Terms Matter

Terms matter. We all know that –but that knowledge is stored behind our brains. When it comes to day-to-day communication we quite often choose to not use that knowledge.

I was recently reminded of this when my doctor gave me a prescription of antibiotics. At the end of the consultation he urged me to finish the course because otherwise I would help strengthen [sic] the bacteria and aid in the evolution of new species of drug resistant bacteria.

Now, doctors are supposed to be professionals. They study basic genetics in medical school (unless they specialize in genetics –in which case they study advanced genetics) and hence they shouldn’t go about making such statements. Drugs do not make bacteria stronger –they kill them or at least try to. What he instead should be saying, given his academic background, is that if I don’t finish the course I would aid in the “selection” of drug resistant bacteria. Now that makes more sense and is the right thing to say as well.

Going on, what do you say when you see a car crashed on a highway? I have seen police in many countries labelling it as an accident. The [London] Metropolitan Police Service is to be admired here because they recommend that officers on duty call such events a “collision” until investigation is complete and the cause of the crash determined. Why do they insist so? Because an accident implies that the crash happened because of some unfortunate random error –example a crane collapsed on the car or suddenly one of the tires got punctured. But by labelling it a “collision” they mean that they have not ruled out the possibility of a forced error (someone drugging the driver; shooting the driver; someone intentionally disabling the steering wheel; drunken driving etc.).

There are countless such examples of bad terms that come out of us naturally (mostly due to a habit or because we just happen to copy others around us). My point is not to enlist all such errors here but to share with you the thought that most of the times such errors seem harmless but in the minds of those who do not specialize in the field they help plant wrong notions and hence can be dangerous. If all of us avoid using wrong terms in our fields of specialization then the world would be a slightly better place.

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The ECB Nuclear Deterrent

Last week the ECB released a press statement declaring its commitment to back the EuroZone debt with potentially infinite monetary assistance for up to three years. It says:

No ex ante quantitative limits are set on the size of Outright Monetary Transactions.

In simpler words, it shall, if necessary, print more money and buy the sovereign bonds of these countries that mature between one and three years.

But there are conditions for this assistance. The recipient countries must stick to the “macroeconomic adjustment programme” –in other words Brussels gets to dictate how these countries run their economies.

The markets cheered –the Euro appreciated, EU borrowing costs plummeted, and the banking sector globally saw a share rally. When Ms. Merkel said roughly the same thing they didn’t. And there is a sound reason to explain that difference. Germany, for all its economic weight in the EuroZone pie, cannot print more money and buy bonds indefinitely. The ECB on the other hand can.

But I think it does not make a real difference. And here are three major reasons why:

1. The Franco-German austerity measures have just assumed a different name –the “macroeconomic adjustment programme“. A foreign creditor still gets to say what a debtor country can do or should do. Many EuroZone countries had a problem with the first form and will definitely have a problem with the second form. The voters in those countries won’t care who tells their country to shut down a school –to them it is the same thing. And hence, the governments of these debtor countries will still be under immense pressure to adjust their macroeconomy.

2. The ECB’s firepower, despite what the ECB says, is not infinite. It is limited although not in the same way as Germany’s. When the ECB prints all that money to buy those bonds it will stoke inflation –at least in the short term. One of ECB’s mandate is to check the EuroZone inflation. Surely it cannot go on printing money forever. Even if it does, more money will simply mean that other creditors will want to buy  bonds of other EuroZone countries (that are not receiving the said assistance and are probably doing great on their own) at a lower price –to account for this inflation risk –thereby increasing the borrowing cost for the entire Eurozone. And even if no one else buys those bonds we will anyway see the single currency fall in the international markets if inflation rises.

As I have previously argued, inflation is not a risk if these countries produce the matching wealth to those bonds. It therefore appears that either the ECB is under pressure to calm the markets in the short term or it has a well placed confidence in the ability of other EuroZone countries to generate that wealth using the integrated single market.

3. The moral hazard factor is still there. The ECB plan is to print more money and buy the bonds of countries that are struggling. As I argued in point 2, this plan relies on the success of at least some EuroZone countries (including perhaps even the struggling countries) to generate that wealth. This can, and I think will, be seen as redistributing the money. True enough this problem lies with all large sized economies –some poor states in India/U.S. for example receive central assistance at the expense of  richer states. But whereas India or U.S. very rarely discussed separation the EU is currently discussing it and has been discussing it for a while. The risk of this factor becoming a deterrent to the ECB’s efforts will be visible in the upcoming elections in the Netherlands and Germany.

The ECB has definitely made a strong commitment to save the Euro. Sometimes all one needs is a nuclear deterrent. Perhaps it won’t come to using its nuclear option of printing more money. The current holders of the EuroZone bonds may see this deterrent as a safeguard and hold on to these bonds. It is all about perception anyways.

But all this rests precariously on the factors I have enumerated above. A small sell movement by someone who acts on these factors could increase the perception of the markets that perhaps the nukes will be launched. That can turn that small sell movement into a big one and bring us back to square one. And that is why I think this plan is insufficient and mainly a political move by the ECB (in light of perhaps the German economic slowdown).

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Link Share: History stack exchange

While I have been pretty lazy at posting new blog entries I have been active at the history stack exchange. I’ll like to share some interesting posts from that website. I will split them in two categories:

Not answered by me

Why did Britain not purchase Alaska?
Where did the Romans store their cash?
Poofy pants in the military.
Oldest building still in use.

Answered by me

The Cost and Benefits of hosting Olympics.
Why is the Queen’s husband not referred to as the King?
King Henry VIII and his troubles with the Catholic church.
British Industrialization.
Iranian Revolution of 1979.

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Debt, money, and the system -part 2

Continued from Debt, money, and the system -part 1

Section 5: The role of government as the ultimate creditor

For better or for worse, the government does not directly loan out money to entrepreneurs such as the one I described in section 1. Government allows you to be a creditor too and enforces a court system protecting your rights as a creditor while at the same time limits what you are entitled to in case your debtor defaults. Some of these creditors will ultimately make it a business to extend credit to such entrepreneurs. They would specialize in assessing the credit quality of the debtor and should be responsible for any miscalculations on their side. But where would they get the money to loan out? The government with its huge mints and deep treasury sure has enough money to take such risks. But how would a small enterprise manage to issue such loans in the absence of such powers? They can start to fund these loans by accepting deposits. But if the amount of money they were allowed to loan out were in any way to be limited by the amount they have as deposits, we will return to the condition as described in section 1 (zero sum game). Remember, it is pertinent that money be created ahead of the wealth that has been created.

That is chiefly why the government allows these enterprises to create loans out of thin air. This saves the government from the troubles of assessing all the debtor’s credit history, determining each project’s sustainability, foreclosing the bad debts, minting the abstract money, buying services or goods from the system and destroying it when the debt is paid. Instead, it just monitors a handful of such enterprises and only performs the aforementioned activities for them. It is the labour pyramid approach to solve this huge problem in a big economic system.

So in summary, here is the picture we have. The government authorizes some enterprises to accept deposits and issue debt (abstract money) to other participants in the economy. The enterprises can back all this debt by the deposits they have but if they run out of these deposits, the government will have to back them up –they are supposed to be doing the government’s job after all. But what if these enterprises get it wrong? What if they start issuing debt to unworthy people or worst their friends? Therefore, the government imposes restrictions on how much debt these enterprises can issue. This limit is called the fractional reserve limit (as is explained in the video I mentioned at the start of the post). It also enforces strict guidelines on how these enterprises can and cannot issue debt and how these enterprises can ensure their own solvency. Examples of such restrictions range from capital reserves to leverage limits. If the latter restrictions are not strong and sound an economic system can end up in the same state as most advanced economies ended in after the sub-prime crisis of 2007.

So far I have simply explained some problems that any economy faces and have attempted to shed light on some of the concepts important to my actual argument. I will now deal with the problem of perpetual debt and of interest.

The problem of perpetual debt

The documentary that I mentioned in my last post shows debt as an ever hungry monster chasing the globe that has limited supply of food. The monster of course eats money (debt repayment) and the food that the globe has is, I guess, the wealth of the world. This is where the documentary gets it wrong –the wealth in the world is not limited. It is constantly being created in the shape of goods and services we all produce. As I explained in my last post, without creating an equivalent amount of money to back the created wealth, the wealth would become worthless and a burden to the society.

In summary, it is not at all true that the debt is perpetual.

The problem of interest

Ever since ancient times, interest has been seen as a wicked cunning plot by the rich to get more money from the poor. Ancient societies created usury laws and religions prohibited the practice. The documentary also goes on the same lines and portrays interest as a monster, which is again a very wrong portrayal. Let us see the picture from the creditor’s point of view.

Let’s say you have the ability to loan €1,000. You have two choices –you can invest it in your own enterprise and in one year from now you will get €1,000 from that enterprise. Will you invest it? Even if there were no inflation and no interest in the world, the enterprise would spend time but would leave you with the same wealth. Unless you are an immortal elf and have 0 value for time, you will not choose to invest in this enterprise.

Let’s say you do that anyway. What would happen if another opportunity were to present itself in 3 months time or 6 months time and require €500 then and give €1,000 1 year hence? You would not be left in a position to invest in that opportunity if you had invested in the first one. Would you rather not be compensated for this risk?

And what if, in the beginning, you had two alternatives for investment. Project A that takes in €1,000 now and gives €1,000 one year hence and project B that takes in €1,000 now and gives €1,500 one year hence. Which one looks better? And does anyone look better than the scenario where an opportunity may present itself 6 months hence, require €500 then and give back €1,000 6 months later?

That is chiefly why the creditor charges a certain fee when she lends you money –that is her compensation for the risk she takes when she lends you money. As in our previous scenarios, your project should create enough wealth to pay back both the loan and the interest. If your project does not create the interest amount then it is a loss to the economy (see section 4).

Conclusion

It is true that financial institutions create money before the wealth is created but that is necessary to promote risk taking, in the absence of which the economy shall grow very slowly and the wealth will only come to those who command it in the first place. Too much lending on the other hand will create a problem of its own as every member of the society, whether skilled or not, shall gladly take the risks and may fail and reduce the size of the economy. The interest is a compensation for choosing between available options and foregoing other future endeavours. The way forward for any system is to access its participants for what they are worth and lend accordingly. Remember, wealth is created by the people and not by governments.

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Harry Potter and the worst movie

Spoiler warning: I will discuss the plot of Harry Potter and the Deathly Hallows Part 2 below. Even if you have read all the books, the spoiler applies (as you will see for yourself).

I confess that I made a mistake years ago. I had claimed that they could never make a movie worse than Harry Potter and the Order of Phoenix. After having seen the Deathly Hallows Part 2, I now transfer the honour to the last movie in the series. My main problem with the whole Harry Potter movie franchise is not that they don’t film every little detail mentioned in the novels but that they take too much liberty with the main story. For example, I hated when McGonagall (instead of Binns) told the students about the Chamber of Secrets. I hated it when they skipped the many journeys that Dumbledore and Harry made to Riddle’s past in the sixth movie. You must be wondering why I even watch these movies if I have so many complains. Well folks, you hate somethings but you have to do them anyway. For some people it is going to work everyday, for some it is buying grocery, for some it is cleaning the apartment on a holiday. For me watching these movies is one of those things.

I sincerely hope that someday a better director will have a go at these books and compile an epic out of it. Meanwhile, we will have to live with this pathetic attempt at a screenplay of a fantastic story that unfortunately, because of people such as myself, is a blockbuster hit.

I enumerate my main problems with this movie below (major in red, minor in blue):

  • Not every movie looks good in 3D. Especially if 90% of it is filmed in the night. If you want to watch this movie, go watch the 2D movie –however be warned, the plot sucks in the 2D version as well.
  • Dear directors and script writers, some conversations from the book can be left out because they don’t add to the story. But some should not be left out. Harry’s final conversation with Dumbledore at the King’s cross station is one of them. It was the most crucial bit of plot element. It is through that conversation that Harry figures out what the hallows are and why he should never have them. The latter was in fact never mentioned in the whole movie but is the most crucial point in the whole story –Harry is the master of the hallows because he knows why he understand how to use them for good.
  • Another such conversation is the one Lord Voldemort and Harry have just before they duel for the last time. Here, Harry addresses him fearlessly and explains why Lord Voldemort’s magic is not working for him. That bit was never made clear at all.
  • A lot of people whom I know and who didn’t read the books watched the movie and wondered why Dumbledore had to die at all. It is not clear from the movie that Dumbledore was himself interested in the hallows and that it was under the spell of that very obsession that he ended up being cursed. This is also an important part in the story –why Dumbledore just didn’t give Harry all the details to begin with.
  • Harry cannot duel Lord Voldemort. Lord Voldemort, although a dark character and evil, is vastly more talented than Harry. But let’s assume that they can duel. Now, if the Elder wand belongs to Harry, it would serve him from the first duel itself. It won’t, for example, wait for the climax conveniently.
  • How exactly do you explain how Harry is able to find all the horcruxes? Yes, there is the connection between him and Lord Voldemort and that is what the story writers used so liberally. But he also has a very good idea of what to look for. Remember all those scenes you didn’t film in the sixth movie where Dumbledore and Harry venture through Riddle’s past? They held the key. The lessons that Harry drew from those ventures eventually guide Harry, Ron, and Hermione through this quest.
  • No you cannot hear a horcrux. And no, you don’t feel a thing when your horcruxis is destroyed. Remember, a horcrux is the exact opposite of a living being. It is in an inanimate object, disconnected from you.
  • Harry does not talk to Hermione and Ron when he leaves for the forest. He arrives there in his cloak –the cloak in fact was never used in the whole battle when in fact Harry used it so effectively in the main story. Also, it is one of the hallows. Given the movie’s title, hallows should have been given more prominence than horcruxes.
  • You cannot block Avada Kedavara. Even when Goyle casts it and Hermione is the one blocking it.
  • The horcrux in Ravenclaw’s lost diadem is destroyed by Goyle not Ron.
  • Lord Voldemort was not an idiot. He had put Nagini in a protective cage. He most certainly did not let Nagini lose as is shown in the movie. You don’t need special magic to destroy horcruxes that are hidden in a living object (chiefly the main reason you should never make a living being your horcrux). It was that protective cage that needed to be destroyed using Griffindor’s sword. The snake itself could have been killed by any means available once it was outside that protection.
  • Ollivander had no idea of the hallows at all. He just knew about the Elder wand.
  • Harry did not roam around Hogwarts talking about horcruxes with everyone. He was very clear when he spoke to others regarding what to reveal and what to keep concealed.

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Debt, money, and the system -part 1

This is a two-part article in response to this video. Before reading these posts, please go and watch that video. It explains the fractional reserve system without using much jargon and highlights some alleged problems with that system.

Objective

I write these posts with an aim to defend the fractional reserve system as it stands today. While I do believe that not all of it is perfect, I do believe that a complete overhaul of the system is unnecessary and that the video over dramatizes the issue.

Clarifications and notes on terminology followed

Wealth and money: I am treating money as different from wealth. Wealth in my post would mean any additional goods or services produced from raw, and otherwise unusable, materials available in nature. Creation of goods or services of zero demand would result in no wealth creation. Money these days has become synonymous with currency. In my post, by money I mean an abstract or real object that can be bartered for goods and services. Thus, money also has an extrinsic value determined by the market.

Enterprise: Any economic activity that seeks wealth creation is an enterprise by my definition. And because it seeks wealth creation it has to aim to produce more resources by consuming fewer resources (less and more measured by the demand in the society). Even your day to day office work will fall under this category. Ultimately you consume oxygen, water, food, entertainment, etc. and charge yourself to work the next day and transform these raw materials into presentations, tractors, flour, clean gardens, cooked food, sold pizzas, blog posts, iPad applications, bank spreadsheets or whatever else your trade demands you to produce.

Section 1: Why create money before wealth?

Let’ say there was no fractional reserve banking system in your society. All money would then eventually come from either the government mint (henceforth, the mint) or through someone else. The government mint in such a scenario would mint the money to account for the wealth that has been created. How it figures out the value of the wealth created will be discussed in section 3. And why it needs to be would be discussed in section 2. For now let us examine why it needs to create money even before the economic activity has begun.

Say you are a poor but talented entrepreneur and you come up with an idea of producing electricity from your local spring. You estimate that this project, when completed, would allow your society to create more wealth. But to begin this project you need to raise some capital. Consider the extreme scenario where even if everyone emptied their pockets you would not get enough capital to fund this project. Therefore, if the government does not mint more money and loans it to you, your project would never start and the net result would be a possible loss to the society. Therefore, for the society’s good, the government would have to intervene and mint more money. In a more practical example, the society will have enough money but it will come at a cost in terms of foregone opportunity. The best way to avoid such a loss of opportunity would be to conjure money out of thin air and to return it back to thin air when it has served its purpose.

Regardless of how the government determines the amount of money to mint, this process would create additional money before the wealth would be created. Because this money has to be conjured from thin air it needs to be abstract –meaning that its nominal value (market value) should be greater than its real value. For example, the cost incurred to mint a €1 coin should be less than €1. If it were not, then the mint would simply be playing a zero sum game with the society and our objective won’t be met. You would of course be obliged to pay back to the government. But at least you will get started with your enterprise.

This idea is essential to equal opportunity –skilled or talented people should not be left behind just because they have no resources or capital to command.

You would pay the government back when your project generates sufficient money for you. In an ideal scenario, the government should then destroy this money and thus bring the abstract money amount back to zero. But in practice, it would instead put this money in a reserve and would bring it out again when it runs, once again, into a similar situation. Note that the net effect of this approach would the same as destroying that money now and minting new money when the need arises.

The other scenario would be if your project fails. In this case, the abstract money would have been consumed in the form of services or goods to no effect. You will default in this case. I will revisit this point in more detail in section 4. For now, I have given arguments for why money needs to be created before the wealth itself has been created.

Section 2: Distributing the created wealth

Suppose you succeed with your project and your customers do create goods and services using the electricity that your plant produces. How do we know they have created wealth? First and foremost, whatever they create should be in demand by the society. But of course, whenever someone will pay for the goods or services produced by your customers they will have to forego some other good or service. It is easy to see that this demand cannot be internally met with the existing money in the system because there is a surplus of wealth. If it were to be met internally it would mean that something else dropped in value (lost demand) –thereby bringing the net wealth created by the activity to zero. In short, the government needs to mint an equivalent amount of money (note that by our definition, money is abstract) to account for this surplus wealth. How it determines this amount is very critical and will be discussed in section 3.

The question then becomes to whom should the government give this money? May be it has no need for the goods and services that were actually produced in which case it would have no reason to give money to the person who produced them. But for the money to trickle fairly into the system the government would ultimately have to purchase some goods or services from the society. Thus, the government in this case would always be external to the society. That, by the way, is why government spending is so critical in sustaining the economic growth. The spending is usually for a common cause such as national defence. Government spending is not a magical bullet to solve all growth problems –the society has to take the first step by creating this wealth.

But what if your customers fail to produce any wealth? Then your project though successful in implementation would fail in its end result of being beneficial to the society. Whether it fails at the implementation stage or at the consumption stage would be immaterial. The net effect would be a loss to the society. I will revisit this further in section 4. In summary, I have argued that any wealth creation has to be backed by an increase in the money supply.

Section 3: How much money? Who decides?

Now to the critical question I’ve avoided so far. How much money should the government mint out? Who decides the fair value of the new wealth? It is essential to determine the price because that will ultimately guide government spending. If your society were an island of 1000 people, the government might have no problem monitoring every economic activity and determining the amount of money to mint. However, most modern societies are simply too large for this model to succeed. Take the case of United States with millions of people under its boundaries or India where there are billions of people going about their daily lives. An extreme example is the EU where multiple countries are served by a single central bank. The government could in theory appoint several agencies tomonitor a certain geographical region and report the economic activity in that region. The government could then compile all this data and determine the amount of money to mint.

However, there are cheaper alternatives to this. A free market approach would be to let the people in the society determine the price for their own consumption. The government would intervene at a stage when it shall become necessary to pump more money into the system or take some out of it. This could be monitored by the price index of key items in the economy. In this scenario, the government would not mint the money as soon as the wealth would be created. Rather, it would observe the demand for this money.

Let’s again go back to our example. Consider that your project succeeded and your customers were able to create additional goods or services which were in high demand in your society (thus, they created wealth). In such cases, the demand for something else would ultimately have to fall because the net money in the system would not have yet increased. This existing demanding could be monitored by monitoring the market price of that good or service and more money could be minted and introduced into the system. Conversely, if the project failed, it would have consumed raw material that could have otherwise been used in a successful enterprise. This therefore would drive the prices of something in the economy up. That something may not be the raw material in question. In this case, the government would have to step in to take some money out of the system.

Section 4: Why is it necessary to take money out of the system?

If either the project fails or if the customers fail to create wealth (that is they have consumed something from the society but have not given anything back), the price of something else will ultimately rise. This point is important so allow me to illustrate it with the following examples.

Consider that a customer has decided to convert wood, stone, sand and clay into houses using that electricity. She shall consume all these materials from the society, driving their prices up. But in return she would have produced a house of zero net worth (net demand). And thus, the society would be left with little material for use in other endeavours (foregone goods). Assume further that the demand for wood was met for by foregoing furniture. Then the price of furniture would rise and the price of wood itself would remain at more-or-less the previous levels. The point I am trying to illustrate is that it does not matter price of which good or service would rise. The point is that something in the system will become dearer.

Regardless of what prices rise the situation is that you have extra abstract money in your system and even lesser wealth to back it up. Therefore, the government needs to take some money out of the system and restore economic equilibrium. This is a logical conclusion of the failure of the enterprise –a net shrinkage of the economy. What happens when an economy keeps consuming raw materials but does not create wealth? Well of course, it goes bust. A great example would be a fictitious society that instead of turning wood into furniture simply burns it down.

Summary

To summarize, I have argued why a society needs to create abstract money to support enterprises and economic growth. I have argued why the government needs to spend and what happens when it does not. I have also argued as to what governments should do when enterprises fail or succeed.

In the next part, I shall build upon these arguments and tackle the questions and concerns raised in the video. The next part will go public on 9th August 2011.

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The Etymology of Interrogatives

This started from a post on stackexchange. I strongly suggest that you read the high quality answers there. They are very informative. I and my friends then compiled the following table of interrogatives. To make the comparison easier languages that are more closely related to one another than they are to the rest in the table are given the same row colour.

What we want to show below is that all PIE (proto-Indo-European) languages have a recurring consonant in these words –w in English and German, kyā/que in the SlavicRomantic, and Indic languages. Grimm’s law seeks to explain this observed difference between the Germanic languages and the rest of the PIE languages. Chinese on the other hand stands out altogether. But you can observe a pattern there as well.

I am convinced that this branching from the root interrogatives began at different times for different cultures (perhaps because they realized the ambiguity or perhaps because they sought to mark the difference). The context resolution mechanism in the considered language could have played a big part in this branching.

Here is the table for your examination:

English what why where who when
German was warum wo wer wann
Russian Что (chto) Почему(pochemu) Где/которого кто когда
French que pourquoi là que/où qui quand/où
Spanish qué por qué que que cuando
Italian che perché cui che quando
Hindi kya kyon kidhar kaun kab
Konkani kasane kasale khai koun kena
Chinese shénme wèishéme qízhōng shuí dāng

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