Author: nivtric

Banking Operations

nivtricLeave a comment

Commercial versus savings banks

Historically, the banking sector comprised several types of banks. The distinction between commercial banks, which create money, and savings banks, which don’t, has lost its value due to the existence of efficient financial markets, where banks match terms through borrowing and lending. The distinction between created money and savings is arbitrary, as the following example demonstrates. Suppose that I work at a farm, and the farmer rewards me with a plot of land and leftover wood and materials from a defunct shed, which I use to build my home. After finishing my house, I go to the bank and take out a mortgage. The bank creates money out of thin air.

Until I went to the bank, no money had changed hands. Still, I was able to save for a home of my own. In other words, savings aren’t the same as money in a savings account. In this case, my savings are my home, and if the mortgage is a debt, the money I take out is my savings. To further illustrate the point, suppose that I have no money and also own no home. When I go to the bank for a car loan, the bank creates this money on the spot. If you think there are no savings, you are wrong again. The person who sold you the car had saved the car. I can even borrow money and put it in a savings account. And so, I created savings from thin air by borrowing money and lending it to the bank.

Full-reserve banking

A well-known monetary reform proposal is full reserve banking, as outlined in the Chicago Plan, which means there are only savings banks and no commercial banks that create money. It often resurfaces when banks go bankrupt. With full reserve banking, banks can’t lend out funds deposited in demand accounts or current accounts. Money in these accounts isn’t debt but backed by central bank currency or cash. And depositors can’t withdraw the money from their savings accounts on short notice. In this way, banks can’t go bankrupt because of depositors demanding payment in cash. With full reserve banking, loans must come from savings, which are funds that depositors can’t withdraw on demand, as they have entrusted them to the bank for an extended period.

Lack of cash is usually not the primary reason banks fail, but rather, loan write-offs. That was also the case during the 2008 financial crisis. Full reserve banking addresses a liquidity problem, whereas the crisis was a solvency issue that subsequently led to a liquidity issue. Banks ran into trouble, not because they lacked cash, but because they incurred losses on their loans. As a result, banks began to distrust one another and stopped lending to each other. The financial system can be safe with zero reserve banking, provided that banks are solvent, thus have sufficient capital, and own adequate liquid assets, such as government bonds, that they can sell to meet withdrawals. And so, a reserve requirement can better include liquid safe assets, such as government bonds, rather than currency alone.

Some proponents of full reserve banking are socialists who oppose privately controlled money creation, as they view it as a public subsidy to the private banking sector. Others desire a banking sector free from government interference, so a ‘free’ banking market without central bank interventions and deposit guarantees. At least that is something socialists and their opponents might agree on. Bank credit can contribute to economic cycles and financial crises. With full reserve banking, there would be less bank credit, and interest rates would be higher. To make lending possible, depositors must part with their money for a designated period of time to make it available for lending. As a result, fewer funds are available for lending, and interest rates would be higher.

Shadow banks

Full-reserve banking makes financial markets less efficient, allowing alternative schemes, such as shadow banks, to fill the gap. An example can illustrate that. Suppose that God has ordered banks only to use money in savings accounts for lending so that there is full reserve banking in Paradise. Eve and Adam only do business with each other. Both have €100 in their current account, which they use for their daily business transactions. This money is suitable for payment because it is in the current account. For that reason, they don’t receive interest. Assume now that the bank also offers savings accounts with an interest rate of 4% but money in savings accounts isn’t suitable for payment.

Then a financial advisor comes along, disguised as a snake, advising Eve and Adam for a reasonable fee on how to manage their payments between themselves and to deposit their money into a savings account. So, what you now read in Genesis is made up by bankers to hide their fraud, a conspiracy theorist might infer. But it is just a story. In this way, Eve and Adam both earn interest on their €100. They give each other credit, so that Eve can borrow €100 from Adam, and Adam can borrow €100 from Eve. They don’t need to keep money in their current accounts, so they deposit their funds into a savings account and earn interest. Everybody wins, Eve, Adam, and of course, that snakelike creature.

Initially, Eve and Adam had no savings, only money in their current accounts. The advisor’s scheme allows them to fabricate savings out of credit. It seems like creating money, but Eve and Adam gave each other credit. They agreed to pay later, which exposed both to credit risk. One of them might not repay because you can do so many different things with €100 than put it in a savings account. You can use credit, which is an agreement to pay later, and use it like money. And so, Paradise was lost. Similar schemes exist on a larger scale. These are shadow banks. Shadow banks don’t create money but credit. The difference between fractional reserve money and this type of credit may not be significant in practice, except that it is unregulated, resulting in little oversight.

When banks create money, they do the same. The banks act as intermediaries between Eve and Adam, allowing them to lend money to each other even when they do not conduct business with each other or do not trust each other. The bank also assumes the risk that a debtor will fail to repay and receives a reward in the form of interest. It is also credit, but we refer to it as money because the law regards bank credit as legal tender, thus money. The government backs this scheme, as a stable financial system is a key public interest. Banks must have sufficient capital and reserves to meet emergencies. For that reason, banks are subject to regulations, while shadow banks are not subject to these rules, allowing the latter to offer more competitive interest rates.

As a result, the role of traditional banking has declined. Large corporations could lend and borrow in money markets at rates better than those offered by banks. At the same time, retail investors could invest directly in money markets and get better yields than banks offer. This development started with corporate borrowing. It later expanded into mortgages. The primary reason for regulating banks is that they operate the payment system, which is of public interest, and can borrow from the Federal Reserve. It prompted banks to strip their balance sheets and expose themselves to off-balance sheet risks to generate higher returns on their capital. For instance, offering an emergency credit line to a shadow bank generated profits while not appearing on the balance sheet.

The 2008 financial crisis originated in shadow banks that invested in risky assets, rather than conventional banks that create money through lending. Shadow banks aren’t subject to the same regulations as traditional banks, so they made speculative investments in mortgages. These investments appeared safe because rating agencies failed to do their jobs. Regular banks encountered trouble because they had backed shadow banks, hoping to reap a quick profit from credit insurance. The word they use is off-balance sheet financing. The regular bank didn’t lend money, but guaranteed credit to shadow banks in case of emergency, which is as dangerous as keeping the mortgages on its own balance sheet. But that was legal. It allowed banks to make more money from the same capital. Money creation, therefore, wasn’t the problem, and replacing regular banks with shadow banks could further destabilise the financial system.

If a financial crisis were to occur with loan write-offs, full reserve banking would only ensure that money in current accounts is safe. However, the same problems would emerge in savings accounts. Savings banks can expose themselves to off-balance sheet risks, unless that is forbidden. And they can also go belly up. And they did. If the debtors of a bank fail to meet their obligations, the bank may face financial difficulties, and the savings it holds may be at risk. Also, with full reserve banking, governments and central banks may end up supporting savings banks and even shadow banks to ensure financial stability, thereby rendering the benefits of full reserve banking void. After all, the initial cause was never a liquidity problem, but a solvency issue.

Commercial versus investment banks

The Glass-Steagall Act in the United States severed linkages between regular banking and investment activities that contributed to the 1929 stock market crash and the ensuing depression. Separating banking from investing can prevent banks from providing loans to corporations in which they have invested. The measure aimed to make bankers more prudent. The separation of commercial and investment banking prevented securities firms and investment banks from taking deposits. The reason for the separation was the conflict of interest that arose from banks investing in securities with their own assets, which were their account holders’ deposits. Banks were obliged to protect the account holder’s deposits and should not engage in speculative activities.

The Glass-Steagall Act included the Federal Deposit Insurance Corporation (FDIC), which guaranteed bank deposits up to a specified limit. It also comprised Regulation Q, which prohibited banks from paying interest on demand deposits and capped interest rates on other deposit products. Maximising interest rates can limit the risks banks are willing to take on loans, as these risks can destabilise the financial system.

Until the 1980s, the legislation mainly remained unchanged. With the rise of neoliberalism, government regulations became increasingly disapproved of. Hence, the Glass-Steagall Act became increasingly disregarded, and diligent deregulators repealed it in 1999 as part of their effort to relieve businesses of government regulations that stood in the way of corporations making profits at the expense of the public good. Regulation Q ceilings for all account types, except demand deposits, were phased out during the 1980s. After the 2008 financial crisis, a renewed interest in the Glass-Steagall Act emerged.

In the United States, money market funds circumvented the limits imposed on banks by Regulation Q, luring depositors with higher interest rates, thereby undermining the prudent banking paradigm. The money market funds, which are shadow banks, invested in collateralised debt obligations (CDOs), such as mortgage-backed securities (MBS). The 2008 financial crisis started in money market funds, not traditional banks.

Natural Money works with the same principles. It distinguishes between regular banks, which provide loans, and investment banks, which are partnerships that invest in equity. Islamic banks also operate similarly. The maximum interest rate of zero works like Regulation Q, aiming to limit the risks banks are willing to take on deposits, as interest is a reward for taking on risk. Banking in a Natural Money financial system works as follows:

  • Regular banks make low-risk loans. The money in these banks is secure. The maximum interest rate is zero. And so, deposits have negative yields.
  • Investment banks don’t lend but participate in businesses by providing equity. They can rent houses and lease cars. Investment banks offer higher returns.
  • Both regular banks and investment banks can invest in government securities to manage their risk and meet withdrawals.
  • Regular banks can promise a fixed interest rate. The government may offer support and deposit guarantees.
  • Investment banks don’t guarantee returns. They pay dividends based on their profits. Its depositors are investors who can face losses.

Natural Money enhances financial stability by favouring equity investments over debt investments. The maximum interest rate makes debt investments less attractive. And there is no reward in the form of interest for engaging in high-risk lending, which enhances the financial system’s stability. It stands to reason that the integrity of the system depends on strict adherence to its principles and the termination of evasive, get-rich-quick schemes of financial parasites, which requires a belief in the vision behind the idea of a usury-free economy. Let’s not dismiss that as a fantasy immediately.

Sanitation of banking

The primary cause of the financial system’s failure is usury. Imagine what a maximum interest rate of zero on debts can do. Only the most creditworthy borrowers can get a loan. You may have to save and bring in equity before applying for a mortgage, and that may be the only credit you can obtain. Even an overdraft may be impossible. That may seem harsh, but it is even worse when indebted consumers reach the point of interest payments and can’t make ends meet. If you want to buy something, you have to save for it. Likewise, corporations need to attract capital rather than debt to meet their liquidity requirements. The financial sector will shrink, and much of modern finance may become redundant.

That said, individuals and businesses may obtain better deals in the money market, allowing them to opt for this option rather than a bank. The distinction between traditional banks and shadow banks may blur. Tradional banks may need fewer regulations while shadow banks may need more. That is because without interest, risk may disappear. The central bank may stand behind the payment system, but it may not have to stand behind the lending system. The implicit guarantee of central banks buying debt and issuing currency with a holding fee means that the warranty will remain unused.

Two other themes emerged during the 2008 financial crisis: ‘too big to fail’ and ‘too complex to understand.’ Complexity and size are the outcome of competition. The failure of a large bank can bring down the financial system, and the products traders in financial markets use to hedge their risks or improve their profitability can be complex. Our future civilisation could be simpler, so the sanitation of the financial system should encompass cooperation, simplification and diversification. It may look as follows:

  • There should be an exhaustive list of all legal financial products and their requirements. We shouldn’t allow other financial products to exist.
  • No bank should hold more than a certain percentage of the global market, and no bank should expose itself to more than a certain percentage of another bank.
  • Banks should share services where scale is crucial, such as technological infrastructure and advanced knowledge.

Smaller banks can achieve efficiency improvements by using the same technological infrastructure. As long as they are independent financial institutions, they may share an IT department and operate their businesses on the same software. It may even be a public infrastructure that all banks share, allowing for significant cost savings, while also sharing knowledge and implementing measures related to issues such as fraud prevention.

Latest revision: 13 November 2025

Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.

Fiscal and Monetary Policies

nivtricLeave a comment

Economic cycles

Mismatches between supply and demand cause economic cycles. A harvest may fail, and food prices may rise, leaving us with less money to spend on other items. Mismatches can concern the supply and demand of money, capital, labour, raw materials or consumer products. Interest charges also contribute to economic cycles. Interest rates reflect the market for funds. If all markets were perfect, economists argue, supply could adapt to demand instantly, and there would be no economic cycles. Not unlike many others, economists love fairy tales about a Paradise where everything is perfect. And so, they may advise us to make markets perfect, so that an economic Paradise will ensue.

Economic cycles occur because mismatches between supply and demand emerge periodically and eventually resolve. Economists use the term equilibrium in their models to explain the relationship between supply, demand, and price, but these models are simplifications of reality. There is rarely a stable equilibrium, and fluctuations in demand and supply cause changes in prices, inventories, and employment. There are several theories and explanations regarding those mismatches, economic cycles, and their effects. Most notably, money, credit and interest deserve attention.

According to Say’s law, supply creates its own demand because we make goods and services to use ourselves or to acquire other goods and services. It is most applicable to a simple barter economy. When money serves as a medium of exchange, we can postpone our purchases, leaving producers with excess inventory. Money hoarding can be a serious problem as it interrupts the circular flow of money. When money loses value, we are less likely to postpone purchases. It is why central banks aim for a bit of inflation. However, inflation shouldn’t be too high, as that can undermine trust in the currency.

Expectations are another factor. When consumers feel good about the future, they are more willing to spend on big-ticket items. Likewise, when investors expect brighter prospects, they anticipate higher profits, making them more willing to invest. Conversely, when consumers and investors are pessimistic, the opposite happens. And so, expectations can become a self-fulfilling prophecy. Likewise, when people expect a bank to collapse, it may collapse because that expectation triggers a bank run. Policy makers try to instil confidence in the system because a lack of confidence can break it. The reason is that credit means trust, and trust is what keeps the system going.

During good times, businesses and individuals tend to be confident. Credit is often available because businesses’ and individuals’ future income projections serve as the basis for banks to lend money. And so, companies and individuals can borrow more in good times. When the economy slows and their incomes decrease, they may struggle to make their interest payments. Consumers would have more disposable income without debt, since they wouldn’t have to pay interest. Similarly, businesses can go bankrupt even when they are profitable overall because of interest charges. And so, interest charges can exacerbate and prolong the bust.

Leverage contributes to the overall risk in financial markets. Liquid financial markets make it easier to enter and exit positions, leading investors to believe it is safe to operate with leverage. If markets were not fluid, leverage would appear more dangerous, as it would be more difficult to exit a position. For example, if you aren’t sure that you can renew your mortgage after five years, you aren’t going to buy a home. Liquidity enables risk-taking, allowing the overall level of risk in the financial system to increase. That can become apparent during a crisis. People who have to sell their home during a housing crisis may end up selling it at a low price, leaving them with a debt that takes years to repay. Therefore, maintaining a liquid market is crucial for its safety, and limiting leverage further enhances its security.

Bureaucratic interventions

In the wake of the Great Depression and World War II, government and central bank interventions have become standard tools for bureaucrats to manage the capitalist economy. Fiscal policies involve steering the economy through government expenditures. Ideally, it works as follows. When the economy is performing poorly due to sluggish demand, the government increases spending to boost demand. Conversely, when the economy is overheating due to excessive demand, the government reduces spending to curb demand. Likewise, central banks can lower interest rates to promote borrowing and boost demand, or raise interest rates to discourage lending and curb demand. These policies can have the following undesirable consequences:

  • The timing of the measures may be off, so when the measure has been decided upon and is taking effect, the economy may already be on the desired path.
  • Politicians may interfere and press for increased government spending or lower interest rates to boost the economy and get them re-elected.
  • Central bank interventions cause market participants to take more risk because they expect the central bank to intervene.
  • Due to usury, debt levels increase, so once these policies are commonplace, there are no corrections to cleanse the system from its excesses.

By failing to periodically cleanse the financial system of its excesses, either through a debt jubilee or an economic depression, the economy becomes addicted to credit expansion, and the final collapse will be even more severe. As the US dollar is the world’s reserve currency, a collapse in trust in this currency can trigger a global economic apocalypse. Usury is the primary reason for fiscal and monetary policies, because interest on money and debts generates a money shortage, driving a demand for credit. Debtors must repay more than they borrowed, but that extra money doesn’t exist. And so, governments and central banks fill the gap to prevent the usury scheme from collapsing.

Due to usury, it has become a permanent requirement. To prevent a shortage of money or a liquidity crunch from materialising, governments borrow, and central banks print money. The shortage arises when the private sector fails to borrow enough to cover the interest on existing debts. To counter the problem, the government can borrow and spend this money. Central banks can lower interest rates to make borrowing more attractive. They do so by buying up government debt, thereby decreasing the supply of government debt and increasing the supply of currency, which lowers interest rates because there are fewer debts and more currency to buy them with.

Economists assume that there is a natural interest rate at which the economy grows at its trend rate while inflation is stable. There is no direct way to measure or calculate the natural interest rate. Economists estimate it using their theories and models. The elusive natural interest rate is a crucial element in central bank decisions. The natural interest rate may differ from the actual interest rate due to credit in the financial system. Deviations from this rate trigger booms and busts. The interest rate below the natural rate can generate a boom. In that case, people borrow too much because interest rates are too low, leading to overspending and overinvesting. An interest rate above the natural rate can lead to a bust, resulting in underinvestment and underspending. By setting short-term interest rates and thereby influencing long-term rates, central banks steer credit creation.

The economy can do well by itself

With Natural Money, the economy can manage itself, making fiscal and monetary policies redundant. The holding fee removes the zero-lower bound, providing stimulus during economic slumps. The maximum interest rate curbs lending during economic booms, providing austerity. That mitigates business cycles. And so there will be fewer debt overhangs and financial crises. The market, combined with the price control of the zero upper bound, steers interest rates and the money supply, thereby reducing the role of central banks. The central bank’s currency will then become a unit of account or administrative currency. Natural Money has the following favourable consequences:

  • The holding fee on currency allows for negative interest rates to provide a stimulus, while the maximum interest rate provides austerity by curbing lending.
  • As interest is also a reward for taking risks, a maximum interest rate will take away the incentive to take risks and limit lending to the safest borrowers.
  • In the absence of usury, debt levels don’t increase, while only the safest borrowers can borrow, resulting in fewer bad debts.

There is no need for governments to engage in deficit spending, except to provide liquidity in financial markets, as government debt, rather than administrative currency, serves as a form of liquidity. The holding fee makes it unattractive to own administrative currency. Provided their finances are sound, governments can borrow at negative interest rates and earn interest on their debts. They could aim for the debt level giving the highest interest income. If market participants are willing to lend at -1% when government debt is 100% of GDP and at -2% when government debt is at 70% of GDP, the government could harvest 1% of GDP in the former case and 1.4% of GDP in the latter case.

It will be the end of fiscal and monetary policies. The economy will manage itself. Interest payments don’t create a need to add additional debts. Governments may step in during a crisis to restore trust in the financial system and the economy, but whether such intervention will be necessary is unclear, as there will likely be fewer crises. Natural Money also doesn’t require central banks to do more than handle the daily transactions between banks, as the holding fee terminates the demand for the central bank’s currency.

Latest revision: 12 November 2025

Der Untergang der Titanic. Willy Stöwer (1912)

Harbinger of Things to Come

nivtricLeave a comment

In 2006 or 2007, a software upgrade of the disk controllers on the principal systems went wrong. For a week, they were out of operation. It was one of the biggest crises in the history of the government office CJIB, and perhaps the biggest of all. At the time, Kees and I were working on the systems renewal project at another location. The other database administrators dealt with the issue, as did many others. I knew there was a serious problem because we received regular email updates, but I didn’t realise how serious it was. After a week, the telephone rang at home. It was 9 PM. My wife, Ingrid, took up the phone. It was the IT director. He said there was an emergency and asked me to come to the office. His voice reflected fear. ‘As if the Titanic had hit the iceberg,’ Ingrid later noted.

I hurried to the office and arrived by 9:30 PM. Many people were still in. It was a massive crisis. There was an atmosphere of fear. The database administrator on duty, Dirk-Jan, brought me up to speed. I searched the database log files, found the error messages, and typed them into the Google search bar. In this way, I found an online document with the remedy. I then repaired the failures and brought the systems online one by one. Board members and senior managers were standing around me, watching me type. Solving the issue wasn’t complicated, but few people used Google to find the answer at the time.

I learned that the last backup was over a week old, and the mirror copy was offline. You may know what backups are and why you might need them, but you may not know what a mirror copy is. A mirror copy is a safety measure. If you own a computer or a mobile phone, it contains data. That data is on a device. In the early 2000s, it was usually a hard disk. If that disk fails, your data may be gone forever. If you lose some photographs of your late cat, you might feel sad about it, but after a few years, you get over it, perhaps after consulting your psychiatrist and taking a lot of pills.

Corporations can’t afford to lose their data. That would bankrupt them. Their business is their data. Without it, they are out of business. If you have a backup, only data after the latest backup may be lost, but that can still kill you, especially if you haven’t backed up for a week. We were a government agency, so loss of data wouldn’t have bankrupted us, but it would have been a national political scandal.

Corporate computers have multiple data storage groups in different locations. If one group catches fire or stops operating because of a failed software upgrade, the other groups still have the data. These groups are called mirror copies. We had two groups: the original and the mirror. You can imagine my bewilderment. We had no backup, and the copy wasn’t available. So much had gone wrong that it was a miracle that I succeeded in recovering all the data. But having no mirror and no backup meant we were still on the brink.

An even greater surprise was yet to come. The managers and the board wanted to return to business as usual and run the backlog of batch jobs. Then I said, ‘This is perhaps the most important advice I will ever give in my entire career. Don’t start the batch jobs yet. We are on the proverbial edge of the precipice. Running the jobs might just push us over. Everything went wrong for a week and there is no guarantee whatsoever that it will be all right now. We should bring the mirror copy back online and make a backup first.’

They planned to ignore my advice. Bringing the mirror copy back online and taking a backup would take eighteen hours of precious time. It was a lot of data to back up, as it was everything we had. I was a low-ranking official while the IT director had claimed there was nothing to worry about. But he had left the building. I kept stressing that making a backup was the right thing to do. ‘If something goes wrong that could finish us,’ I told them. It was the worst crisis ever. And so, I pressed for an extensive check-up to see if everything was in order. On that, they could agree.

During the check-up, I found another failure that everyone had overlooked. That scared the managers and the board, prompting them to start another meeting. And then they followed my advice. The IT director was no longer there, and they faced a determined saviour who told them in no uncertain terms that they were about to do something stupid. The operators brought the mirror copy online and made a backup before we resumed normal operations. In this way, rational decision-making prevailed. Nothing went wrong anymore, but no one could have known that beforehand.

If it had gone wrong, the agency would have survived. Operations would likely have had to stop for several weeks—that had already happened for a week—and it may have been impossible to recover all the data. That would have made the headlines. But it never came to that. When the local newspaper’s journalists smelled a rat, the board could tell them that the situation was under control and that the data was safe. My wife’s comparison of this situation to the Titanic hitting an iceberg was not entirely apt. Saving the Titanic once it had hit the iceberg was technically impossible. It would have required a miracle. What I did may have appeared to be a miracle, but it was technically possible.

The audit department later evaluated the crisis. The auditors noted that after a week of failures, all the problems suddenly vanished, which they found already hard to believe. What they found even more difficult to fathom, and they stressed the inconceivability of it during a meeting, was that after a week of irrational decision-making, sanity suddenly took hold as we had brought the mirror copy back online and made a backup. They couldn’t figure out why that happened. Our management had kept them entirely in the dark. I didn’t enlighten them either, as it would make our management and board appear incompetent.

My manager, Geert, complimented me for handling the situation. He stressed that my colleagues had been content with me. ‘I was a pleasant colleague,’ he added. Strangely enough, Geert didn’t say something like, ‘Your contribution was critical in saving us from a disaster.’ It reveals something about Geert’s thinking. To him, it was teamwork. Geert wasn’t present that evening, so he may not have learned the details of what transpired. And so, it didn’t help my career. A few years later, the senior database administrators received a higher salary grade, except me. Geert was involved in that decision. If you save people from their own stupidity, you shouldn’t expect gratitude. In this case, the truth had remained hidden because it would have hurt the egos of those in charge. My dealings with the crisis could be a harbinger of things to come.

Latest revision: 25 February 2026

Featured image: Der Untergang der Titanic. Willy Stöwer (1912). Wikimedia Commons. Public Domain.

Confucius. Gouache on paper (ca 1770)

Fairness Matters

nivtricLeave a comment

Working and sharing in groups

Humans are social animals cooperating in groups. We divide the workload and share the fruits of our efforts. How we do that is a matter of economics. The group might be a band of hunter-gatherers, a corporation or a society. We agree, either by negotiation, custom or force, on who does what and who gets what. Otherwise, we can’t work together. In a society, this agreement is called the social contract. It helps if we think the arrangement is fair. Violations of fairness provoke strong negative feelings. What is fair isn’t always straightforward. Some people contribute more to the effort than others, either because of willingness or ability. And some people have more needs than others.

Monkeys also have a sense of fairness. During a study, researchers found that if one ape received less valuable rewards for the same work than its partner, such as less tasty foods, it could become angry and reject the reward. You can become frustrated if your colleague gets a higher reward for the same job. Children have a sense of fairness early on. Giving one person more than another without reason can surprise toddlers. Children also wish to see you help those they like and harm those they dislike. They already prefer people similar to them (the in-group) to children who are different (the out-group).1

We believe that those who contribute more to a group’s success deserve more. If a venture’s success hinges on a single person’s efforts, we may reward this person more. It is an excuse for high pay for CEOs of large corporations. In a competitive environment, a CEO can make the difference between failure and success, while a factory worker can’t. When we cooperate, we are more willing to share, but in competition, we are more willing to accept inequality. In sports, the winner gets everything. Yet, if a team wins, the members share the prize, even if the team’s success depended on a few talented players.1

Moral fundamentals

The golden rule says you should treat others the way you want to be treated. Yet, the treatment people desire varies, depending on character traits or culture. For example, some people desire attention while others wish to be left alone. That may be an individual preference or a cultural trait. Apart from individual preferences and culture, there are general rules. Contributing to the group and not harming others in the group are the most basic ones. Yet, we may differ on the practical implications.

A most crucial issue is the groups we identify with. We cooperate and compete in groups, and what we consider good is good for the groups we identify with. The group can be a family, gang, organisation, tribe, nation, or humanity. And we can identify with multiple groups, so that you can run into conflicts of interest. Something can be good for business but bad for the community. We also differ on what is beneficial and harmful. Groups may face questions such as whether it is a good idea to go to war with another gang.

An interesting question is whether moral rules are innate or learned. If our sense of fairness is innate, moral rules apply to everyone. If it is learned behaviour, fairness is a matter of taste. If someone is helpful, we react positively. If someone acts harmfully, we react negatively. Infants already do that.1 And so, some of our moral conduct appears innate, and relates to being helpful or doing harm. Being helpful and not causing harm are the most basic moral rules, despite our disagreements in practical situations.

Ideas regarding fairness can be learned or cultural. Researchers tested children from several cultures to see how they would react to unequal rewards between them and another child when they were in control and could either accept or reject the deal. They always rejected deals that were unfavourable to them. In some cultures, older children rejected options that would have unfairly benefited them. Refusing a bad deal seems a natural instinct, but forgoing an unfair good deal is learned behaviour.1

Another, very fundamental, rule is might makes right. The powerful make the rules. What we believe is right and wrong greatly depends on power structures. The West conquered the world because of its cultural values, which included an entrepreneurial spirit driven by greed and inquisitiveness. The medieval Christian values were quite different. Its success leads many to believe that the liberal world order of capitalism and liberal democracy is good, even though we now face its failure. And so, only might can fix this issue.

The mistakes we make

Are we responsible for our choices? What is the influence of choice on fairness? During an experiment in which pairs of students performed a task together, one student received the pay. The one receiving the pay was randomly picked. Those who received the pay could choose how much they would give to the other. Receiving pay was a matter of luck, and most people believed it was unfair and were willing to share the pay.

Adding a choice, for instance, between getting a small reward or participating in a lottery to get the full reward, changes the picture. That made the participants less willing to share. If both participants opted to participate in the lottery, we think it is fair that one of them wins. People often think poverty is a choice, as poor people decide not to get an education or divorce, and, as a result, can’t work full-time.1

They made these choices, but sometimes they lacked better alternatives or believed that they did. Possibly, the small reward was not enough to live off, and participating in the lottery gave a chance of getting enough. The alternative to a divorce can be living with an abusive spouse. But then again, you could have paid attention before marrying. Perhaps a good education was too expensive, or you were unqualified, but you still have options and may even have a significant influence on your life.

If we don’t face the consequences of our choices, choices stop mattering. The unfairness of that becomes clear if two individuals with similar opportunities make different choices. If one decides to spend his money while the other saves for retirement, we think it is unfair to tax the latter to pay for the former’s retirement. In this case, it might be better not to have options and implement a mandatory retirement savings scheme.

In nature, there is no excuse for failure. Those who fail bear the consequences. It has a disciplining effect. Shielding people from the consequences of their failures is problematic. Their failure may be due to bad luck, like having a poor upbringing. And that is unfair. A society could help these people. Yet, the disciplining effect of bearing the consequences of your actions is essential to keep societies from collapsing.

Progressives focus on equality and seek to promote equal outcomes for everyone, but disparities in health, education, and wealth persist. Wealth inequality is partly due to the accumulation of capital and partly to individual circumstances and life choices. Conservatives think that working hard and making the right choices should make you better off.1 Some societies invest in equal opportunities, for instance, by investing in the education of underprivileged children.

Luck is everywhere

Luck is never fair, but it is everywhere. Some live long, some die early, some have love, some remain alone, some are healthy, and some suffer from severe illnesses. It isn’t always possible to fix that. Your place of birth, the upbringing you received, your education, and the opportunities you had in life affect your success in society. Successful people often think that their brilliance and hard work are the reasons for their success. Efforts and talents matter, but your success is also a matter of luck.

If we could eliminate luck, that would be fairer. Yet, not rewarding success, even when it comes from luck, results in undesirable outcomes as it promotes failure. If a group’s success depends on the risk-takers, the hard workers, or the talented, an extra reward can inspire them to do their utmost. Low-skilled labourers receive low wages because they are interchangeable. A minimum wage can help to reduce inequality.

The economy works with the forces of nature, which are cooperation and competition. We cooperate in groups, such as corporations, to compete or cooperate with other groups, which can also be corporations. These corporations operate in markets, so they sell their products at market prices and pay market wages. In a village economy, villagers can distribute the fruits of their endeavours in ways they see fit. Yet when markets exist, people may seek better deals outside the village, thereby undermining the community.

The shadow of the past

The past casts a shadow over the present. We live with the consequences of past developments. Your country of birth, as well as the family you grow up in, affects your life opportunities. The emergence and spread of capitalism have transformed the world. It brought a dramatic increase in wealth, but it came with exploitation. Today, there is a massive wealth inequality driven by economic relationships that some classify as exploitative and others as voluntary agreements.

Organisation and trade contribute to surplus value, but those in control take that surplus. Trade practices could turn into outright theft. An example is what the British East India Company did. It collected taxes in India and used a portion of them to purchase Indian goods for British use. Instead of paying for them, merchants obtained these goods for free by buying them from peasants and weavers with money they had taken as taxes. Through this scheme and other scams, the British stole from India.2

Had that theft not occurred, the Indian peasants and weavers would have been better off. Yet, they didn’t have a capitalist mindset like the greedy English merchants, and they wouldn’t have invested their money into new production methods and facilities to increase India’s capital. The wealthy British traders invested part of the proceeds of their thievery in the London Stock Exchange in ventures such as steam-powered factories. That capitalist spirit eventually raised living standards around the globe, including India.

History advantages some people and disadvantages others. In India, the caste system determines what jobs you can do. Some women in India have to clean toilets for $1,50 per month because of the caste in which they were born.2 The Indian caste system is a relic from the past. Those who inherit estates may think they deserve them because their grandparents wisely invested the money taken from poor Indian farmers, while those who have no such parents inherit nothing. Inheritance looks a lot like the caste system.

It may seem strange that we think that the caste system is unjust, while we think that inheriting large estates is okay. Yet, rules exist to make a society functional. If you can hand over your assets to your children, it can stimulate you to save or build a business, which can be beneficial to the economy. The caste system brings no such benefits. Yet, in a time where we face a capital excess combined with billionaires running politics, the inheritance of large estates has become a serious problem that needs addressing.

Latest revision: 5 May 2026

Featured image: Confucius (possibly the inventor of the Golden Rule)

1. The Price of Fairness (film). Alex Gabbay (2017).
2. Independence Day: How the British pulled off a $45 trillion heist in India. The India Times (2023).

Model Thinking

nivtricLeave a comment

The limitations of one-dimensional thinking

The Hegelian dialectic is about argument, counterargument and resolution. It locks us up in thinking along a one-dimensional line with two opposites. Perhaps the best solution is outside that line. The debate about capitalism versus socialism dragged on for over a century and has dominated world politics. But markets and states can’t create agreeable societies on their own. Much of politics is theatre rather than reasoning and solving questions. We often think of good versus evil rather than the advantages and disadvantages of alternatives. We might find better solutions if we can meaningfully model humans and their interactions.

The limitations of thinking along a line like capitalism versus socialism become clear once you represent a line in a field. Suppose the grey area reflects the possible solutions, and the red dot is the optimal solution. If you reason along the black line, you only consider solutions on that line. If you design solutions by only thinking about how free markets should be and how much government interference we need, you might never consider the prevailing values in society. Your reasoning ignores human values. Thinking that markets and governments can solve society’s ailments is simplistic.

A line has one dimension. A plane has two dimensions, like the freedom of markets and shared values in society. You can represent three variables in a cube. For instance, you may add the state of technology as an additional variable. You won’t find the best solution if you think along a plane inside a cube. The number of variables can be higher. Freedom of markets and values in society are vague notions you can break down into dozens of more concrete variables. And if you have variables, you need ample data to estimate their impact. That data can be inconclusive. How do you know some other variable you didn’t think of didn’t interfere with the outcome? Despite all the models they used, central banks didn’t foresee the 2008 financial crisis. So yes, models can be wrong.

Still, models can be helpful. Our minds have constraints. We often take a perspective and reason from there. A socialist economist might tell us why capitalism fails but not what is wrong with socialism. There are economic theories that explain specific phenomena under certain conditions. And you might find additional answers in psychology, sociology, or even history. You might want to know what is wrong with your ideas before trying. You can run the idea through those theories. And that might give new insights. You can’t be sure you are right, but you can eliminate errors using models.

Natural Money is a research into an interest-free financial system. It draws from economic theories, monetary economics, banking, psychology and even history. I reviewed that idea with the help of existing theories and historical evidence to investigate how it might work in practice. During the process, issues came to light that I hadn’t thought of. Once interest rates in Europe went below zero, a resistance against negative interest rates manifested. Savers are irrational and prefer 2% interest and 10% inflation over -2% and 0% inflation.

It suggests we measure our gains and losses in our currency rather than purchasing power. And behavioural economics says we give more weight to losses than gains. The 4% loss in interest income impresses us more than the 10% reduction in inflation. These irrational emotions are human nature. It seemed pointless to try to convince savers that they were better off. Once I realised that, I could look for a fix for this awkward human feature by making negative interest rates appear as inflation.

The insights models give

Economic theories are models. Models are simplifications or abstractions. They can be loose and without numbers, like raising interest rates leads to lower economic activity. They can go into detail and include mathematics and predict that raising interest rates by 1% will slow economic growth by 0.5%. Models have limitations. Reality is much more complex than we can comprehend, so a model’s predictions are often off the mark. Still, models require us to use logic to establish which ideas might work under what circumstances by analysing an issue from different perspectives.

Proverbs can disagree with each other. Two heads are better than one, but too many cooks spoil the broth. And he who hesitates is lost while a stitch in time saves nine. Contradictory statements can’t be simultaneously correct, but both can be correct in different situations or times. Hence, we want to know which advice is best in which situation or what combination works best.

Models usually are better than uneducated guesses, and using a combination of models can lead to better outcomes than using a single model. That is why weather forecasters use up to fifty models to make a weather prediction. People who use a single model do poorly at predicting. They may be correct occasionally, just like a clock that has stopped is sometimes accurate, and endlessly tout their few successes while forgetting about their endless list of failures. These people will never learn anything from experience.

Intelligent people use several models and their judgement to determine which models best apply to the situation. Only people using multiple models together make better predictions than mere guessing, but they can be wrong. Models help us think more logically about how the world works and eliminate errors we would make otherwise. They can also give us insights into phenomena we wouldn’t get otherwise. To illustrate that, we can use models to investigate why people of the same ethnicity often live together and why revolutions are difficult to predict.

Sorting and peer effects

Groups of people who hang out together tend to look alike, think alike and act alike. If you look at the map of Detroit, you see people of the same ethnicity living together. Blue dots represent blacks, and red dots represent whites. We can’t change our skin colour, so if we hang around with people who look like us, that is sorting. We also adapt our behaviour to match that of others around us. When you hang around with smokers, you may start smoking too. Alternatively, if you hang out with people that don’t smoke, you might quit smoking. That is the peer effect. Both sorting and peer effects create groups of similar people who hang out with each other. Models can help us understand how these processes work. The phenomena seem straightforward, but we can model them.1

Schelling’s segregation model gives a possible explanation for how segregation works. Schelling made a model with individuals following simple rules. Suppose everyone lives in a block with eight neighbours. Red boxes represent homes where rich people live, and grey boxes are homes where poor people dwell. The blank box is an empty home. Assume now that everyone has a threshold of similar people who will make them stay.

A rich person might stay as long as at least 30% of his neighbours are rich. Assume a rich person lives at X. In this case, three out of seven or 43% of the neighbours are rich, like the person living at X. If one of the wealthy neighbours moves out, and a poor person takes that place, 29% of the neighbours will be rich, and the person living at X will move.

You can use a computer to simulate how that works out over time. Assume there are 2,000 people; 1,000 are poor, represented by yellow dots, and 1,000 are rich, represented by blue dots. Suppose they are distributed randomly at the start, and everyone wants to live amongst at least 30% similar people. In that case, the average is 50% alike, and only 16% are unhappy because less than 30% of their neighbours are alike. As a result, people start to move, and you will end up with a situation where the average is 72% similar and 0% unhappy.

Even when everyone likes to live in a diverse neighbourhood where only 30% of their neighbours are like them, segregation occurs. Segregation may not be the intention of the individuals involved, as they might be tolerant people requiring only a minority of similar people living in their neighbourhood.1 Whether that is the case is a different question. But if it is so, and if we believe segregation is undesirable, managing the ethnic makeup of neighbourhoods makes sense.

Peer effects cause people to act alike. Contagious phenomena are peer effects. They often start suddenly, seemingly out of nowhere. In uprisings and revolutions, extremists frequently determine what happens, for example, with uprisings such as the French, Bolshevik and Maidan revolutions. In hindsight, several pundits saw it coming, but things could have proceeded differently. It is difficult to predict revolutions. Granovettor’s model gives a possible explanation as to why that is so.

Suppose there is a group of individuals. Each individual has a threshold for participating in an event like an uprising and will join if at least a specific number of others join. If your threshold is 0, you do it anyway. If your threshold is 50, you start if you see 50 participants. The outcome varies depending on the thresholds of other people that might get involved.

Suppose there are five individuals, and the behaviour is wearing a suit. One individual has a threshold of 0, one has a threshold of 1, and three have a threshold of 2. The following will happen: one individual starts wearing a suit because her threshold is 0. The second individual joins because his threshold is 1. Then, the three remaining individuals join in because their threshold is 2.

If the thresholds had been 1, 1, 1, 2, 2, nobody would have worn a suit despite the group, on average, being more open to the idea. If the thresholds had been 0, 1, 2, 3, 4, and 5, everyone would have worn a suit after five turns, even though the group, on average, was less keen on doing this. In this case, extremist suit-wearers determine the outcome.

It indicates collective action is more likely to happen with lower thresholds and more variation. The influence of variation is surprising. It might explain why it is challenging to predict whether or not something like an uprising will happen. Not only do you need to know the average level of discontent, but you must also see the spread of discontent among the population and connections between individuals and groups.1

The proof is in the pudding

Do similar people hang out together because of sorting or the peer effect? That is the identification problem. Sometimes, it is clear. Segregation by race occurs due to sorting. Other situations are less clear. Often, you can’t tell whether it is sorting or peer effect because the outcomes are the same. Happy people hang out with each other, as do unhappy people. Both sorting and peer effects may have caused this.1

Models provide new insights, like why similar people hang out together and why revolutions are difficult to predict. Other models help us investigate what might happen under which circumstances. Thus, models explore the dimensions of complex questions and help us identify the spots where the best solutions dwell. In this way, models can assist us. For instance, if we intend to make everyone contribute to a good cause, we might want to model humans to see how we can do that. But not everyone is the same.

If we see humans as rational beings with good intent, we can convince them with arguments to do the right thing. If we see humans as religious creatures, an inspiring story can make them do it. If we think humans are calculating individuals, incentives and punishments can make them do the right thing. If we see humans as status seekers driven by pride seeking recognition, we might achieve the objective by telling them how great they are. You may get the best result if you use a combined approach.

Model or myth?

You can look at a model in several ways. How well does it explain the facts? How well does the model predict future events? Is the model correct? Is the model useful for a purpose? All models come with limits. They can be simplifications that explain a particular selection of events or predict specific future events. We also have worldviews that are our models of reality. We are creative thinkers and connect the dots in different ways. Our worldviews might be fiction mixed with facts. But a model doesn’t need to be correct to be helpful. Worse, irrational beliefs might save you. Believing is about surviving, not about being right. That is why humans are religious creatures. An example can illustrate that.

The replacement theory alleges that the elites aim to replace white populations with non-whites through mass migration and lowering the birth rate of whites. That can ‘explain’ mass migration and lowering birth rates of whites, and also pro-life activists trying to ban abortion because the abortion rates of whites are lower than those of non-whites. You might even believe there is a sinister anti-white force operating behind the pro-life movement, probably Jews. It explains the facts neatly as long as you ignore evidence to the contrary. The theory is so flimsy that it is hard to believe that rational, intelligent people would think it is correct. Only the rationality of a belief is not in its correctness.

Had the Native Americans believed from the onset that whites were an evil race with nefarious inclinations, not humans, but trolls from a dark place where the Sun never shines who were planning to murder them, so that they had to eliminate these pale abominations at all costs, they might have fared better in the centuries that followed. But there was no reason to believe that when the first starving whites washed ashore. You had to be crazy to think that. And if the natives had eliminated the whites and prospered, critics might later have argued it had been unnecessarily cruel to genocide these pale faces. But in this case, an irrational belief might have saved them from disaster.

Most immigrants have no evil intent and seek a better future for themselves and their children. Business elites may need additional labour or aim for low wages. Immigration is a way to achieve that. Political elites may try to keep the peace by promoting diversity. Western countries signed humanitarian treaties to allow asylum seekers. In recent decades, policies in Europe and the United States aimed to limit immigration. However, immigration continues unabated and has led to a border crisis in the United States, and the theory gives a so-called explanation.

Renaud Camus is the intellectual father of the modern replacement theory. According to Camus, replacement comes from industrialisation, de-spiritualisation and de-culturisation. Materialistic society and globalism have created a replaceable human without national, ethnic, or cultural specificity. Camus argued that the great replacement does not need a definition, as it is not a concept but a phenomenon. Indeed, the predominant liberal ideology in the West is globalist and serves the interests of the capitalists. And if money becomes our primary measure of value, other values lose meaning.

Humans cooperate based on shared myths like religions and ideologies. The replacement theory is a shared myth. It helps bond the group members and prepare them for collective action. That might be limiting migration, sending back migrants, or even a race war. The myth needs not to be correct but helpful for its purpose. If you fear the consequences of mass migration or are living together with far-right people, it is rational to accept the myth. It can generate collective action or make you acceptable within the group.

Critics argue that the replacement theory can be an excuse for right-wing violence. In a similar vein, multiculturalism can be an excuse for left-wing violence. In both cases, there are examples, and the perpetrators often have mental health issues. In 2002, a left-wing extremist assassinated a Dutch anti-immigration politician after another had been permanently handicapped in a previous attack sixteen years earlier. In 2011, a Norwegian right-wing terrorist assassinated 77 people in a bid to prevent a ‘European cultural suicide’. Most of them were whites.

Modern multiculturalism is also a myth. Multicultural societies supposedly have people of different races, ethnicities, and nationalities living together in the same community. In multicultural communities, people retain, pass down, celebrate, and share their unique cultural ways of life, languages, art, traditions, and behaviours, or so we are told. In most cases, it is not a reality. Ethnic groups often live in separate quarters, and cultural differences can cause trouble. But the purpose of the myth is to keep the peace.

Once you accept a myth, it becomes a faith, and you start ignoring evidence to the contrary. That may be why progressives and conservatives drift apart on this issue. It is a survival mechanism. We can’t foresee the future. Maybe multicultural societies will disintegrate and descend into gang violence and civil war. Alternatively, multiculturalism may promote world peace. For both outcomes, plausible scenarios exist. Your future and that of your children are on the balance, so it is natural to have strong feelings about the matter and rally around a myth that can generate the collective action you think is needed.

Latest revision: 13 April 2024

Featured image: Line And Dot On A Grey Rectangle. The artist wishes to remain anonymous because who wants to be as famous as Piet Mondriaan?

1. Model Thinking. Scott Page. Coursera (2014). [link]