve: to maintain constant average prices of electrical and mechanical work, and to do so, it is only allowed to purchase either a) US gov't debt or b) bonds of US based power producers (with ratings of a certain quality.)

So, let's first look at the case in which electricity prices are dropping. Since prices are dropping, this means that the Federal Reserve can print money. Since the Federal Reserve now has more money with which to purchase bonds & US treasuries. The immediate effect will be to lower interest rates, but over the span of a few weeks, the interest rates may go back to where they were before printing the money because more power producers may decide to sell bonds and build power plants. (Why?  Because long-term electricity prices will be constant, but now interest rates are lower. This means that power producers just below the margin will look profitable. Also, in the long run, interest rates will naturally go back up because the lower interest rates encourage people to consume rather than invest.) Interest rates should be free to float. The Federal Reserve should make sure that it can obtain the highest rate of return on investment available given the money that it has printed. This can be done through a market auction, and it should not occur quickly. The purchasing of new bonds/treasuries with the new money should occur over the whole time period between which the Board next reconvenes.

So, let's look at the other case, the case when electricity prices are increasing. Here, the Federal Reserve needs to sell bonds or government debt. This will drive up interest rates in the short term because in the short term there are only so many investors. But as interest rates increase, this incentives people to invest and save. This means that more people will eventually enter the market. As this money enters the market, the interest rates will begin to decrease. This is the whole point of what should have happened in 2006-2007. As oil and electricity prices were increasing, the Federal Reserve should have removed money from circulation, which would have driven up interest rates in the short term, but it would have encouraged us to invest more in power plants and less in luxuries. That is what the economy required in 2006-2007. Instead, the Federal Reserve did just the opposite. It printed more money, allowing interest rates to decrease, and this decreased the incentive for saving. In other words, there's a reason why we need rules regarding the amount of currency in circulation:  If left in the hands of one person or one board, these people have the tendency to make mistakes that have large negative impacts on the global economy.

An electricity-backed currency, as detailed above, is really just a form of chaos control. In fact, it provides a form of negative feedback control so that we can obtain stable prices and a growing economy. This is very different than Keynesian economics. The goal of Keynesian economics is to maintain constant unemployment rates and no real growth. The unemployment rate is controlled through borrowing and gov't debt. You can always keep people employed by borrowing money. There's no magic there. The question is whether borrowing money is sustainable in the long run. Keynesians aren't interested in the rate of return on investment on what the government invests in. In fact, welfare checks do better than investment in power plants because the money/energy often gets consumed faster. For them, all that matters is consumption, and they (such as Paul Krugman) are perfectly okay if this means no real growth, as long as nobody gets fired in the short term. In fact, there is no difference in their models between buying sports cars and building power plants, as long as the money is being spent at the same rate. They don't care if there's an energy return on energy invested,
-->i.e. a return on work invested.

This ultimately was the downfall of Keynesian economics: Reality requires that we obtain a Positive Return on Work Invested in order to survive and to grow. You can't borrow your way out of recession. You can keep people employed, sure, but you can't get out of a recession by building sports cars, by paying people to not work, or by military spending. The only way out of a recession is to refocus on obtaining large, positive rates of return on investment. That means figuring out ways to lower the price of electricity and transportation fuels. And that's the job of the 300 million people living in the US, not the government. We deserve a government and a currency that respects our capability to adjust how much we save vs. consume during a recession.

And so with that, I am now going to leave you with the suggested concrete plan of action I outlined earlier.

Concrete action plan
1) Slowly  (i.e. over the span of a few years), the Federal Reserve should sell mortgage-backed securities and purchase bonds from power producers. A goal of 50% gov't bonds and 50% bonds from power producers would be a good goal to achieve in less than one decade.
2) Maintain a constant average price of electrical and mechanical work  (perhaps a running three month average)

3) Allow the Federal Reserve to purchase bond funds of power producers as well as government bonds.
4) The money in the Federal Reserve should be separated between private funds and public funds. The profit from private funds should go to the banks. The profits from the printed money should go to the US government. There should be a clear demarcation between how much of the money in the US Federal Reserve is private and how much is public money. What I'm saying is that no individual company should profit from when the government prints money. The profits from the printed money are 100% ownership of the US government. Right now, I don't think that the Federal Reserve is doing a good job of drawing a line in the sand between government money and private money from the banks. For everybody's sake, we need a clear demarcation. This way, the public would be clear that the banks aren't obtaining free money from the US gov't.

In the comment section below, please let me know what you think about this concrete plan of action.

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