Economy 1.0
The first economic paradigm - Economy 1.0, where buyers and sellers were physically present in the market - was decentralised but disconnected. The price of corn in one town's corn exchange would have been different to that of the next town's corn exchange, never mind corn exchanges in other regions or countries.
An intellectual battle is currently raging among economists, historians and even anthropologists in relation to whether this Economy 1.0, which existed for thousands of years, involved primitive forms of credit or whether it was based upon barter transactions.
The answer is that both mechanisms were in use. Firstly, units of currency - objects of value - which were accepted in exchange because they were perceived as a store of value which would be accepted in turn by others. Secondly, credit was routinely extended by sellers who created - in exchange for value provided - obligations by counter-parties to provide in return something of value in exchange.
Currency
Forms of currency developed which were mutually acceptable forms of value or money's worth such as standard amounts of silver and gold, but other forms of value have been generally accepted over the years from cowrie shells to copper, and from cigarettes to salt (hence the word salary).
Governments provided standardisation, so that currency became understood as a pricing reference or unit of account; and also quality control, in the case of gold and other precious metals, by assaying, weighing, and minting coins as a standard unit of currency.
Credit Instruments
The first form of credit instrument or IOU was the tally stick.
A tally stick was a wooden stick, marked with notches which recorded the value of a transaction. It was split lengthways, and part of it - the 'stock' - was given to a creditor who had provided value in exchange. The debtor retained the 'counter-stock' or 'foil', and undertook to provide value in exchange when the stock was returned to him for redemption by whoever held it - ie the bearer.
In order for 'stock' to be generally acceptable in payment, it had to be issued by a creditworthy counter-party. This would typically be a merchant of good standing (hence merchant banker), or an institution like a temple which levied tithes on the population, or a sovereign who levied and collected taxes.
Economy 2.0
The second economic paradigm, which evolved over a period of several hundred years, is the present centralised but connected economy, where transactions take place at a distance, through middlemen ie intermediaries who aim to make transaction profit and put capital at risk to do so.
The development of regional, national and international trade was driven by the growth of generally accepted and trusted currencies and documentary credits and from the Middle Ages, the innovation of double entry book-keeping and accounting.
The second great innovation was the creation of the Corporate body, which enabled productive assets to be owned over generations, and was initially developed by the Church and by municipalities - such as London's City Corporation. Such corporations eventually came to be created for commercial purposes as an enterprise agreement between individuals with a view to profit.
The first of these 'Joint Stock Companies' in which individuals shared risk collectively - but not, as with partnerships also individually - was the British East India Company in 1600 - but the Dutch East India Company was the first to issue 'Stock' to raise investment. This was a credit instrument which gave permanent rights of asset ownership and to the fruits of ownership, and which was typically divided into 'Shares' denominated in the national currency..
Private Credit
There were essentially two sources of documentary credits. Firstly, traders who deposited their bullion and coins on 'bancs' in goldsmiths' vaults for safe-keeping began to use the goldsmith's receipt as currency instead of the gold itself. The goldsmiths - realising that the gold they held was rarely withdrawn - began to create additional receipts and loan them for a period of time at interest. This essentially fraudulent practice of private credit creation formed the basis of modern-day banking, and was subject to a breakdown in confidence in the bank - 'runs on the bank' - and hence bankruptcy..
The second form of documentary credit was the issue of 'bills of exchange' by merchants, which began to be accepted by third parties through an endorsement or assignment, often many times over, before the bill of exchange found its way back to the issuer to be exchanged for value. Trust in the issuer was key.
These forms of credit enabled the flow of goods and services to take place, oiling the wheels of commerce, and were essentially based upon the capacity of people, individually and collectively to provide goods and services.
Public Credit
The historic role of public credit has been almost forgotten. From the 12th century onwards the Exchequer of UK sovereigns would pledge the sovereign's credit -against value received - through the issue of Stock which was later returned by the eventual holder in payment for taxes. The very phrase rate of return alludes to this long forgotten practice of returning Stock to the issuer for cancellation.
The important role of Stock in UK public finances may be gauged by the fact that by 1694, when the Bank of England was privately incorporated, more than £17m worth of government Stock in the form of tally sticks were still in circulation, at a time when the cost of running the government was £2m to £3m per year.
But by this time, the Exchequer had also - in order to finance public expenditure, particularly military - begun to issue Stock in documentary form. Issue of interest-bearing perpetual annuities, also known as Stock, met a need for a 'risk free' investment bearing a reasonable return. In order for interest to be paid, registers of entitlements were usually kept, although some documentary instruments carried coupons which could be detached and presented to collect payment of interest.
Privatisation Begins
The Bank of England was a private UK Joint Stock Company incorporated by Royal Charter and it began to create and provide credit on the basis of gold deposited with it. The Bank of England began to finance the UK government by purchasing its interest-bearing Stock and annuities and indeed had a monopoly on this activity.
In 1705, the remarkable Scottish gambler and adventurer, John Law, proposed in Scotland a form of money backed by land rentals, which came to nothing, but his proposal contained some remarkable insights as to the nature of money and credit. By 1716 Law had become the trusted adviser to the French Prince Regent, and after many successful economic reforms in France as Controller General he created the Banque Générale.
The credit created by this private bank created the first modern day bubble, which was not directly in land value but in the shares of the French Mississippi Company, which had a monopoly on trade in the French territories which then formed almost a third of the modern US land-mass, right up to the Canadian border.
The collapse of the Mississippi Bubble ruined the French economy, and a very similar bubble in shares of the South Sea Company, which collapsed in 1720, and had been fuelled by credit from the Bank of England, caused similar widespread ruination in the UK.
Twin Peaks
Since this time, the Twin Peaks of finance capital - investment through Joint Stock Companies and debt created by private banks - drove the development of the modern industrialised world, assisted by further innovations such as the privilege of free limited liability for Joint Stock Company investors in 1855.
In the mid 19th century a number of failures/bankruptcies of private Free Banks - who had issued their own bank notes, but were unable to provide gold when these were presented for redemption - led to the Bank of England being given a monopoly on bank note issuance, which at that time was a very significant part of credit in circulation.
A sophisticated system of wholesale and retail banking has since evolved, central to which is the relationship between the Treasury and the Central Bank, and a vast pyramid of credit was built upon a tiny base of gold.
In 1971, even the technical ability to demand gold was dispensed with, and the present day system of public and private financing and funding reached its final form, at the heart of which is a Black Hole.
A Very Secret Agent
The myth underpinning virtually all schools of economics is that the Treasury has a banking relationship with the Central Bank. The pervasive belief is that the Central Bank lends money to the Treasury and is therefore a creditor of the Treasury.
This is a myth. The Central Bank is actually the fiscal agent of the Treasury, and it creates credit on behalf of the Treasury either in note form or by crediting clearing bank accounts with new fiat currency.
The truth of this is demonstrated in the US by the fact that a few million US Treasury Notes (credit issued by the US Treasury) still circulate alongside Federal Reserve Notes (credit created by the Federal Reserve Bank) and they spend exactly the same. US Treasury Notes are to all intents and purposes modern day US paper Stock, since they are accepted by the Treasury in payment of taxes.
So what is actually going on, and it is a continuation of what the Bank of England began in 1694, is that private banks create credit on the basis of a cushion of capital specified by the Bank of International Settlements in Basel, and this credit created out of thin air is exchanged for interest-bearing Treasury debt.
In this way private bank credit - which carries an overhead of substantial salaries to management and handsome returns to shareholders - has come to replace public credit.
This reality is actually obscured by deceptive language in the balance sheets of central banks who describe both undated demand deposits - of cash held by the central bank as custodian - and dated term deposits, of cash loaned to banks at interest for a period through a sale and repurchase (Repo) agreement as liabilities. These are two completely types of liability: the first is an ownership obligation -a credit instrument - while the second is a debt obligation/instrument.
This misrepresentation leads to further myths in respect of how the system operates in reality, and these in turn feed completely mistaken economic policies and political rhetoric to justify them.
Fractional Reserve Banking
This is a myth. In the modern banking system , bank deposits are not, as most people suppose, money which is taken in and then lent out. The creation of new credit/money by private banks is no longer constrained by reserves of cash deposited with the Central Bank, since clearing banks may obtain deposits by borrowing from other banks. The only constraint on credit creation is now the capital cushion which banks must hold to cover defaults by borrowers and operating costs.
Tax and Spend
Another myth. Tax has never in 800 years in the UK been collected and then spent, and the tally stick system is the evidence.
Public spending on credit came first, and when stock was returned in payment of taxation this credit/money was retired. This is also true of all modern economies using a privatised fiscal and monetary architecture centred upon a Central Bank, but that fact has been obscured.
What actually happens is that Treasuries first spend - using central banks as fiscal agents - and then fund that expenditure through the unnecessary issue and sale of interest-bearing debt to private banks, and through taxation, which is the only way that either public or private credit may be retired and extinguished.
The truth of it is that tax-payers' money has never been anywhere near a tax-payer.
Peak Credit
In or around 2007 the financial system reached a point of Peak Credit at which the debt obligations taken on by populations exceeded their capacity to pay.
This occurred because banks began to outsource credit risk, and free their capital for further lending, to 'shadow bank' investors:
(a) Totally - through securitisation and sale of debt;
(b) Temporarily - through credit derivatives ie time limited guarantees;
(c) Partially - through credit insurance eg by AIG or Ambac;
(d) Toxic cocktails of these, such as Collateralised Debt Obligations (CDOs); CDO squared and so on
The result was a series of massive bubbles in property prices which imploded from 2007 onwards, and led to a breakdown in trust in the banking system so that banks ceased to lend to each other.
I believe that the collapse of Lehman Brothers in October 2008 will come to be seen as the definitive end of the centralised, but connected, Economy 2.0 paradigm operated by and for the profit of middlemen.
Economy 3.0
The direct, instantaneous connections of the Internet make possible direct people-based (Peer to Peer) credit relationships between individuals and direct asset-based (Peer to Asset) credit relationships between individuals and productive assets.
On the face of it, it could be expected that such dis-intermediation - which I term Napsterisation, after the music file sharing phenomenon - would be resisted by banks as credit intermediaries. But in fact, the opposite is true.
Inflation Hedging
In parallel with the credit innovation which eventually led to the point of Peak Credit and the collapse of the banking system, there has been a parallel series of innovations in new legal vehicles for investment in productive assets, involving trust law and partnership law, rather than company law.
From 1995 onwards, beginning with the Goldman Sachs Commodity Index fund, a new breed of funds was created which took on commodity risk - initially through holding long term positions in the futures markets -with a view to 'hedging inflation' and a decline in the value of commodities relative to the dollar.
From 2005 to 2008 these funds grew rapidly and began to inflate commodity market prices as producers began to lease - through sale and repurchase agreements - commodities to the funds in return for a loan in dollars. The outcome was to enable oil producers to literally monetise oil stored in the ground, in tanks or in pipelines, and the flow of dollars into funds led to the bubble and collapse in oil prices in 2008.
The Federal Reserve Bank addressed the collapse of Lehman Brothers by reducing dollar interest rates to zero, and by creating dollars which were used to buy Treasury Bills - so-called Quantitative Easing.
At this point, through 2009, the flow of inflation hedging dollars became a flood as banks queued to launch new funds and to set up the necessary support and trading operations.. Commodity and equity prices became completely detached from the underlying reality of physical production and consumption, and of flows of profits and dividends, as funds took ownership - through purchases or leases - of commodities and equities purely as an alternative to holding dollars.
Dis-intermediation
Since the credit market is essentially dead, or at least on life support, the reason banks flocked to sell funds to clients is that market risk is not with the banks, but with investors. Banks need relatively little capital to be service providers to the funds, and are able to make substantial profits in very short term trading on behalf of the funds.
The banks have knowledge in respect of the ownership of market inventory which is not known to other market participants. These are the merchants who buy and sell physical commodities, and speculative financial traders such as hedge funds or even risk-taking individual investors, who attempt to make transaction profit. Through such information asymmetry, and the use of new trading tools such as High Frequency Trading which provide often dubious liquidity, high profits may be made on minimal capital.
The Adjacent Possible
The point is that - as capital became scarce after October 2008 - banks evolved their business model to the adjacent possible of marketing and operating new quasi-equity instruments. They transitioned from an intermediary role to a service provider role because it was and is profitable to do so.
But these instruments, and the presence in the markets of investors who aim to avoid loss rather than make profits, have now led to what are essentially two tier and false markets.
In my home turf of the oil market, all the signs are that in the absence of massive new flows of QE dollars from the Fed, and/or substantial cuts in oil production, especially from OPEC, there will be a collapse in oil market prices in the first quarter of 2012. Indeed, some market participants have already taken option positions in the oil market in anticipation (or in fear) of a fall in the oil price as low as $45 per barrel in 2012.
The coming collapse in commodity prices will lead to the next great regulatory scandal of mis-selling, when the risk averse investors who bought these funds from the banks make massive market losses to which they never realised they were exposed.
At that point the way will be open to go Back to the Future - to the next adjacent possible - which is direct people-based credit and direct asset-based credit.
P & I Clubs
People-based credit is not the direct Peer to Peer interest-bearing credit provided by companies such as Zopa. Instead, trade credit is extended directly from trade sellers to trade buyers, within the kind of mutual risk sharing agreements which have existed for thousands of years. To this day, mutual 'P & I Club' insurance of shipping and other risks still takes place in the City of London, and these mutual Clubs have been managed by the same service provider for 135 years.
In a mutual 'credit clearing' system within a P & I Club risk sharing agreement - or Guarantee Society - buyers and sellers would pay no interest on credit but would pay for the use of the system, and would also pay a guarantee charge or provision into a pool in common ownership to guard against defaults.
21st Century Stock
21st century issues of Stock will enable direct credit creation not only for short term/high risk development financing but also when productive assets are complete, for long term/low risk funding.
Owners of productive assets simply create and issue undated credits/units which are redeemable in payment for the use of the asset. For example $1.00's worth of rental revenues pre-sold for 80c will give an absolute return of 25%, but the rate of return depends - literally - upon the rate at which units of Stock may be returned to the issuer and redeemed against use.
Instead of debt fragmented by date and rate of interest, there will simply be single classes of Stock, and even if financial investors do not buy Stock for investment, users of productive assets such as occupiers will always buy Stock at a price less than face value in order to redeem it against use.
The fact that the issuance of Stock is as possible for assets in public ownership as it is in respect of assets in private ownership opens up simple but radical new options for public financing and funding.
Open Capital
Stock may in fact be seen as currency sold forward at a wholesale discount, and I think of such undated credit as open capital, to distinguish it from closed and proprietary forms of debt and equity finance capital.
My vision of a 21st century Open Capitalism is of new forms of stock based upon land rentals which will come to be what are essentially networked land-based national currencies created literally from the ground up.
Other forms of stock, some locally acceptable, others internationally, will be based upon the intrinsic value of energy, such as stock redeemable in payment for carbon fuels; electricity, and even heat.
These currencies will change hands 'Peer to Peer' against goods and services with the backing of a mutual guarantee based upon the capacity of individuals to provide such goods and services.
Finally, the reference point or pricing benchmark against which transactions will be made will logically be an absolute amount of energy, and the global economy will go onto an Energy Standard for exchange, thereby enabling the transition to a low carbon economy.
(Published by kind permission of Asia Times)
