Wednesday, July 15, 2009

The Theory and Practice of Credit Exchanges and Alternative Money

Money represents wealth. Money can be issued based on anything of value, be it a good or a service. Creating money to represent some object of wealth is called monetizing. Any collateral can be monetized to create new money. Even labor can be monetized to create money.

Money that is created apart from collateral wealth, apart from real goods and services, is inflationary, because it causes a surplus of money relative to wealth. Money can be printed, but unless wealth is created along with it, it does not make anyone richer.

Credit, the kind issued by a credit clearing exchange, can only be issued in the same fashion. Credit can only be created based on the monetization of some collateral or service. By definition, the creation of credit only makes sense to facilitate some mutual transaction. Credit cannot be given out freely, any more than money loans can be given out freely.

For this reason, in a credit exchange, people should not be extended unearned credit lines. Credit clearing exchanges die because of negative balances. Credit clearing must proceed on the same time-tested basis as any other banking function: on good collateral.

A credit clearing exchange cannot be run solely on idealism. It has to be based on real wealth and offer a real profit motive, both for the members and the exchange operator.

Without the availability of an interest charge on loaned money, the credit exchange operator has to rely on an alternate source of revenue: brokerage. The exchange is not offering a good, like money, it is offering a service. The service is to broker economic transactions, and to track objectively and accurately the mutual credit streams created.

A credit exchange is backed by nothing more or less than the full faith and credit of its members. The exchange only profits insofar as it facilitates economic transactions. The interests of the exchange and the members are aligned: profitable economic transactions.

This is the only economic function of a credit exchange: facilitating economic transactions that would not otherwise take place. The economic problem the exchange solves is a lack of cash. For example, a plumber and a mechanic have both lost their jobs. They are both without money, so in the regular scheme of things, neither can afford each other’s services. However, the credit exchange can step in and facilitate their mutual transaction, garnering a small brokerage fee for the service.

If the tradesmen were flush with cash, they would not need the credit exchange broker. Thus, the target audience for a credit exchange is clear: the unemployed and under-employed. People who have excess time, but not a steady cash flow, need the services of a credit exchange. Some people would also like to join the credit exchange as a form of advertising. The larger the labor pool, the more transactions would take place.

Thus, in practice, the exchange operator must seek out and recruit clients into the exchange. The operator should have an eye for specific industries and skills that would be most beneficial for the overall health the exchange network. The operator must deliberately and systematically seek to maximize in-network credit transactions. Each new member should be encouraged to invite others into the network as well.

New members should not be extended free credit, as the problem of free-riders would get too large. Rather, new members should be required to deposit their own good/service into the exchange vaults. Economically speaking, this is a deposit of wealth which the credit exchange then monetizes. The deposit would earn a balance in the network, and mark the official entry of the member into the exchange’s economic system.

Members have to monetize their own wealth-building service as a form of capitalizing their own credit account. For example, a mechanic could monetize 8 hours of his own labor, or he could monetize 80 hours of his own labor. It would be up to the exchange operator to establish an upper limit on the credit value that could be monetized by any member. This is a very intuitive form of a credit limit that even a new member would understand.

Beginning members might not be allowed to monetize any of their labor at first, but might have to operate solely on an service-rendered-first trade basis. Or beginners might be allowed to monetize a day’s worth of labor. But as their reputation score rose, the credit limit could rise with it. Soon, a member might be able to monetize a week’s worth of labor, or more, as appropriate.

Monetizing labor means that trade credit is granted a member, under the expectation that future labor will be done. The member would literally sign over a labor check, or labor bond, stating how much labor was deposited with the exchange. It is nothing more or less than a personal IOU signed over to the exchange.

The exchange operator would then be able to market that IOU. Someone who needs that service would purchase that service with their own IOU. This is how a purely credit exchange network would operate. The IOUs function as money, but they are backed solely by the full faith and credit of the issuer. A member would deposit their own personal IOU with the exchange, then complete that service when someone purchased the IOU.

If someone refused to, or was unable to, honor their IOU, functionally, that means they have defaulted on their credit. In such cases, the loss would have to be absorbed by the exchange operator. The operator must be running at a sufficient profit to enable the write-off of defaulted credit by unfaithful members. Obviously, this is exactly parallel to how a money bank must earn enough dollars in interest and fees to offset loan losses.

Members would be encouraged to be faithful guarantors of their IOUs by the benefits of being in-network. Their faithfulness and skill in fulfilling their IOUs would be revealed by their reputation score. If someone refused to honor their own IOU on day one, before they used anyone else’s services, there would be no harm done to the exchange itself. However, if someone spent two weeks using the services of the exchange, then refused to contribute in turn, that would be a huge loss for the exchange to absorb.

Everyone contributes with the expectation of getting something back, so widespread defaults could easily shake the confidence in the faithfulness of the exchange network itself. Members should be fully briefed on the high ethical standard that they are expected to maintain when they join the network. Obviously, refusal to honor even one IOU could be grounds for removal from the exchange network, and new members should be limited to very small account balances until they established their credit worthiness.

So far, I have only discussed the monetization and trading of services, but goods can be monetized into the exchange network as well. Rather than capitalizing their own labor through an IOU, someone might simply contribute a bicycle, or a car, or a bus, or whatever, into the capital fund of the exchange network. The member would receive trade credit, and the exchange operator would then market the collateral. Within network, members could offer their own goods directly for sale to other members for trade credit.

Counterfeiting is a huge problem for alternative currencies, as the printing technology is likely to be simplistic and the ability to track or prosecute counterfeiters almost non-existent. Trade credits and other alternative currencies should be electronic to the greatest extent possible. When printed, they should be printed in cheque form, to be countersigned upon transfer, so that a chain of legitimacy can be established. Using checks has the added advantage of preventing theft.

6 comments:

Cascadia Commons said...

Paper currency is getting more secure all the time, especially with RFID. The Hitachi Mu Chip (http://www.hitachi-eu.com/mu/) is so small, it is barely recognizable. It does not have a lot of memory. It can only hold a 38-digit number, but that is sufficient for preventing counterfeiting.

Nevertheless, very interesting article. I like the idea of backing a line of credit in a mutual credit exchange. It could be seen as a security deposit. We at the Community Exchange Network of Portland are debating how we can operate a mutual credit clearing system. The thought occurred to me after reading your article that we could 1) work with local banks, 2) require a security deposit that earns interest 3) require participants to participate in the mutual exchange for a given period, say five years. After the five-year period, the depositor could withdrawn their funds at will and participate in the mutual exchange.

Justin said...

Ah, very interesting! Thanks for the update on the security of paper, that is important to know. How much does it cost to print it?

wraft said...

It seems that local currencies could get into discounting real bills. Antal Fekete discusses Adam Smith's Real Bills Doctrine at The Daily Bell

Discounting 90 day bills could be a profitable endeavor for local currency organizations.

Justin said...

Thanks for the link tip, wraft, I will read up on that. I have done previous research on Real Bills, and I agree, they are highly applicable to our contemporary situation. Check out my post on the topic and let me know what you think:
http://cancelourdebt.blogspot.com/2009/02/real-bill-economy-part-1.html

wraft said...

Hi Justin,

I posted a comment on your real bills article.

wraft said...

As I was reading Richard C. Cook's review of Tom Greco's latest book that a selling point for local currency is that banks don't allow accounts in anything but FRNs, so if one wanted to live on a cash basis . . . There'd be no trail.