What is money?

Submitted by wake the roach on 04/09/2010 06:44 -0500

The General Discussion Forum

We all know that money acts as a store of value, a medium of exchange, a unit of account and that trust in moneys value in exchange for goods and services is paramount.

Here is the $64000 question. Given that the vast majority of money used today is fiat, and therefore is generally considered to have no actual claim on any limited physical resource, why is it that throughout recorded history, we have always hit some invisible wall of debt.

If the fiat money we know today was backed by nothing and knows no objective physical limits, we should be able to continue on a merry 3% inflation rate, and simply hack some zeros from a monetary units numeric face value every 50 years or so right?

A monetary unit represents a claim on energy.

A monetary unit represents a claim on energy. Energy humans can neither identify or quantify with our physical sense’s without a unit of account to represent it. A monetary unit entitles its owner to a quantity of energy that can be utilized from available energy resources.

A monetary units energy value (purchasing power) is determined by the sum total of energy consumed from energy resources in an economy (including food energy) at any given point in time (scarcity).

Every resource or product of limited supply mankind either needs or desires requires energy to extract, produce or consume and thus money as a unit of account is required to enable fair exchange of energy value.

From hunter gatherers with simple torque multiplying hand tools. To agriculture and food energy surplus. Utilizing animal muscle power to coal and the steam engine. Oil and internal combustion, turbine and rocket engines. And finally nuclear power with many other sources in between, the story of man and money cannot be told without understanding net energy gains.

Net energy gains.

A net energy gain is expending less energy to acquire another source of energy than is contained in the source to be consumed.

All natural resources or products we grow and manufacture, are given value by how much energy is required for extraction or production, and once it reaches the consumer of course, good old supply and demand.

For example, if we can extract one hundred barrels of oil for every one barrel of oil equivalent of energy consumed in the process, we make a net energy gain and therefore, as money represents a claim on a given unit of energy, we have created a monetary profit.

But what happens when we can only extract one barrel of oil for every barrel of oil equivalent energy used? No net energy gains and yep you guessed it, no monetary profits.

The same rules apply to mining gold, logging timber or producing Gucci handbags, corvette roadsters and big Macs. What we refer to as making a profit, is nothing more than making a net energy gain, when we pay for a product, we are transferring our energy claim to the seller.

Human labor is the conversion of food resource energy into net energy gains. If a machine has replaced human labor at any mechanical work, it is simply because a machines labor is more energy efficient (produces greater net energy gains therefore greater monetary profit), than is required to feed, house, clothe and purchase all other goods and services a human laborer either needs and desires.

Is it merely a coincidence that wage arbitrage takes place in nations that consume less energy per capita than the nation in which those goods are consumed? Or that nations with low per capita energy consumption always have a lower valued currency? Wage arbitrage or mechanizing human labor is simply net energy gains at work within a nation that cannot increase its energy resource consumption (without driving prices higher that would result in the loss of energy value per monetary unit).

Money represents a claim on energy, the more one begins to think in terms of energy, the more obvious this will become.

The beginning.

Food was the original and always will be the primary currency. Food is the only energy resource humans can consume that allows us to perform mechanical work.

Food in all its varied currencies (beef, potato, mango) is given its value by each food currencies energy content and availability to be consumed at any point in time (scarcity). Of course, a food currency’s nutrient content also determines its value but that is secondary to its energy content as without energy, nutrients cannot be metabolized.

Man as a hunter gatherer, needed to expend less energy in acquiring food energy resources than he gained once the resource was consumed.

For homo sapiens and all animals alike, this is the most basic net energy gain required for survival, it is wealth in its most primitive form.

When mankind discovered agriculture, the cultivation and domestication of animals, it now allowed us to further increase energy surplus or “net energy gains” and thus the requirement for a unit of account to allocate this energy surplus came into being. Money was born, but as we have all come so far from the early days of agriculture, we have forgotten that it is energy that gives money its value.

Today our primary source of net energy gains is hydrocarbon resources, coal, natural gas and of most relevance to our present economic situation today, crude oil. There is not a product or service humans can manufacture or provide that is not dependent upon our ability to utilize energy resources for net energy gains, 86% of that energy being provided directly by hydrocarbon resources and being of finite supply, sustainable consumption is obviously mathematically impossible.

Oil.

I don’t need to describe how fundamental oil resource energy is to our global economy. Oil makes up 40% of energy resource GDP expenditure in the United States, oil therefore makes up 40% of each dollars energy value and purchasing power but because of oils incredible energy density and the need for oil resource energy for the production of coal, natural gas and food resources in the huge quantities our economies have come to rely upon, the value of oil increases dramatically. Modern agriculture is essentially the conversion of oil resource energy, through mechanical work, into food resource energy. We are so dependent upon oils derivatives that it is no stretch of the imagination to say that our lives have come to depend upon it and given its finite supply, I hope that fact is just a little bit frightening. Even generating nuclear power is dependant upon hydrocarbon resource energy, just like coal or natural gas fired electricity production is so dependent upon oil.

It had taken 72000 years for the worlds population to grow from zero to just under 1 billion people (homo sapiens) in the year 1800.

In a little over 200 years, according to the IMF, that population has ballooned to over 6.6 billion and counting. It may seem ridiculous to mention, but the slow population growth rate in mans first 72000 years was not due to mans inability to find a suitable monetary unit of account but rather it was mans inability to produce the required net energy gains.

As this incredible energy fueled population continues to grow, we are fast approaching peak oil in all liquids, that is the point where we can no longer increase the rate of production but placing a time frame on peak production misses the point completely. If supply does not meet demand, prices rise.

When the price of energy rises to the point where consumer demand drops, economic activity and thus GDP falls with it.

Energy recessions and the economic cycle.

It is my personal opinion that what we refer to as economic (business) cycles can be fully explained by understanding that money is nothing more than a claim on energy. It always has been, and it always will be. We must recognize money as having its value determined by the sum of the energy consumed in an economy at any given time and nothing else.

When energy resources are in high supply, and thus consumption can be increased, we may state that prices are low or affordable. And when energy resources are in low supply and consumption decreases, we may state that prices are high or unaffordable. These are both misleading statements.

When energy resources are consumed at higher rates, monetary units now have a higher energy unit value. The higher the energy unit value, the more work each monetary unit can do and thus, increased purchasing power. When consumption of energy resources decreases, each monetary units energy unit value decreases with it.. The lower the energy unit value, the less work each monetary unit can do and thus, decreased purchasing power.

Now lower or higher than what exactly, what is the equilibrium point?

I believe that energy equilibrium within an economy is the point when growth in the credit supply becomes stagnant but at which positive economic activity is sufficient to service the debt liabilities within the economy. An economies GDP is therefore sufficient to service the debt within the system or in other words, the ratio of monetary units to energy units is at equilibrium.

But of course, the supply of credit will always precede the increased consumption in energy resources needed to maintain energy equilibrium once a nations energy resource spare capacity has been utilized. And this is, in my opinion, the cause of economic cycles. You cannot consume energy you do not have correct? I believe that requires no further explanation.

But, when it comes to fractional reserve banking, the subjective economic laws of mans creation come into direct conflict with the physical laws of our universe. And it goes without saying, the physical and mathematical constants of our universe cannot be overruled by even the most religious economists.

When monetary units are created in an economy through fractional reserve banking and the money multiplier, this dilutes the energy value of the total monetary supply and thus, the money supplies energy value falls below the point of equilibrium. Now this is not a problem when the energy supply available to market can be increased within a reasonable time frame and just as importantly, at a price that does not further lower the monetary units energy value. Mild inflation may become evident. However, if energy supply and consumption cannot be increased to meet demand and energy prices rise to the point that further decreases energy consumption and therefore each monetary units energy value, purchasing power declines and economic activity and demand for credit, goods and services begin to fall.

What has actually taken place is that the energy denominator (supply) has decreased and thus each monetary units claim on energy has decreased.

This requires more monetary units to purchase goods and services that required energy to produce and thus it appears to be monetary inflation. So given that higher energy prices have reduced demand for goods and services economic growth slows, and with it, the demand for credit.

This appears to be monetary deflation so in response, central banks cut interest rates that only further increase the problem, that is, that there is already an oversupply of monetary units relative to energy units being consumed and each monetary units energy value has fallen below the point of equilibrium. What lowering interest rates after an increase in the price of energy does do however, is make credit more affordable for the “financial economy“. And as we are all to aware, this cheap money leads to high risk leveraged investments and asset bubbles, the biggest of all occurring in real-estate.

And here is the kicker.

When we allow credit money to be used to purchase real-estate the problems become extremely aggravated. This is because the land that the infrastructure is built upon requires no capital input (energy consumption) to produce, other than say, clearing of vegetation, leveling etc. Land is natural capital formed by energy man cannot utilize so obviously, we cannot manufacture it. When we allow credit to drive the price of land beyond the point at which it can be purchased through real savings (money with an energy value at equilibrium), the real energy this credit “represents” becomes completely unproductive. The banks that loan credit for the purchase of land are the only beneficiaries of this practice and as this “fake money” represents a claim on real energy consumption, the base moneys supply is devalued of its energy claim, i.e. Those with savings have their moneys purchasing power stolen to fund the recipients of bank credit.

Allowing credit money to be used for the purchase of natural capital can only be called what it truly is, theft. Using any other word to describe this act is an insult.

This is how I now define some well known economic terms relative to energy.

Inflation.

Inflation is the decrease in energy value of the total money supply. This occurs when the ratio of monetary units increases relative to the consumption of energy units within an economy.

Deflation.

Deflation is also the decrease in energy value of the total monetary supply. However, this occurs when consumption of energy units in an economy decreases relative to the supply of monetary units.

Stagflation.

Stagflation occurs when the price of goods and services increase in an economy but at the same time, the economy is experiencing a high rate of unemployment.

I believe a more appropriate definition is that stagflation is when the energy value of an economies total monetary supply has fallen below the point of equilibrium. This decreases the purchasing power of each monetary unit, causing the price of goods and services to rise and thus, economic activity becomes stagnant or decreases leading to a high rate of unemployment.

Stagflation can occur as a result of either inflation or deflation as they both decrease the energy value of the total money supply below the point of equilibrium. This causes economic activity to decrease and thus, energy consumption decreases further devaluing each monetary units claim on energy. Stagflation occurs when efforts are made to artificially “stimulate” economic activity. What is really being attempted however, is to increase energy consumption which can only occur with increased economic activity. Remember, increasing energy consumption increases the monetary supply’s energy value (purchasing power). However, economic “stimulus” can only be achieved by increasing the total monetary supply which will only further aggravate the problem unless the increased money supply can be directed into economic activity that can successfully produce net energy gains at a sufficient rate to make up for the monetary supply’s lost energy value.

Where are we today and where are we going?

Today, global demand for oil far exceeds what production rates can possibly meet.

But it is more accurate to say;

Oil production cannot be increased to a rate that reduces price in developed nations to a point of equilibrium that would allow economic growth. Economic growth is needed to create demand for credit and demand for credit is needed to fund the debt liabilities already owing in the system. This is the real cause of what is known today as the “credit crisis” but in actual fact is an energy crisis.

High oil prices have decreased energy consumption in developed nations and has therefore lowered the energy value (purchasing power) of developed nations monetary units. But developing nations such as China for example, have dollar surplus, its citizens have little price history and their economy has been built upon higher priced energy resources. China has the monetary surplus to maintain (stimulate) positive economic activity and thus, it consumes the oil that nations in recession have freed up to the market which is keeping the price too high for the very same nations that desperately require a return to an oil price equilibrium. I.e. China’s monetary units now command a greater energy value.

But China is not immune to the worlds energy crisis. They too have helped stimulate economic growth with credit expansion that devalues their monetary supply but this cannot be maintained forever. Ultimately, the only way China can avoid going down with the developed nations economies is to begin dumping its holding of U.S. dollars. Of course, China will take a heavy loss and enter an economic depression but it will do so with no foreign debt and with a currency that will have incredible purchasing power which will enable China to consume the large amounts of energy they require, and to begin consuming the products they produce domestically.

In my opinion, oil demand destruction has now become a permanent self reinforcing loop for developed nations economies. The debt ridden developed nations are attempting to increase economic activity by expanding the monetary supply at a scale never before attempted in history but deflationary/inflationary forces are winning. Again, it is my opinion that the result of attempting to stimulate “artificial” economic growth on such an incredible scale is inevitable and will be catastrophic. And I use the word catastrophic with purposeful intent.

Unless the price of oil can be dramatically reduced by drastically increasing the rate of production (increasing net energy gains), there can be only one outcome. A deflationary collapse and the very real possibility of a complete loss of trust and therefore value in most, if not all developed nations currencies (hyperinflation). Keep a very close eye on energy consumption, especially oil because every time demand falls, an economy inches ever closer to the deflationary black holes event horizon. Timely and accurate information on an economies energy consumption is the most essential measure of economic health.

The economic model of consuming ever increasing rates of finite resources is over and will never return. That should be clear.But after the collapse will come the only solution, Global emissions trading.

But that is for another day ;-)

Chris Martesons crash course.

http://www.youtube.com/watch?v=cwNgNyiXPLk

UKERC Homepage, latest report avalable.

http://www.ukerc.ac.uk/support/tiki-index.php?page=Home

FEASTA energy report, Tipping point.

http://www.feasta.org/documents/risk_resilience/Tipping_Point_summary.php

And this is one of my favourite gems, offers great insight into the big guys knowledge of the inevitable energy crisis and how it has and is shaping geopolitical events and foreign policy.

http://www.btinternet.com/~nlpWESSEX/Documents/contentsfall.htm

A very interesting 2008 transcript from the council on foreign relations re. energy security. A lot is said between the lines here and I will add that the CFR website should be explored by all ZHers. Lots of insight into the future from directly from the mouths of those who shape it.

http://www.cfr.org/publication/15559/global_economic_trends.html