In a comment on the article "Is this how quantitative easing works?", I wrote: "We have a medium of exchange which, in its basic form, can be taken out of circulation by anyone who happens to have a surplus; because of that the rich are able to charge everybody else for the privilege of using it. Until we change that, we will always be the servants of the financial system rather than its masters."
In reply, Tony Curzon Price asked: "Once we are masters of money creation, how do we ensure it goes on the right projects?"
The short answer is that if we are truly its masters it'll go to the right projects automatically - or, at least, the ones that people want - because it'll be created where it's needed. The longer answer needs a fair bit of background; money serves various functions which are inextricably linked, but which are to some extent in conflict with each other, and we have to understand why it serves us so badly in the current system before we can develop a system that will serve us well.
The different functions are inextricably linked because its ability to act as medium of exchange depends on its function as store of value and its ability to act as store of value depends on its function as medium of exchange - nobody would accept it in the first place if they couldn't redeem it in the future. Those functions are in conflict, however, because as medium of exchange its value is determined by current supply and demand, but as store of value it depends on society's capacity for future production. These factors are both varying all the time (and 'current' and 'future' have no clear dividing line), and are sometimes pulling its value in different directions, so the real economy has to make painful adjustments to compensate. Its function as unit of account is caught in the middle and is compromised by this conflict - we use money as a common measure of economic value, but its own value isn't stable.
Approaching it from a slightly different angle, its role in the majority of transactions is to facilitate consumption rather than production (i.e. we buy consumables and services more often than we buy tools etc), so the supply of the medium of exchange really needs to grow and shrink in line with demand for consumption. But because its basic physical form endures, its creation has to be primarily governed by its role as store-of-value, with the money supply responding only to investment needs.
This causes problems in two ways; it means that (in prudent times) transient economic activity - which enriches the present but may not make any contribution to the future - is constrained by shortage of the medium of exchange; but because there's no effective means of shrinking the core money supply, when money is created (in more exuberant times) in response to consumer demand, there are periods when there's more money in circulation than the economy can use - which pushes up prices, compromising its function as standard of value.
One of the difficulties about the perpective I'm presenting here is the fact that cash transactions represent only a small proportion of the economy (in terms of total value - though not in volume of transactions), so it's easy to treat it as relatively unimportant; but people's willingness to use other forms of money rests on their convertibility into cash. If we had to pay to keep money in the bank, many of us would keep it under the mattress instead; so any attempt to introduce negative interest rates (which is what's needed when the money supply needs to shrink) would almost certainly lead to increased demand for cash .... but less of it actually circulating. The root of the problem is the fact that (unless the money supply is debased) cash holds its value indefinitely.
To disentangle the two functions we would need some form of 'degradable money'; cash would have to be created in a form that would lose its value if it stopped circulating, and there would have to be a separate, intangible form of money for savings. As well as reducing the tendency for wealth to accumulate in the hands of the rich, this could improve the stability of the whole system; it would introduce additional levers for managing the monetary system, because the latency period (the time it keeps its full value for) and the speed at which it loses its value could both be varied in response to changing economic circumstances, as could the exchange rates between the two forms of money.
It wouldn't, of course, guarantee that the system was managed wisely - there probably isn't any way of guaranteeing that - but it would make it easier in a couple of respects to "ensure it goes on the right projects"; firstly because, with conventional money, the tendency for wealth to accumulate in the hands of the rich means that many major spending decisions are made by people who are not intimately affected by the consequences; and secondly because, by providing the means to remove money from the system cleanly, it makes it safer for the creation of money to be at the discretion of local communities.
Looking at the scenario in "Is this how quantitative easing works?", the tourist and his 100 euro note weren't actually necessary to clear all that debt; the village could have created its own "money". In its crudest form all it needed was for one of them to write an IOU, which could be passed round the circle. So the farmer, say, gives an IOU to the feed merchant, who uses it to pay the prostitute, who uses it to pay the hotelier, who uses it to pay the butcher, who clears his debt by returning it to the farmer - at which point the IOU could be torn up, and that piece of 'money' would cease to exist.
A major problem with this scenario is the concentration of risk. If the farmer's pigs escape and he drops dead of a heart attack while trying to round them up, then obviously he can't make good on his IOU, and whoever is holding it at that time loses the whole of its value. A primary virtue of a monetary system, to my mind, is that it socialises personal debt; it diffuses the risk of default, spreading the loss across a wider group. (Historically the wider group has been the shareholders and customers of the bank which created the money, but the credit crunch has shown that it's now society as a whole.)
So the village could create its own money by adding a step; instead of the pig farmer giving his IOU to the feed merchant, he gives it instead to someone the village has appointed as 'treasurer'. In return the treasurer gives him an IOU in the name of the whole community, which he uses to pay the feed merchant; it then circulates until it comes back to him and he redeems it. If he drops dead before he's able to repay the loan, then the village as a whole bears the loss .... but it has gained from the transactions that the process has enabled.
In fact, the loss will only manifest when the note is presented, which may never happen - it may just continue to circulate. Unless the note specifies repayment in pork there's no connection between it and the dead farmer, so his death won't affect the behaviour of the person holding it. But that does raise a couple of questions - ones which our current system doesn't really answer - how should the value of the note be denominated and what should it be backed by?
Connected with these is the question of how the loan should be repayable. If the farmer's debt has to be repaid in euros or gold or some other commodity, he won't have the confidence to take out the loan unless he's reasonably sure he'll be able to obtain some - which makes the whole process dependent on external factors. It's a little better if he has to repay it with the same commodity that he's borrowing - i.e. the village's money - but still problematic, because it depends on a closed loop, and it means the money has no underlying value. Ideally, he should be able to repay it with something that everyone knows he has, something in fact that everyone has and everyone values - time and labour.
This provides an answer to the other questions because it gives a unit of value which is meaningful to everyone and which, assuming they're all expected to contribute towards the community, is of value to everyone directly. If the village requires a basic contribution from all its members of so many hours per month of unskilled labour, that gives it the basis of a money supply. The farmer can offer to do x number of extra hours work for the village, the treasurer gives him notes representing that number of hours (less the treasurer's costs) and anyone in the village can use those notes to discharge their own obligation by presenting it to the treasurer.
From this perspective, it can be said that the village is stimulating trade between its members simply by allowing one person to fulfil someone else's obligation to the community. As long as people can discharge their obligations through service of some kind, the process costs no more than a very small amount of the treasurer's time. But if the community demands payment of taxes in some other form (such as a currency controlled elsewhere, or a precious metal), then it makes its prosperity dependent on the availability of that commodity. So, from this perspective, the economic health of the community rests on its willingness and ability to accept (and require) non-monetary contributions from its members.
For the most part, this is independent of the wider community; the village can be within the euro zone and having its own currency won't prevent the villagers trading in euros with others (and with each other). Indeed, most people promoting alternative currencies (i.e. Time Banks, LETS, etc) take it as a given, I think, that local currencies will co-exist with national currencies, as completely separate entities - but there are undoubtedly huge advantages to having a single currency.
Or, more precisely, there are huge advantages to having a single standard of value; there are major advantages to having a single medium of exchange (along with some disadvantages); but there are major disadvantages to having a common store of value. The advantages come from the possibilities for increasing the overall volume of transactions and easier access to forms of wealth which aren't available locally. The disadvantages come from the fact that money going out of a community can no longer stimulate trade within it, so there has to be some means of ensuring that outward flows are balanced by inward flows - which is very dfficult, with conventional, non-degradable money.
With a degradable medium of exchange, however, it becomes much easier. I said above that regulators would have a lever in setting the exchange rates between the medium-of-exchange money and the intangible store-of-value money, but they have more than that; they have the possibility of different exchange rates in different areas - so they'd be able to attract investment funds into areas which were losing liquidity. Creation of the medium of exchange would be in the hands of local communities, but creation of the store of value would be largely controlled at a higher level.
There's a lot of detail which I haven't tried to cover here - much of it I haven't explored myself, and perhaps there will be difficulties which would make the ideas I've outlined here unfeasible. But I am wholly confident that many of the problems we wrestle with today result from basing our financial infrastructure on a form of money which doesn't - and cannot ever - properly reflect the nature of the real economy.