The Compounding Debt Fallacy

It's pretty well known that the US federal government is in debt to the tune of twenty trillion dollars. The Economic Collapse Blog is reporting that, if we account for personal debt as well, such as mortgages, students loans, credit card debt, etc, that number balloons to $41 trillion. That comes out to $329,961 per household, which amounts to 584% of median household income. The numbers are almost numbing and don't even account for corporate debt, state & municipal debt, or debt in the form of unfunded liabilities likes pensions, Social Security, and Medicaid.

You might be asking yourself how it is even possible that we could have so much debt. Can the size of the debt really exceed that of the monetary supply? Is the whole system intrinsically insolvent? Let's look at a couple relevant articles that are highly placed in Google searches on the subject. The first is from ZeroHedge, titled It Is Mathematically Impossible to Pay All of Our Debt. They assert,

There is no way in the world that all of that debt can ever be repaid.  The only thing that we can hope for now is for this debt bubble to last for as long as possible before it finally explodes.

Hoping for the debt bubble to last as long as possible is short-term, almost malicious thinking. The longer bubbles take to pop, the worse the resulting turmoil. In general, the longer the market ignores reality, the more severe the eventual correction will be.

The other item is from Simon Thorpe's blog, in an article titled Global Debt is now 2.5 times the total Money Supply - the system is clearly unworkable. He paints a similarly gloomy picture but goes even further to offer an explanation into how our monetary system would allow debt growth to outpace the monetary supply, as well as offering a systemic fix for the issue.

How on earth did we get into this situation?

For me, the answer is pretty simple. Commercial banks create money when then make loans to individuals, businesses and governments. But when they do this, they create enough money to make the loan, but don't create the money that will be needed to pay the interest. Thus, if a bank creates $1 trillion in loans with interest at 2% and waits for 20 years, the total amount of debt  in the system will have increased to nearly $1.5 trillion. This is what has been happening for centuries, but the effects of that compound interest have now become totally out of control.

It is clearly time for us to change the system. All money should be created interest free. Full stop.

Both his analysis and his conclusion are very wrong. He's wrong because of a very common misconception about the economy, which we'll dub the Compounding Debt Fallacy. The author keeps a blog and a video series dedicated to the discussion of economics and still falls into the trap. We'll walk through the reason his analysis is wrong. After that, you'll have a better understanding of our debt-based monetary system than the vast majority of Americans, even many who dedicate a substantial amount of their time to the study of economics.

The Compounding Debt Fallacy is something like this.

When banks make loans, they create debt that must be repaid out of the monetary supply. Thus the debt will compound perpetually until there isn't enough money to repay the debt.

Or something like that. It's pretty much what Mr. Thorpe was saying in the above quote. These people are often consumed with the notion of runaway debt creation. But they miss two very big aspects of the process. First, the bank actually does create currency when it issues debt, and second, that currency is destroyed when the loan is repaid. Think of debt and money like matter and anti-matter. They are equal and opposite to one another, and, when they meet, they annihilate each other. Some time ago this blog did some thought exercises on the subject of debt creation in a fiat monetary system. Let's run through one again to try to understand all this.

Suppose there is $100 in the monetary supply. (Which also means there's $100 in national debt.) You work in the economy, which means that you trade your labor for money out of the monetary supply. You make enough that you can dedicate $2 each year to housing. The house you want to buy is $10. What do you do? Remain homeless for five years until you save enough to purchase the house? Probably you'll go to the bank for a loan.

The bank says, "We'll loan you ten dollars for a house, and you must repay us a dollar a year for ten years, and it will be paid off. But you must also pay us an extra dollar a year in interest as our service fee."

Noting there is a cold front moving in, you respond, "Ok."

The bank deposits ten dollars into your account. Where did it come from? In our system of fractional reserve lending, the money was simply created. As long as the bank has 10% of the loaned amount on reserve -- in this case, a dollar -- they can generate the loan. They create a mortgage contract and then give $10 to the seller of the home. Here's the part where people who only see one side of the equation lose their minds. Some say, "They created money out of thin air! Runaway inflation! Unsound monetary policy!" Others say, "They created debt out of thin air! Debt bomb! We're all debt slaves!"

The bank created both, the money and its complementary debt. Now the money supply is effectively at $110. Eventually, the bank gets their $10 dollars back. They then use that money to cancel the mortgage bond. This is the part everyone misses. The bond and the cash annihilate each other and we're back to where we started, with a money supply of $100 and privately held debt of $0. The only long-term effect of the mortgage is the transfer of wealth from you, the homebuyer, to the bank, in the form of interest payments. But that's just exactly what we expect to happen. You pay them for providing a financial service.

What's happening here is that people don't understand our fractional-reserve fiat monetary system, so they aren't making the proper critiques or offering valid fixes. For instance, the author's suggestion that all money be lent interest-free is absurd. So he wants all banks to go out of business, and no one gets a mortgage. Cool. People think of money as an asset-backed system, but the dollar is a contract-backed system. In an asset-backed system, the value of money comes from the value of some commodity. Not terribly long ago, US coins contained silver, giving them value, and the paper dollars had value because they were (supposedly) redeemable for gold. So holding a dollar was as good as holding it's equivalent in gold.

Today's money has value because it is created out of debt, and someone has the legal obligation to repay that debt. If the government did not enforce contracts (one of its primary duties), the currency's worth would be equal to its BTU value on combustion. If the government of the United States ever collapses (**crosses fingers**) the dollar will be destroyed with it.

There's nothing wrong with a contract-based monetary system, but that doesn't mean that in practice it is being operated properly, or that it is remotely solvent in the long-run. Going back to the original article, how is there $41 trillion in debt if the money supply is significantly smaller? This is an important question. It's not because banks issue home loans. Either the money supply is somehow not being properly accounted for, or something is very screwy in the way things are being done. The fact that we don't constantly hear people asking the question why doesn't the debt equal the value of the money supply? means that (a) a lot of people don't understand the modern monetary system, and (b) the people who do understand the modern monetary system mostly decide, for whatever reason, not to ask that question.

Distortions in the Financial and Political Markets

Financial Markets

If you're a regular to this blog, or to some of the other blogs in the sidebar like oftwominds, then you understand that our financial system is marred by massive market distortions. The market is supposed to work as an information-processing entity that rewards smart enterprises with capital, and smart investors with profits. The investor analyzes companies and decides which, if any, he wants to fund.

In reality, things don't quite work that way. Most people invest through proxy. They give their money to a fund manager who does the legwork of poring through financial data for a multitude of ventures, trying to find those most likely to give the best return. Thus, the valuations of the various companies relative to each other have some basis in reality. But the market overall, that's another picture. Aunt Betty doesn't allocate money to the stock market based on the aggregate financial data available to her. She probably sends a fixed amount. For the vast majority of investors, the amount of money they send to market is determined by (a) their pension program, which they have no control over, (b) their 401(k) policy (most people just put in whatever their employer will match), or (c) the recommendation of a financial adviser. (I'll save you the fee; they recommend 15%.)

Most people don't invest in companies; they bet on the market. For those who do trade their own stocks, mostly they buy index funds when they see a bull market, and sell when they see a bear. [Some buy individual stocks, although not always on the best information. Aunt Betty likes her iPhone, so she buys Apple stock. She doesn't know what dividends are, or why she would want to have those.] The question for the typical investor becomes whether the market will rise or fall. Will people keep pumping money in, or will they get scared and pull out? Company valuations become a minute data point, because the amount of money coming in mostly has to do with the overall health of the economy (or its perceived health) and the monetary policy. The Fed can pump the market by lowering interest rates, or deflate it by raising them. That's a lot of power! No wonder investors watch meetings of the Fed Board in real time. The Fed also owns so many assets, some $5 trillion in toxic assets it acquired from TARP, that it can direct the market at will. They could crash the market tomorrow if they decided to dump everything. So the value of your Google stock next month has more to do with monetary policy than how Google is being run.

The gist of this is the market, previously an engine for efficiently matching investment capital with business enterprises, is now a casino that matches investment capital with monetary policy and the hope that everyone else will keep investing. Think of the difference. In the old system, if you sniffed a sweet investment, you didn't want other people knowing about it. You prefer your investment dollars to be at a premium, thus more valued by the business venture, meaning you might expect better returns, such as higher dividends. None of the FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) pay dividends. They don't need to. If you buy them you hope everyone buys them, driving the price up, because that's the only way you're going to make any money off them. The old feedback loop has been dismantled. So when will company financial data feed back into market investment? At the next crash, one presumes. The efficient processing of information is gone. Reality only feeds back into the system in intermittent, jarring, and chaotic events.

Political Markets

There are two major ways to view democracy, and probably lots of minor ways. It's a complicated thing. One way to look at it, as suggested by Jim's Blog, is that democracy is a proxy for war. Instead of drawing up sides and fighting it out on the battlefield, we simply count heads to determine who would have won, and put them in charge. Democracy circumvents the horribly self-destructive process of civil war, and everyone gets to go home to their families. We'll come back to this.

The other way to think of democracy is as a marketplace of ideas. The various entities in the nation use the methods of persuasion at their disposal to influence the populace, then we count heads to see who had the best ideas. This is why we hold our freedoms of speech and of the press in such high regard. Those are not idealistic moral judgments. They are absolutely essential to the efficient flow of information in the marketplace of ideas. Without them the market of democracy is distorted, and doomed to eventual, and painful, market corrections. There are some other requirements. The voting public must be rational and operate in good faith. The government must faithfully execute the decisions of the democratic process.

I'm sure you see where we're going with this. In all critical aspects, our democracy-as-marketplace is seriously distorted. The mainstream media is primarily propaganda, not honest journalism. Other avenues of information sharing are corrupted. Just today Twitter killed another trending hashtag damaging to the Democrats. In this one, a DNC IT staffer, who was fired 6 months ago for obvious fraud and apparent data theft, was still being paid by Debbie Wasserman-Schultz (remember, she was fired from her position as DNC chair after email leaks revealed she was throwing the election for Hillary), and was only fired after he was arrested by the FBI while trying to flee the country! But those hashtags are removed in favor of Russian conspiracy theory nonsense. Clearly the channels of communication are not conducive to pragmatic decision-making by the populace. The public is fed fiction and believe it to be objective truth.

The other aspects are failing as well. The voters need to be rational and acting in good faith. Well half of them believe the Russia conspiracy theories after 13 months with no evidence and not even a description of the alleged crime. It would seem that about half of the electorate does not satisfy the criteria of rational. And a significant number are ideologically opposed to even having a dialog with their opponents whom they see as literally Nazis. So certainly they are not acting in good faith. The other requirement, that the government faithfully abide the decisions of the people, is also violated. Half of the deep state, and nearly all the propaganda machine, are working to reject the president elected by the people. The government frequently ignores the will of the people, or adopts their preferred policies but does not act on them. Nearly everyone, from both aisles, opposed the Wall Street bailouts, and they still happened under presidents from both parties. A decade ago their was bi-partisan legislation passed to build a border wall. It never materialized. Everyone wanted banksters to be prosecuted for fraud that contributed to the 2008 financial crisis. Not one person, not even a patsy, saw jail time. And now, the Republicans own the whole federal government, largely by promising to repeal Obamacare, yet we are seeing that no meaningful repeal will happen, and maybe not even a nominal repeal. 

All the requirements for an efficient democratic market are, well, requirements. The loss of one can destroy everything. All are failing today. The prognosis for a democratic collapse is nearly the same as that for a financial crash. It's not a matter of if, but when.

Let's go back to the other perspective of democracy for a quick second; that democracy is a proxy for civil war, and awards those who would have won on the battlefield. The key requirement for this arrangement to endure is that the people who would have won the war tend to win the elections. At the very least they should not be treated as vanquished chattel. Otherwise, at some point, the would-be warriors start to think, "Gee, maybe we'd get a better deal if we just took this all over by force." Think of our situation now. The military, the police, and nearly all men who own firearms are Trump supporters. Yet he is currently under soft coup by the party populated by gender-fluid feminists and limp-wristed manlets, who want to take all the money they can grab from the former group. They can hardly be reasoned with, and eventually the right wing will realize that they can only defend themselves by physical force, not by engaging in the defunct marketplace of ideas.

The financial and democratic feedback loops in this country are wildly dysfunctional. Remember, the number one rule of economics is the markets always correct. Reality denial is not a sustainable condition. The only practical advice here is to become antifragile. Expect that there will be abrupt and chaotic market corrections in our future. If you don't yet know how you would benefit in those kinds of scenarios, then you are certainly fragile to the inevitable.

Downward Redistribution Doesn't Boost the Economy

Background

In a discussion on universal basic income, it was postulated by one member of the group that by moving money from the rich to the poor the economy would be stimulated for growth. The notion was that rich people tend to save their money, but if transferred to poorer people it would more likely be spent on consumption, i.e. economic activity.

This was said by a professor of philosophy at the local university who, while clearly not an economist, is someone who can be categorized as educated and intelligent. It seems that the fundamentals of macroeconomics should be common knowledge, at least amongst people of that intellectual tier. If you have a grasp of macroeconomic fundamentals and understand the professor's mistake then there is no need to read any further. However if redistributing wealth downward sounds like a good way to boost the economy then this article is for you. Please note that I'm not claiming there are no good arguments to be made for downward re-distribution, just that overall economic growth is not one of them.

There seems to be a misperception of the very wealthy as Scrooge McDuck types who keep an enormous vault of money used for the purpose of recreational swimming. While clearly many rich people are guilty of overconsumption, that is not where the bulk of their money goes. Look at the example of Warren Buffet, who is the normal go-to example of how billionaires don't pay their fair share. Famously he pays a lower tax rate than his personal secretary. But he is also a model billionaire, who has stayed in Omaha rather than heading for a trendy city and still lives in the relatively modest home he's been in for decades. Almost the entirety of the man's wealth is not "saved" in the overstuffed mattress sense, but is invested in businesses. It is capital.

Perhaps to those who naturally recoil to the word capitalism then Buffet's capital investments are a waste and should be re-allocated to the poor who will spend it, as money is meant to be spent. And in fact, after I responded to the professor, another in the group (it's worth noting most of the discussion group are Trump-hating liberals) stated that capital investments do not contribute to economic growth. If that doesn't strike you as ridiculous it will in a moment.

Before we get into the economics part, there are a few ways to question their statements logically without even getting into economic theory.

• If moving money from to capital investment to consumption boosts the economy, then why don't we move all of the money? Why aren't capital investments heavily taxed?
• If capital investments don't lead to economic growth, then why do so many businesses spend their money on it?
• If consumption is the primary driver of economic growth, why would we ever limit it? Sales taxes should be immediately abolished, and savings discouraged. The Fed would have every incentive to keep the inflation rates high.

Macroeconomic Growth Theory

If we include human capital and technology into the category of capital investment, then it is not only a way to drive economic growth, it is the only way to drive economic growth. The size of the economy is measured in GDP. The formula for GDP is:

GDP = consumption + investment + government spending + trade balance

What happens to GDP in the short term if we move money from investment to consumption? Nothing! What happens to GDP in the long term if we move money out of investments? It decreases. The only way it might make sense for increasing consumption at the expense of capital would be if there was excess production capital not being utilized. It would be an unusual circumstance, caused perhaps by a massive economic contraction. So universal basic income might make sense in case of zombie apocalypse.

Example: Sticks & Scones

Let's consider a very simple economy to see what effects capital investments can make.

Please contact me if you need custom cartography work done.

In Simpletonia there are two towns: Woodville and Cornucopia. Woodville is deep in the forest and their sole natural resource is wood. Cornucopia lies on the plains and their only resource is grain. The two towns are connected by a road of very poor quality. Grain is used to make scones, the only food in Simpletonia. A citizen needs at least a batch of scones a year to survive, two to be comfortable, and 3 or more for luxurious consumption. Wood is the only source of energy, used for heating and cooking. It takes one bundle of wood to cook a bushel of grain into a batch of scones. A citizen requires a minimum of two bundles of wood to survive the winter, four to be comfortable, and six for luxury comfort.

Citizens of Woodville work as either lumberjacks or bakers. There are three classes of residents in Woodville.

• Five are low-class. They consume a minimum of resources: one batch of scones and two bundles of wood.
• Four are middle-class. They consume two batches of scones and four bundles of wood.
• One is an upper class baron. He consumes three batches of scones, six bundles of wood for heating, and extra bundles to expand his palatial home.

The total food consumption is 16 batches of scones per year. The four middle-class Simpletons work as bakers; each converting 4 bushels of grain to scones, and using 16 units of wood in the process. Grain is acquired from Cornucopia. They are always happy to trade a bushel of grain for a bundle of wood. However the trip is treacherous, so the traders require payment of two bundles of wood for the voyage.

The baron owns all the land. He hires the lumberjacks to cut wood, and pays them enough for minimal subsistence. Any excess wood he uses for his own luxury.

The five lower-class citizens works as lumberjacks. They can each cut 20 bundles of wood per year. Wood consumption is as follows:

• 32 for consumption
• 16 for cooking
• 48 traded for grain
• 4 per year used by the baron to improve his mansion

Let's look at some different scenarios and how they might impact the Woodville economy.

Redistribution

Some Simpletons suggest that the economy could be improved by redistributing wealth downwards. A tax is levied. All the baron's extra wood is given to the poor, and his own consumption is lowered to 5. All the lower-class wood consumption is thus raised to 3, somewhat above subsistence but not quite to the middle-class level. Nothing fundamental has changed in the economy; consumption has just been shifted.

Expand labor

The baron realizes he can get more production out of the lumberjacks by making them work more hours. They lumberjacks now each cut 24 bundles per year, for 120 total per year. The baron hoardes all the extra lumber.

Infrastructure investment

Seeing how well Woodville is doing, the King of Simpletonia conscripts one of the lumberjacks as a road worker. Wood production falls to 96. However the road is improved so much that the traders now only demand one bundle of wood. The wood distribution is modified.

• 32 traded
• 32 consumed
• 16 for cooking
• 16 extra

Capital investment

The baron decides to invest his extra wood and uses it to build a bakery. The bakery is much more efficient, doubling the production of each baker. The baron hires 3 of the bakers, who make 24 batches of scones per year. This raises the food consumption of nearly everyone. All lumberjacks now get 2 scones per year, and the three hired bakers get 3. Only the 4th baker, now unemployed, does not see his standard of living rise. The wood usage looks like this.

• 48 traded
• 32 consumed
• 16 for cooking

Human capital / education

The unemployed baker heads to Simpleton University and is trained as a master in lumberjack management. After graduation he returns to Woodville and is hired by the baron. He improves lumberjack efficiency 100%. After cutting back their hours, the baron is able to let one go and still produces 120 bundles of wood per year.

Analysis

The process for growing the economy is consistent. Production improvements free up labor that can be used to drive even more improvements in efficiency, yielding even more production improvements, and so on. Investments in capital, labor, and technology are the only practical way to grow the economy. Then notion that transferring money downwards because the rich are hoarding it all is a myth: the money they aren't spending is being used for capital investments.

The Real Reason for Redistribution

In our example the workers were always able to make an appropriate transition. For instance the lumberjack was able to transition to road worker, since they're both low-skilled labor. The baker, being already somewhat skilled, was able to retrain into industrial management. Typically technology will tend to eliminate low-skill jobs and open up high-skilled jobs. This is one reason for our obsession for education. But what happens to the people who can't be trained up? Certainly we shouldn't expect the 80 IQ laborer to ever be qualified for intellectual pursuits. It's quite possible these people will be left behind. And as AI advances, the displaced will be of increasingly higher IQs until, at the technological singularity, all humans are replaced from the economy. So there are very real arguments for a redistribution of wealth, but economic growth is not one of them.

Energy Regression: the Looming Apocalypse

At the end of my post on Energy-Backed Currency I mentioned that I viewed energy regression to be the fundamental existential threat to western civilization. It is worth spending time on that subject, as it is key to understanding the second problem that EBC solves. The first problem is in having a currency backed by a valuable asset that grows linearly with the economy. The second problem is in re-orienting society so that it is inherently focused on the energy situation at all times.

I regard energy regression to be the fundamental existential threat to our world. Even more than nuclear holocaust, and that is always a real danger. Even more than civil discord, and I do believe we're on a path to a clash of civilizations within the west like has never been seen. Even more than climate change or economic stagnation or disease epidemics. Because all those problems, whether they occur or not, whether they are easily solved or not, don't change the fact that energy regression is something we will face, no matter what. There is no avoiding it. It is a constant looming threat to every civilization.

Energy regression has happened repeatedly through world history. Until modern times, energy input was in food, and to some extent firewood. Societies collapsed because they deforested their environment. Societies collapsed because crops failed for a multitude of reasons: disease, drought, flood, climate change, soil exhaustion, poor management. Many of the most successful empires in history were fueled by plundering the stored reserves of those they conquered. Once they ran out of new resources to steal, they tended to collapse under their own weight.

I think most Americans, or many at least, have an overly casual relationship with energy. They view it as just another aspect of modern life, right there with having running water and paved roads and classic rock stations on the local radio. We see this taken to an extreme lately with really the entire mainstream left protesting about oil pipelines, as if they were some unnecessary evil. They are depicted as ticking times bombs that might at any time destroy the environment and livelihoods of poor and oppressed people, with the only benefit being to enrich greedy oil corporations. These people then go fill up their gas tanks without a second thought about it. Such an outlook can only be had by someone who has never lived in society without abundant and cheap energy supplies. (And yes that is basically all of us).

This is the viewpoint that having abundant energy is just the natural state of affairs in the world. Oil is greedy, why can't society just use friendlier energy like wind and solar? An abundance of energy is simply assumed. The fact that our entire civilization depends on its energy supplies is easy to lose track of. The fact that most civilizations have collapsed for that reason is not something widely understood. And the fact that we don't really have anything to replace high-density fossil fuels is often ignored.

You have to wonder where we would be if there was no such thing as fossil fuels. If coal and oil and gas weren't, by extreme luck, available to us in great quantities. Would our economy just be fueled by some other source, like solar or nuclear power instead? No, if we never had fossil fuels, it is questionable if we would have ever advanced beyond horse-drawn transportation. No modern agriculture means no modern society, means limited technological development. I harbor the somewhat spiritual notion that fossil fuels were a gift granted to us, just enough to get us boosted to the next technological level. We should use them, but use them wisely. We are not using them wisely now, and a troubling number of people are advocating that we don't use them at all.

Here is the scariest thought exercise I know of, from a civilizational viewpoint. Imagine society suffers some catastrophic setback. Economies fail, war breaks out, maybe nuclear. The power grid stops operating. Imagine a vast calamity. That's bad enough in itself, of course, but not as scary as what comes next. You're one of the survivors. The economy includes subsistence farming and scavenging from the old infrastructure. You and your tribe decide the only thing to do is to begin rebuilding society back to where it was. You know that you have to remodernize agriculture. What do you need? Machinery. You need equipment, but even more you need to fuel it.

The problem is in acquiring oil. The first time we discovered oil it was quite simple. In places like Pennsylvania it was so accessible it could sometimes be found right at the surface. (Which is why we see oil brands such as Pennzoil and Quaker State). As we used the oil to power society we were able to develop increasingly sophisticated techniques to get the less accessible oil. Now we're fracking and running deep-sea oil rigs. There is no way a primitive society can get to that oil. And there's no way a primitive society can build solar panels or nuclear plants. If society fails now, it fails forever. The next big energy regression might well be permanent.

Energy-Backed Currency

Intro

What follows is a framework for a monetary system based on energy. In this system the government operates and monopolizes the entire energy sector. The government issues a fiat currency in the same way it does today, but it recollects the currency through energy sales rather than direct taxation. This approach was influenced by an understanding of modern monetary theory (MMT) and by Joseph Tainter's Collapse of Complex Societies. (video).

Societal complexity is tightly intertwined with energy consumption. Societies require additional energy to become more complex, and additional complexity can allow a society to increase its energy input. Think of the deep-sea oil rig, which requires great societal complexity, and returns great energy value.

As a society advances it must constantly be solving the energy problem. We can roughly categorize all societal functions as serving as one of the roles.

• Economic - anything that creates wealth or productive capacity
• Regulatory - manages societal complexity
• Energy acquiring - provides energy to the society

In our current society the economic and regulatory functions are largely split between public and private sectors. The energy sector tends to straddle the public and private sides in an ad-hoc manner. In an energy-based monetary system, solving the energy problem becomes the foremost duty of the central government.

Energy

Tenet 1: Energy production is not an economic activity. 

In standard economics energy production is categorized as a supplier. Suppliers provide inputs to economic activity, be it materials, capital, energy, and any other products or services necessary. Energy is unique in that it is a requirement for all economic activities, in all political systems. Energy is also a product, as it is consumed by households, which is a complexity we will ignore for the moment.

When society is viewed through Tainter's model energy can be described as external to the economy. The size of the economy is limited by amount of energy that can be supplied to it. This externally required energy does not intrinsically add wealth to the society, but it enables wealth creation to take place. Some energy is used that does not directly contribute to production, such as home heating or leisure driving.

Currency

Tenet 2: Currency is synonymous with energy.

 Currency today is a token of wealth. It represents a claim on a portion of the real economy. But as I've mentioned, energy is always an input to economic processes. So currency is already an approximation for energy. When we pay for something, we are mostly paying for the energy that went into the production of the product. New cars cost in the tens of thousands of dollars, but only have a scrap value of a few hundred. The difference between the purchase price and the material scrap price is energy.

The US dollar is especially equitable with energy because of it the reserve currency for international trade of energy commodities. (see relevant post here) Dollars traded in the petroleum markets are often dubbed the petrodollar, which is emblematic of the close association between the dollar and energy. Ultimately however the dollar is not synonymous with energy. The dollar has value because if US government taxation, and it's worth is dependent on the value of the economy and the number of dollars in circulation. The price of energy in dollars is free-floating and responsive to market forces.

Free-floating currency

The dollar is free floating. It's value is not pegged to some resource, but it is determined by the market and subject to supply and demand forces. In our free floating currency the government has three methods of altering the value of money: spending, taxing, and modifying the reserve rate for bank lending. 

Gold-backed currency

Until the 1970s the dollar was backed by gold. It had value because anyone could take their dollars and exchange them for an equivalent amount of gold, and the ratio was set by government edict. The problem with gold is this: it is finite. As the economy grows larger, the underlying money supply must grow proportionally to prevent inflation or deflation. The money supply is limited by the gold supply, thus in a growing economy the money will tend to deflate, which government desperately try to avoid to prevent currency hoarding. Ultimately governments end up ditching gold because it is the only way to loosen the money supply.

Cryptocurrency

Cryptocurrencies such as Bitcoin are digital currencies that rely on theoretical computer science for their validity. A Bitcoin is a solution to a factorization problem, and are generated by computers that slog through the solution space. It is designed so that early bitcoins require little processing time but as more and more solutions are found it takes increasing amount of processing (i.e. energy) to find additional solutions. These diminishing returns are reflective of what is seen in nature when extracting gold, oil, and other resources. The value of Bitcoin is that it is a limited token that can not be forged, and its transactions can be tracked while granting a some anonymity to the user. It is sort of like gold with benefits. Its value is only in its intrinsic scarcity. Ultimately it is subject to deflationary forces.

Energy-Backed Currency

In a way Bitcoin is an energy-backed currency (ECB). They are mined by the application of energy and the supply steadily increases logarithmically. But the economy grows linearly (we hope) and is subject to oscillations. The supply of Bitcoin does not reflect where we are economically, but where we have been. This is also true of commodity-backed currencies like gold. Both types of currency will exhibit deflation when the economy is growing, and inflation when the economy sinks, and since we expect economic growth in the long run, we also expect currency deflation in the long run and a tight money supply.

Eventually the money supply can't keep up with economic growth.

What is desirable in a currency is that is backed by some valuable asset, and the quantity of that valuable scales linearly along with the size of the economy. As it turns out energy production scales very closely with economic growth.

(source)

Not only does energy production scale linearly with the economy, but it is also universally valuable as it is an input to all economic activities. Let's look for a second at what traits we need in a practical currency.

Valuable

There roughly are three reasons a currency might be valuable.

1. Rarity. If something is rare and can't be forged, it can be used as a token of exchange. Gold, silver, and diamonds are the most common, as well as cryptocurrencies.
2. Intrinsic value.  Gold may have once held this trait, but today there are many cheap alloys that can be substituted for gold in most of its applications. 
3. Debt value. From Modern Money Theory (MMT), which describes modern fiat money as having value because they must be acquired to settle tax debts.

Energy would have value for all three of these reasons. Rarity because there is only so much energy production in a country. Intrinsic value because it is used as an input to all economic activities. Debt value because currency would be issued as an energy debt to be repaid. Because energy is not fungible, it would have to be represented with paper currency, just as gold-backed currencies are.

Energy-Backed Currency Lifecycle

At its simplest the lifecycle can be described in 3 steps.

1. The government spends money into existence. If it spends a dollar, it creates an energy bond.
2. Citizens and business trade goods and services to acquire the money.
3. The money is used to purchase energy. A dollar spent on energy annihilates one dollar of energy bond.

Anyone who's been reading my MMT posts (click the MMT label at the bottom to see them) will see the analogy in play. Just as the concepts of energy and money have been merged, so have the concepts of energy purchases and taxation. The completely removes the need for a national tax code. The government no longer controls that side of the loop. Currently the government tinkers everywhere. Think of how chaotic it is. Every aspect of our lives is peered into by the government for purposes of taxation. Pick up a side job? The government wants its piece. Loan money to a family member? Even it was interest free, Uncle Sam demands a cut of it, under threat of physical force. Future generations will be amazed at how much meddling into our day-to-day interactions we permitted.

Tenet 3: Energy purchases and taxation are equivalent.

Spending

The government will still maintain large control on society through spending. I can already hear objection to the plan on the guise of it being a regressive tax scheme. That it unfairly targets the poor. But it is not really a tax scheme at all. There is no tax code. There is nothing for the government to tinker with on that end. If citizens feel the system is too hard on the poor, they lobby the government to shift spending in a way to make the desired changes, and in a way that is more upfront and transparent to everyone. The current system is like a two-ruddered ship. It is inherently unstable.

Temporalness

The tricky aspect to this is the temporal nature of energy production. For convenience we will think of spending in annual budgets, just as we did for the MMT thought exercises. So at the beginning of the year the government creates energy bonds equal to the amount of energy it that it will be able to generate in one year. Let's just assume it's 100 megawatt years (MWy). This means the government is expecting to generate an average of 100MW over the course of the year. 

This brings up many questions. What if the government spends too much money into existence? Is it limited to one year's supply? As we've shown before in MMT, excess government money must always be backed by bond financing, or the money will have no value. EBC does not inherently change that dynamic. Should the government expand the money supply (i.e. borrow and put the cost on future generations) to maintain status as global reserve currency? These are finances questions, and not impacted by EBC. We've not at this point talked at all about finance or the role of the central bank, and we may not need to, as they seem to be unrelated to merging of money with energy, and of the requisite political restructuring.

Tenet 4: EBC changes are orthogonal to finance and banking

Political Shifts

In addition to backing the currency with energy, the political structures would be realigned to properly balance society with the understanding of the roles of complexity and energy in the rise and fall of civilizations. As mentioned before there are now three roles within society: productive, administrative, and energy.

Productive

This what we consider to be the non-governmental sector of society, but that definition doesn't quite describe things. For instance, there is no real difference between a private clinic and a state-run clinic from an economics perspective. Much of this is due to the fact that people these days tend to believe it is the role of government to provide certain services to the people. Generally anything we consider as contributed to GDP falls into this category

Domestic Administration

This is everything to do with managing societal complexity. Policing, schools, social programs, everything that is internal. The governing structure could take several forms. In America the states would adopt almost the entirety of the role, and in fact that is pretty much how it was intended by the Founders. But other countries are meant as a collection of states, like the US, and have relatively strong federal governments. For those countries internal aspects of government would be largely separated from the rest.

Energy & International Affairs

The top level of government issues currencies, monopolizes the energy sector, and provides all the outside facing structures of government, such as the military, foreign ministry, intelligence, and so forth. Ideally the outer government would operate almost completely isolated from the domestic government. Such a division allows the outer government to primarily on its task as energy provider, and its ability to operate in the world to acquire and defend those resources. However they would be tied in one key aspect: spending, which is a topic to discuss in another post.

Further Topics

Other topics to explore are how the government takes control of the energy sector, a further discussion on the relationship between the inner and outer governments, how different energy forms are valued (for instance gas is cheaper than electricity) without distorting markets, and how markets might be intentionally distorted, such as by encouraging renewable energy use. As worthy of exploration are the societal impacts. Clearly the economic shifts will change incentives. Driving to work will get much more expensive, but incomes won't be taxed in half.

There are political benefits to an EBC system. It will government control of society simpler and more transparent. It will drive efficiency of energy usage, which will increase the improvement to standard of living per energy consumed. But most importantly at all, it will prolong the energy we need to power our advance civilization long enough to make the next leap forward in energy technology. Otherwise we will sink back into the valley behind us. I view this as the fundamental existential threat to modern civilization.

The government must run a deficit

In my previous posts in describing the economy from a viewpoint of Modern Monetary Theory, I have stated that money only has value because it must be used to pay taxes. In this description, the government spends all "high-value" money into existence, and the banks leverage some of the surplus to create bank credit. This would seem to make the government the issuer of currency, and the banks users.

But actually it is the central bank that issues the currency, and the government is merely a user. The government can be thought of as a corporate entity with some special privileges. From an economics perspective it behaves like any company. It borrows money to spend, and it repays the loans from the revenues it generates. Rather than selling a product or service it has the power to take money from the economy in any manner it sees fit, but ultimately it's just a revenue. The only difference from a financial perspective is that corporate entities must pay back more money than they borrowed. The government does not have this requirement, and in fact it wouldn't be possible.

Let's look at how the money is circulated.

Lifecycle of fiat money

The lifecycle proceeds like this:

1. The central bank buys a bond from a borrower. The bank holds the bond, and in return the borrower gets money. The money didn't come from anywhere, it was just created. The bond has value because someone is legally obligated to repay it. The money has value because someone is willing to exchange good & services to repay the bond.
2. The borrower spends the money, and it goes into general circulation in the economy.
3. The borrower gathers money back out of the economy. Citizen borrowers do so by trading out goods & services in return for money. The government does so by simply taking it.
4. The money is returned to the central bank, and the money and the bond annihilate one another like matter and anti-matter.

Look at just the banks loans cycle. Because loans are always repaid with interest, the collections inflow will be larger than the capital outflow. By lending at interest the central bank removes money from the economy. Well where did that money come from? The only way it is possible is if the government is putting in more money that it is taking out. That is: it is running at a deficit. If the government ran a balanced budget, the banks would suck money out of the economy and cause deflation. Thus a balanced budget is actually a deficit where the government overspends by an amount equal to what is returned to it by the central bank. (The regional central banks return 6% of their profits to the banks and give the rest to the government.) 

I'm not sure if the central bank refund is calculated into the federal budget or not. I assume it is, and I'll update here when I find out for sure.