PRINCIPLES

EDITING: This is a new page and further editing may take place from time to time. Editing in progress NOW.

LATEST: The course is now putting this together as PART 2 of the first module. 

But it has now been edited a few times and the remaining problems are a little repetition (not always a bad thing) and spelling and and typing errors. New editing on all pages is always reported on the LATEST UPDATES page unless it is just small changes.

INTRODUCTION
As a past student of management control systems and as a one time owner of my own financial advice and management company, Ingram Investment Services Ltd, and previously Anglia Insurance Brokers, I have spent most of a lifetime reading about macro-economics and the efforts being made to improve the performance of economies. My self-education in these matters spans at least four decades. I feel that it is time to bring to the world the new perspectives that this classic and well proven discipline of Management / Control Systems can bring to the world of macro-economic design and management. Besides allowing prices to adjust as per the economics text books, there are a few basic principles which, according to my observations are consistently not being followed. The result of not following those basic principles are easy to predict (lots of financial instability), and to observe as I have been observing them in the world of macro-economics all this time. You can see how well my investment portfolios benefited on the link to Ingram Investment Services given above. The financial instability outcomes of failing to follow basic principles of pricing and management are there right in your face. The origins are there in the text books, and also right in your face. Yet it seems that they are hidden in plain sight to people that are not looking for that kind of solution. Rather the world is responding by trying to introduce more and more sophisticated ways of managing so-called 'inevitable' instability. It is better that the world should go back to the text books and apply the basic principles. That is as I see it. As taught in the engineering, medical and social text books, if, in a complex system, any one thing is not being done 'by the book' then problems appear all over the system. You can choose: address all the symptoms, or put an end to the source of the problems. Why not add this to the macro-economics text books?

What follows is a 'fairy tale' about an island and how its economy developed. It is not intended to follow the real history of how things developed. That gets too complicated and may lead to a lot of controversy. It is written in a way that makes clear what contributes to financial and economic instability and what may be considered to be useful as a way around that. It follows principles in identifying the problems and in looking for solutions which the writer has learned over a lifetime of watching what goes on from a systems management viewpoint.

THE PRINCIPLES
The main principles to follow in order to gain and retain financial stability in the world's economies as laid down herein are mostly about creating a financial framework which does not distort prices, costs, or values. Prices should be free to adjust so as to automatically stabilise the system and eliminate the possibility of major or sustained imbalances from occurring. Otherwise it is like trying to ride a bucking bronco.

If prices are free to adjust properly there will never be any major imbalances other than from unexpected impacts like war and devastation. 

Unfortunately the prices involved in savings and debt are not free to perform their function. The cost of mortgage repayments and business finance dance around like a yo-yo as interest rates change. At the macro-level they are not adjusting to balance supply with demand. It takes a little thinking to understand the alternatives but that thinking has been done and the mathematics of lending can be found right here on one of my web pages. The value of fixed interest bonds can be anything as both inflation and interest rates change. None of these, nor the associated asset values like bond and property prices, behave normally. They do not grow steadily like everything else tries to do as the level of aggregate demand rises (or falls). The consequences are devastating. as explained and illustrated on the Home Page.  The cost of debt servicing payments are seriously over-responsive as explained both there and on the mathematics page. They are not responding to the right thing. They link monthly repayment costs to nominal rates of interest and multiply their interest rate sensitivity by around ten times. Hence the yo-yo.

Looking further afield, there are prices that get involved in more than one field of activity such as interest rates, (the price of credit), and the price of currencies. Both of these prices interfere with what each other are doing. Interest rates interfere with property prices and bond values. And they interfere with currency prices. And also that works the other way around: when currency prices are far from where they should be policy-makers can say that it is the turn of interest rates to address the problem. None of these prices have a separate or well ordered function. There is no 'one price to stabilise one field of activity'. But if you look in the management systems text books one instrument per function is always how things are made to work. Why not in economics? In economics, everything is confused and entangled.

Then there are management systems that have the wrong targets, such as targeting prices inflation rather than the level of demand inflation, leaving prices to adjust themselves...

I have invented a fairy tale place where all this confusion does not happen. In this fairy tale island every price has one market to work in and one function to perform. It makes a difference, just as it helps if a bus has a steering wheel for steering and a separate instrument to adjust the speed and yet another thing to absorb the shocks to smooth the ride. The shock absorbers adjust to the bumps. They do not control the speed and not too much, the steering. The wheels are round and not oval so that there is no yo-yo effect on the housing sector. How could all that possibly work for the economic bus? Read on...

It is as if the world had never heard of the basic principles of management systems and the associated principles of the design of financial frameworks which can easily adjust themselves to the 'bumps in the road'.

Economies are full of people. Think of a bus full of people but the bus is out of control. It has the wrong steering, speed control and shock absorbers. The wheels are oval. The steering is loose. How would the passengers feel? People could behave very well on the whole if they know what they are doing and can make financial plans that work: that is, if those plans are not disturbed by the unexpected financial events and shocks which come as a result of the badly designed financial framework and management systems that we have today. My story about Money Island is well liked because it throws some light on where the problems are coming from and how things might have been if we had had the wisdom of hindsight to do things differently.

THE PRINCIPLES
The main principles to follow in order to gain and retain financial stability in the world's economies as laid down herein are mostly about creating a financial framework which does not distort prices, costs, or values. Prices should be free to adjust so as to automatically stabilise the system and eliminate the possibility of major or sustained imbalanced from occurring. Otherwise it is like trying to ride a bucking bronco.

If prices are free to adjust properly there will never be any major imbalances other than from unexpected impacts like war and devastation

Unfortunately the prices involved in savings and debt are not free to perform their function. The cost of mortgage repayments and business finance dance around like a yo-yo as interest rates change; and the value of fixed interest bonds can be anything as both inflation and interest rates change. none of these nor the associated asst values like bond and property prices behave normally. They do not grow steadily like everything else tries to do. The consequences are devastating. as explained on the Home Page.  The cost of debt servicing payments are seriously over-responsive. They are not responding to the right thing. They link monthly repayment costs to nominal rates of interest. 

Looking further afield, there are prices that get involved in more than one field of activity such as interest rates, the price of credit, and the price of currencies. Both of these prices interfere with what each other are doing. Interest rates interfere with property prices and bond values. And they interfere with currency prices. And also that works the other way around: when currency prices are far from where they should be policy-makers can say taht it is the turn of interest rates to address the problem. None of these prices have a separate or well ordered function. There is no 'one price, to adjust to stabilise one field of activity'. But if you look in the management systems text books one instrument per function is always how things are made to work. Why not in economics? In economics, everything is confused and entangled.

Then there are management systems that have the wrong targets, such as targeting prices inflation rather than the level of demand inflation, leaving prices to adjust themselves...so I invented a fairy tale place where all this confusion does not happen. In this fairy tale island every pricing has one market and one function to perform. It make a difference, just as it helps if the bus has a steering wheel for steering and a separate instrument to adjust the speed and yet another thing to absorb the shocks to smooth the ride. The shock absorbers adjust to the bumps, not the speed and not too much, the steering. How could all that possibly work for the economic bus? Read on...

It is as if the world had never heard of the basic principles of management systems and the associated principles of the design of financial frameworks which can easily adjust themselves to the 'bumps in the road'.

Economies are full of people. Think of a bus full of people but the bus is out of control. It has the wrong steering, speed control and shock absorbers. The steering is loose. How would the passengers feel? People could behave very well on the whole if they know what they are doing and can make plans, if those plans are not disturbed by the unexpected financial events and shocks which come as a result of the badly designed financial framework and management systems that we have today. My story about Money Island is well liked because it throws some light on where the problems are coming from and how things might have been if we had had the wisdom of hindsight to do things differently.

MONEY ISLAND
Imagine a world, an island, in which there were no foreign nations to trade with and no significant savings and no loans but there was money. There was no international trade nor international capital flows, just the island and its people. People would help one another and they would not have any real problem in using money to settle their 'favours' to one another. The dynamics of such an economy would not have any major problems. They would be in a fairly steady state. At first there were no savings or loans, no credit and no inter-island trade. The only issues they might have had would have been on the creation of new money and finding the value of money. "How much money should be created, by whom, who would get the new money and why, and what is money worth?" There was no credit so there were no credit cycles. All the money was real money. Here is a fairy tale about an island that did not even have any money until some dropped out of the sky...let us see what happened next and how things changed when people started to save money and borrow it and then later, when credit was invented and again when other islands were discovered, and inter-island trade developed, and how each and every one of those things created problems which the islanders thought about and addressed. Slowly everything got more complicated but somehow they kept inventing ways to cope with those new issues...how did they manage to do that? Read on and find out.

VALUATION OF MONEY
At first they would negotiate the value of money. Imagine that it all fell out of the sky. Everyone would get some. They all knew what money was for. But they did not know what value to give to it. The problem with bartering was its inconvenience and the time taken to set up a deal. So very soon people started to experiment by setting up deals with this money. It was easier and faster. They made offers. They knew that the amount of money around was limited and that their share of it was just what they had got back home. So they acted cautiously and tried not to offer too much. Bargaining ensued. Some people did pay too much and they ran out of money. But soon someone offered them some money for doing something for them and so they learned their lesson and used money more carefully after that. Over time, people got to see that money is not limited to the amount that they have at home. They can earn money if the price is right. Money can be exchanged for goods and for services and as things started to work better and better some people got hired and their services got paid for by wages. The wages were negotiable. Prices paid for everything was negotiable. It was all negotiable. They soon discovered that the value of money is the amount of money that they want in exchange for their skills and time. And it is the amount that they are willing to pay in exchange for other people's goods and services. It is all negotiable at both ends - income and spending. Because, in the early days, they kept on running out of money they quickly understood that in order to have value money needs to be limited in supply. Thus, over time, the economy settled down and everyone seemed to be happy and had a fair idea of the value that they could get for money, or for their skills and time. Everyone had an income because everyone had found out what it was that they could supply to others and get paid for. In other words, there was no unemployment except in cases where a few people were greedy or incompetent and could not give, or did not want to give, value for money, or they simply preferred not to work all day long, which is fair enough. Why should they carry on working if they have enough food and shelter and their various needs have been satisfied?

SHORTAGE OF MONEY AND WAGE NEGOTIATIONS
Problems arose when the island community got more industrial and people got wages. They started wanting more money as their skills developed and their contributions to the company got better and more important. Employers found that the prices they could get for their products were not always the same and the demand for them was not always the same. Wages had to be re-negotiated. It is easier to negotiate a wage rise than a wage fall when times are hard. But there was not enough money around to give everyone, on average, a wage increase. Furthermore, after a few years the islanders found that the population had increased quite a lot. There was a scarcity of money with which to settle their accounts. People everywhere had to wait to be paid before they could pay their own bills. People could have taken a wage cut, based on the idea that money had increased in value. But that was not popular. They could have cut their prices but they could not easily cut costs. This attitude resulted in a shortage of money and because people had to wait to be paid before they could pay their bills, that slowed everything down. A lot of accusations started to fly around about unpaid bills and some people got hurt.

ONE POSSIBLE SOLUTION
In today's real world economy, that shortage of money is not a big problem. At least not at first. People just get the wage increases and with that increased income they go to a bank and borrow some money. The bank does not have lots of savings to lend so they just create some money by writing a big IOU in a ledger. They rely upon savers and depositors not to ask for all of their money back at the same time. They open a totally new deposit account which never existed before and which is not backed by any savings or deposit accounts, and they allow the customer to spend the money that they put into that account as long as they agree to pay it back with interest. They write a contract specifying that the customer agrees to pay it all back with interest. If they fail to repay and the bank loses money which it owes to depositors with real money on deposit, then there is big trouble. But as long as things work well there are big profits for banks. When that loan has been repaid the loan vanishes and the money that was created by having that loan account also vanishes. It does not have to be the same money. The original loan money became deposit money in many people's accounts as they accepted it as good money. They saw no difference between this money and real money. To them it was all the same. Some of them eventually had to pay money to the borrower when he started to earn money out of the investments he made or he got paid an income by his employer, and that money then disappeared when it was used to pay off the loan. It went out of circulation. Because the world gets used to having all this 'false' money around so that they can pay their bills on time, another loan then has to be created to replace it. As a result of this process around 97% of the money in existence, in the UK at least (it is reported),  has been created in this way. As long as enough people borrow money there will be enough transaction money, (deposits and cash), around for the rest of the nation to trade using that same money. But if people stop borrowing enough of often enough, there is an immediate shortage of money with which to trade so people have to wait to be paid and everything slows down. Then we find that the shortage of money is still a problem...so it does not actually solve the problem.


GOING BACK TO MONEY ISLAND
MONEY CREATION
On Money Island, at first there were no banks and there were no major savings. Somehow, to facilitate those wage negotiations and to ensure that there would be enough transaction money around as the population expanded, new money had to be created. People had not yet got around to savings and borrowing. One day, a clever guy called Arthur Bent, forged money and he became very wealthy. Everyone knew that there was more money around and that things had started to work well as a result. It was only later that they came to ask about Arthur's extraordinary wealth and he got found out.

KEEPING THE BALANCE
The elders met and it was decided to centralize the creation of money and to make sure that it could no longer be easily forged. The question was, "Who gets the new money?" This was discussed by all the elders and finally it was decided that everyone should get their share. One of the nation's best thinkers realised that jobs depended upon spending and the level of new spending coming from this new money should favour all kinds of spending equally. In this way, all of the work being done for the people by the people would continue to be done by the people for the people as before and all of the employment and all of the supply of goods and services that people expected to get would be safeguarded. Supplies would continue and jobs would continue. So it was decided that the new money should be given to all people when they spent money in the usual way and that they would get the new money in proportion to their spending and as a reward for spending.  

HOW THAT WAS DONE - new money sharing

AN INSTANT AND WELL BALANCED STIMULUS WITHOUT DEBT
By that time a government had been formed and as with all governments, people paid taxes and taxes increased prices. So the mechanism used to give all spenders some new money was to reduce the tax revenues from sales taxes, like VAT, or just sales taxes. These were reduced by 5% for three months.  Tax-exempt spending on charities and savings plans etc also got a 5% subsidy to make that spending cheaper too. The lost tax revenue was replaced by the new money  and the subsidies were also paid for by the new money. Effectively, everyone got their share of the new money because it was not kept by the tax department. It was given away as this subsidy. The boost to the spending in the whole economy was instantaneous as people went out to buy 'while stocks last' and the boost was balanced: no one sector of the productive community received a much bigger or smaller boost from customer spending than any other. All jobs were safe and all the output that people wanted to spend on continues to be available. There was no government borrowing to pay back. Just the stimulus. There was no more waiting to be paid and no more fighting over slow or delayed payments.

People ended the month with some new money in their accounts due to the savings that they had made. Others spent all of their 5% savings as well, but the new money then ended up in other people's accounts. It was still in circulation and available to pay bills. The result was that the level of spending got back to normal and there was no longer a shortage of money in circulation. Christmas came early that year!

NOTE: The UK recently reduced VAT and the effect was, as one might expect, a fast boost to the economy. But instead of printing the money to achieve that boost, the government borrowed it and then had to repay it. They increased VAT and got an immediate slowdown. Meantime they printed money to ease the shortage of money. It was called Quantitative Easing, QE, (easing the shortage of the quantity of money). But it was not given out to reduce VAT nor was it given to everyone equally. I remember writing to the Bank of England about this telling them that QE was OK but it had to be done in the right way.

THEN CAME SAVINGS AND BORROWING
Things started to change when some people started to save a lot of money. They took money and did not put it back into circulation. They saved it. More money had to be created to replace the money that was no longer in circulation. Everything got back to normal. Then banks were invented to create a safe place for those savings. At first, banks charged a fee for doing that - they provided safe custody. Eventually two things happened to disturb the level of spending in the economy. Until then spending had just been a steady process and everyone had had a job of some kind. What happened was that some people started to spend their savings rather fast and other people started to borrow from the banks that held those other savings. Then there was too much spending going on. Wages rose and prices and costs rose: money began to fall in value. Prices went up and wages went up. But still, that was not much of a problem: there was more money around and it was brought into balance because all prices, costs, and values, including the cost of wages and hiring, adjusted upwards. When supply of goods and service does not increase much and spending increases much faster, then all prices, costs, and values and incomes too (limited supply of workers) adjusts upwards to re-balance the supply of goods and services (including the services of employees, companies, and the self employed), with the increased spending being done. Let me explain how that happened: people and businesses found it really easy to find customers and so they made more profits and they shared the profits with their employees or they just spent more. They could also sell everything at a higher price. 

The problem came when borrowing and spending slowed down and savings began to increase again. People repaid their loans. Incomes had already risen and so had the cost and the price of everything. Prices threatened to start falling and wages stopped rising. But then some more new money was created and everything settled down again. When too much money was created all the prices adjusted again and balance continued.

THE REAL ECONOMY that we all know, (not Money Island)
So now we can see that a modern economy with savings and loans has problems that were not there before. The present way of creating money in our real world makes matters worse because it depends upon people borrowing to get new money created and people that have borrowed too much stop borrowing and start paying down their debts. As the borrowed money gets paid back and not re-lent, the supply of transaction money needed for Jerry to pay John reduces. People have to wait to get paid. There is also a recession. Unemployment rises and spending reduces again. When there is too much borrowing, prices rise all over the place, lots of new money gets created and in particular, house prices rise and people see that as a good investment. Then we get what management scientists call momentum and what economists call the 'Herd Instinct'. Everyone starts to pile in and wants to borrow, creating more money via the banks in the process, and they buy a house or they panic and buy whilst they can and before the property prices go too high to be affordable. The banks continue to create all of the money needed for borrowers to buy these things and everyone ends up owing the banks more than they can afford. The central bank raises interest rates and now people cannot afford to repay the interest on the money they have borrowed, and new borrowers cannot afford the cost of a new home loan. Everything falls apart. Some people think that the central banks can do better by raising interest rates earlier and letting interest rates fall less. That would probably help. Why probably? Remember the interaction between interest rates and currency pricing and remember that currency prices affect retail prices and the central banks are targeting retail prices with this instrument called interest rates. It is not that simple. And anyway, the instrument (the interest rate) still has to cope with the momentum, the herd instinct, so the response is not like a precise hit on the right target rate which controls the level of spending. It is more like  trying to position a heavy ball on a rope right in front of you when the rope is made of elastic. The weight of the ball stretches the elastic and the recessionary forces slow down. Then the ball begins to move as borrowing increases, but when the ball (spending) reaches the right balanced position, it rolls straight past. Then the central bank has to pull it back in the other direction. 

MY ALL-DAY UNIVERSITY LECTURE
I explained this on video to a university audience in (I think), about May 2008 along with a lot of other things like how ILS lending could be used to solve a lot of problems of adjustment to get the world economy back on course. Some of that, and the need for a balanced stimulus, is seen in this VIDEO excerpt. More can be found on the page called the LOW INFLATION TRAP. And the ILS models for saving and lending and for government debt which I illustrated in a the whole slideshow (I still have the slides) can be read on the page entitled WEALTH BONDS. The maths is there as a LINK. Some of the illustrations using real past data and imaginary data used by engineers to test the dynamic response of a system have yet to be added. It was a whole day lecture. Afterwards the head of the business school wrote on his feedback form that the university might consider offering me a professorship. But it was found that first the book needed to be published and accepted as worthy. Another wrote that this would become a new era in economics.

THE POSITIVE FEEDBACK MULTIPLIER
One of the major problems in the real world that we live in is that the cost of loan repayments rises very fast when the slowdown starts and they fall very fast when there is plenty of money around. See Figure 1 on the Home Page. This has a strong positive feedback effect, first re-enforcing the 'herd movement' upwards and then re-enforcing the 'herd movement' downwards. Positive feedback is destabilizing - it pushes in the direction of movement, whereas negative feedback pushes against the direction of movement. Lenders make it worse by lending more when interest rates are low and everyone is buying. So property prices get inflated twice over, once by the rising demand, and again by the rising loan sizes and reduced monthly repayment costs which multiply their response by around tenfold compared with other price and cost adjustments. They fall twice in the same way when interest rates are raised, and the tide turns the other way.

BACK TO MONEY ISLAND
In Money Island the banks were not allowed to lend more just because interest rates were low. In fact, if property prices started to rise and more people wanted to borrow, interest rates rose and the supply of credit from savings ran out. The whole process stopped. More accurately, the shortage of credit raised interest rates and a balance between the supply of credit and the demand for it was achieved without a run-away house price boom. More people saved and more money got created so the situation eased a little bit.

THE RISE OF CREDIT CREATION
This turned out to be a bit of a problem when the government and some big businesses wanted to borrow a lot of money. There were not enough savings to lend for such big projects and what would happen if too many savings were called in before the loans were repaid? (That is not really a problem as discussed in the slideshow. Maybe I will publish that slideshow with a commentary). The seniors of the island discussed this problem. They decided that some credit money should be created - money that belonged to no one but could be borrowed. A bit like what the real-world banks do today. What they did not want to see was too much spending coming out of too much credit money being created and spent. No one had previously thought of creating credit money as a separate entity. If they did that, it would create new jobs in construction and the manufacture of heavy goods industries and those industries would not be held back. They were needed. The elders realized that. Some people would leave old jobs needed to supply people with the smaller goods and services but then they were creating important things that were very much needed. People would not have to build a home one barrow load of bricks at a time. They would be able to borrow and buy a whole house built by experts. It was suggested that if they created enough new transaction money it would lie idle in bank accounts and then it could be lent. But then it was realised that this would speed spending and cause inflation.  There was no guarantee that it would be saved and then lent. The problem remained - how to finance roads and major projects and more houses which people really wanted. The elders gave in and they created some credit money. There was some inflation and there was some re-balancing of jobs and of spending. The Money Supply Authority (MSA) had already been formed. It had been creating the new money when needed. The MSA body was now charged with the additional task of making sure that there would be a reasonable limit to the total amount of credit created. All credit that was created had to be repaid, and in the meantime, once lent and spent, it became transaction money that was either spent or saved - some of each - by others. So this did somewhat disturb the amount of transaction money in circulation which was needed for John to pay Jerry.

The result was much the same as in our modern economies, or it threatened to become like that. But there were some differences. The MSA was not allowed to keep on creating more and more credit money and they had to ensure that the credit money repaid was put back on the market. They were not allowed to touch interest rates. Lenders and big borrowers had to go to the money and credit markets for borrowing credit and savings at the market rate of interest. Smaller borrowers went to the banks / lenders who arranged their loans and managed their repayments, either returning the money repaid to the money market or re-lending it. Larger borrowers would issue bonds and people and institutions would buy them. These were Wealth Bonds, whose value adjusted in value to the level of National Earnings. After the initial period of growth of big projects, when things settled down, the amount of credit needed also settled down. And then interest rates also settled down.  

SELF ADJUSTING SAVINGS AND LOANS
The loans were all arranged on the basis of the Ingram Lending and Savings (ILS) models described in these web pages. See the page on WEALTH BONDS and the page on NEW FINANCIAL PRODUCTS RESULTING. This meant that savings were protected by enough interest to balance the supply with the demand for credit and the demand for savings to lend. Savers could decide which lenders could manage their savings and at what rate of interest as long as that was the market rate for that kind of lending.  The rate in question had two parts - the adjustment rate to keep the value of the account and the true rate which added value. Or the savers could put their savings on the money market. Bidding for a higher than average true interest rate would leave the saver with no takers and bidding lower would get takers right away. The MSA had to ensure that the amount of transaction and credit money in circulation in the economy did not lead to too much earnings growth because that would lead to too much spending from earnings / income. Their mandate was to manage that rate of Average Earnings Growth (AEG% p,a,) and to make sure it was enough to help with wage settlements but not too much to create run-away inflation of wages or prices.

MSA MANAGEMENT TARGETS
The MSA identified that true interest rates, the marginal rate above AEG% p.a., would slow demand for credit from all sources - savings and credit funds on offer, and that the true rate of interest needed to be always positive to prevent borrowers from abusing the system to make themselves wealthy without making any real contribution to the economy. If they created too much credit then this marginal rate which they called the true rate of interest would fall a bit and under the ILS models for saving and borrowing, all monthly costs, property values, and NAE would rise more or less at the same pace but some things would lag because not everyone would get a raise at the same time and not all prices would be raised at the same time. So they did not worry too much about that but a secondary target was to keep the true rate of interest fairly steady and positive.

LOW INTEREST ABUSES
It became clear that if interest rates were below AEG% p.a. there would usually be more demand for credit than there was supply. The reason, it tuned out, was that people knew that property values rise when NAE rises (that is National average Earnings rise), because they can all afford to pay more for that desirable property and there were never too many of those nice homes, or even homes of any standard, around. Competition forced rentals up and properties gained in value more or less at the rate at which NAE rose. Then the investors (borrowers) would get a rental income on top. The rental paid off the loan. In accounting terms they borrowed at AEG% interest and got 2% or more, even up to 5% more  in rental on top. They would be happy to borrow unlimited amounts. Similarly, companies could borrow, take over a better business which they did not know how to manage, and use the profits to pay off the loan. A free gift. Sometimes they would end up managing the company and destroy it.

THE FOREIGN EXCHANGE MARKET
One day people discovered other nations and they started to import goods and services because some of the things that they could import were not available back home or because the quality or the cost was better. A rate of exchange was needed and it was negotiated. Some money ended up in other countries and some of theirs ended up in Money Island. Money Island just printed more when there was a shortage and encouraged the recipients of foreign money to buy foreign goods and services. But many of them preferred to exchange that foreign money for local currency and buy from the home market rather than to buy more foreign goods and services.  A market for the exchange of that foreign money was formed. There were willing buyers on the local market and willing sellers. The price of the currency exchanges depended upon what people were willing to exchange it for in both directions - buying foreign currency to spend on imports and selling foreign currency to buy local output. Again, there was a price at which the exchange could clear the buyers and sellers, leaving supply and demand in balance. Economists call that the clearing price. The clearing price determines the value or price of a currency in terms of other currencies. All the Islands had these markets. The clearing prices for any one currency in any pair of islands was usually about the same because if they were not, people in one island would go to the other island to get a better bargain.

PRICING STABILITY
Some islanders wanted to borrow money from other islands and spend the money back home after exchanging it on the currency exchange market. This made a difference to the value of both currencies because it increased the supply of that foreign currency on the money market. In Money Island this process was not allowed. They wanted the currency price to be stable and to keep the balance of trade stable. Of the two it was keeping the price of the currency stable that was the priority. This meant that businesses could plan further into the future and invest more in production based upon import and export trade. And it would also help to steady the volume in both directions. That would stabilise jobs. In that way there would also be a fairly stable level of imports and exports and the trade-sourced undulations in the overall level of spending would not be too much. They would be caused only by changes in the amount and value of imports and exports from time to time. With unstable currency prices planning ahead very far and investing in import and export trades would not be safe. It is already enough to gamble that the exports will continue to be wanted and that competition would not crowd a supplier out of the market. Having a currency price that could suddenly dip would be just too much. A lot of businesses would simply play safe and not expand. Others would take the risk and some of those would go under.

THE FORBIDDEN TRADES
Some other islands tried creating more money and then asking to buy into Money Island's government bonds. If this had been allowed, it would have flooded Money Island's economy with more money from the sale of those bonds and the arrival of that foreign money on the currency exchange market would also have changed the value of the currency. The same thing was tried for buying shares on the island's stock market. Money Island laid down some rules.

CAPITAL SWOPS ALLOWED
It was decided that foreigners would be allowed to swop some currency in Money Island with an equal amount in value of their own currency. That money would stay in that other island. The  money that they got from Money Island would also stay in Money Island. Just the ownership would change in both cases. The deal would be done at the rate of exchange of the currency exchange market. Money Island's MSA would release the same value of Money Island's currency to the foreigner who would then have a share of the same money stock as everyone else on Money Island. The MSA would also acquire ownership of the same value of money in the other island. There would be no money changing hands on the currency exchange market so there would be no effect on the value of the currency.

MORE GROWTH FOR ALL ISLANDS
Both owners, the Money Island MSA and the foreigner would get the rate of interest on their money that prevailed on the respective money markets for credit or savings as the case might be. The foreigner said that he/she wanted to invest it, maybe in a factory, maybe in bonds, or maybe in equities. Their choice. If their ventures worked well and the economy grew, the MSA would create more money to allow more of the same foreign capital to come in to keep the economy growing faster. Similarly Money Islanders could expand their successful businesses to other Islands.

INTEREST RATES INTERNATIONALLY
Money Island's true rate of interest was always around 1% to 3% p.a. and those other islands that adopted the same systems also had that kind of interest rate. Those that were growing fast had higher true rates but that did not greatly affect the interest rates on Money Island. People could not borrow in one Island and invest the money in their own Island to take advantage of the different interest rates. They could not affect the value of currencies that way. The transactions needed were not allowed. Each Island had its own economy, its own trade in its own credit markets at interest rates that were best for its own economy.

RISK BALANCING
As time passed, most Islands had their own MSA's and they all owned money in the currencies of other Islands. Some of these devalued and some revalued as the market in their respective currencies were traded on the exchanges. To offset the risk of losing out during this process the MSA's created a ring of members and a pool of such money so that the falling currencies were offset by the rising currencies. The risks more or less cancelled out. The money remained available for use in each originating island - just the ownership had gone to the ring of MSAs in the form of savings that could become credit and spent or credit. The transaction monies and the credits were still traded on the money markets of the originating islands. Some thought is needed here about the dynamics of these two entities - savings and credit. 

The question now is, "Do these Islands need a reserve currency?" What problem would it solve? How would it work? Would one island's currency become the currency of choice? Why? Right now these questions are too big for me. But I will work on them.

BACK IN THE REAL WORLD THAT WE LIVE IN
The banks create far too much money and spending tears away. There is not enough output to satisfy the demand and prices rush up and imports rush in. Interest rates are low and this is a factor that is allowed to affect capital movements between nations, unlike in Money Island and their neighbours. Capital investment money is not money for any particular trade or use. It is just capital moving around. Capital rushes out of one currency  to get better value in interest rates and the local currency drops in value rather too fast - faster than it would have done otherwise. The value of the currency is already dropping far too fast in price on the exchange markets because local interest rates are low and so much money is being created and spend, so many imports are being bought due to the excess money and the profits being made from fast rising property and other values is encouraging spending and more money creation.  And in particular, there are rapid rises in profits from normal business activity. It is the age of 'let everyone do what they think is best for themselves.' All kinds of new derivatives and clever arrangements are devised to manage these new currency value risks, risks which would not have been there in Money Island. People have to go to get years of training to learn how to handle this. The financial sector is the fastest growing sector in the economy as people need advice to cope. The best traders make billions at everyone else's expense. They get paid well.

Eventually everything has to stop. The imbalance of trade is too much, imports are too expensive. The central banks raises interest rates making all that debt too expensive so panic sets in and the entire pack of cards comes down in the property and other sectors as explained on the Home Page.

MANUFACTURED INSTABILITY
At times some nations, like South Africa, where 40% of sovereign debt is allegedly held by foreigners, find that the falling currency has nothing to do with all this. It is caused by foreign investors that have bought into their stock and bond markets (not allowed in Money Island unless they first do a currency swop). Now, when they get nervous the foreigners sell those investments and the currency dives. The government, (usually the central bank), tries to prop up the value of the currency by selling more bonds to foreigners or by buying their own currency held by foreigners. More capital movements take place that are not allowed in Money Island. This is very expensive. When bonds are sold by the government interest has to be paid on them to the foreign buyers. Eventually that works the other way round: no more bonds get sold and the interest payable undermines the value of the currency again. The foreigners then get worried and they decide to sell the bonds - are you following this? Or like most people, are you just getting confused? Go get a degree in this and maybe you will understand. What a waste of good talent. It seems to be yet another case of making a mess of things and then employing half the world's experts to train and then to try and sort it all out instead of giving them something constructive to do. Just moving money around and insuring risks that should not be there is a waste. Allowing them to gamble on the instabilities is OK maybe but unless they are reducing the instability in the process this contributes nothing. It actually seems to work out the other way around and they make billions out of everyone else.

COMPLEXITY TOO GREAT TO MANAGE
To make matters worse, today's real economies have internal imbalances caused by the way in which they write savings and borrowing contracts. It had already been noted on that linked page that when interest rates rise by 1% as a part of the adjustment process needed to preserve the value of savings and loan accounts, the lenders in our real world nations demand that monthly payments should jump up by 10%. This always unbalances the entire spending pattern in the whole economy forcing people to spend less on everything else and more on repaying the capital and interest on their loans. Are you confused? You certainly should be. Our interest rates are not permitted to find their own level, they get involved in international capital flows, and the price of the currency is buffeted by those anyway. Now we have distorted interest rates to cope with as well because they cannot rise properly without causing a crisis.

We no longer have a nice steady state economy and we cannot accurately control the rate at which money is created; and certainly everyone does not get their fair share of new money. The banks get it all. Spending patterns get altered by unnaturally large cycles of borrowing and savings and by changes in the value of the currency which swings around because we have alternately too much borrowing and spending and then too little and because foreign capital gets tangled up in the exchange rate mechanism.

Whereas the price of the currency is supposed to create a balance of trade, governments can manipulate that price using borrowing and investments in the debts and other assets in other countries so that the role of the currency price gets disturbed and people cannot rightly predict what will happen to the price of the currency. Investors in foreign currencies take degree courses to try to fathom what will happen next and they know that the interest rates in other countries will be taken into account when they borrow from or invest in other nations' capital markets. Everything is confused, no one can make a safe financial or business plan going forward more than a few years at best. The value of money is uncertain and the cost of borrowing is uncertain. The value of property is uncertain. Busts follow booms. What a mess!

So it is far past time to look at what is causing this mess and to straighten it all out.

THE BASIC PRINCIPLES USED
With that in mind I have written a summary of the principles of Macro-economic Design as used in Money Island (what the financial contracts, rules and regulations are supposed to do so as to bring order and balance to the system) and I have listed the few key rules for the better management of that more orderly system. First, make it orderly and balanced by use of Wealth Bonds and ILS lending to keep spending patterns balanced and then manage the supply of new money creation in a balanced and orderly way, thus making sure that there is not too much spending resulting and no big supply or demand cycles. Then let interest rates clear the market for credit in the money markets. Do not allow currency prices to be disturbed by the capital markets. The price of the currency is there to balance trade, not to balance capital flows as well - an impossible task. Find another way for capital to move around using currency swops. The rest will look after itself.

The principles of macro-economic design and management all come from the text books: one price one function, prices (including costs and values) must be able to adjust to help to balance supply with demand and keep things orderly.

MANAGING THE TRANSITION
Here are the rules. How we find ways to abide by the rules is the clever part and that needs careful thought. I have done a huge amount of work and mathematics and testing of lending models to address these issues. And I have done a lot of thinking about how best to introduce the wealth bond concept so as to allow an escape from the LOW INTEREST / INFLATION RATE TRAP. How we get from where we are now in money creation to where we should be also needs some thought. That is the kind of thing that the rest of this book (currently in the form of the websites and essays published for www.fin24.com) is all about.

We have to take things slowly and we have to learn a whole new way of thinking. That takes time, and it takes a lot of education like what was done when VAT was introduced. It needs planning. Or we can start slowly on a small scale trying out the ILS Models for example in a limited way like they are doing in Turkey. Civil Servants only. But in my opinion the risks of moving slowly are too big politically. We need to understand that when things are done 'by the book' everything will get safer.

When it comes to interest rates, they are a price and they should act as a price. They are supposed to do two things:

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Firstly the interest rate has to make adjustments for the falling value of money so as to keep everything in balance - so there is a part that has to add interest to accounts at the rate at which prices, earnings, costs, and values are all rising. Take the rate of increase in National Average Earnings (NAE) as the measure and make sure that all prices, costs and values CAN rise at that same or similar rate by using the right savings and lending contracts and regulations. Then the interest needed to keep pace with that falling value of money (rising price, cost ad value of everything), will be the rate of Average Earnings Growth, AEG% p.a. Below that rate things will not be in balance: borrow at below AEG% p.a. and invest at AEG% p.a. and you make a profit. You benefit, the nation does not (much). Remember: all prices, costs, and values are supposed to adjust as NAE and spending rises and at about the same rate as AEG% p.a. In fact you make even more profit if your investment pays rental or dividends. So the second role of interest rates is to ensure that the price of credit (borrowed money), the interest rate, needs to be higher than that AEG% p.a. level so as to create a balance between supply and demand. That extra interest (the marginal rate above AEG% p.a.) is called the true rate of interest. In a healthy economy the true rate of interest is positive.

           
PRINCIPLES OF MACRO-ECONOMIC DESIGN AND MANAGEMENT

The main principles needed to avoid a mess are simple and straightforward:

1.     Create a framework in which all prices, costs, and values can adjust easily and without distortion to the changing level of aggregate demand. This puts everyone in the same 'elevator' so that spending patterns are not altered during the adjustment process as the level of demand in the economy rises or falls. To keep everyone employed, all prices, costs, and values along with National Average Earnings / Incomes (NAE) should be free to adjust proportionately to the generality of prices and incomes as they rise or fall, based upon the general level of demand. Demand comes from spending and that comes primarily from earnings. We do not want the monthly repayments cost of borrowing to rise and fall faster than anything else and we do not want savings to get left behind through lack of enough interest. The new Ingram Lending and Savings (ILS) contracts are designed to fit into this scenario, thus taking away a major source of disturbances to spending patterns. Without booming and crashing property values and with investments in debts like government bonds that also keep their value and their cost of servicing,  (interest coupons), everything will stay balanced. The herd instinct to run with the crowd when that balance is lost will not be a major concern as things will settle down: those money contract-based and significant imbalances will no longer occur. So rule number 1: create a self adjusting prices regime in which the cost of repayments and the cost of labour and the price of everything adjusts to keep spending patterns, what is spent on everything, in balance. That will preserve the jobs that people are asked to do when people spend. Everyone and every price and wage will be on board the same 'elevator', hardly noticing that the elevator of prices and incomes and the value of savings and the cost of monthly repayments is moving. Everyone participates in the increases. Business as usual. There is just the fact that some raises happen before others to worry about. So do not let just anyrate of inflation take place. Keep it in single figures.

2.     Create a management system that is fairly precise and fast acting when it comes to the management of aggregate credit and the creation of enough transaction money for the economy not to be either held back by having too little money and credit or over-heated by having too much. A little inaccuracy in the amount that needs to be created and is created can be accommodated if the first principle above has been implemented. So the timing and quantity of credit and transaction money creation does not have to be precise. Do not allow conversion of foreign money or foreign credit to increase or to decrease the national (domestic) stock of transaction money or credit. Use currency swops for that. Keep spending balanced across all sectors. Do not disturb that balance when creating new money. The way in which money was created in the above story is an ideal way to keep spending patterns balanced. Everyone gets some extra money to spend because at the end of the month there is money left over as prices were reduced. And there is more money afterwards to keep the economy going.

3.   Do not create a moral hazard by giving the new money to a government to spend. They will make sure they spend it on their cronies and get themselves re-elected that way. They will unbalance spending patterns.

4.   Use one price to work in one field of activity only. You can find this rule in any text book on management systems. For example, interest rates should relate to the needs of the domestic economy, keeping the balance between credit supply and the demand for credit. That is enough 'work' for one price to do. It must not also get involved in management of the value of the currency. One price, one task. So we have to stop that cross-currency capital investment and borrowing process from getting entangled with this process - with monetary policy or the supply of credit. As mentioned, using currency swops may solve this problem. Similarly, currency prices should relate to the balance of trade and not be influenced by interest rates or the level of international investment transactions. Again, use of currency swops can prevent or limit that kind of interest rate intrusion. These international capital movements should not impact on the stock of transaction money or the stock of credit. Currency swops can be permitted to allow people with foreign capital to get access to our domestic/local/national supply of capital in our economy. We get some of theirs and they get some of ours. We have to work out a system for doing that. One such idea has been outlined in the Money Island story. That will prevent any disturbance in the amount of spending in either economy and the stock of transaction money and interest rates will not be disturbed. Foreigners can compete with us on equal terms for the use of our money and credit that we have created in our nation. But they may not bring in more money or more credit from elsewhere. That will over-heat the economy and unbalance the value of the currency and interest rates will get involved. If we need more credit or transaction money we can create more. We must only create enough so that the output of the nation has buyers, but not too many, and not too few. If the local (domestic / national) economy needs more transaction money or credit as the result of foreign investment increasing the level of activity in the economy, then that can be created under item 2 above.

5.     When making an intervention to create more money the selection of the target is important, measurements should be relevant and up-to-date, and the instrument used should be appropriate, fast acting, and balanced across all sectors. The outcome should be delicate boosts to the whole economy as and when needed without borrowing. Prices inflation should not be the primary target but can be a secondary one. Prices adjust themselves to the level of demand / spending. Free oil will help prices but it is the level of demand that we have to manage. Zero oil will affect prices upwards but making it easier for people to get money to offset that will not create more oil. The primary target has to be management of the level of aggregate demand or National Average Earnings. Economic growth is not a certainty and that rate will find its own level. Prices will adjust. The danger of targeting aggregate demand / spending per person or real economic growth is that these can vary of their own accord without needing any intervention. National Average Earnings basically determine the level around which aggregate demand will vary as the various levels of savings, borrowing, and imports and exports undulate. A further secondary target to bear in mind would be to keep the true rate of interest[1] positive so that people and institutions that borrow money are obliged to make good use of it. A low true rate of interest creates opportunities to borrow that may benefit the borrower more than the nation and which may actually damage the national interest. A stable positive true rate of interest is an indication that the amount of credit in the economy is about right. A rising true rate and a rising level of unemployment or a slowing economy is an indication that more money creation is needed. The amount of that money that becomes savings or credit will find its own level.

6.     Again, as regards targeting: most economists believe that a positive level of earnings inflation helps with wage negotiations and the politics thereof. This may be so. Also most investments and savings will be related to the rate of AEG% p.a. and holding cash without any interest compensation will not be profitable if AEG% p.a. remains positive. Creating conditions in which holding cash is a beneficial investment because AEG% p.a. is negative is not seen as being helpful. This situation is easily reversed by creating more spending in the economy. An example of how to do that through a reduction in sales taxes and providing a subsidy on non-taxed spending for a limited period has been given above. The money created does not have to be precisely calculated: applying the first principle of price adjustments, item 1 above, will ensure that stable spending patterns are not greatly disrupted should the stimulus be over-done. The result will be a higher rate of money devaluation and a higher rate of increase in all prices, costs, values and earnings. Everything will re-balance easily and quickly if we use ILS savings and debt structures. See the page on WEALTH BONDS.

7.     Taxation should not distort any price, cost, or value or divert it in a way that destabilises the above issues at play. For example, when AEG% interest or an AEG% level of capital gain is taxed, or when tax relief is given on that AEG% par of the interest, that can interfere with the market values relating to interest rates and prevent the nation from getting the best use out of its resources.

8.     Policy changes including rule changes and tax changes should be small, not back-dated, and should be discussed and amended as appropriate in line with the above principles well in advance of passing into law. Policy changes should not disturb business plans or savings plans that are already in place unless there is no choice. Compensation should then be considered. Policy changes should not be done at short notice or in an unending cascade year after year if possible. The reason is that businesses need to have confidence when they put their assets and staff jobs at risk. With the new, self balancing framework, many policy interventions currently used to compensate social and business distresses will not be needed as the problems will no longer arise. When it comes to elections there will be fewer economic issues that governments can be blamed for. Governments will be able to address the real issues and get elected on those.

9.     As a matter of principle and personal preference I do not like interventions which benefit some people at the expense of others except perhaps for political reasons called social engineering. I prefer to find a way for nature to re-balance prices, costs, and values and spending patterns and spending levels wherever possible.I prefer to have a self-adjusting framework. Interventions are just an alternative to getting the framework right so that everything stays close to being in balance. Interventions that benefit some at the expense of others become political battlegrounds and they potentially cause unrest and lost elections when a government might otherwise be doing a good job. Wars and extremist movements get fed their food of life when imbalances thrive and the resulting unemployment levels rise and opposition parties make great use of the way in which social benefits are deployed because there is always a grievance somewhere. I want to prevent those things from happening automatically as a result of the framework or the management system. Let people benefit from their own endeavors. Make life more predictable and safer financially. Then they will not need help to cope with unfortunate imbalances because there will be very few of those. But they may need help for disability and for unexpected disasters and so forth. Creating the financial stability that people need is  what this book is all about. Enabling the economy to thrive by this means will provide governments with a greater ability to tax and to supply social benefits where they think they are needed. That is what governments do whether we like it or not. They get elected that way. I am not taking sides. What the voters want they should get. But they should be well informed and they should be financially safe. Given that, we will be able to eradicate greenhouse gas problems with massive capital projects using safer finances and cheaper finances than are currently possible.

Footnote: The above are ideals. The question now is to what extent we can find ways to comply and how to implement the necessary changes. Any non-compliance will result in lost output, and costs in some shape or form.

ACKNOWLEDGEMENTS
I thank all the hundreds of economists and practitioners and the education I got in management systems design,  and as a practitioner in the financial services sector, for giving me these insights and helping me to express them.




[1] Interest equal to the rate of increase in demand or as a proxy, the rate of increase in National Average Earnings, (NAE), is just enough to respond to that rate of increase. If all prices, costs and values are responding to that rate of increase in NAE then the value of money is falling at that same pace. All prices rise, the value of money, (what it can be exchanged for) falls. The true rate of interest is any additional interest that gets added to savings and loans. If this is not high enough there will be too much borrowing demand and loans will finance asset purchases that earn dividends and rental giving borrowers a free increase in wealth and assets. The rentals and dividends and the profits of good companies taken over using borrowed money will pay off the debt. The rate of growth of NAE is called the rate of Average Earnings Growth, AEG% p.a.

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