A money-substitute can be embodied either in a banknote or in a demand deposit with a bank subject to check (“checkbook money” or deposit currency), provided the bank is prepared to exchange the note or the deposit daily free of charge against money proper. FULL ARTICLE by Ludwig von Mises
Source link: http://blog.mises.org/11261/there-is-money-and-then-there-are-money-substitutes/
There is Money and Then There Are Money Substitutes
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I’m not sure I agree with all of this. Money is an intermediary for another transaction, and a means to make relative comparisons.
This means the seller has to accept that the money can be exchanged for goods at a later date. That’s the crucial point, be it tokens, dollar bills, letters of credit, or gold. It doesn’t matter.
Bar using gold for something else, it still relies on someone else accepting it in the future as something valuable in an exchange otherwise its use is limited since its just another metal.
Ditto for the token. It’s value is the raw metal
As for paper, this is interesting. http://tinyurl.com/yg7kmhv The other use for Zimbabwe dollars
Nick
The article makes sense to me: commodity credit is redeemable, circulation credit is not. In other words, when the money and its substitutes are fully redeemable, there is as much solvency as in a barter system. Otherwise there are the problems we face in banking.
I think you need to look at the raw value of commodities. That means the use to which the commodity can be put.
So oil, coal, steel etc has a value related to its end use – transport fuel, heating, building, …
Gold, silver etc has a value that isn’t related to its end use, its related to the willingness of others to accept it as a means of exchange. That’s the same as fiat money. It depends on the willingness of others to assign a value to it.
Quote from Nick: “Gold, silver etc has a value that isn’t related to its end use, its related to the willingness of others to accept it as a means of exchange. That’s the same as fiat money. It depends on the willingness of others to assign a value to it.”
Gold’s use as a medium of exchange is just another end use, the same as jewelry or as an electrical conductor or whatever. It isn’t fiat money, because it’s tangible and can’t be created out of nothing. It’s only value as money comes from the willingness of others to assign it value as money.
I’m always puzzled as to how the British money supply fits into these categories.
We have several different parallel money supplies within the British Isles:
Bank of England notes
The Bank of England (the Central Bank) issues pound (sterling) denominated banknotes. These are legal tender in England, and accepted commercially throughout the UK and the Crown Dependencies.
Scottish banknotes
Several private banks in Scotland are authorised to issue their own pound (sterling) denominated banknotes. I’m told these are not legal tender (that in fact there are technically no legal tender banknotes in Scotland), but are always accepted commercially in Scotland and are usually accepted commercially in the rest of the UK. They are always accepted by banks throughout the UK and the Crown Dependencies.
By law, Scottish banknotes have to be 100% backed by the issuing bank holding Bank of England banknotes (except for a small amount of pre-1844 “legacy†issue). However for administrative ease this backing is provided by the Bank of England issuing special £100million banknotes to the Scottish banks.
Northern Ireland banknotes
Several private banks in Northern Ireland are authorised to issue their own pound (sterling) denominated banknotes. These are commonly but not always accepted commercially in the rest of the UK, but are always accepted by banks throughout the UK and the Crown Dependencies. I don’t know what backing they have.
Crown Dependencies banknotes
The governments of the Crown Dependencies (Jersey, Guernsey and the Isle of Man) issue their own pound (sterling) denominated banknotes. Each is legal tender in its own jurisdiction, and in practice is always accepted in the other Crown Dependencies. They will sometimes be accepted commercially in the UK, but usually not. However they are generally accepted by banks throughout the UK and the Crown Dependencies.
These banknote issues are not backed by Bank of England banknotes, but are instead backed by UK government bonds (gilts). The advantage for the Crown Dependency governments is that they receive interest on their gilt holdings.
Overseas Territories banknotes
The governments of three British Overseas Territories (Gibraltar, the Falkland Islands and St. Helena) issue their own banknotes. These are technically separate currencies, although the exchange rate to the pound sterling is fixed at 1:1 and Bank of England banknotes are used alongside the local currency.
Gibraltar pounds are issued under the authority of the UK, and by UK law are exchangeable 1:1 for Bank of England notes (although I don’t know what backing they have). They are not usually accepted commercially, but are generally accepted by UK banks.
I don’t know what the status of Falkland Island and St. Helena pounds are; they do not seem to be generally available off the relevant islands.
Now, what is the economic status of these?
One would tend to say that Scottish banknotes are “money certificatesâ€, because they are 100% backed by Bank of England notes. However the backing notes are in unusably huge denominations, so theoretically a Scottish bank might not be able to convert its notes into Bank of England notes on demand (although it could within a few hours by exchanging a £100million note with the Bank of England for more useable denominations). Does this mean that they fail to be money substitutes?
Are the Crown Dependencies’ banknotes money substitutes, since in practice banks throughout the UK will always exchange them for Bank of England notes? Do they fail to be “money certificatesâ€, because they are backed by gilts rather than banknotes?
The Overseas Territories’ currencies are money in their own right (although in very limited economies). However does the mandated 1:1 exchange make them money substitutes in the UK?
The term ‘fiduciary media’ is not appropriate, because the bank of issue or deposit does not have a fiduciary obligation to the note holder or depositor, only an ordinary legal obligation as debtor. As Mises himself above states, they are ‘payable and redeemable on demand, against a debtor’.
Other writers call bank issued money credit or debt money, or debt as money, and this is to be preferred.
Although the supposedly defining function of money is its use in indirect exchange, money is also said to have several functions, such as the standard of value or measure of value or standard of payment. It is here that the term ‘gold standard’ means that gold coin is the standard of value rather than the only medium of indirect exchange. E.g. where banks issue banknotes and accept deposits on current account repayable to the customer’s order, such bank obligations can serve as a medum of indirect exchange, while not being the standard money, i.e. not legal tender. So, instead of exchanging title to a gold coin for goods, one can exchange title to a creditor claim on a bank, embodied in a bank note. If the seller accept it, the transaction has been carried out with credit rather than the commodity gold coin.
The bank’s obligations on current account and bank notes are themselves legally payable in legal tender, i.e. gold coin, but as with the individuals using bank credit to exchange goods in the market place, the bank can also use credit to discharge its obligations in many cases. For example, in the payments system, inter-bank and intra-bank payments can be settled not by payment of gold coin but by netting or offsetting payments between banks, and using net deferred settlement on a typically daily basis. And even the net deferred amounts payable, need not be settled in gold coin, because the banks can hold accounts with a settlement bank, on whose books the settlements can be effected by book entry. Of course there is still a need for some holdings of commodity money by the banks, however its amount need not be large in relation to the total outstanding demand deposits and banknotes, or the daily gross payment values processed.
In 1710, when paper money was becoming popular, people claimed that paper money was merely a substitute for coins, and not real money. In 1840, when checking accounts were becoming popular, people claimed that checking account money was merely a substitute for coins and paper. Since 1950, as credit cards became popular, economists have claimed that credit card dollars are merely substitutes for checking account dollars, paper dollars, and coins.
In every case, people have failed to understand what a permanent float is. As a new kind of dollar is issued on loan, people see that the new dollar must ultimately be paid back, so they deny that it is ‘real’ money. Eventually, people realize that as one dollar is repaid, another is lent to take its place, and the permanent float of paper, checking account, or credit card dollars is finally recognized as money.
I predict that in the year 2050, economists will recognize the permanent float of credit card dollars as part of the money supply. However, there will be some new space-age money that they will insist is merely a ‘money substitute’ or ‘economizing expedient’ for real money.
I think this division is the weakest point in monetary theory of Mises.
And it starts with categorizing money as a good.
Money is not a good, it is a function (Mises also knew the difficulty of categorizing money as a good and thus invented a third category of good just for money). Just like “good” is a function. A function solely dependent on the minds of individuals. “Good” function is a function of commodities to satisfy consumption, directly or indirectly. The more of the good the better. Also goods equal wealth. Money on the other hand is something different. Its supply is irrelevant and money does not equal wealth.
Usually money function starts in a commodity with a good function. General marketability or relative liquidity allows the commodity to gain money function. Once the commodity is chosen as a medium of exchange its money function starts increasing and its good function starts decreasing relative to money function. No one can say the exact ratio but at one point the gold coin had a lot of money function and some little good function. Todays banknotes also have both money and good functions although since scrap paper is very abundant and cheap banknotes good function is very small relative to its money function unlike a gold coin.
Whatever serves as money, is money. Whatever has money function adds to the money supply. . But since money is a function inherent mostly in commodities and entries in ledgers, it is really impossible to measure. All the money measures are arbitrary just as CPI is arbitrary. They can give some ideas regarding the increase or decrease of the money supply. and sometimes confuse people as in the case of current inflation\deflation debate
Why commodities? Why not services?
For example when industrialisation come in, people said they weren’t real jobs. They were derivative jobs dependent on agriculture.
The same is said now for service based jobs against industrial jobs.
Money is just a means of simplifying the transactions. A mediator.
You’re correct on measure Kerem. Many don’t realise that when it comes to the dollar. It’s just a measure.
Nick
Karem, You are right about money as a good. Commodity money such as a gold coin has a non-money value, e.g. to make conductors and jewelry, and in equilibrium, demand to hold gold coin for money and demand to consume gold coin to make stuff are not in any conflict. One is an asset holding, a capital investment, a form of savings and wealth, the other is a consumable input to producing something else. The coin stock can accumulate via more mining and manufacturing of coin and less consumption of it to make other stuff. Or it can be consumed by using it as an input to make stuff faster than it is being mined/manufactured into coin.
However, Austrian school economists can’t accept this. They don’t think your house or your gold coin is a capital asset, they think the former is a consumer durable and the latter is some other category of good, a “present good” just like, err.. I mean not like other industrial input material stocks. Thus they can’t accept the idea that gold coin can have a productive yield of benefits to its holder, that can justify it being held instead of some other investment.
Uses of gold.
The value of gold to make conductors is very small. You can tell this is the case.
Very small amounts of gold is used for this purpose.
Jewelry, there are alternatives. The main reason here is that gold is expensive. ie. It’s being used as a store of value, just like coins or cash. Try buying a cheap token for the girlfriend/wife. It’s bought because its expensive.
Gold at its heart depends on the demand, and its as a store of value that drives the demand, not its use as a plating compound in electronics.
That means you are back to the dependence on others accepting the same.
Nick
Mises article here, like all of his writing, is clear and cogent. Those who challenge him, particularly on the subject of money and credit, however self-confident they are in their premises, should be even more certain that they are mistaken.
In this article Mises said, “The task of the catallactic theory of money — as differentiated from the legal theory and from the technical disciplines of bank management and accountancy — is the study of the problems of the determination of prices and interest rates. This task requires a sharp distinction between money-certificates and fiduciary media.”
Mises presentation makes it virtually impossible to logically dispute his point that money certificates cannot increase the supply of money and thus have no affect on prices or interest rates; and he explains with impeccable logic that fiduciary media can and often will increase the total supply of money, and thus it can and sometimes does affect prices and interest rates, because it is sometimes money that did not previously exist until a bank granted credit (viz., lent/created it). Therein lies the need for the sharp distinction. Mises explanation is so simple and clear that even a caveman like me can understand it.
All of the critical comments in this blog make no dent whatsoever in anything Mises posits here
Karem: “Money is not a good, it is a function (Mises also knew the difficulty of categorizing money as a good and thus invented a third category of good just for money). Just like “good” is a function. A function solely dependent on the minds of individuals. “Good” function is a function of commodities to satisfy consumption, directly or indirectly. The more of the good the better. Also goods equal wealth. Money on the other hand is something different. Its supply is irrelevant and money does not equal wealth.”
Prove it! These are mere assertions and denote a misunderstanding of money in the catallatic sense. Money certainly performs functions, but to call it a function says nothing helpful about money and the economic problems related thereto. Like many of the so-called theories of John Maynard Keynes, your comments do not so much clarify as confuse. Your statement denies the logically indisputable economic theories of supply and demand. You can make your assertion that the supply of money is irelevant only if there you can furnish logical grounds for your assertion that money is not a good but a function. In other words, prove it. Present, as Mises does here for the points he is making, your logical argument demonstrating that money is a function not a good.
Mike Sproul: “In every case, people have failed to understand what a permanent float is.”
Not every case, unless you exclude Mises, who understood as far back as 1912 the role of float in monetary analysis. The last paragraph of this article makes it obvious that Mises understood “float” and its significance in catallatic analysis of fiduciary media.
Dave Hillary: “The term ‘fiduciary media’ is not appropriate, because the bank of issue or deposit does not have a fiduciary obligation to the note holder or depositor, only an ordinary legal obligation as debtor. As Mises himself above states, they are ‘payable and redeemable on demand, against a debtor’.”
Mises use of the term “fiduciary media” is accurate and descriptive, and entirely appropriate for catallatic purposes as opposed to legal, management or accounting speak. Fiduciary implies trust (google it), and the money of which Mises speaks is backed by nothing more than trust in the bank that creates it. Your argument is entirely legalistic, and Mises explicitly stated that his use of the term was for catallactic purpose–not for a law suit. He is explaining why fiduciary money can and often does impact interest rates and other prices.
Nick. I think Goelh adequately corrected your misunderstanding.
meriam webster says media is
http://www.merriam-webster.com/dictionary/media
1 : a medium of cultivation, conveyance
“invented a third category of good just for money).”
i guess gold/silver when made into money (coined, assayed, stamped, etc) is a medium of conveyance….the price as an indication of scarcity of a good.
@Richard
It’s quite amusing, when I used to work in a bookie’s office in England we had to accept Scottish notes as tender but customers always rejected being paid out in them. I wonder where that innate suspicion comes from?
Ned wrote:
‘Mises use of the term “fiduciary media” is accurate and descriptive, and entirely appropriate for catallatic purposes as opposed to legal, management or accounting speak. Fiduciary implies trust (google it), and the money of which Mises speaks is backed by nothing more than trust in the bank that creates it. Your argument is entirely legalistic, and Mises explicitly stated that his use of the term was for catallactic purpose–not for a law suit. He is explaining why fiduciary money can and often does impact interest rates and other prices.’
Fiduciary is a legal term for a person has an obligation to put someone else’s interests ahead of his own, e.g. a trustee or agent is has fiduciary obligations to the beneficiary or principal. In the case of bank issued money, the bank has only an ordinary legal obligation to repay, and thus does not merit the use of the term fiduciary. See Foly v Hill (http://www.uniset.ca/other/css/9ER1002.html).
Acceptance of credit risk is not the same as trust.
You are right his point is about the impact of bank issued money, but unfortunately his fundamental claims are not sound, as well as using inappropriate terminology.
Ned,
“Karem: “Money is not a good, it is a function (Mises also knew the difficulty of categorizing money as a good and thus invented a third category of good just for money). Just like “good” is a function. A function solely dependent on the minds of individuals. “Good” function is a function of commodities to satisfy consumption, directly or indirectly. The more of the good the better. Also goods equal wealth. Money on the other hand is something different. Its supply is irrelevant and money does not equal wealth.”
Prove it! These are mere assertions and denote a misunderstanding of money in the catallatic sense. Money certainly performs functions, but to call it a function says nothing helpful about money and the economic problems related thereto. Like many of the so-called theories of John Maynard Keynes, your comments do not so much clarify as confuse. Your statement denies the logically indisputable economic theories of supply and demand. You can make your assertion that the supply of money is irelevant only if there you can furnish logical grounds for your assertion that money is not a good but a function. In other words, prove it. Present, as Mises does here for the points he is making, your logical argument demonstrating that money is a function not a good.”
Firstly, I agree with most of Austrian monetary theory.
But concepts and definitions aren’t all that well defined.
As in the case of defining money as a good.
A good, is literally a good thing and the more is better. The more of the good you have wealthier you are.
On the other hand money is not wealth, and its total supply is irrelevant. There can be 1,000 units of money or 1,000,000 it doesnt matter, money still works.
Surely Mises knew this, but instead of classifying money as a liquidity function, he invented a third category of “good”, other than “consumer good” and “producer good”. This invention is actually useless because the third category of good has no relation to the other two.
If this categorization didn’t have any consequences it wouldn’t matter much, we would say “semantics” and move on, but it unfortunately does.
Why do you think with all the measures like M1, M2, M2, MZM and MTZ there witll is a confusion whether there is inflation or deflation as of now? Inflation is the increase in the money supply and deflation is the opposite, that much is true. But if you can not tell if there is a increase or a decrease in the money supply, that should tell you it is impossible to measure the money supply.
It is impossible because money is a function that is inherent in many different things. And it changes constantly, from person person and from time to time.
Even if the whole world would use gold coins and nothing more as money, you still couldn’t measure the money supply. The total weight would give you a figure, but gold coins are not only money they are also goods. 1,000 ton of gold are valued because they have money functions AND sometimes for some people they are valued because they can be consumed as a good.
That is why also the distinction between money and money substitutes is meaningless and doesn’t help from a theoretical view. You may classify gold coins as money and paper as substitute but both of them add to the money supply.
Karem Tibuk:
The correct way to think of M1, M2, etc, is that they are call options. For example, a checking account dollar is an American-style call option on a green paper dollar, with an exercise price of zero and no expiration date. A green paper dollar is a European (inconvertible) call on the assets of the Federal Reserve.
A few results from option theory that are applicable to money:
1) The price of a european call is normally equal to an american call. i.e., convertibility is irrelevant
2) It is difficult or impossible to count the number of calls that exist, but since each call is issued by one party and owned by another, all that matters is that the parties involved know what calls have been bought and sold.
3) The issue of calls does not affect the price of the base security, i.e., the creation of checking account dollars and other derivative dollars does not affect the value of the dollar.
Mike, can you provide any theoretical evidence that European and American style calls should have the same price?
Mike, using options theory for money is problematic because:
1. bank demand deposits are freely issued and redeemed at par, and as options, have no time value, only intrinsic value. This means that the options pricing theory is redundant, since the option has the same price as the underlying asset.
2. irredeemable paper money has no defined underlying asset, i.e. it is not an option to get anything in particular, and it is not exercisable now, nor in the foreseeable future. Instead the central bank has a put option with a strike price as low as zero, i.e. it can buy back its notes for potentially as little as it wants to pay at any time.
Money is any generally accepted intermediary of exchange.
Something which serve only for one transaction or a few ones is not money, at least in the austrian theory on money.
To be ‘money’, it has to be generally accepted.
David Hillary:
There are many websites explaining the american/european call relation. Here’s one:
http://demonstrations.wolfram.com/AmericanCallAndPutOption/
“the value of an American call with zero dividend is the same as that of the European call with the same parameters. ”
1) The option model, while redundant, is still correct. It helps us to see that the issuance of checking account dollars does not affect the value of the base dollars, in the same way that the issuance of calls does not affect the price of the underlier.
2) “irredeemable paper money has no defined underlying asset, i.e. it is not an option to get anything in particular, and it is not exercisable now, nor in the foreseeable future. Instead the central bank has a put option with a strike price as low as zero, i.e. it can buy back its notes for potentially as little as it wants to pay at any time.”
It is also easy to imagine call options where the underlier is not clearly defined, the redemption time is uncertain, the right of exercise belongs to the writer instead of the buyer, and the strike is subject to the whim of the writer. These thing complicate the model, but they do not invalidate it.
I don’t know of any historical example of a bank that issued notes (of positive value) without holding assets at least as valuable as those notes. That tells me that bank notes are valued according to the assets backing them, even when convertibility is suspended or uncertain.
Mike,
The point is that the issuer of irredeemable paper money can decide how much of its assets will be equity and how much will be debt.
Can you remind me once again, what is supposed to be the benefit, according to you, of NOT providing holders of central bank notes with legal certianty as to what they have a right to be paid, and having them able to get that within a reasonable time, e.g. 1 business day?
David Hillary:
The issuer of irredeemable paper money can “decide” within fairly narrow bounds. During the panic of 1837 most private US banks suspended convertibility. They continued to operate normally in most respects, because they were still going concerns who were concerned about their reputations. Even a central bank can only abuse its position until the voters step in.
The benefit of allowing banks to suspend convertibility is that it allows banks to avoid runs. After all, if a bank lends money to imperfect borrowers who might default, then we can’t expect the bank to be some kind of perfect institution that never defaults. Forcing banks to always maintain convertibility at par amounts to forcing them to make promises they can’t keep.
Let’s say that a bank has various assets worth 300 oz. of silver, as backing for 300 paper currency units of its own issue (‘dollars’). If the bank loses 30 oz worth of assets, then the exchange value of the dollar on the street will be E=270/300, or E=.9 oz./$. But if the bank is forced to maintain convertibility at E=1 oz/$, then customers have an arbitrage opportunity. They will buy dollars on the street for .9 oz. and redeem the dollars at the bank for 1 oz, until the last 30 dollars are left claiming nothing. Meanwhile, the bank will collapse, the community’s money supply will evaporate, and a recession will result.
It would clearly be better to allow the bank to suspend convertibility, with the understanding that the bank will not simply run off with the assets. That way the dollar will trade for .9 oz/$ on the street, and the run and resulting disruptions will be avoided.
Mike,
There is a better option than the one you suggested for dealing with insolvent banks. On a gold standard, banks can issue bank notes, demand deposits, term debt securities and equity securities. If the bank becomes insolvent, then the equity securities become worthless, and the demand debts run off, leaving the bank to either a) suspend payment or b) run out of liquid assets and suspend payment. After that, the bank can be creditor recapitalised, converting a proportion of its debts into equity, and re-open for business. In this way the losses of the bank are allocated firstly to the equity holders, then to the creditors, the monetary standard is maintained, and the bank can be re-opened with minimal disruption. This is normally desired for banks considered ‘too big to close’, smaller banks can just be shut down.
An example of this can be found as long ago as Australia in the 1890s:
‘The Commercial was faced with a run it could not meet. It applied for assistance from the Associated Banks, but was unable, or perhaps unwilling, to satisfy the conditions for a loan, and it duly suspended on the weekend on 4-5 April [1892].
When it suspended, the Commercial simultaneously announced plans for a capital reconstruction under the terms of the recent Victorian legislation [that allowed for 75% of creditors by value to approve a restructuring plan]. (There was some suspision, indeed, that its application for assistance had simply been a feint to provide justification for suspending in order to implement a reconstruction plan that had already been decided upon.) Reconstruction involved setting up a new bank with the same name as the old; there were extensive calls on shareholders for more capital; and deposit repayments were generally deferred, with existing deposit claims being transformed into a combination of preference shares and deposits of varying (and often long) maturities. The ‘essence of the scheme was that the bank asked for more time to pay those creditors who demanded immediate repayment, but it promised to pay them in full, in interest and principal’ (Blainey 1958: 165), and the fact that they preferred it to any viable alternative. Small depositors with 100 pounds on current account: ‘were given three 10 pound preference shares, and a fixed deposit receipt for 70 pounds when the bank re-opened….’ (Blainey 1958: 165-6)
A curious feature of the reconstruction, and one that was later copied by the other suspended banks, was the opening up by the Commercial, four days after it suspended, of trust accounts, which enabled deposits and withdrawals to be made without involving any of the funds of in the bank’s ‘old’ business. These banks ujndermined the banks that remained open, and there ‘ensued the spectacle of depositors in banks still open, hastily withdrawing their funds to escape the threat of reconstruction and promptly depositing in a trust account with the Commercial’ (Butlin 1961: 300)’
In this way most of the Australian financial system was restructured, while remaining on the gold standard.
Today in some countries, including the USA, large banks are required to be able to administer a creditor recapitalisation within 1 business day. The manager of the crisis management department at the Reserve Bank of New Zealand also told me that, should it be required, any large NZ bank could be creditor recapitalised within a short time.
To me it seems a lot better to have a fixed monetary standard, and to restructure banks using creditor funds if and as required, where the this is better than closing the failed bank down. I also think that if all major banks could be creditor recapitalised within 1 business day, this could be the standard large bank failure response, avoiding government bail-outs and prudential regulation.
David Hillary:
That all makes perfect sense. In my example of 270 oz worth of assets backing $300, recapitalization was not an option, as there were presumably no other resources the bank could get its hands on. In this case the dollar must fall in value to .90 oz. That would happen either through suspension or devaluation.
Normally, of course, the bank’s losses would fall first on the equity-holders, and last on the note/deposit-holders. But I suppose that as good libertarians we should not make this a matter of law, but should allow banks and their customers to write their own contracts specifying who bears what losses.
Kerem:
If you read all of Chapter 17, entitled INDIRECT EXCHANGE, in HUMAN ACTION, (http://mises.org/Books/humanaction.pdf), I think you will find that Mises makes a very sound case for referring to money as a good rather than as a function. Here are just a few pertinent quotes not in the article I picked out which tend to make the case that money has many characteristics in common with other goods.
“Money is a medium of exchange. It is the most marketable good which people acquire because they want to offer it in later acts of interpersonal exchange. Money is the thing which serves as the generally accepted and commonly used medium of exchange. This is its only function. All the other functions which people ascribe to money are merely particular aspects of its primary and sole function, that of a medium of exchange…Media of exchange are economic goods. They are scarce; there is a demand for them. There are on the market people who desire to acquire them and are ready to exchange goods and services against them. Media of exchange have value in exchange. People make sacrifices for their acquisition; they pay “prices†for them. The peculiarity of these prices lies merely in the fact that they cannot be expressed in terms of money. In reference to the vendible goods and services we speak of prices or of money prices. In reference to money we speak of its purchasing power with regard to various vendible goods. Every piece of money is owned by one of the members of the market economy. The transfer of money from the control of one actor into that of another is temporally immediate and continuous. There is no fraction of time in between in which the money is not a part of an individual’s or a firm’s cash holding, but just in “circulation. It is unsound to distinguish between circulating and idle money…[T]he appraisement of money is to be explained in the same way as the appraisement of all other goods: by the demand on the part of those who are eager to acquire a definite quantity of it…The demand for money is determined by the conduct of people intent upon acquiring it for their cash holding…The insight that the exchange ratio between money on the one hand and the vendible commodities and services on the other is determined, in the same way as the mutual exchange ratios between the various vendible goods, by demand and supply was the essence of the quantity theory of money….Modern monetary theory takes up the thread of the traditional quantity theory as far as it starts from the cognition that changes in the purchasing power of money must be dealt with according to the principles applied to all other market phenomena and that there exists a connection between the changes in the demand for and supply of money on the none hand and those of purchasing power on the other.”
Karim, Let me point out what I think are some flaws in your argument that money is not a good.
You define a good as “literally a good thing and the more is better. The more of the good you have [the] wealthier you are.”
Not necessarily. Water is a good that has great value in the middle of the Sahara desert, and no economic value whatsoever in other places, and too much of it can impoverish you or even kill you (think hurricane Katrina.) I think most economist would reject the definition you have given.
Karem, you say, “On the other hand money is not wealth, and its total supply is irrelevant. There can be 1,000 units of money or 1,000,000 it doesn’t matter, money still works.” I think you err here because you are speaking of some agglomeration rather than individuals for whom the good, money, which they own, is indisputably a part of their wealth, every bit as much as those consumer goods in their pantry they intend to eat for diner. Their money will buy them a meal at a restaurant. Austrian economics is founded on the indisputable knowledge that individual human’s, and only individual humans, act purposively.
In Chapter 17, Mises quite provides many sound reasons why money is a good whith many of the characteristics of all other goods, and he points our its distinctions therefrom. I am confident that he rejected “classifying money as a liquidity function” would lead to confusion rather than enlightenment. By the same line of reasoning, you might classify corn for its food function or value, bur those who use corn for cattle feed, fuel, or booze might object. I don’t even know for sure what you mean by liquidity function, unless you are using it in the sense that Keynes used liquidity preference, upon which he stumbled to several erroneous conclusions.
Mike, you have missed the point. If par value of $1 is 1 oz of silver, then if the bank has assets of only 270 oz silver and has liabilities of $300, then the bank can, if the law or the contract allows, restructure its affairs as follows: Promise to pay out 80c in the dollar, and issue 10c in the dollar of equity shares in the bank, so that the new balance sheet of the bank is:
Assets: $270
Liabilities: $240
Equity: $30
This makes the bank solvent again, allocating the losses to creditors. The creditors also own the equity of the restructured bank.
The ‘dead haircut’ would have been 10c in the dollar, so the additional 10c in the dollar haircut is a living haircut, being not only the extent to which losses exceeded capital, but an additional amount to provide the bank with a normal capital ratio. The creditors can, of course, sell their shares to get the difference.
Mike wrote: ‘The benefit of allowing banks to suspend convertibility is that it allows banks to avoid runs.’
Actually it does not avoid the run at all, it only ends it sooner (in default) and makes it more likely to begin.
The real way to avoid runs is to have large banks, with strong capital ratios, high asset quality, and adequate buffers of liquid assets.
“In my example of 270 oz worth of assets backing $300, recapitalization was not an option, as there were presumably no other resources the bank could get its hands on.”
i was wondering about this…if the bank had some imported brass railings in a branch…the could ‘capitalize’ them in the form is bank-notes/dollars??
is that the essence of what is called rbd?
Scott t: to some extent it does not matter what form the bank’s assets are held. For example, South Canterbury Finance has holdings of dairy farms, industrial firms, Helicopters and so on, in addition to its loan book (see http://davidhillary.blogspot.com/2009/10/share-market-to-south-canterbury.html ). If you look at my extensive writings about this particular troubled financial institution, you’ll know I’m concerned about its viability and prospects.
However, to another extent, it does matter. The Real Bills Doctrine originally was, if I understand it correctly, bank management advice rather than an economic doctrine per se. The advice was that the bank should primarily invest in commercial trade bills of exchange due within 90 days. The idea is that, should the bank need more reserves, it can just sell the bills. Here is how it worked. A manufacturer (call him A) would accept an order to sell goods to a merchant or wholesale or retailer B. A would draw a bill of exchange on B such as ‘A orders B to pay A, or to A’s order, on 01 Feb 2010, the amount of 1000 pounds, signed A’ A then gives it to B who signs it too, and hands it back to A. This means B is liable to pay the holder of the bill 100 pounds on 01 Feb 2010, and if B fails to pay, A is liable on the instrument, too. A then discounts the bill with bank C for, say 960 pounds, i.e. A sells the bill to the bank C in exchange for 960 pounds, and indorses the bill to bank C by writing on the back ‘Pay to bank C, signed A’. Should bank C run short of reserves before the bill matures, bank C signs it too, indorses it to the buyer, making the bill A, B and C all liable on the bill. Such a bill should be marketable even if C’s financial status has deteriorated, since the bill can be sold at a discount to give the buyer a high return investment, and the buyer is unlikely to bear a loss on maturity.
These days banks are counselled to make loans and advances on good security, to reliable borrowers, and to finance some of their assets through term debt, in addition to funds raised on demand deposits and/or bank notes. And to hold a stock of marketable assets and to maintain a strong capital position.
That said, basically all banks hold some land, buildings, leasehold improvements, computer systems and other assets that are largely not marketable, but these holdings are generally very small in relation to total assets.
ok..that didnt make alot of sense to me.
i was wondering from previous posts — how does one capitalize? if an asset is owned i was thinking that was because it was owned because some existing money had purchased the asset…and i was reading that rbd and to some extent current banking and federal reserve actions allowed money to be created beacause someone says that have an asset ‘worth’ the money that they jsut poof into existence??
is that incorrect?
Scott t: assets are recorded in accounting records, using the historical cost convention, less any impairment or depreciation or amortisation.
Scott t: the asset can be an advance made by the bank, e.g. if a borrower makes a promissory note to pay $1000 on 10 Feb 2010, and the bank makes 97 $10 promissory notes payable on exchange, this transaction originates an asset to the bank with an historical cost of $970, and creates a bank liability for the same amount. The bank thus exchanges its credit for the borrower’s.
“and the bank makes 97 $10 promissory notes payable on exchange…”
makes 97 $10…would this be ‘money from thin air’ or are you referring to 97 notes in savings resulting from prior proftimaking? without some of the bank-ease please.
this would be bank issued money, so long as someone wants to hold it for use as money, they are lending the bank that much of their savings.
And if or when no one wants to hold those notes, the bank will have to repay those savers, and either sell assets or borrow some else’s savings by issuing another instrument such as bonds or shares.
For example, the borrower could immediately present the $970 in notes for payment in coin, and the bank could immediately indorse the promissory note issued by the customer and sell it for, say, $990. (In this case the bank retains an exposure to the borrower’s credit risk, but no longer owns or funds the loan).
Another example: The borrower presents the bank’s notes for payment in coin, and the bank borrows $970 by making another promissory note for $980 payable on 10 Feb 2010, and selling it for $970 today.
you said the bank makes 97 $10 somethings what is it that the bank is making….is that making a money out of thin air , so to speak.
or, you can say it is people making money out of the bank’s demand notes by holding them for the purpose of offering in exchange for other assets or goods, i.e. for indirect exchange.
Money is just a way of using an asset, where that asset is a manufactured good (coin) or a financial instrument (bank note). The former is made by a manufacturing process, the latter by borrowing (using other people’s savings) and lending (allowing other people to use your savings).
David Hillary:
“Promise to pay out 80c in the dollar, and issue 10c in the dollar of equity shares in the bank, so that the new balance sheet of the bank is:
Assets: $270
Liabilities: $240
Equity: $30″
I think you must mean that the 10c equity shares are given to the note-holders, who presumably have a first lien on the bank’s assets. The note holders then become the owners of the bank, but in the end, the bank still has 270 oz worth of assets, so the note holders, one way or the other, get .9 oz. worth of stuff for each of their $1 notes.
“The real way to avoid runs is to have large banks, with strong capital ratios, high asset quality, and adequate buffers of liquid assets.”
That’s fine, but give any bank enough time, and at some point its assets will dip below what is necessary to buy back all its notes at par. At that point, the bank must either suspend or devalue. If the bank tries to maintain convertibility at a rate it can’t afford, it will face a run.
Scott T:
“i was wondering about this…if the bank had some imported brass railings in a branch…the could ‘capitalize’ them in the form is bank-notes/dollars??
is that the essence of what is called rbd?”
Correct. The RBD has of course been stated in many ways, but the correct version, which would be better called the backing theory, says that the value of money is equal to the value of the assets backing it, and those assets could include the bank’s brass rails.
An incorrect version of the RBD, which is unfortunately widespread, holds that money should only be issued for ‘productive’ purposes. Banks should lend to farmers, but not to gamblers. But of course banks only lend to people who offer adequate collateral, and if the gambler has better collateral than the farmer, the backing theory would say to lend to the gambler, not the farmer.
Mike, you really are a plonker, and I mean that in the nicest possible way (http://www.urbandictionary.com/define.php?term=plonker). You wrote: ‘the value of money is equal to the value of the assets backing it’
This is WRONG and you should know it. Although the value of issued money cannot equal more than the value of assets backing it, but it could be equal to less. The assets of the issuer will normally be, and should be, equal to more than the value of its liabilities, the difference being its net worth or equity. The holders of issued money are holders of debt securities and have the right to be paid the face value of their notes or demand deposits, and not more, so this is a cap on the commercial value of the issued money. Since when do solvent debtors grant their equity to their creditors?
Ignoring equity is one of the most common and stupid features of debates on monetary economics. Why are you such a plonker for repeating this error?
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