Reducing the Cost of the Financial System

The Financial System regulates the distribution of Capital. It does this through Money Markets. Economists justify using Money Markets as a regulator by assuming the Efficient Market Hypothesis holds.

This hypothesis says that an unfettered market is an efficient way to distribute resources.  Unfortunately, history shows us that large Money Markets are unstable and high cost. The Efficient Market hypothesis does not hold for large Money Markets.

There is a cost to all regulation. In Financial Systems it is in the form of value or costs.  Some regulatory costs in Financial Systems are:

  • Interest on Interest.
  • Interest on Money in bank accounts.
  • Inflation
  • Exchange Rate costs
  • Insurance overhead costs
  • Costs to transfer value
  • Overhead of interest and rental costs
  • Overhead of taxation for the redistribution of value
  • Legal and Accounting costs
  • Enforcement of Regulations
  • Overhead costs of markets
  • Proportion of the cost of Politics

In a modern economy these costs are high.  They are greater than 50% of the cost of producing goods and services. The costs are high because Money Markets are complex and unstable.  We can reduce costs if we reduce complexity and increase stability by introducing methods other than Money Markets to distribute Capital. It is likely that these methods will rapidly replace most Money Markets as the infrastructure to support them is low cost, Most of the existing technologies that support Money Markets is reusable with the new approaches.

Other Models - Control Theory and Cybernetics

Cybernetics is the study of regulatory systems.  Regulatory systems have closed signal loops. The systems cause a change in the environment. The change in the environment feeds back into the system. This in turn triggers another change in the system. This is a feedback loop.  

Negative feedback stabilises systems. Positive feedback causes instability because a small change creates larger changes with several passes through the loops. Maxwell published the first paper on Control Theory in 1867 titled "On Governors".  This quantifies what happens with both forms of feedback.

By removing positive feedback loops in Financial Systems we can increase stability. Two positive feedback loops in Money Markets are interest on interest and inflation.

Other Models - Promise Theory

Promise Theory tells us how to reduce complexity. Promise Theory says that reducing complexity reduces costs.

Complexity arises from the interactions of separate autonomous agents.  Complexity increases exponentially with the number of agents affected by any one change.  Promise Theory addresses this and shows how to build large systems with low complexity. It says that complexity occurs if changes in one agent cause a change in another agent.

Financial Systems are complex.  A change in the value of money held by one agent influences the value of money held by other agents.  The interest rate charged by a Central Bank changes the value of money held by all agents.  Inflation of value in one asset class causes inflation of all money.

The easiest way to reduce costs is to reduce the regulatory costs. The easiest way to do this is to reduce the cost of complexity. The easiest way to do this is to reduce complexity by isolating the effect of changes.

Applying Control Theory and Promise Theory to Loans

Two regulatory mechanisms in a Money Market are inflation and interest on interest.  Inflation facilitates the redistribution of money. Interest on interest compensates for inflation. These are real costs and removing them will reduce costs.  Both inflation and interest on interest are positive feedback mechanisms.  Both lead to instability in Financial Systems. Removing them increases stability.

We can remove costs and increase stability by changing the rules for the repayment of loans.  We use loans to invest in the future production of goods and services. Instead of paying interest on invested money we give a discount on the cost of future production.  This removes two costs.  It removes the cost of interest on interest.  It removes the cost of producing money to pay interest.  We compensate investors for inflation by adjusting the amount owing by the inflation rate. 

It increases stability because it removes the positive feedback of interest on interest and it removes the positive feedback of inflation.

This approach to loans makes each loan independent of any other loan.  Loans are only repaid with goods and services. The loans themselves are transferrable. Promise Theory predicts the isolation of Loans from each other reduces complexity. This reduces costs because many of the administrative processes we put in place to compensate for instability are no longer needed.

Investors need a return on money invested otherwise they will not invest.  The return should make the investment worthwhile and cover investment risk. The approach to loans suggested here does this.  It saves the borrower interest on interest and saves the lender the cost of inflation.