Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

An alternative financial system

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.

Part 1, Theoretical Background

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.

Physical constraints on the economy

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.

System complexity concepts

In terms of complexity, and thus difficulty of analysis and modelling, all systems are not created equal.  Following from a sequence I first saw mentioned by Ron Howard as a professor, I have built the following heirarchy, from easy to hard.

Static - e.g. a bridge, a dam.  Of course this is only static when looked at through human perspective on time, not geologic.

Dynamic - e.g. an airplane, beer making.  Things change in real time for human time scales.

Time Varying - e.g. a car engine, the actual system changes through time.  Think of the many changes that a car engine experiences from new to 100000 miles.  

Stochastic - e.g. the weather.  Given quantum uncertainty, it isn't clear that we could accurately predict the weather even if we had the capacity to model every atom of which it is composed.

Volitional - e.g. the economy.  There are volitional elements of the system that make modelling impossible.

It is this last type of system, that I would like to discuss a little more, since that is the type of system that I am dealing with.  Just like the stochastic system, it is impossible to predict this system.  But even more, it can't be statistically predicted.  

Every human is capable of actions that can affect the whole system, so unless you can model the actions of every human, you can't model the economy.  Since every human has this capability, this is a chaotic system, always on the tipping point, and the tips can't be predicted.  Like a Poisson processes, the likelihood of a tip is constant through time.

Second, humans can come up with new elements for the system.  And they do so every day.  These new elements change the system, sometimes only slightly, sometimes dramatically.  It is impossible to model this.  If we could, we could just set up such a model and let it discover new things for us.  Consider the combinatorics of thousands of new discoveries and behaviors interacting through time.

Since a volitional system can't be modelled, it can't be controlled.  i.e. the Fed is folly.

Volitional system design concepts

No system with volitional elements (people) can be deterministically designed.  When designing systems containing volitional elements, they need to 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.  

Because volitional systems are constantly changing because of their human components, the system that controls them also has to constantly change.  Think of it this way.  Things with a limited lifetime follow the sequence of birth, growth, maturation, decay, and death.  If the system isn't growing (growth implies change), it is dying.  

For a long lived system like a government or an economy, a change mechanism has to be built in.  Not so easy that chaos results, but not so difficult that stagnation (and death) results.

Control theory perspective

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.  Where people could plan with assurance for twenty or thirty years from now.  How would our current system compare to *that* system?

Part 2, New System Proposal, Thermodynamic Money

Money creation is done by an executive department, a true central bank, 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 the central bank 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 central bank creates, a fraction of which the federal government gets to spend, is determined by measuring the actual output of the economy, in thermodynamic terms. Subtract the amount of that output consumed during the month, and also subtract the amount of existing wealth lost to entropy and obsolence.  Note that this uses a thermodynamic definition of money, some sort of equivalence relation between energy and money.  Congress might define a dollar to be 100 MJoules of energy equivalent.  Then, in economic terms, a 100 MJoules invested in creating wheat is equivalent to 100 MJoules in creating steel.  Over time, as productivity improves or degenerates, the ratio will change.  What doesn't change is the measuring stick.  Under our current system, the unit we are measuring with changes every day.  Imagine what kind of house you would build if you used a tape measure that changed the size of an inch constantly.

The money thus created goes down two different paths.  The percentage that Congress has set as the tax rate is deducted immediately and given to treasury to spend for government operations.  The rest is given to a separate account at Treasury and is auctioned off to the highest registered bidder.  Those bidders may be banks, or corporations large enough to post collateral, or even individuals wealthy enough to post the collateral to bid.  They can submit multiple bids, differentiated by the amount of interest they are willing to pay, the amount they want at that interest rate, and the term of the loan.  They are really buying this money.  If they meet their contractual obligations, they own the money.  This gets the created money into circulation.

And that is the end of the financial system design.  The central bank does not try to control the economy.  That is impossible.  They don't offer incentives to encourage actions.  That is the province of Congress.  They only ensure that the amount of money existing corresponds to the amount of wealth in society.  By doing this, they create a stable foundation for economic activity.

Part 3, Consequences of New Design

There are several consequences of this way of doing things.  

1.  Interest rates are set by the market demand for money, not by dictat.  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.

2. There is no need for an income tax collection agency, since the government automatically gets its cut off the top of all production of the economy.  

3.  The government is paid for creating money and maintaining the integrity of that money.  

4.  Think of money as a token representing the physical wealth of the country.  At any given moment the amount of money that exists is equivalent to the wealth of the country, an accounting identity.  

5.  There is no inflation.  Because the value of money is fixed as a thermodynamic quantity, it is constant unless Congress explicitly changes it.  

6.  Because money is only created according to production, it is impossible to run a trade deficit.  Our money can't be devalued by another country adopting mercantilism.  

7.  If the government borrows from abroad, it has to borrow in the foreign currency.

8.  The amount of currency in circulation is always less than the amount of money in existence.

9.  Banks are only allowed to lend money that they have.  This guarantees stability.

10.  If there is no tangible result, there is no productive economic activity, and no wealth is created.  This doesn't mean that only tangible things have value for human beings, only that such value can't be transferred or used to generate wealth.

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.  The Fed tries to prevent the depressive stage by administering huge doses of lithium (printed dollars).

Part 4, Difficulties

Are there flaws in this financial sytem?  Sure, but it is about 1000% better than the financial system we have now.  

Are there theoretical difficulties?  Yes, I list a few below.

1. Government can create inflation at will, by redefining the energy equivalent of the dollar.  However, unlike the current system, such debasement is explicit, and we have direct control over the members of congress and the president every election.  No one really knows what is happening with inflation under the current system.

2. The mechanism of getting money that is created by the central bank but isn't spent by the government is imperfect.

3.  The mechanism for international trade is undeveloped.  If everyone were to adopt such a system, and utilize the same currency/energy conversion, all currencies would be constant.  If this system operated in one mixed with the current system, only balanced trade could occur.  If country A wanted to borrow money from country B, it would always have to borrow in the currency of country B, since there is no world reserve currency.  If the system of country A and B were of the new style, then it is a simple ratio for exchange.  

4.  The treatment of intangible assets is difficult.  Mostly I think this can be taken care of by determining the investment of energy that created them.  For instance, if you educate yourself to become an MBA or a PhD, there is a thermodynamic cost, and that cost yields skill and knowledge in you that has value.

5.  The main difficulty I see with the system is not with its functioning.  It is that the current system allows those with connections, those with power, to play a shell game with money to steal from those who don't have connections or power.  They will be reluctant to give that up, and will fight against the adoption of a system such as this, and try to sabotage it if it does come into being.  It is inherent in a system of thermodynamic money that you have to do something productive in order to be wealthy.  And many of those who are wealthy now don't do anything productive.  Perhaps you think that governments would want such a system.  They are actually those who steal most assiduously from others, so they will fight against such a thermodynamic money system because their machinations would be exposed for all to see.