CURRENCY PRICING

This page is too long and is being re-drafted currently.
26th June 2015


Edited on 21st November 2013

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eingram@ingramsure.com


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 LATEST UPDATES page from time to time.





  
INTRODUCTION

World Trade has grown to become over 30% of world GDP.



With this proportion of average GDPs involved in trade, to have instability in the trading currencies is no longer acceptable.

So here we are trying to get down to the root causes of the instability problem.

Let's try:

WHAT WE HAVE TO BEAR IN MIND

Firstly the main purpose of pricing a currency is to create a balance of trade. The reason for this is to maximise the efficient deployment of the world’s resources and thereby at the same time to maximise world employment and world economic growth.

Secondly, if the money supply of any economy is distorted by the process of trading or of hot or very large international investment cash flows, then this is a distortion which is damaging to the growth of the domestic economy concerned. 

Every economy can create the amount of money needed without any external help. Therefore we should seek ways to prevent international trade or investment from altering the money supply of the nations involved.

Thirdly, if any active intervention seems to be needed in order to attain these twin objectives of managing the domestic money supply and the correct pricing of the currencies involved, then that is a cost and is to be avoided as far as possible. We should seek ways to create automated feedback mechanisms that act on their own and without any intervention.

Fourthly, and in order to achieve the above, there has to be an increasingly effective market force of some kind that trends the price of the currency towards its norm / a balance of trade, which force needs to increase the further the balance of trade has become out of balance. However the dynamics of this process needs careful calibration to avoid overshoots and needless delays.

Fifthly we should note that the practice of expanding a domestic money supply beyond the means of the domestic economy to supply the volume of goods and services that would satisfy the demand created, will result in either unwanted inflation, or an excess of imports, thus creating an imbalance of trade.

So there are two main questions to answer:

FIRSTLY
How do we manage the DOMESTIC money supply? Is it stable and is it under control? And how will it be protected from international money flows without a heavy cost or some kind of intervention?

SECONDLY
How do we ensure that incoming investment monies do not activate a price change in the currency?

It seems logical that if a foreign investment comes in and we have to protect the currency value then we have to either:

1.  ONE -  Export an equal and opposite amount of money without altering the overall money supply.

Or

2.  TWO We have to block the entry of that money supply but arrange access to the local currency for the foreign investor up to the amount that he/she/it (heshit) intends to invest in the local economy. Meantime 'heshit’s' funds must become inaccessible to heshit in heshit’s own currency; yet they should still be available to circulate there as a part of the money supply there.

Does this make sense? 

If we adopt option ONE then we have to create some money and export it. Or there has to be a suitably large fund of reserves that can be exported as and when necessary. These reserves must be a part of the domestic money supply until they are exported and then they must become a part of the receiving economy's money supply to replace the money that was exported. Either the money supply imported must be free to circulate as must the money supply that is exported, or neither.

This looks complicated. We have to explain exactly how that will work. Would there be any distortions caused? For example, money supply is made up of different kinds of money and each kind fulfils its own role. Would this balance be disturbed? Probably not. Both would be of the same type - deposits.

If we adopt option TWO, preventing the import of any Forex, whilst providing access to the local money supply, we have to explain exactly how that will that work.

In the meantime we also have to explain how the normal trading cash flows will happen and how those imbalances will trend the price of the currency to its proper destination.

TOBIN TAX - as a stop gap
I am strongly in favour placing restrictions on hot money crossing frontiers. Millisecond trades are the first target. A tiny tax would eliminate those. 

If an investment is intended to be an investment then it should be medium to long term, so a tax based on the duration of the investment would be a stop-gap measure for now - say a 2% tax reducing to zero after two calendar months, and payable on exit before that time.

Inflation / devaluation of a currency will play a part in fixing the price of a currency.

READERS' SUGGESTIONS ARE NEEDED on how to resolve these issues.

Please send any ideas that you may have to:
eingram@ingramsure.com

A word copy of the above script may be sent to you by email on request.

Further reading - Leigh Harkness - www.buoyanteconomies.com


LATE THOUGHT
What if people wanting to buy shares of bonds of another country were forced to buy through their own stock exchange using their own currency? List complications for that. Advantage - no need to buy the other currency.

One complication - how would those shares get to be there - on that other stack exchange?

For a rights issue - the money raised would need to be payable in the currency of the issuer. A different currency in some cases.


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What follows below are previous attempts to solve these problems. Hopefully the later scripts (the first ones) and the above script are trending towards clearer thinking.


This Blog page is not ready.yet.
BUT I  THINK IT IS WORTH READING. 

Come back later or watch out for the announcement that it is ready in the various media or by checking out the LATEST UPDATES page from time to time.

Now it seems that this ought to be held back and become the essence of a BOOK 2

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Edn 30th October 2013
A ‘START AGAIN’ DRAFT

There are three functions / types of transaction involving cross currency capital / money movements:

1.    ONE   Trade
2.    TWO   Investment
3.   THREE    IMF lending or similar from other sources. Say ‘IMF lending’ for short

The objective is to prevent money supply from being affected at either end of the transactions and to use the currency price as determined by the balance of trade for all other transactions relating to items 2 and 3.

How can this be done without undue cost and complex administration?

In particular, an investor that has money in his/her own currency B will be entitled to expect an exchange for currency A not to cost any interest burden upon him/her. The money value is the same  although the currency is different, and the money still belongs to him/her. The problem is keeping the money supply unchanged.

Well the total money supply of both nations will be unchanged, so a counter-balancing movement of the same quantity of currency in the opposite direction, arranged by the central bank or other authority would resolve that issue. It would also prevent the value of the currencies from being affected.

The devil lies in the details. How is this to be done and what liabilities are created?

Clearly, the investor takes a risk by being a resident in economy B whilst now owning assets in economy A.

The central bank in currency A collects Forex of currency B and passes it back to the central bank of currency B. There is no currency risk there to either central bank.

The problem  comes from firstly the transfer of currency B bank deposits away from the bank concerned in economy B; and then in the aquisition of bank deposits in currency A by the investor.  Where does that money come from?

Suppose that the returning currency B is given back to the bank that lost its deposits, but with a new owner – the central bank. That seems reasonable but there are interest rate implications to think through.

In economy A the bank used by the investor already has all the deposits that the economy can handle. But here comes some more deposits. Or not? Remember, the Forex that arrived from economy B were collected and returned to the source bank via the central banks. That leaves the bank in economy A with nothing to offer the investor in return for the deposited Forex.

At this stage, that money is now owned by the Central bank B as a deposit with the bank B that previously held the same deposit money in the name / ownership of the investor.

Clearly, Central bank B owes the investor that much currency B. But the investor does not want that currency B any more. The same value of currency A is wanted to deposit in bank A.

Bank B has the money, so it just lends that money to Bank A who then incurs a debt, reducing money supply and then gets the money supply restored by creating deposits of equal value owned by the investor.

Now for the moment I am going to assume that the two currencies remain at the same exchange rate indefinitely but that they both have the same rate of earnings growth / money devaluation upon which interest earned of the same amount p.a. has no cost to wealth for the borrowing bank.

So Bank B earns interest at AEG% p.a. from Bank A and Bank A earns interest of AEG% plus its usual margin from the deposits that it lends.

We are operating in an environment of no credit creation over and above the deposits that are with the banks in each nation.

This is fine and it works out fairly to all concerned.

But the fact is that whilst on average, the exchange rates between the two countries may remain the same, they will differ from time to time.

It is not the responsibility of the banks A and B to resolve that issue. This is for the Central Banks. How will they do that?

They can have a fund each upon which to draw if called upon to do so.

We can further assume that if the rate of AEG% p.a. in one economy is faster than that in the other economy, then on average the interest rates will differ by the same percentage and that the currency values will change at the same percentage rate – so the interest payable by the weaker currency will offset the weaker exchange rate – on average.

Some kind of arrangement to level everything at no cost on average to the central banks looks to be possible.

But that leaves us asking how the exchange rate will be made to adjust both for the different rates of inflation and for the imbalance of trade that occurs from time to time.

I think we are getting close to a solution. But it is a bit complicated to think it through.

Here is what I was thinking the last time I wrote – and below that are earlier attempts.

They are just here for the record. I don’t think they add much.






 Oct 28th Attempt starting with the list of three items as above:

There are three functions / types of transaction involving cross currency capital / money movements:

1.    ONE   Trade
2.    TWO   Investment
3.   THREE    IMF lending or similar from other sources. Say ‘IMF lending’ for short

DEBTS AND INTEREST RATES
Examination of the options for handling these transactions reveals that if money supply is not to be affected then interest rates get involved because existing money that belongs to someone has to be exchanged for Forex and interest will fall due on both sides on both currencies, each with its own interest rate. Entity B from nation / currency B exchanges its currency for currency A. Entity B lends its currency B at a rate of interest and borrows currency A at another rate of interest, each rate of interest being that which is applicable to its own currency as determined by some kind of arrangement that does not distort any market forces / create any unfair imbalances.
The interest rate used will depend upon the source of the money that is lent – is it a bank or a Central Bank / MSA? At what rate of interest?
QUESTIONS ARISING
A.      Who will set the interest rate on each side of the transaction?
B.      Who is liable for any difference in the interest rates incurred on opposite sides of the transaction?
C.      Will that difference be fully offset by the differential rate of inflation – there being two currencies, two interest rates due to the swop of one currency for another, and there will be two rates of inflation.
D.      Will there be any maturity date upon which a settlement of some kind has to be reached? Or will the imbalances simply oscillate, sometimes in favour of one nation and sometimes in favour of its trading partners? If the price of the currency is  doing its job there should on average be a balance of trade over the longer term enabling a settlement of all transactions to be made from time to time without loss to either party – assuming that the parties involved are the central banks or other national or international banks set up for the purpose.
E.       How can these imbalances be used to bring pressure to bear on the value of the currency – those pressures only relating to the imbalance of trade and not to investment flows across currencies?
The main purpose of the whole exercise is to open up the option for international trade to take place and for currencies to be priced in such a way as to create a near balance of trade at all times, but not an exact balance. There has to be some leeway because trade is lumpy and imbalances are inevitable.
At the same time, we need to find a way of isolating investment transactions from trade transactions so that the former do not interfere with the price of the currency but they do take place at the price of the currency as established by the balance of trade.
NO FRACTIONAL BANKING
To keep matters simple it is assumed that money creation is done by the central banks in each nation and that it is done as and when needed by the domestic economy.
There will be no fractional banking because:
I.                    This creates unwanted leverage and risk
II.                  It creates an imbalance in the level of demand in the economy which is increased beyonf the level that can be supplied by the domestic economy resulting in a trade deficit and upsetting everything that we are trying to achieve – Leigh Harkness on his website www.buoyanteconomies.com
It is further assumed that the ILS Model for finances and savings of all kinds (including investment in all kinds of bonds) is in operation. See Edward C D Ingram’s draft book
This means that the local economies of all participating nations – all trading nations in the group – have a sustainable and orderly economy with interest rates determined by their domestic market, and based upon the current supply of money and the demand for it so that there is a match or a near match.
When a foreigner wishes to access that money supply so as to make local purchases or investments, a lender has to be found and that means that an interest rate must be incurred.
If the money is for trading purposes then this money can be provided by the central bank / MSA (Money Supply Authority – a division of the Central Bank if so determined).
If it is for investment purposes then it must be raised from the clearing banks or other deposit taking institutions or the stock exchange or equivalent.
The distinction is for the following purpose:
a.       The trades must create market forces that act on the price of the currency
b.      The investments must not create such forces in the pricing of the currency but they may alter the domestic rate of interest because this is competition for resources that have to be put to good use in a competitive environment. The foreign entity must be vulnerable to loss and able to make a profit on equal terms with those nationals that are competing for the same funds or already have those same funds.
                                                               i.      The foreign entity must for these purposes become as much of a local citizen as local citizens are  - in terms of their rights and cost of money. The foreign entity had the money originally and should not need to pay to do a swop / to exchange that money for the local currency. Any costs for that should  fall on the MSA or MSAs concerned but should not affect the value of either currency.
                                                             ii.      This means that whilst imbalances may occur in the respective liabilities of the respective MSAs these imbalances may (or may not) trend towards a balance over time. We have to keep an eye on this aspect as we plan the structures to be used.


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Edn 5 starting 26th Oct 2013 - not checked out for typos etc. or anything

Would you like to help with the development / the research here?

A word edition can be sent to your email on request.

INTRODUCTION

From Business Insider online 25th October 2013

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The Euro Has Been Acting Weird

The currency markets can be very complicated, and there are many theories explaining how and why they move. 



One of the more basic theories is interest rate parity, which argues that fluctuations between two currencies can be explained by interest rate differentials.  The idea is that if one country offers a better interest rate than another, a trader would convert currencies and buy bonds at the higher rate. But what would seem like a guaranteed profit for the trader would be offset by a move in the foreign exchange rate. 



In recent years, the moves between the euro and U.S. dollar appeared to reflect interest rate differentials. 



But in more recent months, that relationship has decoupled. 

Morgan Stanley's Hans Redekar explains:

Concerning the performance of the EUR, we have to differentiate between noise and trends. At this stage, it is the flow into the eurozone equity markets and eurozone banks reducing the size of their balance sheets, which are driving EUR, and not the relative growth trend or even interest rate differential. The chart below illustrates the de-coupling of EURUSD from rate differentials, bearing a very clear message. 



During the week ending October 23, investors plowed $5 billion into European equity funds, the biggest weekly inflow ever. 



"These funds have seen nothing but inflows for the past 17 weeks," reported BI's Matthew Boesler



"Only when banks have prepared balance sheets well enough for the [Asset Quality Review] does the EUR have the potential to fall back to ‘fair’ levels defined by yield and interest rate differentials," added Redekar. "Since the AQR will reference 2013 year-end balance sheets, we think the EUR is likely to peak in early to mid-December." 
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In other words the way that currencies are priced is a complete mess. As usual, economists are not trying to sort out the root causes and to rectify them. Instead they are trying to manage the symptoms - a very unrewarding and expensive business.

So here we are trying to get down to those root causes of the problem.

Let's try:


WHAT WE HAVE TO BEAR IN MIND

Firstly the main purpose of valuing a currency is so as to find a price which re-balances any balance of trade surplus or deficit. At all times we need to bear this in mind.

So this raises the question of how to side step the effect on demand for the currency when investment inflows or outflows hit the currency.

The answer would appear to be to use the current rate of exchange but not to allow the cash inflow to flow in without a corresponding and equal outflow.

This must be reversible when the investments are called back out of the currency.

The next thing we have to understand is that the domestic money supply must not be affected by this, unless the incoming investor is wanting to capture local resources. For example it is proposed to start a business or to take over an existing one in the domestic economy.

The reason why we must protect the domestic money supply is this:

An economy creates the amount of money that is needed by the GDP of the economy at any one time. For now we will ignore velocity of circulation and just consider the median or average value. If there are variations in that velocity of circulation it is for the domestic economy to make the adjustments that are needed if any. Managing the domestic money supply is the business of the domestic economy and so how that is done should have no bearing on the valuation of the currency. These are two separate issues, or they  should be. "Keep things simple" as they say. Keep these issues separate and managed separately by separate means / even separate institutions.

So how do we do that? 

FIRSTLY
How do we manage the money supply and 

SECONDLY
How do we ensure that incoming investments do not activate a price change in the currency?

It seems logical that if a foreign investment comes in and we have to protect the currency value then we have to export an equal and opposite amount of money without altering the overall money supply.

So we have to create some money and export it. 

LATER - I think I change my mind - I capture some money supply and export that whilst accepting the new incoming money supply to offset the loss.

This will up-value the other currency that was going to down-value if they just allowed that investment money to run away. In other words the up-value and down-valuation will cancel and the domestic money supply will not alter.

Printing new money is a matter of pressing a button so that is not a problem.

What happens to the money supply at the other end - the receiving end?

Now there is an excess of money but it is in Forex. It does not have to circulate domestically. It can be held in reserve. There is no need for it to earn any interest because it is not in use. But it needs to retain its wealth value, so by mutual agreement it will be index-linked to a wealth-index, such as AEG% p.a. of the sending economy or to its GDP or some index that is mutually agreed.

This means that at least some nations will have a reserve of other nations' Forex.

What happens when the process reverses? The investment money returns to the mother country?

Now the reserves can be sent back so as to avoid any effect on the tradable value of the two currencies. To protect the domestic money supply in the receiving nation those reserves can be added to its money supply so as to replace the lost investment monies. But wait - that money was created and was not a part of the original money supply there. Now it has been added.

So this does not work. A re-think is needed here. I will come back to this later.

And the investment monies that were exported and are now returning will somehow have to be changed into the domestic currency and somehow the overall domestic money supply in the receiving nation needs to remain undisturbed.

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Additional instruments that we can turn to:

Firstly it is possible to swap incoming Forex for domestic money supply as a form of loan whilst keeping the Forex as collateral. This is not perfect because the collateral value will no longer match the value of the local currency given to the sender of Forex once it is in use. That is because it will be used badly and fall in value or it will be used well and rise in value. How do we deal with that? 

I think the answer to that is fairly simple: We treat the imported investment monies as belonging to a local entity or person and carry on as before.

Now we have to answer the question of how and from where do we access local currency to do such swaps?

Well all the banks will have some spare money on deposit and some of that can be placed with the central bank as immediately available. BUT it must also be immediately available to the domestic users or it will not count as money in circulation or money supply. Think again.

When the new money comes in from the foreign investor it forms deposits in banks and thus it increases the domestic money supply. The recipient banks are then instructed to place an equal amount with the central bank for holding as a reserve and not something that circulates.

Again this money will be index-linked so as to preserve its true value.

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I need a rest but we may be getting somewhere. 

I have a feeling that this is enough to manage the problem but I will have to illustrate everything with numbers and balance sheets.

It should also work for any number of currencies.

BELOW
What follows below is my original muddled and messy thinking. I want to keep it for now as there may be something there worth keeping.

BUT FIRST - i THINK i HAVE IT.

Here we go:

When a foreigner wants to invest in our country's economy he must first in effect immigrate and become one of us. Then when he wants to leave we reverse the process and he becomes like one of us that is just going the opposite direction. The two processes are the same because we made his assets into out assets as far as money supply is concerned.

How do we keep our money supply stable during this operation?

The foreigner goes to a bank of ours and records that he  wants to become a client and that he has Forex to deposit.

The bank takes the Forex, and sends it to the Central Bank or Money Supply Authority MSA (which) can be a division of the Central Bank.

The MSA sends the Forex back to its counter-party MSA / Central Bank in the source country so that there is no net intake of Forex to disturb the trading value of either country's currency.

The MSA then authorises the bank to lend money that it has available for lending to the incoming investor up to the value of the Forex deposited.

The MSA permits the lending bank to claim interest from the MSA up to the value of the money deflation index (maybe Average Earnings Growth, AEG% p.a.). This costs nobody anything - no wealth transfer is involved.

The Counter party MSA in the source nation also index-links the currency that it is holding for the local MSA not to the same index but to its own index so as to preserve the value of its own currency held 'in trust' , again at no cost to anyone.

This now leaves the tricky question of why the foreign investor should borrow his/her own money and pay interest to the bank on it.

Rather than borrowing he/she should be able to swop / exchange his Forex (the principal) for local currency for at most, a commission or a fee.

Let's try that:
He / she goes to a bank and demands an interest free currency swop / exchange. The bank loses that much of its lendable deposits which now it cannot lend or earn anything on - that is until the foreigner deposits that money in that bank.

The MSA insures the bank against any currency risk - loss of value of the currency that is deposited. How?

I simply take possession of that currency and deposits it with the counter-party MSA which then index-links its value at the local rate of currency depreciation - eg AEG p.a. at no cost to wealth to any party.

This now means that the MSA's are in a system that is at risk of a currency value change. The Forex is back in the source nation, but the source nation has lost some money supply which is now on deposit with its MSA.

Thus the MSA has to now deposit that money with its banks who can then lend it out and earn interest.

SUMMARY
It appears that this arrangement will solve the false currency price problem and the money supply problem but there is a residual cost in any mis-match in the value of the currency held and 'lent' to the counter-party MSA compared to the currency value released at the local bank to the foreigner as a swop.

No liability falls on the bank because that Forex is passed to the MSA and the money given to the Foreigner is deposited back with the local bank instantaneously.

At the back of my mind is the worry that the swop has no time limit and should be considered to be done for all time. Otherwise if it is of limited duration then certain liabilities based on the maturity date will become operative. We do not want that. We said at the start that the foreigner's money would become like a permanent citizen for all time.

With no maturity date there should be no liability.

The local MSA simply does another free, no strings, swop with the counter-party MSA. The counter-party MSA simply gives the Forex back to the source bank used by the foreigners.

Now what has happened? And did the MSA people need to be involved at all?

The net outcome is that the originating bank in the foreign country has contacted one of our local banks chosen by their depositor, and as a result the local bank gives money to the foreigner in the form of a deposit. It is an interest rate free loan and a deposit secured by an agreement with the foreign source bank.

The fact is that a foreigner has got some of our currency by an exchange of his/her own currency at the current trade-related exchange rate. Someone has to be responsible for the currency risk. That could be the MSA / Central Bank.

This will not be the only transaction of its kind and there will be transactions of this kind in both directions or in all kinds of directions if there is a world centre for netting out all of these liabilities between all trading nations.

Who should accept the liability for net imbalances?

Not the foreign investors. They need to be encouraged and will be taking their own risks in what they do with the money. They may set up a company, buy into one,or buy local investments just like any citizen can.

Not the banks at either end.

That leaves the MSA's / Central Banks.

No actual currency is needed to do this - only that needed to pay any liability that falls due. But when would it fall due and why?

TIME TO TAKE ANOTHER BREAK
























Further down the script is a story about two island economies that may help me / us to experiment with ideas - we need to see how this story may end...when even more islands join the fray of international trade.

Meantime the script is experimenting with principles that may lead to the development of the story – PART 2 when the island starts trading with another island with another currency and then PART3 when a third and more islands join in.

What we are trying to do is to find a way of keeping economies in balance (supply and demand) using the pricing mechanism and market forces whilst managing the money supply in a simple and stable fashion to match the needs of the economy. 

The question of money creation using credit creation – whether this is needed and helpful or not needed and unhelpful will be thought through. It may even be a complicating factor. Greater simplicity is a value for any complex system. 

In PART 1 of the story, credit creation is not done and at face value it appears not to be necessary. 

In real economies around the world, as explained in the draft BOOK, there are some things that prevent prices and therefore market forces, from acting as they should. That means that the supply and the demand are thrown off balance and it causes volatility and deviation from mean pricing values that can be excessive and at times of long duration. Interest rates in particular are a price and should therefore not need to be used as an instrument of policy. Money supply should set the interest rate in the context of the level of the demand for loans and the ability of the economy to satisfy the level of demand.

PART 1 deals with a single island with no international trade. It is OK and summarises what we know about the domestic / home economy based or my understanding anyway. The island (both islands) have a steadily rising money supply that is well managed so that incomes, prices, wealth, and interest rates (the price of money) all respond to any changes in aggregate demand (using as a measure, the proxy of Average Earnings Growth (AEG% p.a.). The exact definition of AEG can be debated and if used when not exactly appropriate distorted responses are going to happen but the resulting distortions hopefully, will not be a lot.

Because money supply is under control and the prices of everything including wealth, interest rates, and debt are able to adjust to changing rates of AEG% p.a., the rate of economic growth will in theory, undulate - no extremes,no crises, no major distortions, no asset price bubbles, no significant recessions. These are peaceful and politically stable islands. Any excess money leads to an increase in incomes and this leads to an increase in prices and devalues money; the interest rate finds its own level because it is a price, not an instrument. The instrument is the printing of base money - enough to keep the economy on a growth path.

PART 2
In PART 2 another island economy is discovered and they have another currency. What should they do? Both islands want to trade.

The following script may need to be read a number of times. It is a series of thought experiments in advance of drafting the story of how two islands with separate currencies manage their trade and their cross-currency money flow of various kinds.

BALANCING TRADE
The problem is to enable the currency / exchange rate to be priced so as to balance the level of trade between the two islands; and at the same time we have to ensure that the money supply in both islands is kept stable and appropriate. Each island has to have control of, and to retain control of, its own money supply. International trade must not be allowed to interfere with that but trade between the two islands must be facilitated.

COPING WITH CROSS CURRENCY INVESTMENT FLOWS
Then there is another cross-currency activity – investment in the other islands’ stocks and shares and the setting up of businesses in the other island. How can this be allowed without undue cost barriers or administration barriers being created and without disturbing the value of the currency for trading purposes?

How do these islanders manage to do all of that?

These are some of the questions to be answered.








CHAPTER ONE
A First Look at Pricing the Currency to create a Balance of Trade.

ISOLATING FOREX
Will there be foreign currency reserves held in both islands? How will those reserves be created? Will that enable the money supply authority (MSA) (this could be a part of the central bank with very specific functions of managing the money supply), to exchange one currency for another?

Given that the islands do not want to import money supply from each other, there needs to be a way for any cross-currency transactions to avert this outcome. Storing Forex in a separate account that does not add to money supply within the island’s main economy seems to be an option that can work.

WHAT INTEREST WILL FOREX RESERVES EARN?
When importing goods or services from the other island, money has to be sent to that island. How will that lost money supply be replaced? Will the exported money be held as Forex reserves and will it earn any interest? When, Why, How? I am thinking that the reserves will be frozen, inactive, not a part of any money supply. Will those reserves earn any true interest, or just AEG% p.a. Readers that have not read the book will need to know that it has been shown that as average incomes increase, investments need to keep pace with that (AEG) so as to keep everything in balance. Doing that does not transfer any wealth to the investor or the store of money.

It simply keeps the store of money growing in line with everything else except prices which have other forces acting on them. An economy that has double the incomes needs double the money supply all other things being equal, ceteris parabus.

We do not want the reserves to be earning / transferring wealth or costing wealth do we? Not if it is otherwise idle money just there as a supply of Forex when needed and NOT a part of the money supply of either island - which is as it should be. At least that is how it should be if the reserves are only there to facilitate trade.

How will AEG% p.a. increments in the Forex reserves be defined in that case - will AEG be based on the joint GDP / AEG of both islands or will each Forex in each island be increased by one index in one island? Which island? The island whose currency it is, or the other island, the one that is the custodian of the currency? I think each currency should be index-linked to its own island's AEG. That preserves the wealth / share of the island's GDP that is held abroad.

Indexation can be arranged by mutual agreement between the islands.

Each island is able to print more base money if exporting these reserves takes away from their money supply. What then happens if the reserves get returned to the original island? Does that over-supply that island with too much money? Will that affect the exchange rate? Something to think about. Maybe the returning reserves will be kept idle by the Money Supply Authority...

Let’s try an example.
Each island starts with a money supply of 100 in its own currency, currency of 100A for island A and currency of 100B for island B.

A group of traders from island B wants to buy 3A worth of goods from Island A. They give 3B of their own currency to the MSA in island A.

The MSA finds 3A of local currency (where from) and exchanges that for the 3B of Forex from island B. For the moment we do not know if the exchange rate has been set correctly. We will assume it has been correctly set for now.

This isolation of the 3B of Forex in the ‘vaults of the MSA’ means that no additional domestic money supply is created in island A by the import of 3B of Forex.

Now Island B is down to 97B of money supply. The MSA in Island B prints 3B and gives it to everyone in proportion to their spending.

Hmmm that is a stimulus. Was a stimulus needed at this time? Does it create an imbalance in spending? The importer will get a bonus this way for importing....both the goods and a share of the 3B of new money created.

What if no money was printed?

Instead, Island B waits for Island A to import 3B worth of goods and services and that will restore the lost money supply.

The problem now is that this takes time and there will always be some money supply held in the vaults of both islands’ MSA. It will become a problem as the imbalance continues; and the economies of both islands will start to slow. Island A will be exporting too much at the expense of what can be supplied to local people leading to a short age of goods and suppliers of local goods and services will not be able to compete for labour – their costs will rise. And island B will be importing too much at the expense of local suppliers and job losses.

All of that will be a signal for a new rate of exchange. What targets should be chosen and who would choose the target? Will it be market driven or managed?

In other words, to counter this loss of money supply, there may be two actions needed:

1.   Print more money in both islands up to the amount of the ‘float’ needed – the reserves average level and/or until the economies of both recover from any slowdown.

And

2.   Adjust the rate of exchange.

Let us say that Island B is importing 4B worth of goods and services – 4A worth, whereas island A is importing only 3A / 3B worth of goods and services per period.

After three such periods without any new rate of exchange, what are the balances?

Money Supply     Forex Reserves   Money Printed   Money Supply Forex Reserves
      A                           A                                             B                     B

100 A                           9B                     9B                   100B                0 A

The imbalance shows up as an excess of Forex reserves held by MSA A

To improve the model, allow two way trade. Allow Island A to import 2 B worth of goods and services whilst Island B imports 5A of goods and services per period. One A is values as one B as before.

After three trading periods the balances are as follows:

Money Supply     Forex Reserves   Money Printed   Money Supply Forex Reserves
      A                           A                                             B                     B

    100A                          9B                 9B 6B             100B                6A

The total held in the Forex accounts is the same as the value of money that has been printed. There has been no effect on the money supply of either island.

But now the rate of exchange needs to be adjusted by mutual consent or by market forces. What market forces might there be and how would they be crated?

Leaving that question aside for the moment, let’s see how the values held in the reserves would alter if it was decided to raise the value of the B currency by 20%.

This means that we have to have a base currency with which to do the valuation.

We can choose a fictitious currency C or use one of the existing currencies.

Let us use currency A as the base currency.

The effect is to change the values ion the above table to value A but first to raise the value of all B values by 20%. We get this:

Money Supply     Forex Reserves   Money Printed   Money Supply Forex Reserves
      A                           A                                             B                     B

    100A                       10.8A              9A 6A             120A                6A

The value of money in circulation in Island B rises because it has been revalued but so has GDP by the same 20%. But their reserves have fallen because they have been devalued – but the fall is only in terms of the value for which they can be exchanged for B currency. It does not change the number of A held in the MSA vaults.

The value of Reserves held by Island MSA A rises by 20%. No more money has been printed, nor is needed by wither island.

The new exchange rate slows imports by Island B and helps exports from Island A.

It would be helpful if a market force was used to make such adjustments. What are the choices? I will leave this aside for now. If no money had been printed to replace money lost to the MSA Vaults then the resulting devaluation of money in both islands would have resulted in the devaluation of the A currency faster than the devaluation of the B currency.

This might be used as a measure to devalue the A currency by without having to increase the money supply of either island. But it is an arbitrary number of gearing 1.0. Other gearing numbers could be used.


This thought experiment ends here for now.











CHAPTER TWO
Setting up a Business on the Other Island

A SECOND ISSUE
If we solve the balance of trade currency pricing problem, the currency pricing problem, enabling a balance of trade to be fairly stable, what will we do when a company in one island wants to set up in business in the other island making use of its own money?

If they exchange their own money for the domestic money in the target island how will that exchange of currencies be done so that the total money supply in the target island is not disturbed? Basically we are saying that all money spent in an island must be sourced from that island's money supply in competition with local people and businesses. Where will the money come from? The local banks?

It means that the Forex coming in must be used to take possession of some of the domestic money supply. That is a good idea because competition for resources leads to best use of resources. Here we are talking of the money supply resources and the labour resources of island A.

Normally to capture money for investment there needs to be some competition - may the best offer win... If and when the GDP of the target island benefits from the new industry with an increase in GDP, then the target island will create more money in the usual way. That is not a problem - until the opposite happens... when the investing people from Island B want to close the business or sell it and repatriate their money?

All we have to decide is where the local A money will come from

If there are losses sue to a business failure does money supply reduce? Not any more than for a local company that fails. More money can be printed.

If the same money is to be repatriated to Island B what then? That can be trated as a fresh investment by islanders A wanting to invest money in Island B. Just the identity of the people is different, so the answer is to do that. Use the same process that allowed the money in to Island A and apply it in the reverse direction.

All we have to decide is where the local B currency will come from.

What if the foreign company goes out of business or wants to sell up and return the profits / assets back home? How can that be arranged without disturbing the price of the currency, or the money supply in either island? 

When we tell the story in PART 2, assuming we have solved these and other problems and can tell the story, we will see the islanders pondering these issues, maybe making some mistakes and then learning from those mistakes.












CHAPTER THREE
A Problem Solving Criterion


It occurs to me that this exploration of the problems is somewhat like what happens when a maths problem has to be solved. In that case one looks at the situation and identifies the variables that apply, one defines each variable by writing an equation showing how they inter-act with each other. 

Then more such equations are written showing other interactions between the same, or at least some of the same variables.

When there are more independent equations than variables the problem has a solution. The mathematician has to find it.

So I will now try to make a list of those variables that we have at our disposal and try to show how they inter-act with each other - which basically is what I just did but without the list of variables - yet.

Offhand the variables are:
INSTRUMENTS
1.   Forex Reserves for trade
2.   Forex Reserves for investments – separate reserves if necessary
3.   A home for the Forex Reserves –
a.   the banks in general or
b.   the MSA or
c.    A mix of both
4.   Domestic Money Supply

I could add a devaluation authority but I want this function to happen automatically. So it is item B below. I do not want any intervention in interest rates, we have money supply to do that and local demand to set local interest rates. Thus:

RESPONDERS
A.   Balance of Trade
B.   Currency Price
C.  Domestic Interest Rates
D.  Inward investment flows – both ways inwards and outwards when reclaimed – and
E.   Hot money, like speculative and derivative trades, to and from external sources.

There are more responders (5) than instruments of policy (4). Logically there is no solution on that basis. But if item ‘E’ is not permitted to cross the currency frontier, then there is a balance – 4 of each. That should be solvable. And if item 3 is split as in 3c, (Forex reserves held both by the banks and the MSA), then maybe that could add a further instrument. Maybe.

If the balance of trade responds to the pricing of the currency, then it will not be a separate responder. This reduces the responders to three. Potentially there are four instruments to manage three repsonders.

CONDITION FOR A SOLUTION TO BE FOUND
For a solution to be found there should be more instruments and than targets / responders. We might be able to remove the Balance of trade and put it in as a signal. If the currency is correct that should be trending the economy towards a balance of trade.










CHAPTER FOUR
The Access to Local Money Supply Issue

ACCESS TO MONEY SUPPLY
If credit creation is not used, as in PART 1:

If local currency is to be used by foreigners to pay for locally produced goods, without increasing the money supply, where will the MSA obtain the needed domestic currency?

Will it be interest free, reducing the money supply locally and affecting interest rates for others, or will it need to compete to borrow the local currency, possibly raising interest rates in that way?

These are questions to ponder.

Remember that a business person normally invests capital without paying interest on the money that is already in place and can get shares in return. Why would it need to be more expensive for a person in Island B to invest in a new business, or to make a takeover for example, in island A?

The process of saving money to invest in shares, if done only in island B does not reduce money supply in Island B. The money is usually kept in deposits and savings and can be lent by the banks.

When the shares are created in island B that same money is shown in the accounts as share capital but the money itself was not destroyed – was it?

Maybe the shares become a new form of money – they can potentially be traded on the stock exchange and used as collateral security. They can be used as a form of payment.

So should Island A send some money supply to island B when accepting such money?  The money supply of Island B would be reduced when this investment money is sent to Island A. Sending an equal value of currency A or of currency B reserves to Island B solves the problem for Island B whose money supply would thereby remain unchanged. And it neutralises any market force on the value of the currencies involved for balance of trade purposes.

The following questions arise:

Q 1. From where will the MSA obtain the local currency?
Will it print it - that would be inflationary.
Will it take it from the local banks as a debt? Who will pay the interest in that case?
Will it be interest free by dictat?
Will it be taken from the reserves placed with the MSA by the banks? If so, that can be index-linked to AEG and otherwise essentially interest free. No true interest. That costs nothing and keeps everything balanced when the value of money falls or rises.

But that raises the question of what to do if those reserves are needed by the banks in question as a result of losses made.

Q 2.
Which currency should be sent to Island B and from where would it come?

The MSA of Island A will be receiving the Forex B currency from island B and it could return it under an IUO to the Island B’s MSA.
Where would the IOU be held? What would happen in the event of a default? What would be the duration of the IOU?
Now island A has no collateral for issuing local currency to the island B investors – except the IUO.
But this has neutralised the pricing effect on the currencies involved for balance of trade purposes.

What other options are there?









CHAPTER FIVE
Carry Trade - A Highly Questionable Practice

There is also something called the Carry Trade. In Carry trade, when the interest rate is low in one currency an investor in another currency will borrow at that low interest rate in that foreign currency and will carry the money borrowed to another nation where it will invest it to obtain a higher return, thus making a profit.

The result is pressure on the currency borrowed to raise its interest rates and also to increase the value of its currency.

The whole process, as currently practiced, raises a lot of questions about domestic money supply and domestic interest rates. The idea is that this will act to bring about a parity of currency values and so is not a wasted resource, even though it enriches the operators that gamble right and win. Only those institutions and businesses that are already wealthy will profit much from this.

There must be another way to adjust currencies naturally. And it is risky to borrow in another currency – a practice that the writer deplores because it is risky and because many financial advisers have got their clients into deep trouble by tempting them to borrow at low rates of interest in foreign currencies which later revalue causing the borrower to pay a lot more and to owe a lot more unexpectedly.

SOMETHING TO ABOLISH
Therefore the practice should be abolished unless no better alternative can be found as a way to manage the price of a currency for trading purposes.

Until we fail, we will assume that other ways of managing the price of currencies do exist and that we are working out what they will be...














CHAPTER SIX
An Alternative Solution?

What does Leigh Harkness suggest? See his three papers published on his blog.
Papers 1 – 3 taken from this menu:

First a reminder from Chapter three:

INSTRUMENTS
5.   Forex Reserves for trade
6.   Forex Reserves for investments – separate reserves if necessary
7.   A home for the Forex Reserves –
a.   the banks in general or
b.   the MSA or
c.    A mix of both
8.   Domestic Money Supply

I could add a devaluation authority but I want this function to happen automatically. So it is item B below. I do not want any intervention in interest rates, we have money supply to do that and local demand to set local interest rates. Thus:

RESPONDERS
F.   Balance of Trade
G.  Currency Price
H.  Domestic Interest Rates
I.     Inward investment flows – both ways inwards and outwards when reclaimed – and
J.    Hot money, like speculative and derivative trades, to and from external sources.

There are more responders (5) than instruments of policy (4). Logically there is no solution on that basis. But if item ‘E’ is not permitted to cross the currency frontier, then there is a balance – 4 of each. That should be solvable. And if item 3 is split as in 3c, (Forex reserves held both by the banks and the MSA), then maybe that could add a further instrument. Maybe.

If the balance of trade responds to the pricing of the currency, then it will not be a separate responder. This reduces the responders to three. Potentially there are four instruments to manage three repsonders.

DR HARKNESS’ ALTERNATIVE
Dr Harkness has the following Instruments (SEE Chapter three listings repeated above):

INSTRUMENTS: 1,3,4

and the following responders as every theorist has:

RESPONDERS: A, B, C, D, E or if A is removed from the list, then we still have responders B, C, D and E to influence / manage.

If Dr Harkness agrees to abolish E (hot money for currency speculations and currency derivatives), keeping those hot money transactions out of external economies, making them into home economy gambles and risk insurance for domestic speculation and other (investing in Island A) purposes, or if he will be combining them with item D, (he can have a solution with the three instruments and three responders.

Why three variables / responders, and not the four listed in Chapter three? I think Dr Harkness only uses three instruments and maybe there are only three responders actually needing to be influenced / managed if we read again the notes on those two lists.

What is not quite clear to Edward (me, the writer) in Dr. Harkenss’ solution is how tight the controls will be, and how much deviation from mean in the responders there will be, and therefore how stable the variables (responders) and the economies involved will be.

IS THIS MISSING?
And the solution needs to be as accommodative / facilitating, and as cost free as possible, whilst at the same time ensuring that the domestic money supply is put to best use. Putting resources to best use means that there has to be a price for using the money supply of Island A at the domestic interest rate then current in Island A.  Are there any other choices in that regard?

WHAT WE KNOW
We know that if money supply is under strong control and there is no fractional banking, (credit creation):
1. Enough Base money can be created
2. It can be created without giving it directly to the banks - people will leave it in their bank accounts as in PART 1 and as explained in the BOOK.
3. Interest rates will respond so as to balance supply and demand across all sectors as in PART 1 and as explained in the early chapters of the book.
4. Isolating Forex from the money supply can be done by the central authority - the Money Supply Authority, the MSA, which may be a division of the Central Bank.
5. The price of both currencies ought then to be set by what? We are trying to use the price of the currency to create a balance of trade. What market forces will achieve that, and how will those market forces be affected by imported / exported businesses and their funding needs? Do these forces need to be kept separate and in the process can it be possible to avoid additional administration and additional costs for the external (Island B) investor?

6. What role will be played by the derivatives market? Will those players gain any access to the target currencies (Island A) or will they trade only in their own domestic currency?

7. How will the solutions found for these two islands be extended to the world as we see it today with over 190 nations and not so many fewer currencies?















CHAPTER SEVEN
Here is the Story that I want to place in the book as it is so far



MONEY ISLANDS

This is an update on the original story entitled ‘Money Island’.

Money Island is a fictitious island that I invented as a part of my lecture to the National University of Science and Technology (NUST) to explain my vision of a stable domestic economy that developed naturally from scratch, having no money until a lot of money was air-dropped over the whole island.

Everyone managed to get a share of the money dropped and the story told how they knew what money was but never had any before. How they started to negotiate with each other the value of the money which led to it being adopted as a medium of exchange.

The problems started when the island’s prosperity rose, average incomes kept rising, and there was not enough money for everyone to pay their bills when due. This slowed the economy and gave rise to unpaid bills, additional costs and related frustrations. Meantime prices started to drop and people were rewarded for placing their money ‘under the mattress’ because it was rising in value just being there either in cash or as cash deposits at the bank. Some said that this was slowing spending and reducing jobs. Average incomes started to fall and return to where they had been so as to save those jobs. Some economists said this was just a natural adjustment which was needed. But they agreed that prices would still fall and there would still be some delayed spending as a result.

The islanders were still waiting to see if this would all settle down when the problem mysteriously seemed to disappear.

It was discovered that a man had started to print forged notes and he had become very wealthy. This had solved the money shortage. The man said that everyone was now able to trade more easily and that he was providing a service.

To an extent they agreed but they said that he must cease doing that and they set up an official Money Supply Authority (MSA) whose duty it was to print more money when needed.

By this time the government had started imposing some taxes on sales of goods and services. So when new money was needed they suspended the sales taxes and gave the new money to the tax authority which now used that money in place of the lost revenues.

The result was that people got their goods and services at a discount and the discount left them with surplus money in their accounts equal in total, across the whole population, to the amount of new money just printed and credited to the national tax revenue account. The books then balanced. It was just that money lost value. All spending on debts and all debts and savings that had a market link or a defined link to AEG% p.a. simply adjusted for that fall in value. All spending was able to continue in the same proportions as before and all jobs were unaffected by the devaluation of money.

People that did not spend during that period lost out so the result was an incentive to spend more and in fact a slight increase in spending over the period was the result - it gave a stimulus to the economy. For this reason the money was not usually printed until there were some signs that a stimulus was needed. An alternative strategy - just printing money on a daily or weekly basis and adding it to the tax revenue account was also tried. There was no stimulus and the money supply kept on rising as fast as needed to keep the economy strong. The rate of money creation determined the rate of inflation of incomes and, net of efficiency and other factors, it determined the rate of inflation of prices. 

The Money Supply Authority experimented to try to find the best rates. That took many years, using various rates and watching to see what rate optimised the rate of economic growth over a decade or more. They targeting a fixed value of money among other things and they tried other targets. They have not yet recorded their findings leaving us to find out for ourselves.

The money supply was managed very well and on average incomes barely increased but prices of some goods and services did reduce as people managed to produce more efficiently or as competitors came in to a particular market. This was most noticeable in the price of new technology and drugs. Once the development costs had been paid off and competitors entered the market, prices would fall rapidly. But mostly prices would not rise on average by more than 1% - 2% p.a.

One day, the banks started to lend the money that was left with them for such things as mortgages and businesses and personal loans.

They did not lend more than the money that they had available on deposit. They had to offer interest on savings money / bonds that got tied up for the longer term. This increased the demand for money and so some additional money was printed, and GDP increased due to the new industries that were being created, like house construction – more and better and more expensive houses could be constructed.

They also lent to businesses so that major projects could be financed out of debt as well as out of equity capital (shares).

When they lent money for housing they offered mortgages on the condition that the borrower repaid more in the early years and less in the later years, reducing at a fixed percentage per annum of around 4% p.a. in money terms as described in the BOOK’s early chapters and the mathematical chapters.

This enabled the banks to compete by offering interest on deposits. Some offered bonds of fixed duration with a fixed true rate of interest. This helped them to stabilise their accounts balancing the assets and the liabilities.

TROUBLE AGAIN
Then one or two banks started to lend money that they did not have.

The result was that the money supply rose and spending in the economy exceeded the capacity of the economy to supply the good and services.

Realising this, employers started to compete for labour and the labour force started to demand higher wages. With all the excess demand the employers we well able to pay more to attract the labour needed to meet the level of demanded. They were also able to increase their prices.

The total demand in the economy continued to rise as long as the banks were creating more money in this way. Total demand was the same as the total spending and that was rising more or less as fast as average incomes and profits were rising.

SOLUTION FOUND
The money supply authority realised what was going and clamped down on this practice of the banks. As a result the inflation of incomes slowed and then stopped before much damage was done.

But in the meantime, in order to preserve the value of savings that people had with them, they had found that they needed to index-link their bonds to some measure of inflation. And they had to make similar index-linked adjustments to debts owed to them.

They had to choose between a prices index and an incomes index. They chose the incomes index for reasons explained repeatedly in Chapters 1- 4 and especially in Chapter 4 where there are examples 1 to 4 given to illustrate the point.

The result was that those with mortgages had to increase their expected / scheduled payments at the rate of this index p.a. thus compensating for the falling value of money. Instead of falling at 4% p.a. as they would have done had money not fallen in value, the payments fell more slowly and when inflation passed 4% p.a. the payments started rising slowly.

On this basis the banks were still able to lend the same income multiples for housing finance they had always lent and there was no need to worry. They were even able to take relatively small deposits knowing that property values were slowly rising. They did not get any property price bubbles and crashes as explained in the chapters 1 - 4.

As for fixed interest bonds, these became unsafe because no one knew how much they would be worth after incomes inflation and money devaluation had run its course. Pension funds lost a safe investment that had kept safe the investments made by their funds. Since incomes were barely rising and they could earn good interest by lending that money, they were not having any problem when asked to provide pensions that were related to average incomes.

To overcome this problem the banks offered index-linked bonds linked to the AEG incomes index and these were used to fund mortgages and businesses.

At some stage the government decided to start borrowing money so as to build the kind of infrastructure that the island needed and so they also issued the same kind of AEG index-linked bonds. These were quite popular as an investment with people that wanted to save for retirement and for retirement annuities.

The complexity and range of such bonds and savings and pension products increased but basically everything adjusted in value and price as the value of money was falling, which rate it was determined approximated well to the rate of the AEG incomes index that had been selected. They called it the Average Earnings Growth (AEG) index so as to include the incomes of the self-employed and net company earnings.

For some purposes this index did not suit everyone and some variations on this index definition were created and used. For example, to calculate the appropriate rate at which the cost of mortgages were reduced they used an index that was more representative of the borrowers’ incomes involved. But this had an effect on their calculated true rate of interest which was based upon an index that investors wanted to preserve the value of pension funds; and so they had to take care. Some lenders just used the investor’s index and increased the value of Payments Depreciation, D% p.a. which increased the cost of a mortgage and reduced the amount that could be lent. It came to the same thing. The safe amount to lend was no different. It was the same no matter which way the cost was calculated.

So much for detail. The point was that as aggregate demand rose as a result of rising average earnings, the demand in the economy exceeded the supply and everything from prices to bonds and interest rates and debt servicing costs had to adjust so as to get everything back into balance. Some prices rose more slowly as efficiency increased and all of the usual market forces continued to work as before. Some prices crashed as before and so forth.

Anyway, that all stopped when the money supply authority stepped in and took precise control of the money supply in the way already described above. But the indexation and the reduction in payments on loans that was in place continued to apply, just to smooth out any ripples in the value of money and undulations in the AEG index. A falling AEG would create a stimulus or at least prevent the opposite, as debt repayment costs rose less quickly. No one used fixed interest bonds because when incomes were falling this produced rising costs-to-income and led to an unstable condition for the economy as a whole.

And so the economy prospered and there were very few problems.

There was a problem occasionally when the money supply authority printed too much money and then wages would rise faster, money would lose value faster, but the indexation part of arrangements resulted in everyone being compensated for the falling value of money. The effect was that the excess money created was mopped up in higher wages and higher prices across the board.

Some economists said that a little inflation was be good for the economy, helping employers to sell their goods and services faster because people would not be waiting for prices to fall before buying. And it gave them room to negotiate wage increases that otherwise might not happen and they thought that this made the annual wage round easier to manage. It is not easy to negotiate someone’s pay cut. It is easier to freeze a pay rise for some while giving a small rise to others.

The arguments about this has not been clearly resolved to readers’ satisfaction, but in the early years anyway, that is how the decisions went  – to create a little surplus money supply rather than creating too little was thought to be safer.

One reason for playing the cards that way was that there was never enough information about how much money was needed by the economy to make an accurate judgement about how much the economy actually needed.









CHAPTER EIGHT
Money Island Starts International Trade

This essay is a work-in-progress. It is looking at what has been written above, before chapter seven And it is not fully edited yet to take account of some ideas that emerged whilst writing all of the above. There may be errors and untrue things written. This will all have to be re-visited..


One day, the island lost its isolation in the world. People from another island landed and found that they needed money in order to trade.

The problem was that their currency was different.

No one knew what their currency might be worth.

It was decided to invite people from Money Island to go and have a look at the other island and see what they had to offer and what they were paying for those goods and services.

They invited the people of Money Island to trade using both currencies.

Some people accepted this and they sold their exports in exchange for Forex.

But there was a problem. A lot of people were unsure of what the Forex was worth and anyway all their accounts were done in local money. Many people refused to trade in Forex on Money Island.

EXPERIMENTAL SCRIPTS START HERE
To solve this problem the Money Supply Authority placed a value on the Forex at which they, as the Money Supply Authority (SMA) were prepared to exchange the Forex for local money.

Three problems arose.

Firstly they did not have the money to exchange. They had to print that money. That increased the local money supply. This did not matter at first, but as the volume of trade rose it became a significant increase in the money supply. It was decided that this should stop.

Secondly, the other island started getting short of money. The money that the left with the MSA was not in circulation. They had to print more money. They did, But then, some of the exported money returned and that increased their money supply again.

Thirdly, spending patterns changed in both islands. Basically I wrote about spending pattern disturbances in Chapter 3(?), saying that any change in spending patterns slows economic growth and gives rise to job losses and re-distribution of jobs - old jobs go and new ones have to be created. It takes time.

When new goods and services can be bought from another island there may well be some job losses. But that is always the case when new goods and services appear even in a single economy. After some time things settle down. The outcome should be an overall increase in the quality of goods and services and maybe some real economic growth.

So we can say that the first two problems reduced as Money Islanders started to import from the other island using their Forex.

What happened was that when an import had to be paid for the importer would get the Forex from the Money Supply Authority at the rate of exchange on offer.

What market forces acted on the rate of exchange?

Well, when one island finds the goods and services too expensive, it stops applying for Forex at the MSA.

The other island applies for a lot more Forex.

The first MSA finds that their Forex stock is not in demand. The second MSA finds they are losing their stock of Forex. As this happens, if it prints the money needed, that increases the money supply in the island as they provide local currency in exchange for the additional Forex. But that takes a long time to be noticed. It has little effect at first. It is not an appropriate management tool.

It would be better if the MSA, instead of printing the money needed, goes to the local banks to find it.

The question then arises about what interest is paid and by whom. The originator of the transactions, the importer from the other island, was not wanting to take out a loan or to pay interest. They just want to spend their money. The MSA borrows money to give to them in exchange for Forex.

So the MSA has to pay the interest. Where will the means with which to pay that interest come from?

There will be market forces working whereby if a lot of such money is borrowed then the local interest rates will rise, discouraging further operations. The MSA could respond by raising the exchange rate to discourage more transactions and therefore slowing exports.

The question remains, though about who will pay the interest needed to borrow from the local banks?

What about a deal with the MSA on the other island? They will be doing the same thing – paying interest to their banks on the Forex money coming in.

What if instead of paying interest, the MSAs simply increase the reserves that they commandeer from the local banks and use that money to supply local currency? The local banks will not like this, but if they are all treated equally and if that keeps the money supply in check that is helpful. There will be an increase in interest rates as local money supply reduces.

How will this feed into a market force acting on the value of the currency?

As the demand for the local currency from the other island rises, the Forex held will increase and the money supply in the other island will fall which will eventually raise interest rates. The delay is too long to add any precision. Delays create cycles and uncertainty and the longer the delays the bigger the cycles and the uncertainty.

A more accurate measure of what is going on would be the stock of Forex held by each MSA in each island. They would see whether there was an imbalance of trade very quickly. It would deplete the Forex in one island and increase it in the other.

The Forex stockpile would have been created by printing more money in both islands at first, just so that the dead money they held as Forex reserves could be supplied without creating a shortage of money in either island state.

At some point it would be judged that this had gone far enough. There would be enough stock of Forex in each island’s MSA to facilitate trade in both directions.

How much would be enough?

Well let us suppose that the exchange rate set by each MSA (which may be different under this arrangement) was adjusted when the stockpile reduced threatening to run out. This could be a fast acting and mobile rate of exchange, but within narrow limits because it is fast acting and assuming a high volume of transactions.

There are always once off major transfers as when a multi-billion trade is set up and paid for – say an aircraft carrier! The statisticians will need to come up with some formula to smooth everything out.

The effect on the banking sector of having to part with local currency to place with the MSA will be to raise local interest rates, but that money will then return to them as new deposits from the export receipts. In fact that will resulting in zero impact on interest rates? Maybe. Maybe not. Remember that goods and services will have been sent to the other island and there will be less for locals to consume, unless they import from the other island. What market forces will bring this into balance? If there is a balance then there will not be a scarcity of goods and services nor a scarcity of money supply in either island.

The MSA’s task is to set the exchange rate so as to bring this about.

What measures will they use?

The stockpile of Forex for one thing.

What else? As trade expands, more Forex Stockpile will be needed by both islands.

That can be solved by printing more money and adding to the stockpiles of both islands.

What about the falling value of money? Either the stockpiled money is allowed to earn interest at AEG% p.a. from the island from which it originated – which costs nothing to allow, or more of that money needs to be created / printed and sent to the MSA of the other island. It seems simpler to allow an indexation of the stockpile at the rate of AEG% p.a. of the originating island.

Is the stockpile an IUO that never gets paid?

Maybe. Does that matter? I don’t think so.

SUMMARY
It seems that we have something that may work for trade facilitation and currency value management.

A stockpile of Forex is built up in each island as each allows exports to take place. The money lost to the local currency is replaced by the MSA printing more money.

The rate of exchange is a bit uncertain during this phase, but things slowly settle down as the two MSA’s notice any imbalance in the level of trade and fix the exchange rates accordingly.

At first they each set their own exchange rates and that works well enough. But gradually the two exchange rates come close together. They do not have to have the same exchange rates but they may decide to. That may give an unforeseen problem one day. It removes one instrument of policy.

Once the stockpiles are jusdged by the statisticians to be enough to cope with seasonal and other non-average / large trades, and things can be smoothed over without running out of Forex stock, it is decided to stop printing more money to increase the level of Forex, at least until the total volume of trades demands a higher level.

As for incomes inflation and the devaluation of money, each island agrees that the other island may index-link the Forex to the originator’s AEG% p.a. This means that the Forex stockpiles will keep their value in terms of the other island’s GDP / AEG, even though it is idle money.

To keep the local money supply under control, from this point on, when local money is needed to pay for exports, the MSA demands the said money in overnight and ongoing deposits from the local banks. The money then returns to the local banks when it is exchanged for Forex and deposited in those banks by the buyers from the other island.

But doesn’t that mean that local money supply increases if the money returns to the local banks?

Forex holdings rise, money is supplied in exchange. The money comes from the local banks and returns to them. The ownership of the money changes from being held by the banks on behalf of shareholders / depositors, (which?), to being owned by the people from the other island who then spend it and get goods and services.

The foreigners leave their Forex with the MSA and pay no interest for the local currency they get.

The MSA has to manage the reserves using the exchange rate.

If too many goods and services are exported this leaves a shortage of goods and services with the locals, but that will not happen if they import to fill the gap, which they will do if the currency value is managed well.

The indicator of an imbalance is the stock of Forex held by the MSA of each island.

That seems to work as an arrangement. Right? Any objections?

HOT MONEY AND INVESTMENTS
What if it is not goods and services that are wanted by the other islanders? They get the money and instead of buying goods and services the invest the money in stocks and shares.

Do we allow this on the same terms? It may disturb the exchange rate considerably.

It is not the same as an exchange of goods and services which the above arrangement can keep in balance.

Will this have its own exchange rate? Will the trade go in both directions? Will the receiving island benefit from having its stocks and shares bought by other islands?

What about the case when the other islanders have skills and management to offer in exchange for ownership of a business on our island? We may want to encourage this to provide local access to that knowledge and the plants and machinery that may be new and imported; and to import the skills, and to learn the skills.

So there is a problem – a currency cannot have two prices unless there are two separate channels, one for trade and one for investments.

That means a lot of administration to create a second channel.

The money supply must not be disturbed so the money needed for the investment must still come from the local banks and be given to the external investors. A second stockpile of Forex may be started for this?

How will it start?
How will it all be administered to keep a separation for currency pricing purposes?

Are we going to get a balance of such trades and set the exchange rate low for the less developed island so they get the imported capital and expertise needed in exchange for their own capital invested outside the island?

Will the MSA export capital to the other island’s MSA so as to offset the imported capital? This would facilitate an otherwise unbalanced situation where the locals are not identifying attractive investments in the other island. But if the exchange rate was favourable enough the locals probably would invest elsewhere and so create a balance. The problem then is leakage – people saying the money is for one thing and then using it for the other (purchase of goods and services) at the more favourable rate of exchange.

Maybe the answer is to have just one exchange rate but when investment capital is imported the MSA exports the same value of capital giving it to the other MSA.

What will the other MSA do with that money? It is Forex. They have lost money supply due to the initial export of capital. In exchange they have either an additional amout of their own currency sent to them by the recipient MSA, or they have an additional supply of their Forex which they cannot use to replace the lost Money supply.

If they resort to printing more money and then the investments exported return, they will have an excess of money supply? We have to think about the return arrangements a bit further.

If there is enough Forex stockpile held by the recipient MSA to just send the Forex needed back to the investor island then that solves the money supply problem for the investing island. It also keeps the balance of cash flows but the signal to the MSAs are misleading if they are just watching the total Forex stocks that they hold.

The MSAs will need to distinguish between the signals due to an imbalance of trade and the signals due to an imbalance of investment trades.

They may need two stockpiles.

If they have two stockpiles and the investment stockpile is running low, what then? Do they simply print more money, more Forex for each other? Or for the island that needs more? They can do that. What consequences?

That is as far as I will go today. We need another summary.

SUMMARY
We seem to have a solution for trade and the exchange rate to keep a bal;ance of trade. Leigh Harkness pointed out that to allow banks to create credit increases the money supply and that this results in either inflation or an imbalance of trade. He says that if the amount of credit created is no more than the reserves held of Forex then that caps this and helps to keep things in balance.

The problem with this may be the management side to limit cycles and keep tight control. We must think about that.

Another aspect of that is that credit first goes to the domestic borrowers and thus disturbs the money supply until someone else picks up the money and imports something.

The advantage would be that we already have credit creation and it may be simpler and more acceptable to let it continue, although in reduced and better managed fashion. But it creates more administration compared to just working with base money which can be printed at any time and given to everyone that is buying anything as a discount on the price.

We have also established that there is a choice of responses to the idea of foreign direct investment and foreign purchases of local stocks / bonds and shares.

The most important thing is that this should not disturb the pricing of the currency for trade purposes and that it should not affect the local money supply.

We are looking at the idea that the MSA might export the same amount of local currency as it imports when a foreign entity buys local stocks and shares or decides to set up a new business locally.


An alternative may be to prohibit foreign investment in bonds and equities. That may not be helpful and it may anger some people being a restriction on the freedom of choice.










CHAPTER NINE
Some Principles

I have just been involved in a discussion on LinkedIn about Reserve currencies, the debt bubbles that they create and the proposal to set up a world MSA of some kind using - IMF SDRs for example.

I list below some guiding principles, especially needed when major changes are made to financial structures:

The main one is:
It is important that nothing disturbs existing balances of wealth or spending.

Thus:
1. If putting the world's currency reserves into such a fund is to be done then each nation would want to keep its reserves - or access to them. 

2. The funds will need to retain their value - so may be index-linked to ensure that happens.

Looking further than that there is the question of whether the funds should be converted to cash. What would that involve? I have to think about it.

The reason is we need to know how to use cash reserves for the kind of things discussed above and especially to counter any hot money flows (which are cash) between currencies so as to leave the value of the currency and the money supply unchanged.

That is another principle.

But this may be a more complex issue than at first is thought. Those reserves were set up by businesses and institutions with long term commitments. Is that a complication?

For now, this book draft has not got to the stage where a number of islands are involved.




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