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Tuesday, August 24, 2010

Index Shares

Given the imminent demise of the US dollar and possibly other fiat currencies around the world, I've been contemplating monetary systems again.

My thinking has reverted from Zero Sum Economics (which is too close to our existing fiat system) back toward my earlier proposal of a fixed number of Quatlus. The new twist leads me to call the monetary units Index Shares, or just Shares, and they work like this:

Consider a broad index fund, just as any mutual fund or ETF might exist today. Make it a whole-world fund, that seeks to buy as broad a mix of the world's assets as it can (within administrative reason), across all asset classes (bonds, commodities, stocks, land, commercial property, etc), each asset in proportion to its market value (as with standard indices like the S&P 500). Essentially this is a whole-world index fund.

Now, what would happen if you started using shares in this fund as a currency? Or, not just a currency, but The currency, so that even assets which the fund was buying were priced in Shares of the fund?

It's strangely circular, and yet as best I can tell so far it would work great. There would be a couple of rules which the fund must follow: Dividends would be reinvested internally, and a single Share would be defined to represent a fixed percentage of the value of the whole world (or at least the whole domain of assets which the fund uses as its proxy for the whole world). Note this is not the same as saying there are a fixed number of shares in the fund, because the fund typically will only own a small percentage of the world's assets.

The free market would balance asset values relative to each other, just as it does now. But it would also control the money supply by buying and selling assets on net.

For example, let's say you're in a small community running on barter, with various small businesses, properties, commodities, and so on, and that it's gotten big enough that people have started bartering shares in their assets and so there is a guide to the relative value of the assets as well as a mechanism for trading them. Still no "cash" per se, and transactions are pretty cumbersome.

Enter the Index Fund. Even from a cold start like this, it bootstraps easily: Everybody in the community wants a bit of cash to spend to make transactions easier, so they sell some of their assets to the fund, who buys them with Index Shares. Nobody is getting something for nothing, and there is no maturity transformation going on. People are simply trading in portions of single assets in exchange for tiny ownership in a very large number of assets.

The value of assets would be set by the free market by people buying and selling assets (such as stocks) in the open market just as they do now. But the fund would also buy and sell as necessary to maintain price parity, which would dynamically adjust money supply. That is, for instance, if the world at large needs more cash on net, they start selling their assets, which pushes the price down, which requires the fund to buy more assets in order to make the percentages balance, thus increasing the money supply and satisfying the world's need for more cash. And likewise in reverse. Yet despite the money supply growing and shrinking on demand, the value of your Shares always stays roughly the same, because it represents a fixed percentage ownership of the world.

In fact the system would be slightly deflationary, but not in a bad way. Cash under your mattress would implicitly earn interest just like stock certificates under your mattress would (even if they aren't paying dividends, they're typically increasing in value over time). That's your return for having "lent" whatever value you gave up in exchange for the cash originally. (I.e., all cash _should_ be deflationary, but most isn't because it benefits the issuers to inflate.) Inflation would be rare if ever, and self-limiting, and hyperinflation would be impossible. I believe large asset bubbles (e.g., the recent housing market) would be more self-limiting as well but I'm not sure about that without more thought.

I would add a rule against fractional-reserve banking (implicit maturity transformation), though nearly the same thing can be accomplished with explicit loan maturity. (Basically if you want more interest on your bank deposits, you have to accept that they will be locked up for a while.)

Anyway, that's my latest scheme to save the world. Anybody know of an existing whole-world multi-asset-class mutual fund which I could use to back my Index Shares? No reason it couldn't be kicked off right now since it can co-exist with other currencies until it replaces them. :)

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