Talk about some needed changes! This week has demonstrated the sheer idiocy that constitutes our beliefs about the economy, markets, capitalism, banking, and many other aspects of our modern lives. I am continually amazed, for example, at the news outlets who continue to bring their talking head experts in to analyze the situation with the financial system melt-down and the proposed bail-out. None of these guys and gals got anything right in the lead-up to the crisis. Why would you turn to them now for sage wisdom?
I at least understand why the government turns to the very people who got us into this mess for help. They simply don't know what else to do. The members of our government are stuck in ideology. Even the Democrats believe in markets and capitalism and growth. And most of all, not one of them can think systemically. They really have no idea how the plateau of oil production of the last three years is actually at the bottom of this whole mess.
In the last episode I covered the need for rethinking the entire political process and the basis of our governance design. I indicated that there needs to be an integration of the economic system — essentially the operation-level organization of civilization — with the governmental aspects of social governance. With this crisis in banking and Wall Street almost everyone is now saying that some form of regulation is necessary to keep markets (and players) honest. HELLO! The economy is the life blood of civilization. How could you ever think that the governance structures were only meant to keep people from beating up on each other. Our US government has been in continuous evolution toward more and more involvement in regulation in the markets since day one. It has to be because that is the natural progression (see my series on Sapient governance starting on the July 20 blog).
So given the call for a reorganization of government along the lines suggested in the prior blog, I want to go into greater depth regarding the role of money as a token of energy, wealth production as physical work, banking as storage of excess energy, and finance as ways to invest in future energy flow. I've discussed this here. Government should be designed to regulate, in the sense of tactical and logistical coordination, these functions.
Money
Reflecting back on my March 25 blog, "What is money, really?, I have suggested that the real meaning of money is that it represents energy available to do useful work. I outlined, there, several implications from thinking about money in this way. Now is time to parse these ideas more finely.
In order to grasp the significance of money as a token of potential work we need to understand what is meant by 'useful' work. It all starts with physiology. Omnivores, like us, eat food to gain new raw materials, atoms, that are needed to maintain our bodies. But we also get energy from that food. Everything that goes on in our bodies, including our thinking, is based on energy being available to drive the processes. Our bodies, actually our cells, contain all of the knowledge needed to guide the flows of energy to the appropriate processes. That knowledge is embodied in the structures of living cells. That is what is inherited in our DNA. One form of useful work, in physiology, is defined to be that which maintains the structures - fights the ravages of entropy. This self maintaining is known as autopoiesis. Another form of useful work is when energy is routed to our muscles so that we can move and, ultimately, obtain more food. That is, we use energy to get more energy. Third, while still immature and body size is small, energy is routed into building more new structure, to growing. Once the body attains its natural size, however, it stops growing and all energy is for maintenance and motion. The body does useful work by maintaining itself and by moving itself to gain more energy.
Not all work is useful. When things go wrong in the body or brain people can expend energy that does nothing to maintain the structure or get more energy. The general term for this is disease.
In the economy useful work can be defined very similarly. Work processes have structures that represent knowledge of how to use energy for a purpose, to produce something that has value. Work needs to be done to preserve the structure — think about maintenance of a home or factory. Then work is done to produce the product or service. Energy is expended.
To be precise about the term 'useful' we have to examine the value placed on the product or service. As I have written about before, there are basically four things that you can do as work. First you can produce a product or procedure that increases the availability of usable energy in the future, either what you do helps increase the production of new energy, for example you build a fire place or an oil well, or it increases the efficiency with which you already use energy, for example you build a crowbar or a computer-controlled robot to weld joints in cars. In both of these instances the usefulness of the work is measured by how much extra energy is then available for more work in the future.
The third form of useful work is simply maintaining what you already have. Work to maintain the infrastructure, for example, is useful.
Or you can use the energy to do work which results in entertainment or relaxation. Toys and movies are examples. Every human needs periods of recreation in order to do more efficient work in the future. So in one sense, such products and services can be regarded as useful indirectly and over a longer time scale. That is, if done in moderation. There comes a point at which playing can go to excess. The human mind does not want to be bored. And if not occupied with useful work (as defined here) it will resort to looking for stimulation in play. It's the way mammals are built. Children play as preparation for social activities as adults. Adults play to recreate (maintenance). Done in appropriate circumstances it is actually useful work. A similar argument applies to esthetics. A beautiful painting or poem can do for the mind what playing football does for the body.
But in a society where so many mechanical slaves, expending nearly 60 times as much energy as we do ourselves, perform most of our work for us, and do it in short order, what are we supposed to do with our time? We play. It's a double whammy to our energy resources and atmosphere in that our energy slaves are burning huge amounts of fossil fuels and at the same time leave us with little to keep us occupied so that we end up burning even more entertaining ourselves.
We now end up expending a lot of energy doing not strictly useful work. How we expend our energy now is mostly convenience and play. If the former is geared toward work to make tools then we are all better off. But that simply is no longer the case. It is pretty hard to argue that a service job like flipping hamburgers is doing useful work. Even if it involves a more convenient food source for the customer, it not only isn't necessary, it actually ends up making that customer worse off, health wise.
If money were defined strictly as being based on energy available to do useful work, and we were clear about what we mean by 'useful', then it should be obvious that modern society is wasting a lot of energy on non-useful work. How many of us can say we are contributing, directly or indirectly, to the increase in energy available to do useful work? I'd like to believe that when I teach computer science, I am preparing students to go out and do useful work. But if their minds are put to producing an endless procession of games or iPods, I can't really justify that to myself.
What has happened in our society is that money, which once long ago actually represented some value in the sense of useful work, has now been so dissociated from the underlying concept of trading tokens for useful work. Money has come to be a free-floating object-of-value in its own right. People no longer work to be doing something particularly useful. They work for money. They think in terms of money. They value in terms of money. And that, among other such deficits in how to think about work, is why no one really knows what anything is worth or why we are in the current crisis.
An immediate fix is to recognize the relationship between money as token and energy available to do useful work. This means recognizing too that useful work relates to increasing or at least maintaining the energy flow itself. Everything else is just throwing money and energy away. The solution is to establish an energy standard for money units. Not just any energy of course. We need to measure the amount of net energy available to do useful work and then establish an amount of actual cash money to be put in circulation to reflect that measure. This is essentially like the gold standard in that it puts a precise value on each unit of paper/computer currency. But unlike the gold standard, this standard fixes the value of paper currency to the real physical currency of work. It establishes a firm foundation for say what something is worth. Psychologically it restores confidence in the paper currency. And, since the laws of physics obtain everywhere on the planet, it is the basis for a stable international trade medium.
This proposal differs from previous energy-based notions of money. In older versions an attempt was made to account for the energy expended in producing a good or service as a basis for valuation. That is, the energy standard for money was associated with energy already used up. The theory was that capital value was related to how much work went into producing the capital. But this raised all sorts of difficulties in comparing values between, for instance, efficiently vs. inefficiently produced capital goods. It was hard to assign a price based on aggregated and averaged energy consumption. In basing money value on energy available the emphasis is on potential rather than realized. If a work process is inefficient and wants to compete it will find its costs will be higher and so its profit margins lower.
In an economy where coordination at the tactical and logistical level is integrated into governmental functions having a monetary standard is critical. The only way overall efficiencies and optimizations can be accomplished is if we can measure process parameters accurately. No form of regulation will work if the measures of performance are distorted by free-floating fiat money. So fixing the energy value of money should be a top priority in developing a rational/sapient social system.
Banking
Banks are storehouses of wealth. But if money now represents available energy, then what a bank holds is the excess of energy that has yet to be put to use.
The concept of storing energy for future use, in case of disaster or to support future expansion, is very old. It is, in fact, one of the first outcomes of the agricultural revolution. Granaries were established and managed in order to store excess foodstuffs when times were good. Humans were wise enough to realize that overproduction could be used in subsequent time periods if future harvests went badly. Similarly, once money became the medium of exchange, money could be kept in a bank, under guard, to be used in the future. The more efficiently a farmer or tradesman was in doing useful work, the more excess accumulated and needed to be stored.
Somewhere along the line, still back in the granary days, a smart granary manager realized that some of the stored seed could be loaned out to newly starting farmers to start their farms. Since a granary is a collective storage facility, the seeds would come as a portion of everyone's contribution and so no one farmer would shoulder the whole risk if the newcomer failed. Seemed like a reasonable plan. And, of course, while human populations were expanding, it was. Of course, you couldn't loan out seed to too many new farmers. There had to be a limit. And it was expected that the new farmer would pay back all the seed borrowed, plus put in his contribution to the future. It was probably the case that the granary manager took his wages out in seed, so he made a bit of a profit off the transaction. Most of the time the scheme probably worked.
But if a terrible crop blight or other disaster befell the farmers, and they needed all of their stored grain to get through to the next season, then things might have gotten pretty dicey. The manager couldn't give them all of their seed because he had loaned some out to the new farmer(s). At such times everybody took it on the chin.
In this simple example of the origin of banking, it is clear that what is stored is energy. The grain seeds were also food. And what the farmers were doing was hedging against future bad times. The same is basically true for early banks with money deposits. They were accumulations of tokens that could, at least in theory, be traded for the underlying goods that represented useful work. Houses, horses, food, all forms of energy tools and energy could be 'bought' with the money. But money was a lot easier to store than houses, horses and food. This worked because societies had gotten sufficiently complex and large and with plenty of specialization. It became possible to generally be able to convert money tokens into something truly useful.
But, just like the new farmer getting a loan to start a farm, new tradesmen needed to have a way to get started in business. Borrowing money from a banker was little different from borrowing seed from the granary. Likewise paying it back with some extra translated quite naturally. In ancient times, there was a fairly widespread belief that paying back a fair amount of extra was alright, but that managers and bankers should not expect too much extra. Fair was fair.
But loaning is also risky. What if the new businessman fails? Somewhere along the line some bright bulb realized that perhaps it wasn't untoward to charge a small premium for the risk associated with loaning. After all, if the money wasn't paid back, the original depositors might get angry. This seemed reasonable, and as long as the amount of the premium (insurance really) was just enough to, in aggregate, cover actual losses then it too was fair.
Enter in human nature. Let's face it, we are all just a little greedy. We are wired to want to accumulate more than we need. After all that is our insurance. It is why farmers started growing more than they would actually be able to eat in the first place. Businessmen and bankers are no different. Suppose that they made a small 'profit' from these premiums, or from the price they charged customers relative to their costs? As long as the amount per transaction isn't too much, they end up accumulating a personal buffer similar to the communal ones. They then put that buffer into a bank!
Now if you are a banker and you are responsible for someone else's money you would think you could charge a fee to execute that responsibility. And so they did. But with the advent of people putting profits into savings, a new thought arose. A banker could be better positioned to make loans (which now produced profits) if he had even more assets in the hold. One crafty way to attract deposits would be to actually pay people to keep their profits in your bank! And we are off to the modern form of banking. Pay the depositors a small interest, charge the borrowers a larger interest and pocket the difference. What a perfect scheme.
Let's pause for a moment to consider what is actually happening. The banker is providing a service for which he should be duly rewarded. Energy, in the form of money tokens, are being conserved and mostly available if the depositor wants to withdraw. As inducement to keep money in the bank, the depositor is receiving a kind of reward, more energy than he put in in the first place. In order for this to actually work, however, the new businessmen who borrowed money had to actually succeed and do useful work that made everyone better off (so they would pay money to buy the product or service). In other words, it only worked if the economy was growing.
Now come down to modern times and see what banking (and I use the term very generically at this point) has turned into. First note that the modern citizen, in the West anyway, is now a consumer, not just a producer of excess energy! Consumers' jobs are to buy things and use them up. They buy houses, horses (well maybe not so much these days), and food. But they don't necessarily work at jobs that produce more usable energy. They don't always receive as much money for their energy expended as they would like. But still to fulfill their role as consumers they need to be able to buy all that stuff and a lot more besides. Solution: borrow the money from the bankers and promise to pay back that and some more, too often a lot more.
But it gets even more peculiar. Whereas once, long ago, a banker would be prudent and loan out just enough to get the new guy started and keep enough to make sure that all of his depositors would have something to withdraw if necessary (in other words the sum of the loans still amounted to a very small fraction of the total deposits), today bankers are actually encouraged to loan out substantial fractions of their deposits.
More to the point, the purpose of loaning money today is so that consumers can consume regardless of what they add to the energy economy. We have gotten to the point of believing that economic good is realized in growth and the only way to sustain that growth is for everybody to consume. That way there are always new businessmen succeeding and needing to continue to borrow money to expand. We have forgotten the true meaning of our wealth and how to conserve it. What we do today is borrow energy now with the expectation that there will be even more energy available tomorrow!
This modern belief in magic came about because we managed to tap into the biggest bank of all — the buried treasure of fossil fuels. Earth stored this concentrated energy that had been built up by millions of years of photosynthesis being buried and cooked. I actually think that this has been a boon to humanity in that it allowed a rapid development of technological civilization. And with this kind of civilization every human being could, in principle, have a comfortable, productive life.
Unfortunately, since we humans have a tendency toward largeness. We interpreted this access to excess energy as winning the lottery rather than prudent borrowing. We tended toward large families and larger shelters/houses. We tended toward trinkets and toys. We were not wise.
Finance
In the context of the modern banking system we have overdone the fractional reserve concept. We have created a class of money that does not represent energy available to do useful work. It is worthless paper, but the illusion of worth could be maintained as long as the production of net available energy continued upward. But since the energy return on energy invested (EROI) has been trending downward, starting sometime in the middle of the last century, the illusion has been gradually coming apart. For the last thirty years the financial sector has had to create a continuing stream of creative instruments to hide this fact from the public. Of course they really didn't know why they had to be so creative. Perhaps they chalked it off to competition (for what?), or maybe they really believed their own myth about money being the ALL of wealth (thanks in part to the Chicago school). But whatever they were thinking, they turned increasingly to instruments that looked like investment, but were nothing more than a Ponzi scheme.
Once, when manufacturing was the basis of wealth production in this country, people could buy shares of the company to provide capital for investment in solid assets. But then a market was created so that stock holders could trade or buy and sell shares, basically to provide liquidity. As the energy backing of money became less and less understood, however, such markets turned into money making machines in their own right. People started thinking about making money on the rise and fall of stock values rather than as investments in wealth production and maintenance. The markets became a gambling machine with winners and losers. It became a game.
Venture capital (VC) too became a game. Capitalists pooled their resources to fund new startups. They became a kind of bank in this sense. But as high tech companies began to show successes in creating new technologies, particularly in the computer and communications realms, this too became a game. VCs began playing with the notion that they were funding risky innovations. Some, indeed most, of the new startups should probably never have been attempted (I speak from personal experience!) But as Moore's Law drove the costs to manufacture digital electronics down, and supported higher densities of functions on silicon, and as the wonder of software malleability created incredible developments, we got drunk with the excitement of new technologies that could potentially transform the world. VCs started funding anything that moved. They expected huge returns on their investments to cover the risks. For every nine ventures that failed, one would succeed wildly, but that meant they had to demand huge returns from that one to cover the losses from the failures. At first this might have seemed completely rational. But the notion of huge returns was contagious. As other kinds of financiers and Wall Street brokers noted the profits from ventures like these, they coveted similar kinds of returns. Greed took over. And within short order any kind of asset might be considered as a basis for high returns — even homes. What we are witnessing now is the result of a long and grubby trend to turn larger and larger profits on investments, or perceived investments. Even home owners have been caught up in the greed. Now viewing their residence as a great investment in the sense that its value would always go up, they have become huge risk takers, borrowing mortgage money in excess, heavily leveraging themselves, on the bet that when they sold they would make big bucks.
We are a country of highly leveraged individuals, companies, and governments (state and federal). We've borrowed against an assumed future of greater wealth but have forgotten where wealth comes from in the real world. And now, with the peak of oil production and a severe downturn in the production of net energy available to do useful work, the Ponzi scheme comes to an end. A few fat cats got money-rich from the scheme. The vast majority of people are going to be very poor. The amount of energy available determines how much wealth producing work can be done. Not the amount of dollar bills in circulation.
The fundamentals of economic activity are not that complex. Once we realize that economics means doing work that results in maintaining the structures of civilization and not endless growth we will be able to comprehend how it works. What needs to be accounted for in the economic system is the energy available to do useful work. That means, in turn, understanding what is really useful work. Once we grasp that we can do no more than what energy is available we will stop thinking that growth is the objective now. We will, if we can muster enough wisdom, find some way to reduce our population level to what can be sustained with equitable distribution of the wealth we can maintain. But as long as we insist that the old framework for thinking about economics is the right one, we are doomed to make the same mistakes until there is no one left to insist that we have a right to over consume. And there may be no one left at all.
Once we grapple with creating an energy standard for money we need to redesign the whole banking system to fulfill its original purpose. We need to focus on savings, that is banking excess energy production, if there is any, against future uncertainty. We need to understand that we should reserve loans for purposes of investment in development and maintenance, definitely not growth. Finally, we need a governance structure that acts to coordinate the flows of energy (money) in a manner appropriate to these objectives.