mdmrjsds'  Instablog

The US financial system is broken.  The solution isn't more regulation
as the breakage is in the fundamental nature of the system.  Herein, I
propose an alternative that I consider to be better.

First, I give some background concepts needed to understand the
suggested new system and the breakage in the old system.  These are
only basic overviews, but should be enough to understand what follows.
Be warned that thermodynamics and control theory are complex topics requiring
applied mathematics skill if you are going to actually use them, but it is possible to read around the math and still understand the concepts presented.  If you want to know more, web search is your friend.  Some possible search terms: thermodynamics, entropy, carnot cycle, general systems theory, system
complexity, control theory.  And here is a paper about executive compensation using
thermodynamic analysis you might find interesting as another
application of this approach. http://www.mdpi.com/1099-4300/11/4/766

There are two 'laws' of thermodynamics.  I put laws in quotes because
these are observational laws, true because there are no documented
exceptions, not because they are givens.  First, that energy can be
neither created nor destroyed, and thus that it is always conserved.
Second, that in the real world, entropy always increases.  Together,
these are the reason there can be no such thing as a perpetual motion
machine.  And the second law is the reason that when you drop
something, it doesn't spontaneously leap back into your hand, or that
the teaspoon of sugar you stir into your coffee doesn't spontaneously
separate out of the coffee again.  The first law would allow that, the
second doesn't.  Entropy is sometimes called time's arrow, because of
the way it enforces irreversibility.  And the second law is the reason for the saying 'There is no free lunch'.  If you do something quickly and abruptly, the entropy cost is higher.  If you do something slowly and gently, the entropy cost is lower.  But the universe always charges an entropy cost.  There are researchers (not mainstream, but not crackpot) trying to find a way around these laws.  If you imagine getting energy directly from the fabric of reality, you can realize the allure of such research.

When designing systems containing volitional elements, it is good that
they should be incentive compatible and incentive congruent.
Incentive compatible means that the participants in the system gain no
benefit by trying to game the system, that the incentives in the
system encourage compliance with the system.  Incentive congruent
means that the incentives for the participants within the system are
congruent with the objectives of the system.  The federal system
designed by the founders in the US is their attempt at putting these
elements into government.  Unfortunately, we have lost sight of the
principle and instead enshrined and worship the form, leading to the
current stagnation and decay of our governing institutions.  Things
with a limited lifetime follow the sequence of birth, growth,
maturation, decay, and death.  Or putting it another way, if the
system isn't growing (growth implies change), it is dying.

The feedback control system feeds back a reading of the output and
adjusts the control variable at the input to change the output in
order to more closely align with a desired setpoint for the output.
Negative feedback means that the change brings it closer or damps any
deviation, positive feedback means that the change moves it farther
away or amplifies the deviation.  For this reason, positive feedback
systems are inherently unstable.  Think of a hemisphere having the
open side facing down with a marble on top.  If the marble moves in
any direction, the system encourages its further movement.  This is
positive feedback, and inherently unstable.  Now turn the hemisphere
over and put the marble inside.  If you move the marble away from the
lowest point and let it go, it will eventually return to rest at the
lowest point.  This is negative feedback and a stable system.

The current financial system is broken in all three of these areas: It
violates the laws of thermodynamics, it is not incentive compatible
and congruent, and it is positive feedback instead of negative
feedback.  At the time it was originally designed, thermodynamics was
in its infancy, and there were no such things as control theory or
systems theory as specific disciplines.  The amount and timeliness of
data was also limited, unlike our time with our wired world and
computing power.  I personally think that the financial interests
through their lobbyists had a hand in creating a system that so
rewards them at the expense of the rest of us, deliberately.  I hear
you say, "But it has worked so well!"  My question to you would be,
compared to what?  Imagine a system that didn't blow up every 5 years,
that had almost zero inflation, that allocated resources where they
were most beneficial.  How would our current system compare to *that*
system?

Here is the bare bones structure of the system I am proposing. 

Money creation is done by an executive department reporting to the
president of the US. The federal reserve is no more.  And banks have
no part in money creation.  They are thus free to fail, no matter
their size.  However, the nature of the new system means that they
will probably not be as prone to failure as they are currently.

Money is created by that federal department only to the extent that
wealth is created by the economy.  This isn't theoretical wealth, but
actual measured wealth.  So each month, the amount of money the
federal government has to spend is determined by measuring the actual
output of the economy, subtracting the amount of that output consumed
during the month, and also subtracting the amount lost to entropy and
obsolence.  Note that this uses a thermodynamic definition of money,
some sort of equivalence relation between energy and money.  A web
search will turn up articles on this.  Perhaps I will do an instablog
on the relationship between money and energy, and what money actually
is.  Hint: it isn't gold.

The money thus created is given to the government to spend.  This gets
it into circulation.  Banks then compete via interest offerings to get
this money.  There is no need for an income tax since the government
automatically gets 100% of all production of the economy.  This could
be looked at as a 100% tax except that no one will notice because it
is transparent.  The current beneficiary of this tax is the federal
reserve and its member banks. 

Banks are allowed to lend the money out at some ratio of their
reserves; that is, there is still fractional reserve banking.  To guarantee stability, it could be required that banks only lend money they have reserves for.  But I think that the system can still be stable with some level of fractional reserve lending.  Is it .9 or .5?  Only experience or more research can tell that.  There will be a regulatory agency that adjusts this reserve ratio on a realtime basis, corresponding to the setting of interest rates now.  During extraordinary times, this provides a mechanism to fine tune control; it should only be needed during extraordinary times.

Interest rates float freely.  During times of boom, they will go up
automatically because the demand for money will go up.  This ensures
that only the most rewarding projects will get funded, and damps the
system back to equilibrium.  During times of recession, they will go
down automatically because the demand for money will go down.  This
ensures that more marginal projects will be funded, and amplifies the
system back to equilibrium.  This is inherently stable, as opposed to
our current unstable system.

A system such as this can be stable for decades at a time.  Imagine a
system where a dollar ten years from now buys, in thermodynamic terms,
near the same amount as a dollar today.  Imagine a system where the
focus is put back on productivity improvements in real wealth, not
financial shenanigans to transfer wealth.  Imagine a system that
doesn't have episodes of mania and depression; unlike our current
manic depressive system, where Ben is trying to prevent the depressive
stage by administering huge doses of lithium (printed dollars).

Are there flaws in this financial sytem?  Sure, but it is about 1000%
better than the financial system we have now.  And it provides a base
to build on.  Is there a shortage of smart people in the US?  No.
Smart people will be able to improve it over time, and it is
fundamentally sound, and so provides a good architecture.

The major flaw I see is that the government can create inflation at will.  However, unlike the current system, we have direct control over the members of congress and the president every 2 to 4 years.  We have limited control of the financial institutions currently running things to their benefit.  And the inflation, is being spent for everyone, not just benefiting a few banks at the core of the sytem.

No system with volitional elements (people) can be deterministically
designed.  Eternal vigilance is the price of freedom.  That vigilance
has to be against ourselves as well as those we consider our
adversaries.

How likely is this to be implemented?  Get real!  The current system
has huge momentum.  The people who are experts in it will not want to
give up all their effort in order to start something new.  And the
financial companies will fight this tooth and nail as it takes away
their gravy train.  And even the political parties that have worked
out an accomodation with the wealth centers will not want to see this
happen;  their representation of the people who vote for them is not
at the top of their list of priorities.  Hmm, another potential
instablog, the correction of our political system using the above
principles for the flaws that have crept into it since its
establishment.

I've noticed that lately there seems to be a trend for stocks to recover in the last hour of trading, especially just before closing.  This seems particularly noticeable on days when the treasury is selling bonds.  I wonder if the money is immediately being sent to FOT (friends of treasury) for injection into the stock market.  This would be a broad based way to help both pension funds and insurance companies that are way underfunded for their liabilities because of the decline of their stock portfolios.

I have no special information, just noticed the pattern and put it together with the avowed intentions of the Fed and Treasury to do anything in their power to help the financial sector. I interpret this as meaning that they consider it easier to ask forgiveness than permission.

The reason I find it anomalous is that the fundamentals are so bleak that I experience cognitive dissonance when I see this happening.  Like seeing rain in Southern California or the San Francisco Bay area in the summer time.  The institutions are supposed to be the *smart* money, right?  Are they just carried away by wishful thinking?  Or are they seeing something that I'm missing?  Is it short covering?

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