Introduction to Capital Maintenance in Units of Constant Purchasing Power

Introduction

 

Historical Cost Accounting is the globally implemented, generally accepted, traditional, basic accounting model used by entities to prepare their financial reporting. It was originally authorized in IFRS in 1989 as an optional (not required) accounting model at all levels of inflation and deflation (including during high inflation and hyperinflation) in the original Framework for the Preparation and Presentation of Financial Statements, Par. 104 (a) which states:

 

‘Financial capital maintenance can be measured in either nominal monetary units or in units of constant purchasing power.’

 

HCA is thus not required by IFRS. It is an optional nominal financial capital maintenance basic accounting model. The other optional financial capital maintenance concept authorised in IFRS at all levels of inflation and deflation (including during high inflation AND HYPERINFLATION) is financial capital maintenance in units of constant purchasing power.

 

The exact wording of the original Framework (1989), Par. 104 (a) is maintained in the current Conceptual Framework (2010), Par. 4.59 (a).

 

Three concepts of capital maintenance authorised in IFRS

 

There are thus three concepts of capital and three concepts of capital maintenance authorised in IFRS since 1989 although both the original Framework (Par. 107) and the Conceptual Framework (Par. 4.62) mistakenly state:

 

‘The principle difference between the two capital maintenance concepts is the treatment of the effect of changes in the prices of assets and liabilities of the entity.’

 

the exact same wording maintained here too between the Framework (1989) and the Conceptual Framework (2010).

 

Capital concepts authorised in IFRS since 1989

 

The following three concepts of capital can be identified in the Conceptual Framework, Par. 4.57:

 

1. Physical capital. See Par. 4.57 and 4.58
2. Nominal financial capital. See Par. 4.59 (a)
3. Constant purchasing power financial capital. See Par. 4.59 (a)

 

Capital maintenance concepts authorised in IFRS since 1989

 

The three concepts of capital identified in Par. 4.57 give rise to the following three concepts of capital maintenance during all levels of inflation and deflation, including during high inflation and hyperinflation:

 

1. Physical capital maintenance concept. Optional at all levels of inflation and deflation. The Current Cost Accounting model is prescribed in IFRS when the physical capital maintenance concept is implemented. See Par. 4.56

 

2. Financial capital maintenance in nominal monetary units. (HCA) Authorised in IFRS, but not prescribed. Optional at all levels of inflation and deflation, including during high inflation and hyperinflation. See Par. 4.59 (a)

 

3. Financial capital maintenance in units of constant purchasing power. Authorised in IFRS, but not prescribed. Optional at all levels of inflation and deflation, including during high inflation and hyperinflation. See Par. 4.59 (a)

 

Constant real value non-monetary items inferred in IFRS

 

In terms of the Conceptual Framework (2010), Par. 4.59 (a), financial capital maintenance can be measured in units of constant purchasing power. There are thus actual economic items with constant real values over time.

 

Inflation erodes the real value of only monetary items over time.

 

‘Inflation is always and everywhere a monetary phenomenon.’

 

Milton Friedman

 

´The purchasing power of non monetary items does not change in spite of variation in national currency value.’

 

Gucenme U and Arsoy A P 2005 Changes in financial reporting in Turkey, Historical development of inflation accounting 1960 – 2005 Academy of Accounting Historians 2005 Research Conference 6-8 Oct 2005 Ohio State University Columbus Ohio USA

 

Low inflation, high inflation, hyperinflation and deflation thus affect the real value of only monetary items over time. Low inflation, high inflation, hyperinflation and deflation have, consequently, no effect on the real value of non-monetary items over time (and never had in the past and never will have in the future).

 

The above-mentioned economic items with constant real values over time are thus not monetary items. Consequently, they are non-monetary items with constant real values over time. They are thus constant real value non-monetary items or constant items.

 

When the stable measuring unit assumption is never implemented, i.e., under capital maintenance in units of constant purchasing power, these constant items have permanently fixed constant real values over time at all levels of inflation and deflation, including during high inflation and hyperinflation.

 

When, however, the stable measuring unit assumption is implemented, i.e., under traditional Historical Cost Accounting, and these constant items are not maintained constant in real value over time (because of the implementation of the stable measuring unit assumption – HCA - , not inflation), then the constant real non-monetary values of these constant items are eroded by the stable measuring unit assumption – HCA - (not by low inflation, high inflation or hyperinflation) over time at a rate equal to the annual rate of low inflation, high inflation or hyperinflation (because they are measured in terms of depreciating money, i.e., the depreciating monetary unit of account - and low inflation, high inflation and hyperinflation erode the real value of only money over time) and increased at a rate equal to the annual rate of deflation by the stable measuring unit assumption (not by deflation).

 

Examples of constant items are salaries, wages, rentals, pensions, borrowing costs, fees, royalties, employment benefits, interest received, interest paid, bank charges, issued share capital, retained income, retained losses, reserves, all other items in shareholders´ equity, provisions, trade debtors, trade creditors, taxes payable, taxes receivable, all other non-monetary payables and all other non-monetary receivables, all items in the income statement, etc.

 

Definition: Constant real value non-monetary items are non-monetary items with constant real values over time.

 

Variable real value non-monetary items inferred in IFRS

 

Consequently, non-monetary items that are not constant real value non-monetary items are variable real value non-monetary items or variable items. They have variable real values over time generally determined by supply and demand in free markets.

 

Definition: Variable items are non-monetary items with variable real values over time generally determined in terms of demand and supply.

 

Examples of variable items are property, plant, equipment, inventories, foreign exchange, quoted and unquoted shares, goodwill, patents, copy right, trade marks, intellectual property rights, etc.

 

Non-monetary items

 

Definition: Non-monetary items are all items that are not monetary items.

 

Non-monetary items are sub-divided in:

 

1. Variable real value non-monetary items
2. Constant real value non-monetary items

 

Monetary Items

 

The definition of monetary items thus determines whether an item is a monetary or non-monetary item. When the definitions of monetary items need improvement as they currently do in IFRS in IAS 29, Par. 12:

 ‘Monetary items are money held and items to be received or paid in money,’

 

and IAS 21, Par. 8:

 

´Monetary items are units of currency held and assets and liabilities to be paid in a fixed or determinable number of units of currency.’  

 

then some monetary and non-monetary items would be mis-classified. This would result in the doubtful calculation and accounting of the net monetary item loss or gain and the net constant item loss or gain only under capital maintenance in units of constant purchasing power if the current definitions of monetary items in IFRS were to be followed. The overall net effect of such mis-classification on the financial statements would be nil: the net loss or gain would in any case be calculated and accounted, as either a net monetary item loss or gain, or a net constant item loss or gain only under capital maintenance in units of constant purchasing power since it is normally constant items (e.g., trade debtors and trade creditors) that are incorrectly treated as monetary items. It is, however, necessary to classify items correctly as monetary, constant or variable items.

 

Net monetary item losses and gains and net constant item losses and gains are not required (net constant item losses and gains are not even identified under HCA) to be calculated and accounted (although net monetary losses and gains can be calculated and accounted under HCA according to Harvey Kapnick in the 1976 Sax Lecture by the ex-Chairman of Arthur Andersen) under the Historical Cost Accounting model as a result of the implementation of the stable measuring unit assumption.  It is assumed, in practice,  that money is perfectly stable for the purpose of the measurement of constant items and constant items treated as monetary items (e.g., trade debtors and trade creditors, etc.) under HCA during low inflation, high inflation and deflation while under hyperinflation the measures in IAS 29 are required, but Pricewaterhousecoopers very correctly states:

 

‘Inflation-adjusted financial statements are an extension to, not a departure from, historic cost accounting.’

 

PricewaterhouseCoopers 2006 Understanding IAS 29 p 5

 

IAS 29 simply requires the restatement of Historical Cost or Current Cost financial statements in terms of the measuring unit current at the end of the reporting period to make them more meaningful. IAS is not a departure from Historical Cost Accounting, even during hyperinflation of hundreds of billions percent per annum.

 

‘The Measuring Unit Principle:

The unit of measure in accounting shall be the base monetary unit of the most relevant currency. This principle also assumes the unit of measure is stable, that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.’

 

Walgenbach, Dittrich and Hanson 1973 p 429

 

The implementation of the stable measuring unit assumption under the Historical Cost Accounting model, consequently leads to the erosion of the real value of constant real value non-monetary items never maintained constant during low inflation, high inflation, hyperinflation and deflation; e.g., that portion of an entity´s equity never maintained constant by the real value of its net assets over time - probably amounting to the unnecessary erosion of real value in the world’s capital investment base amounting to hundreds of billions of US Dollar per annum in the world economy. Replacing the Historical Cost Accounting model by adopting constant real value maintaining capital maintenance in units of constant purchasing power in terms of a daily index would automatically maintain the constant purchasing power of equity constant for an indefinite period of time in all entities that at least break even in real value – all else being equal – at all levels of inflation and deflation, including during high inflation and hyperinflation, whether these entities own any revaluable fixed assets or not. This would maintain hundreds of billions of US Dollar per annum in the world economy for as long as the current level of world inflation maintains.

 

Definition of Monetary items

 

Monetary items constitute the money supply.

 

Examples are local currency bank notes and coins and the local currency capital amounts of home loans, car loans, commercial loans, business loans, student loans, government bonds, commercial bonds, capital market investments, money market investments, notes payable, notes receivable, etc.

 

Three economic items

 

From the above it is absolutely clear that there are not just the generally accepted two economic items in the economy, namely monetary and non-monetary items, but three basic, fundamentally different economic items in the economy and that the economy is made up of three basic, fundamentally different parts as follows:

 

Three basic, fundamentally different economic items

 

1. Monetary items
2. Variable real value non-monetary items (variable items)
3. Constant real value non-monetary items (constant items)

 

Three parts of the economy

 

1. Monetary economy
2. Variable item economy
3. Constant item economy

 

Measurement under capital maintenance in units of constant purchasing power

 

Daily measurement required

 

Daily measurement of all items are required under capital maintenance in units of constant purchasing power since constant items like trade debtors and trade creditors can pay or be paid on any day of the month. The Daily Consumer Price Index is used for this purpose during low inflation, high inflation and deflation and the daily US Dollar parallel rate during hyperinflation. Most countries (representing about 95 percent, or more, of the world economy) issue capital inflation-indexed government bonds. These bonds trade on a daily basis and are priced in terms of a Daily CPI which is a one or two month lagged daily interpolation of the monthly published CPI available in all these countries.

 

Chile has been using an index, the Unidad de Fomento (UF), to index non-monetary and some monetary items since 1967. It has been published daily since 1977. Chile currently inflation-indexes 25 per cent of its money supply daily.

 

During hyperinflation, populations spontaneously start using the daily US Dollar parallel rate to index variable items.

 

Value date

 

The value date under capital maintenance in units of constant purchasing power is the current value of the daily index, that is, today´s value. Everything in a company and economy is always presented, accessed, valued, measured, treated, shown and printed in terms of the current, that is, today´s Daily CPI or daily US Dollar parallel rate (during hyperinflation). It changes every day. Financial statements are not printed on hard copy: they are kept in digital format and updated daily: they change every day in nominal value, but they stay the same in real value.

 

A person quickly learns during hyperinflation that the value date is today: everybody uses the current, today´s, value of the US Dollar parallel rate to price variable items: it changes every day during hyperinflation. On some days it changes more than once a day.

 

Financial statements are thus stated at the measuring unit current at the end of the accounting period, only at the end of the accounting period: on that day. The next day (and at all future dates) all items in the financial statements are updated in terms of the new Daily CPI or the new daily USD parallel rate (during hyperinflation). The real values in the financial statements stay the same, but their daily nominal values change daily- the same for all values in the economy.

 

Constant items

 

Constant items are the easiest to measure under capital maintenance in units of constant purchasing power in terms of a daily index. They are always and everywhere (current period and historical constant items) measured in terms of the Daily CPI at today´s rate. When they are not measured daily as decribed – during the current financial period, then the net constant item loss or gain is calculated and accounted in the income statement. Net constant item losses and gains are constant items once accounted and measured in units of constant purchasing power daily thereafter - like all constant items.

 

Variable items

 

Variable items are valued daily in terms of IFRS, e.g., at fair value, net realisable value, recoverable value, present value, etc., excluding the stable measuring unit assumption, i.e., excluding nominal historical cost. Nominal historical cost is only valid during zero inflation – an economic environment never achieved on a sustainable basis in the past and aparently not soon to be achieved in the future. When variable items are not valued daily in terms of IFRS, as qualified, they are updated (only monetary items can be inflation-adjusted – inflation only affects monetary items) daily in terms of the Daily CPI till they are again measured daily in terms of IFRS, as qualified. Impairment, losses and gains in variable items are treated in terms of IFRS, as qualified.

 

Monetary items

 

Monetary items are always and everywhere (historical and current period monetary items) inflation-adjusted on a daily basis. When they are not inflation-adjusted during the current accounting period, then the net monetary loss or gain is calculated and accounted.

 

Inflation-adjusting the entire money supply on a daily basis in terms of the Daily CPI compensates for (nullifies) the effect of low inflation, high inflation and deflation, and in terms of the Daily USD parallel rate, nullifies the effect of hyperinflation. However, this does not remove actual low inflation, high inflation, hyperinflation and deflation. This means that the monetary economy and constant item economy can be maintained stable with an IFRS. Normally it is seen that the stability of the monetary economy is the responsibility of the Central Bank. In fact it is not. It is the responsibility of the accounting profession to implement capital maintenance in units of constant purchasing power in terms of a daily index correctly under complete co-ordination (everyone doing it). No central bank intervention is actually required to stop the effect of the erosion of the real value of monetary items from the monetary economy. It can be done by accountants with an IFRS: with capital maintenance in units of constant purchasing power in terms of a daily index. Central bank intervention is only required to eliminate actual inflation and deflation. Correct accounting can compensate for (nullify) its effect in the economy.

 

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Capital Maintenance in Units of Constant Purchasing Power

Capital maintenance in units of constant purchasing power would

 

(a) - with never implementing the stable measuring unit assumption – automatically maintain the real value of constant real value non-monetary items constant for an indefinite period of time in all entities that at least break even in real value – all else being equal – at all levels of inflation and deflation, including during high inflation and hyper inflation, whether they own any revaluable fixed assets or not

 

and

 

(b) – with daily inflation-indexing the entire money supply - compensate 100 percent for the effect of inflation and deflation  (including high inflation and hyperinflation) on the real value of only monetary items.

 

It does exactly what its name states: it automatically maintains the constant purchasing power of capital (equity) constant for an indefinite period of time, but, only in entities that at least break even in real value – all else being equal – at all levels of inflation and deflation, whether they own any revaluable fixed assets or not: i.e., the constant purchasing power (real value) of capital is equal to the real value of net assets under this model - in conformity with FAS 33, Par. 24:

 

‘It is essential to the credibility of financial reporting to recognize that the recovery of the real cost of investment is not earnings – there can be no earnings unless and until the purchasing power of capital is maintained.’

 

FAS 33, Par. 24

 

Daily inflation-indexing the entire money supply does not mean low inflation, high inflation, hyperinflation or deflation would stop, because these economic processes are determined by a number of factors, a very important one being the level of increase or decrease of the money supply. It would, however, always compensate for the effect: it would always be as if there were no low inflation, high inflation, hyperinflation or deflation during low inflation, high inflation, hyperinflation or deflation. It would always result in zero erosion of the real value of monetary items, not zero inflation because using the Daily Consumer Price Index (or daily US Dollar parallel – free market – rate during hyperinflation) would automatically result in eliminating the effect of low inflation, high inflation, hyperinflation or deflation.

 

(a) Daily inflation-indexing the entire money supply plus (b) capital maintenance in units of constant purchasing power in terms of a daily index means the local currency is used as a constant (not nominal) unit of account: in effect, the constant item and monetary economies would be “dollarized” in terms a constant (not nominal) local currency.

 

The stabilizing effect of adopting capital maintenance in units of constant purchasing power on real values in the constant item and monetary economies of previously high inflationary and hyperinflationary economies would generally lead to low inflation after adoption of the new accounting model – all else being equal – as it happened after the adoption of the Real Plan in 1994 in Brazil.

 

Capital maintenance in units of constant purchasing power in terms of a daily index is very similar to Dollarization of a previously high inflationary or hyperinflationary economy. However, under official Dollarization the local Central Bank (1) has no autonomous monetary policy capability and (2) seignorage (the practically 100 percent profit Central Banks / countries make on printing new bank notes and coins as required by their growing economies) continuously accrues to the US economy (a foreign economy) – the Fed prints the new US Dollars required - while under capital maintenance in units of constant purchasing power the local economy (i) gains economic stability similar to being Dollarized, but (ii) the local Central Bank maintains its independent monetary policy capacity and (iii) the local economy continuously benefits from the entire profit from seignorage.

 

The previous paragraph explains the use of capital maintenance in units of constant purchasing power in terms of a daily index – a freely available IFRS – to stop hyperinflation overnight at no cost instead of with very costly Dollarization or an equally costly currency board, the solutions of Prof. Steve Hanke, the eminent US economics professor who had already been personally involved in stopping 10 hyperinflations in this fashion. Official Dollarization and a currency board both require vast sums of US Dollars to replace the local currency money supply, often a prohibiting factor for a country in hyperinflation.

 

The very successful Real Plan used by Brazil in 1994 to stop their hyperinflation overnight at no cost was, in essence, capital maintenance in units of constant purchasing power in terms of a daily index although they did not understand it as such at the time.

 

The option to use a freely available IFRS to stop hyperinflation overnight at no cost obviously makes the Dollarization and currency board solutions obsolete and irrelevant. No country in hyperinflation or high inflation needs to use these solutions any more. (A capital maintenance in units of constant purchasing power IFRS – IFRS ´X` - would thus be of great value to high inflationary and hyperinflationary countries although it obviously can already be done in terms of IFRS authorization in the Conceptual Framework, Par. 4.59 (a).)

 

Summary

 

Capital maintenance in units of constant purchasing power would automatically maintain the constant item and monetary economies stable resulting in a stable overall economy at all levels of inflation and deflation (including during high inflation and hyperinflation), which is the basis for real economic growth and increased employment and would result in sustainable economic development.

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Nicolaas Smith

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The stable measuring unit assumption

is never implemented under capital maintenance in units of constant purchasing power.

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Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Nominal Historical Costs

under capital maintenance in units of constant purchasing power are only valid during zero inflation.

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Nicolaas Smith

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Daily inflation-indexing

 

 

of the money supply nullifies the effect of inflation.

 

 

 

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Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Definition of monetary items

Monetary items constitute the money supply.

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Sustainable Development Without Borders (NGO)

FOUNDING MEETING

The founding meeting of the newly formed Non – Governmental Organisation, SUSTAINABLE DEVELOPMENT WITHOUT BORDERS (NGO) was held on the premises of AERLIS in Oeiras on 30 November 2012.

The mission of the newly formed NGO is amongst other sustainable economic development objectives to assist under-developed, developing and emerging market countries experiencing high inflation or hyperinflation to immediately stop

(a) the very erosive effect of such high inflation or hyperinflation in their monetary economies as well as
(b) the equally erosive effect of the stable measuring unit assumption in their constant real value non-monetary item economies (constant item economies) with the Daily Index Plan.

The Daily Index Plan has two parts:

(i) Capital maintenance in units of constant purchasing power as authorised in IFRS in 1989 and
(ii) Daily inflation-indexing of the entire money supply under complete co-ordination.

The Daily Index Plan is based on the very successful Brazilian Real Plan that stopped hyperinflation in Brazil overnight at no cost.

This would stabilise the entire economy which would increase the level of sustainable economic development for an indefinite period of time in all entities that at least break even in real value – all else being equal.

The founding members provisionally elected the following members to the statutory bodies:

General Assembly Board

Chairman: Carlos Baptista

Vice Chairman: António Mendes

Secretary of the Board: Harriet Smith

Management Board

Executive Director: Nicolaas Smith

Vice Executive Director: José Gomes

Director: Ana Ferreira

Audit Committee

Chairman: Rui Feiteira

Relator: Ana Paula Mendes

Secretary of the Audit Committee: Helena Lobão

The founding members also approved the NGO´s Articles of Association, Internal Regulations, strategic orientation and fundamental areas of activities.

The NGO´s first priority is to secure funding for its activities which will almost entirely be outside Portugal in under-developed, developing and emerging market economies with high inflation or hyperinflation.

Target countries with hyperinflation include but are not limited to:

Belarus

Venezuela

Democratic Republic of Congo

Target countries with high inflation include but are not limited to:

Ethiopia

Sudan

Guinea

Democratic Republic of Yemen

Tanzania

Mongolia

Nigeria

Angola

Argentina

Sustainable Development without Borders

AERLIS, Oeiras, Portugal 30 November 2012

Seignorage

Seignorage

Seignorage from the printing of bank notes and coins is a net profit to the Central Bank / government printing the bank notes and coins. Seignorage is the difference between the nominal (real) value of the new bank notes and coins and the cost to print and mould them. The real value of these newly printed bank notes and coins is generally equal to their nominal value only when this new money is first spent by either the Central Bank or by the national government departments on receipt from the Central bank when this new money is paid to the national government as a dividend from the Central Bank. Thereafter their real value is generally eroded by inflation over time. Bank notes and coins generally make up about 8 per cent of the broad M3 money supply in an advanced economy according to the figures available for the US Dollar money supply.

Unique advantage to the US of the reserve currency status of US Dollar

The historic reserve currency status of the US Dollar in the world economy results in the net profit from seignorage resulting from the Federal Reseve Bank of the US having to print new US Dollars as demand for the US Dollar naturally increases in Dollarized economies and worldwide outside the US as a result of economic growth in these Dollarized economies and the world economy outside the US. The benefit of this almost 100 percent profit on printing new US Dollars for Dollarized economies like Panama, Zimbabwe and Equador and for  the rest of the world economy outside the US, continously accrues directly to the well being and security of the people and the economy of the US at almost no cost to them and not directly to these Dollarized economies and the world economy outside the US. This is the result of historic developments in these Dollarized economies and the world economy outside the US. This is not ‘engineered’ by the US government or any entity in the US.

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Stable world economy entirely in the hands of the IASB and the accounting profession

Stable world economy entirely in the hands of the IASB and the accounting profession

Daily inflation-indexing of all monetary items is a direct requirement of capital maintenance in units of constant purchasing power; i.e., it is required by IFRS as authorized by the IASB.

The stable measuring unit assumption is never implemented under capital maintenance in units of constant purchasing power as authorized in IFRS twenty three years ago. The entire money supply has, consequently, to be inflation-indexed on a daily basis. This eliminates the entire monetary effect (eroding or increasing of the real value of monetary items over time) of low inflation, high inflation, hyperinflation and deflation from the entire monetary economy under complete co-ordination.

This requires all banks - commercial and central banks - to inflation-adjust all monetary items on a daily basis in countries implementing IFRS.

The Daily Index Plan is thus entirely implemented in terms of IFRS: no Central Bank intervention is required.

Operating the world economy in constant monetary and constant real value non-monetary items (a stable world economy) is thus entirely the responsibility of the IASB: i.e., entirely in the power of the world´s accountants.

The IASB has, in fact, authorized capital maintenance in units of constant purchasing power as an option to traditional HCA twenty three years ago (in 1989).

However, almost no-one understands it, with the result that although it was, in principle, implemented during 30 years of very high and hyperinflation in Brazil and during 45 years in Chile, these two countries unintentionally and unknowingly went back to HCA.

The IASB is currently (2012) working on (submitted to research) a draft IFRS `X´ CAPITAL MAINTENANCE IN UNITS OF CONSTANT PURCHASING, originally submitted  to the IASB by the Argentinean Accounting Federation in 2010 in conjunction with the accounting authorities in Brazil, Mexico and Chile, - and then amended by me to its current title and form -  that will require  (not optional) capital maintenance in units of constant purchasing power in terms of a Daily Index in all countries implementing IFRS with annual inflation equal to or greater than 10 percent or cumulative annual inflation equal to or greater than 26 percent over three years.

This will mean the beginning of the end of HCA in the world economy after a reign of thousands of years: the only paradigm the world has ever known since the implementation of double entry accounting.

The IASB always specifically encourages early implementation of a proposed IFRS in the process of being authorized. The early implementation of a proposed IFRS is part of the very thorough due process - very responsibly, correctly and essentially - required prior to authorization by the IASB.

You are thus very welcome and encouraged by the IASB to implement capital maintenance in units of constant purchasing power in terms of a Daily Index in your company, preferably in your entire country, prior to its actual authorization by the IASB in years to come.

Free assistance is available  to under-developed, developing and emerging market economies from the newly formed (on 30 November 2012 in Lisboa, Portugal) Non-Governmental Organization SUSTAINABLE DEVELOPMENT WITHOUT BORDERS, provided you (or a private foundation, NGO or sustainable economic development organization related to your country) provide the finance to SDWB to visit your country to advise your accounting authorities in this matter.

 

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Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Daily Index Plan removes country risk from exchange rate

Daily Index Plan removes country risk from exchange rate

The 17 countries in the European Monetary Union are, in practice, “Dollarized” in terms of the Euro. They have stable monetary economies (one third of their economies: the non-monetary economy being made up of the constant and variable item economies), but their central banks have no independent monetary policy capability. The European Central Bank is not a federal central bank: in principle, it is the German Bundesbank in disguise. The Euro is a monetary policy straight-jacket for 16 EMU countries, not for Germany. As long as the 17 balance (or get close to balancing) their government spending with receipts, the Euro is stable and first level Euro countries like Germany and Holland can grow, while – at the exact same time - countries like Greece and Portugal are in recession to the great detriment (maybe for the next 10 to 15 years) of the populations of these countries as a result of no federal political system in the European Union which most probably will never come about (e.g., Portugal and Greece are not East Germany who received 100 billion Euros per annum in development funds for years). The Euro is good for Germany in all respects, not for Portugal and Greece in expansionary monetary policy capability which is zero under the current EMU set up. The Euro is simply the Deutche Mark in European colours.

The central banks of Portugal, Greece and Ireland cannot implement the very successful US and Japanese policy of unlimited credit (what Portugal and Greece actually need now) during an economic crisis or monetary easing like the US does or create 6 percent inflation (the upper inflation target in a growing economy like South Africa, for example) via simply, sovereignly creating new money on a temporary basis (to be removed later on from the money supply: see US quantitative easing) in their monetary economies. Portugal and Greece would be able to do that if we were to first adopt the Daily Index Plan and then leave the European Monetary Union while remaining in the European Union like the United Kingdom.

In exactly the same way as Belgium can have no government for two years (completely secure with a completely open economy in the heart of the Europe Union), so can Portugal and Greece leave the Euro Monetary Union after first implementing the Daily Index Plan while staying in the European Union. The IMF is always there in the background as a backstop to avoid sovereign default. The ECB and the European Commission are not critical for this purpose: see the mission of the IMF.

The individual EMU country risk has thus been removed from the Euro exchange rate by “Dollarizing” EMU countries in terms of the relatively stable Euro. The individual country risk is now reflected in the individual country´s government bond interest rate: the new country risk paradigm.

The same would happen under the Daily Index Plan in any economy with a Daily CPI fully reflecting a currency´s foreign exchange exposure during low inflation or the US Dollar daily free-market exchange rate being used as the actual Daily Index during high and hyperinflation. With daily indexing the entire constant item economy and daily inflation-indexing of the entire monetary economy, the monetary economy and constant item economies would be “Dollarized” in terms of a constant (not nominal) local currency unit always being exactly equal to the US Dollar when the USD free-market exchange rate is used as the Daily Index during high and hyperinflation, but the local Central Bank would have completely autonomous monetary policy capability.

Whenever the foreign exchange rate (USD parallel rate during hyperinflation) would change it would immediately be fully reflected in the entire economy by all constant items and all monetary items automatically being indexed to the new foreign exchange value via the Daily CPI or the actual US Dollar daily exchange rate being used as the Daily Index (as Brazil did for 30 years with their daily indices). It would make no difference to stability in the local economy: all constant items and monetary items would be automatically indexed on a daily basis: in principle, what Brazil did for 30 years in their constant item economy and part of their monetary economy (Brazil did not inflation-adjust their entire money supply during the referred period) from 1964 to 1994 during very high inflation and hyperinflation.

This would remove the country risk from the exchange rate: the constant and monetary economies would be “Dollarized” in terms of a constant (indexed) local currency unit, with a Central Bank with full monetary policy capability. The country risk would be reflected in the government bond interest rate as it is now (2012) happening in Greece, Portugal and Ireland in the EMU.

Two countries (or monetary regions) both implementing the Daily Index Plan would have an almost permanently fixed foreign exchange rate between the two countries with their individual country risks being reflected in each government´s bond interest rate.

The Daily Index Plan would thus generally lead to very low inflation immediately after its introduction – all else being equal - in hyperinflationary countries because of the use of the daily US Dollar free-market exchange rate as the Daily Index in the entire economy (as it happened, in principle, in 1994 in Brazil with the Real Plan).

(The EU part of this article is obviously influenced by my Portuguese self-interest.)

 

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Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Zero Erosion Economy

Zero Erosion Economy

 

The Daily Index Plan would result in zero erosion of real value in:

 

1. Constant items in the constant item economy, e.g. salaries, wages, rentals, capital, trade debtors, trade creditors, taxes payable, etc. since all these items would be indexed daily in terms of the Daily CPI or USD daily parallel rate. They would automatically always have constant real values over time since the stable measuring unit assumption is never implemented under capital maintenance in units of constant purchasing power.

 

2. Real price increases and decreases in the variable item economy (e.g. property, plant, equipment, inventories, foreign exchange, etc.) generally determined in free markets with these prices updated daily in terms of the Daily CPI or daily USD parallel rate when they are not determined in the free market on a daily basis in terms of IFRS excluding the stable measuring unit assumption under capital maintenance in units of constant purchasing power.

 

3. Zero erosion in monetary items in the monetary economy - excluding bank notes and coins outside the banking system - since all monetary items, as qualified, would be inflation-indexed on a daily basis in terms of the Daily CPI or daily USD parallel rate. All monetary items in the banking system would be inflation-indexed on a daily basis resulting in zero erosion of real value in monetary items in the banking system.

 

Definition

 

Monetary items are local currency units held and items with an underlying monetary nature being substitutes of the former.

 

Examples of monetary items that are not local currency units held are money loans, consumer loans, home loans, car loans, student loans, the capital amounts of bonds, the capital amounts of money market and capital market instruments, notes payable, notes receivable, etc. when these items are not in the form of local currency units held.

 

The Daily Index Plan constitutes

 

(A) capital maintenance in units of constant purchasing power as authorized in IFRS and

 

(B) daily inflation-indexing of the entire money supply, both in terms of the Daily CPI or daily USD parallel rate.

 

The Daily Index Plan would result in zero erosion of real value in (1) constant items as a result of measuring all constant items in units of constant purchasing power and (2) constant real value monetary items as a result of daily inflation-indexing the entire money supply excluding bank notes and coins outside the banking system with both (1) and (2) in terms of a Daily CPI or daily USD parallel rate.

 

In practice it would result in a Zero Erosion Economy (ZEE) at whatever rate of inflation or deflation. Inflation would generally fall to very low levels under the Daily Index Plan since the monetary effect (nature) of money is completely compensated for in a fully inflation-indexed money supply economy under IFRS-authorized capital maintenance in units of constant purchasing power in terms of a Daily Index with complete co-ordination.

 

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Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Hidden and unknow cost of Dollarization (gain to the US)

Hidden and unknow cost of Dollarization (gain to the US)

Dollarization and the Dail Index Plan stop hyperinflation overnight. The Daily Index Plan implements the principles used under Dollarization, but with constant real value local currency monetary items and constant real value local currency non-monetary items implemented via daily indexation as was done with the Brazilian Real Plan in 1994.

Dollarization is a very costly, historically proven, but currently obsolete, irrelevant and unneccessary monetary policy option during high inflation and hyperinflation. Dollarization comes at a huge cost with some of this cost hidden and unknown.

Cost of Dollarization

1. The entire monetary base (money supply) has to be substituted with US Dollars.
2. The Central Bank cannot implement any independent monetary policies once the economy is Dollarized.
3. The hidden and generally unknown cost: The people of the Dollarized country continuously loses the sovereign windfall profit of seigniorage when Dollarization starts and every time new US Dollar bank notes are required as the Dollarized local economy grows. This real profit continuously accrues to the people of the United States of America (plus its multiplier effect) at apparently no cost to them.

Only the Central Bank has the authority to print new money, precisely to allow this windfall profit or seigniorage to accrue for the benefit of the entire population of the country where the money is created (the United States of America, in the case of Dollarization in US Dollars).

Example of the cost of Dollarization

(i) Monetary base in Iran (for example): USD 245 billion = cost of Dollarization in Iran.

(ii) Central Bank Monetary policies given up:

1. Monetary easing used very successfully in the US, UK and Japan, but refused by Germany for Greece, Ireland and Portugal. These countries are, in priciple, dollarized in Euros. 
2. Interest rate policies
3. The ability of the Central Bank to be responsible for labour policies very similar to “full employment” policies in the country, like the Federal Reserve Bank´s very successful labour policy responsibilities in the US economy.
4. The complete range of other normal Central Bank discretionary monetary policies.

(iii) Loss of Seigniorage - the hidden cost, hardly understood by anyone.

What is seigniorage?

Definition

Seigniorage is the profit the Central Bank (country) makes from the difference between the real value of fiat money bank notes and coins when they are added to the money supply and the cost of printing them.

Only about 8 percent of the money supply is made up of actual bank notes and coins in an advanced economy (based on the US money supply).

Fiat money has a decreasing real value during inflation: 7 billion plus people use generally decreasing real value fiat money each and every day to buy and sell almost everything in the world economy. When too much fiat money is created, this erosion of real value is reflected by the rate of inflation over time. Consumer Price Indices indicate the change in the real value of fiat money in the world economy within their particular local economies. Countries that issue government capital inflation-indexed bonds already have a Daily CPI that indicates the daily change in the real value of their local currency within their local economy.

Example: The economy grows in terms of GDP at 2 percent per annum. The monetary base needs to be increased. The Central Bank  – in the normal course of its activities - orders new fiat money bank notes with a nominal value of USD 4 billion at a cost of USD 100 000 from the bank note supplier, De la Rue, in the UK, for example.

Real value       USD 4 000 000 000

Printing cost                     100 000

Seigniorage            3 999  900 000

The Central Bank (country) is free to do whatever it wants with the newly printed fiat money bank notes and coins in terms of its articles of association. For example, lend it to commercial banks in terms of monetary policy in order to create more fiat money (this time not printing new bank notes and coins) in the economy via fractional reserve banking, buy new computers, new office blocks, new cars, etc. The Central Bank can also pay the newly printed money as a dividend to the Government who can do anything it wants with the newly printed money – in terms of the constitution, e.g., pay civil service, army, police, health services, military, education salaries, buy or develop / maintain nuclear weapons, if it were a member of the official Nuclear Club (Russia, China, US, Israel, UK, France, India, Pakistan, others ?), etc.

Countries like Zimbabwe, Panama, Ecuador, (Argentina, in the recent past) and other Dollarized countries as well as the increase in the use of the US Dollar outside the US economy continuously contribute in this way to the increase in the short and long term welfare and security of the people of the United States of America at no apparent cost to the people of the United States of America for an indefinite period of time - to the possible detriment of the people of these Dollarized countries. It would be a detriment if these countries were able to do better for their people by not being Dollarized as compared to the stability that Dollarization brings compared to its huge costs as indicated above.

This avoidance of Dollarization is now possible in terms of the Daily Index Plan, i.e., capital maintenance in units of constant purchasing power as authorized in IFRS twenty three years ago plus daily inflation-indexing of the entire money supply, both in terms of a Daily Consumer Price Index (the USD daily parallel rate during hyperinflation). The Daily Index Plan results (guaranteed) in the local economy being “Dollarized” in terms of constant local currency monetary and non-monetary items instead of actual United States Dollars. It results in the local economy operating with monetary and non-monetary items of completely stable real value: i.e., constant (not nominal) real value local currency monetary and non-monetary items of perfectly stable real value.

If Iran were to Dollarize her economy, the people of Iran would continuously contribute to the short and long term welfare and security of the people of the United States of America for an indefinite period of time (forever) at apparently no cost to the people of the United States of America but at a cost (e.g., continuous loss of seigniorage, etc.) to the people of Iran, if Iran were to stay Dollarized for an indefinite period of time – possibly to the overall short and long-term detriment of the people of Iran. This aspect needs credible, specific value, verifiable and peer-reviewed research to determine its real economic implications.

Seignoreige is a windfall profit which only comes about as a result of the double-entry accounting model in the same way as capital, as we know it, comes about. It is the initial accounting of a real value that exists or is newly created in the economy: in the case of capital, as a result of laws (company, commercial and other laws) and the existing real value of net assets. In the case of seigniorage, as a result of the sovereign law of legal tender giving rise to newly created real value in the economy (newly printed fiat money bank notes and coins) and the accumulated economic value of all the underlying value systems in the economy, e.g., sound governance, sound economic policies, sound political policies, sound monetary policies (e.g., no oversupply of the money base as indicated by inflation and hyperinflation), sound accounting policies, sound educational policies, sound health policies, sound international relations, sound legal system, sound defence system, etc.

Nothing of the above was or is specifically “engineered” by the government of the United States of America or any entity in the US. All of it came about as a result of specific historical economic circumstances that resulted in Dollarization in the past. Dollarization in the past was a direct reflection of the level of undestanding or lack of understanding of, e.g. the effect of the stable measuring unit assumption (Historical Cost Accounting) in the economy, daily inflation-indexing of the entire money supply, etc.

The US Dollar is almost always used for Dollarization. It is estimated that 50% of US Dollars is used outside the US economy because of the extraordinary success of the US economy and Federal Reserve Bank over the last at least 100 years: because of the faith people in general have in the US Dollar as a relatively stable currency and unit of account. 

Chile, Angola, Turkey and especially the large Brazilian economy beat hyperinflation without resorting to Dollarization. The Brazilian Real Plan in 1994 signalled the end of official Dollarization as a remedy during hyperinflation. The Real Plan very successfully used the principles implemented under Dollarization without using actual Dollarization in US Dollars to the great and indefinite advantage of the people of Brazil.

Zimbabwe´s spontaneous Dollarization in 2008 occured outside the realm of official monetary policy implementation: the povo (people) decided what to do, not the government of Zimbabwe (Robert Mugabe) or the Central Bank (Gideon Gono) as the agent of the government. Zimbabwe is a very open economy (on the consumer level) surrounded by stable economies, especially the large South African economy which could be up to 100 times larger than the Zimbabwean economy.

As Nelson Mandela stated: (Economic collapse in) Zimbabwe was a case of failure of leadership: clearly true as far as monetary policy, amongst many policies, was concerned.

There is absolutely no necessity for Iran now - or any other country in the future - to Dollarize, except possibly in the case of spontaneous Dollarization by the people of a relatively small economy in total economic chaos like Zimbabwe in 2008. Spontaneous Dollarization cannot be controlled under a total lack of official monetary policy initiatives in a very open economy. It is a matter of survival for the people of the country and they take matters into their own hands like they did in Zimbabwe in 2008 when the government is incapable of looking after their economic well being.

Dollarization is not necessary at present (2012). All Dollarized economies can successfully end Dollarization by implementing IFRS authorised capital maintenance in units of constant purchasing power and daily inflation-indexing of the entire money supply, both in terms of a Daily CPI. The correct implementation of the Daily Index Plan is guaranteed (by proven economic, mathematical and IFRS authorized accounting principles) to result in an economy operating in constant real value local currency monetary and non-monetary items.

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Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

The US Dollar is the substitute for a global unit of real value

The US Dollar is the substitute for a global unit of real value.

Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.

Buy the Kindle ebook at Amazon.com for $2.99 or £1.53 or €2.68