Chris McGreal reports from Harare:
Zimbabweans are shopping like there’s no tomorrow. With police patrolling the aisles of Harare’s electrical shops to enforce massive government-ordered price cuts, the widescreen TVs were the first things to go, for as little as £20. Across the country, shoes, clothes, toiletries and different kinds of food were all swept from the shelves as a nation with the world’s fastest shrinking economy gorged itself on one last spending spree.
Car dealers said officials were trying to force them to sell vehicles at the official exchange rate, effectively meaning that a car costing £15,000 could be had for £30 by changing money on the blackmarket. The owners of several dealerships have been arrested.
President Robert Mugabe’s order that all shop prices be cut by at least half, and sometimes several times more, has forced stores to open to hordes of customers waving thick blocks of near worthless money given new value by the price cuts. The police and groups of ruling party supporters could be seen leading the charge for a bargain.
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Why does the money have to be redeemable for any particular thing? Why can’t it just represent a share in some portfolio of assets, managed by the bank so as to maintain the exchange rate of the dollar with the held assets, as determined by a free market?
In this situation, by definition the reserve is 100% of the currency issued.
In this situation, the claim of the RBD is that the amount of money in circulation will not affect the exchange rate of the dollar with the commodities (if that’s called inflation by some definition, use that definition of inflation – that’s the kind of inflation that doesn’t happen under RBD).
The appropriate thing to measure this total lack of effect against would be the situation absent the bank, and the exchange rates of commodities therein. It should be clear that so long as the bank makes good trades (as required by the RBD), the rates with or without the bank will be the same. Those rates will shuffle naturally, but that shuffling is unaffected bu the presence or absence of an RBD-style bank.
…IF THE TRADES ARE GOOD, which is a requirement of the theory.
Jean Paul,
So what you are talking about is basically using fund shares as money? Is this really what the RBD is about? If so, I can’t find anything philosophically objectionable about it but it sure sounds inconvenient.
RogerM, I am not saying that the Real Bills Doctrine is a good idea, I am pointing out how it fails. In that sense your parallel with socialism is valid. If you look at Zimbabwe today, it is irrelevant whether or not Mugabe had in mind Real Bills; wht counts is that, right now, the bills aren’t real. So, the failure is not of Real Bills Theory but of Real Bills Doctrine. Of course the failure is hubris; only, not from lack of knowledge, but from a Sahakespearean tragedy in which everybody always goes too far and everybody else can always see it coming, if they only look. But there’s the rub.
That’s basically the answer to Jean Paul, too. There is a hybrid in which a bullion base is set up with built in depreciation, so that the money issuers can issue money but only up until a certain point; they can still get a permanent benefit if they apply the seignorage to acquisitions of a revenue yielding asset base, a “domain”, typically of land. (There is historical precedent.)
Simon, you state “…he can’t suppress a country full of angry people forever can he?”, (a) he doesn’t have to, only long enough to remake things his way; (b) he could if he had to, bearing in mind that physically and morally he can resort to massacre and exile; and (c) the whole point is, it’s not the whole country – and, the angry ones didn’t like him to begin with, so he has nothing to lose anyway.
As to what is likely to happen next, based on precedent elsewhere, it’s a rebasing of the currency on the back of a punitive tax regime/land reorganisation, with a functional economic core held by his supporters and non-functional periphery for the rest. Control of restricted imports will provide patronage. Part of the precedent is having hut and/or poll taxes that can be paid off in kind at fixed prices, or in the new currency, with a road building programme or similar to accept payment in labour.
Jesse, the problem with RBD isn’t that “there is an unspoken assumption in the model that values of assets are static”. The assumption is that all bills that are “out there” will automatically – since they were chosen that way – be retired in the short term, and that any discrepancies can then be adjusted on the back of the gains realised by the economic activity they generated. In other words, the financial risk is covered by the bankers, on the back of the bankers’ seignorage. The catch is that the bankers keep letting that time horizon stretch further and further out, and accept book values that are riskier and riskier, always tending to the limit of simply printing money. Ultimately – in fact quite early on – it all inhibits economic growth and there are no gains anyway.
So, Mike Sproul, you’ll see we’re actually in agreement, but I wasn’t clear enough in stating that I was trying to show how it was that people followed the slippery slope. A partial counterexample is something that happened in Jersey at the end of the Napoleonic Wars, though I can’t find the references off hand (can someone help?). There, peace and responsible control came back, the former permitting central authorities to impose the latter on the Jersey bankers who were quite put out since they hadn’t actually hit any problems by then.
Jean Paul: “Why does the money have to be redeemable for any particular thing?”
Who said it can’t? Banknotes can be redeemable for anything. I’m a free-banker myself, so I don’t have any objection to someone attempting to run a bank under RBD principles. However, the RBD is a system of currency management which purports to allow a bank issue redeemable notes without a 100% in-kind reserve without risking bank runs or devaluation. It simply can’t do that in practice, because the condition (always make good trades ex post) is impossible to achieve. If that is a precondition of RBD then RBD is irrelevant; if it is not then RBD is wrong.
Consider, too, that in a bank run the first thing to change would be an increase in the value of the redemption commodity, and a corresponding relative decrease in the bank’s assets. The very situation where the bank’s “good trades” are put to the test could easily render them poor trades in retrospect.
Jean Paul: “Why can’t it just represent a share in some portfolio of assets, managed by the bank so as to maintain the exchange rate of the dollar with the held assets, as determined by a free market?”
In that case the banknote is redeemable for one share, which is still a specific commodity. Also, you’ve just reinvented the mutual fund.
Jean Paul: “In this situation, the claim of the RBD is that the amount of money in circulation will not affect the exchange rate of the dollar with the commodities. . . .”
Which is false, since a revaluation of any one backing commodity will affect the exchange rates between dollars and all the other backing commodities. (Well, provided the composition of the backing varies with issue of new currency — but if it didn’t this wouldn’t be RBD.)
Jean Paul: “It should be clear that so long as the bank makes good trades (as required by the RBD) . . .”
The bank can’t know whether it made good trades until after the fact. It does indeed all fit together if you make that assumption, but that qualification also renders the RBD useless as a guide. In the present, all you can say is that the issue of bills will either inflate or not, depending on whether the bank’s trades turn out to have been good ones from some future point of view, with a bias toward “not” in the event of a bank run. Granted, the fact that it’s not guaranteed to cause inflation is a step above some other systems where inflation is systemic, but it’s still not much of a claim.
“The only thing wrong with the Real Bills Doctrine is human nature”. Since the real bills are being issued by human beings, each of whom must have a human nature to comply with the definition, doesn’t this damn it before it starts?
This reminds me of Basil Fawlty- he felt he could run a really good hotel if he could just get rid of the one annoying impediment to his plans- the hotel’s guests! I believe they made a documentary series about his hotel. you might have seen it.
There’s always more than one way to look at events. When Germany was going through its’ meltdown, eighty years ago, whilst the locals suffered, foreigners (and their good currencies) had a bargain of the whole country!
‘”The only thing wrong with the Real Bills Doctrine is human nature”. Since the real bills are being issued by human beings, each of whom must have a human nature to comply with the definition, doesn’t this damn it before it starts?’
nick gray, that’s what I’ve been bloody saying. Why on earth do readers immediately suppose that I’m too thick to realise that this is a real difficulty? I’m against, because I know what the problem is. It’s just that – as Jean Paul has spotted – the problem does not come from any inconsistency or like flaw in the theory.
licing in Cape Town, I have watched the crisis unfold over the last 7 years or so. Heres a comment I made in another forum yesterday, in the thought that readers here may be interested.
the seeds of the ( Zimbabwe) problem were sown a long time ago – in the grand tradition of European Monarchs of generations past, the Mugabe regime at some point stopped bothering to even notionally limit its civil service spending to the amounts collected by ‘orthodox’ taxes ( Lets not go into the broader tax question here….), and instead debased the currency by simple expedience. In this case, they simply printed ‘money’ to pay cabinet ministers, soldiers, policemenn, and bureaucrats. Directly, in wads of freshly inked paper. And they still do. Theres not even the usual pretence of fiscal repsonsibility that marks other countries’ central banking.
This massive influx of unbacked, unearned currency had a completely predictable effect: more money+ same supplies of goods = price increases across the board, just as sure as day follows night. Of course, the new money has to be injected into the economy first before the prices respond to the increase in demand, so the first holders of any newly-injected money still get to pay the old pre-injection prices, and the rest of the population have to face the resulting round of price increases. thus it is that (assuming a monthly payday) the favoured few (viz. everyone on the government’s payroll) are always one month ahead of the price-inflation cycle, and score big-time.
In oither words, by resorting to the printing press, the regime has been able to tax the whole population at an effectrively asymptotic rate, and hand the proceeds to its employees, without even needing a databse of taxpayers or collections infrastructure! . In effect, they have, quite criminally, stolen the the whole country’s accumulated life ( cash) savings, and appropriated the proceeds in the form of actual goods and property.
Then, in an attempt to displace the responsibility for the resulting economic disruption and ill-feeling, they demonise the merchant classes. (This is also in the grand tradition of the old despotic European monarchs, who spent centuries blaming Jews for all economic woes, howsoever arising). And so they enforce all sorts of price freezes and cuts by decree, neutralising any rationale for any producer or seller to remain in business, and bringing produictive activity to a halt. This price-setting policy as a cure for inflation is exactly analogous to the Health department fighting TB by forbidding the patient to breathe.
The thing that I find sad is the naieve readiness of evereyone, in Zim and elsewhere, to lay the whole thing before Mugabe himself – there is a blind faith that ‘when he goes, everytrhing will be OK again’. Not so. While he clearly has a hand in it and has been a central catalyst, and is something of a figurehead, we neglect to recognise that there is a big segment of Zimbabwean society, largely Shona, that comprises the political elite , and hunjndreds of thousands of second- and third-teir civil servants who owe their livelihoods to the continued entrenchment of Zanu PF, and the only way to keep that going is to assure a continuation of the wholesale inflationary theft from everyone else, such wealth appropriation magnified by an open and tacitly-approved arbitrage between the black and official exchange markets – you see, if you are ‘A list’, you can do it with impuinity, (as long as you don’t make enemies of anyone more powerful than you). And if you are not, you get beaten up and jailed, or worse.
Remove Mugabe, and you still have a well-entrenched, well-armed, and very wealthy constituency which is used to weilding power and behaving with impunity. They will fight tooth and nail to retain their economic dominance and power so continued access to their feeding grounds can be assured. And, a few sincere idealogues aside, theres another seething constituency that is seeking to attain that same position of power and influence, merely by switching the boot to the other foot and getting their own back. And, frankly, who can blame them?. That underlying problem isn’t going to be solved by the death or departure of one belligerent old man.
Zimbabwe is widely viewed as an aberration. I dont think so. I think it is an instructive case study of the natural tendencies of all governments everywhere – this is merely an extreme example of what happens when the institutional and constitutional constraints on the behaviour of the governing classes are removed or weakened.
the first signs of such (con/in)stitutional weakening are, always and everywhere, normally found in three key areas: loss of or compromise in judicial independence, increased control on the press and what it can and can’t say, and interference in free markets. (All 3 of which symptoms, incidentally, have slowly, incrementally, given grave cause for concern in that other land of the free, the yewessovay, these last 7 years).
Which is why I fear, above all else, any hint of government censorship of whatever nature, and any political meddling in the courts, and any form of market interventionism, however well-intentioned the rationale appears to be. For these are the only things standing between us citizens and despotic oppression – quite irrespective of what continent we happen to be on, or who is president, and how nice a guy he might be.
Why does the money have to be redeemable for any particular thing? Why can’t it just represent a share in some portfolio of assets, managed by the bank so as to maintain the exchange rate of the dollar with the held assets, as determined by a free market?
Because that’s not what money is. Read a bit of Mises on how money arises out of barter.
Jesse: “The condition (always make good trades ex post) is impossible to achieve.”
Likewise, it is impossible to choose a commodity (such as gold, silver, potatoes, etc.), which will be guaranteed to hold its value relative to the rest of the market.
So why is this considered a flaw of the RBD, but not alternative approaches?
Jean Paul: “Likewise, it is impossible to choose a commodity (such as gold, silver, potatoes, etc.), which will be guaranteed to hold its value relative to the rest of the market. . . . So why is this considered a flaw of the RBD, but not alternative approaches?”
I’ll start off by stating that, given the precondition that the trades the RBD refers to must be good ex post, I concede that the theory is correct (though irrelevant).
The problem with the RBD is that its only conceivable use is as a guide to running a bank which supposedly won’t suffer bank runs or devaluation despite not having 100% in-kind reserves for its bills. However, it only works so long as the bank always makes good trades. A bank could choose not to follow the RBD and still have no worries about bank runs or devaluation; all that matters is that the bank has sufficient assets to buy up enough of the redemption commodity to cover its liabilities. How the bills are issued, or what they are issued in exchange for, is irrelevant to the end result. RBD doesn’t do anything to reduce the risk of bad trades.
For that matter, the only case where you would end up with inflation in the underlying commodities is if you have legal tender laws; otherwise any notes not backed 100% by something will just trade at a discount relative to those commodities, with values approaching the amount of banking per note.
In sum, the RBD isn’t saying anything we don’t already know, and places unnecessary restrictions on the bank’s operation — but I agree that it’s not actually wrong within its very narrow scope.
That should be “the amount of backing per note”, of course, at the end of the next-to-last paragraph.
Where I have always thought that RBD, as practiced, goes wrong is that it extends the definition of what is money to every possible traded good, over and above what humanity ultimately, through trial and error, settled on- a stable, commodity money like gold and silver. Take some of the examples described in this thread and others- potatoes, IOUs, farmland, my own example-a barn, or in Jean Paul’s treatment- a basket of assets. A bank that issues dollars for any asset, and considers this as backing, is creating inflation if the population believes that the paper dollars themselves are exchangeable for the true commodity monies of gold or silver. Is it ever the case that this is not the expectation? Consider opening a bank that issues banknotes as currency using physical assets as backing. How do you determine how many banknotes to issue for my barn? Of course, you judge my barn’s value based on the commodity that presently serves as money for the economic system. Now who would take these banknotes in exchange for goods and services? Well, if the notes claimed to be exchangeable for a barn, then the takers for my notes will consist of two groups- those that want my barn, and those who don’t want my barn but are willing to take my notes if I give them a discount on their face value. In the second case I have little incentive to make the initial transaction with the new bank in the first place. If the banknotes claim to be exchangeable for true commodity monies, then the bank has to sell my barn for gold and/or silver. If it doesn’t do this, but claims that its notes are exchangeable for commodity money, then inflation occurs for the term between the issuance and the redemption of the notes for gold or silver. We can extend this process to the point of absurdity. Banks open that take as backing any asset one wishes to bring, all in return for banknotes that have denominational value equal to the assigned market value of the asset in terms of the original commodity money, and at each incremental step, that assigned, nominal value goes up because of all the new money that is now circulating.
Let us construct a hypothetical scenario. We have YanceyLand where there are 1000 ounces of gold serving as commodity money and total land that has a total market value of 10000 ounces of gold at time t(zero). Bank A opens and issues 1000 ounce notes, and takes as backing 10% of the total land available in YanceyLand. To the population of YanceyLand, the notes have denominational value of 1000 ounces of gold. Both the notes and the gold itself now serve as money. The money supply has doubled and, eventually, the price level doubles. The total land is now worth 20000 ounce notes/gold. Bank B comes along and decides it will do the same- it issues 1000 ounce-notes using land as backing, but because of the changed price level, its backing is only 5% of the total available land in YanceyLand. Eventually the price level adjusts to all the notes and gold that are circulating and the total land of YanceyLand is now 30000 ounce notes/gold. We can carry this on for quite a while, but each equal incremental addition of new bank notes has less land as backing. Indeed, since the land is all the same, Bank A’s notes are worth more than Bank B’s notes only if the notes themselves are explicitly exchangeable for the same proportion of land taken as backing in the first place. However, if that had been the promise in the very beginning when Bank A issued its notes, we would have the same problem of finding people with which to trade that I described in my first paragraph.
Yancey,
In addition to your contention that the problem with RBD is when asset or bill backed money is believed to be redeemable in the monetary commodity, isn’t the time aspect of the asset itself part of the problem?
From what I’ve gathered, when a bank would print money for a bill supposedly the money is 100% backed by the bill. But isn’t the bill strictly a future good, and the cash money is expected to be instantly redeemable for goods. When considering the banks balance sheet in light of the time aspect of the bill, the assets and liabilities cannot be objectively balanced until the maturation of the bill.
In this way I disagree with Jesse. Even if you concede ‘good ex-post trades’ the problem with RBD is that future goods cannot objectively balance with present goods on a balance sheet.
To be more precise, I should have called the printed money ‘present liabilities’ rather than ‘present goods’, and the bill a ‘future asset’ rather than a ‘future good.’
Dan,
In the form of RBD advocated by Antal Fekete, he seems only to advocate the issuance of bank dollars for soon-to-the-market goods and services, with the bank dollars extinguished by the gold and silver that is ultimately exchanged on the sale of these goods and services. He has claimed that such real bills are needed because gold and silver cannot fulfill the function of “circulating capital”. His desription has always seemed to me to be very short period of inflation followed by deflation (90 days or less in his treatment). I have never really understood why gold or silver couldn’t easily serve as the medium of direct exchange in his system. His RBD seems unnecessary to me. Robert Blumen, I think it is, has dealt with this topic on this site in the past. I am still open to the possibility that Fekete is correct, but he still hasn’t convinced me.
Now, if the trades are always net good, then the bills are extinguished completely within 90 days with the bank making a small net profit for the financing. At least, this is my understanding of the system. Again, I see inflation followed by deflation as long as the bills are extinguished at some point in the future. One thing that I am having a hard time thinking through clearly is whether or not this inflation/deflation cycle is symmetrical- in other words, do they net out evenly for everyone. I have the feeling that they don’t and that this, itself, is the source of the bank’s profit.
Dan: “When considering the banks balance sheet in light of the time aspect of the bill, the assets and liabilities cannot be objectively balanced until the maturation of the bill. . . . Even if you concede ‘good ex-post trades’ the problem with RBD is that future goods cannot objectively balance with present goods on a balance sheet.”
Why not? Future goods have a present market value; that’s what’s being compared. I see no problem with directly comparing the discounted present value of a future asset against the discounted present value of a future liability. People — not just banks — do that all the time. Anyone dealing in bonds will make such comparisons, for example.
Yancey Ward: “One thing that I am having a hard time thinking through clearly is whether or not this inflation/deflation cycle is symmetrical- in other words, do they net out evenly for everyone.”
There’s a simple answer for that: inflation and deflation never balance each other out from an individual point of view, because there are nonlinear changes involved. Basically, one group benefits from inflation and a different group benefits from deflation (both at the expense of everyone else). The total amount of currency doesn’t change, but it’s not returned to its original allocation.
Jesse,
Yes, I think you have it right. I am making it more complicated than it had to be.
This has been an enlightening and invigorating discussion… I have to say I’ve come down solidly on the side of the RBD – in its modernized/generalized form as presented here:
http://www.csun.edu/~hceco008/rbd2000.doc
(Thanks Mike for this!)
The key point that I get out of all this is that the value of money equals the value of its backing – and is not at all dependent on any other factor, including quantity, etc.
Of course the BACKING is ultimately subject to supply and demand, thus the quantities of the commodities underlying the backing assets determine their relative values, but the currency itself MUST equal its backing…
Jesse,
“Why not? Future goods have a present market value; that’s what’s being compared. I see no problem with directly comparing the discounted present value of a future asset against the discounted present value of a future liability.”
The answer is that time preference is subjective. The RBDers want to say that the system is a 100% reserve system, which would mean that each note is redeemable. Redeemable for what? As Yancey went into detail to explain, the notes are EXPECTED to be redeemed on a 1:1 basis with a certain amount of weight in the money commodity.
Not all customers who hold bank notes will accept the bill instead of money, especially the guy -as I’ve said time and again here without a worthwhile response from the RBDers- who wants his money right now this minute, i.e. the guy with a very high current time preference.
If a bank isn’t 100% sure of the redeemability of their bank notes to anyone that holds one or could possibly hold one (and I don’t see how they could be sure given the subjectivity of time preference), then they can’t be 100% sure of the objectivity regarding that bill as a present asset. The only thing that the bank can be 100% sure of is the liabilities that they have NOW, and, pertaining to the bill, the value in money that it will bring upon maturation, as that is written into the bill in the first place.
Only at that time, can the bill’s value be properly placed as an asset on the balance sheet. But what is put on the balance sheet at that time IS money, since the bill has matured and has been cashed in.
Dan, that’s exactly what the “good trades” assumption is: the theory assumes that the bank’s bills can be traded at any time on the market for the amount of money commodity they are supposely equivalent to (the amount issued in notes). If that is not the case they were not good trades.
As I pointed out, however, that assumption makes the theory worthless as a guide. It’s basically just saying the bank will never default on its notes so long as its assets (including bills) are greater than its liabilities (in terms of the money commodity) — which is obvious from the start.
Also, you can put an IOU on a balance sheet just as easily as any other non-money asset, by estimating its current market price. It’s only an estimate, but it is based on objective market data (prices of similar items in past exchanges). Value, including time preference, is subjective, but prices aren’t.
Dan: “Not all customers who hold bank notes will accept the bill instead of money, especially the guy … who wants his money right now this minute, i.e. the guy with a very high current time preference.”
This assumes the note is convertible to an X. Convertibility isn’t a requirement in general.
Anyway, why does he want his X so badly instead of his bank note representing the equivalent market value of X?
To cook a soup? (X = potato)
To fill his car? (X = gasoline)
To make a pair of earrings? (X = gold)
To cast his vote at the shareholders’ meeting (X = stock certificate)
Maybe just for the hell of it?
The only reason for going to the bank to claim your X is if you want to use the X as something other than money. If you intend to use the X as money, then you may as well just use the note.
If you REALLY want the X instead of the note, why not just go to market and get your X from there?
Anyway, the responsible, RBD-adhering bank isn’t just hoping the IOU will pay off. If the IOU doesn’t, then they take the farm or the boat or the fleet of dumptrucks or whatever the collateral was (the RBD-adhering bank does require sufficiently risk-free collateral), and they auction it off, and then they give you your X…
Latly: I don’t see why instant gratification of convertibility needs to be part of it. The RBD-adhering bank, knowing it can’t guarantee on-demand convertibility, just doesn’t offer that as part of the agreement. The non-cnvertible currency is still absolutely useful in its role as money.
I don’t think a lot of the posts above really understand the Austrian explanation of inflation and the real danger of the RBD. Austrian monetary theory is based on the quanity theory of money, which says MV=PQ, where M is money supply, V is velocity, P is price and Q is quantity of production. V is irrelevant to this discussion (and usually a constant), so let’s change the equation to simple M=PQ. If the money supply increases, either P, Q or both must increase. Since Q is generally fixed in the short run, P rises.
Notice that nothing in the quantity theory says anything about what backs M, because it doesn’t matter what backs it. The current monetary regime in the US proves it: nothing at all, not even hot air, backs the US dollar. Do we have inflation, price and monetary? Of course! Do we have hyperinflation? Not even close! The reason is that in the early 1980′s the Fed got smart and decided to keep an eye on price inflation and attempt to squash it with interest rate increases. Those interest rate increases reduce the increase in the money supply by reducing borrowing.
No one accepts the RBD definition of inflation in which the value of the asset backing the paper money falls. No one! For Austrians, inflation is the rise in the supply of money. For everyone else, inflation is the rise in prices. For Austrians and Monetarists, the only possible cause of an across the board rise in prices, such as is measured by the CPI, is an increase in the money supply via credit expansion or simply printing paper dollars. Notice that neither school says anything at all about something backing the paper money, because it doesn’t matter.
RBD claims that by making short term loans to good businesses for the immediate production of goods, the money supply won’t increase because those bills will be taken out of circulation when the businessmen pay back the loans. Then why has the RBD caused such horrendous inflation? Some argue that bankers lack self control and make longer term loans, or bad loans. That may be true. But the other side of it is that when businessmen take out a loan to increase production, they spend a lot of it on wages. And if they use the funds to purchase materials, the vendors of those materials use their revenues to pay wages. Eventually, all of the money loaned on the IOU goes to wages. The employees spend 90% of their increase in wages on consumer goods. By the time businesses pay back their loans and extinguish their IOU’s, the employees have spent their incrase in wages on consumper products and driven up their prices. That’s how RBD creates monetary inflation and therefore price inflation. This is very basic Austrian econ.
Great, so now we have two RBD kooks?!?
RogerM,
I take it from your comment that you don’t believe the deflation that occurs on extinguishment of the bills ever cancels out the inflation from the initial issuing of notes- that the inflation just keeps ratcheting upwards with each cycle.
Peter: Which two? I only counted one, Jean Paul. Sure, I conceded that RBD is correct given its definitions and precondition, but only because it then says nothing at all. A theory which claims nothing is technically correct.
RogerM: The correctness of the theory must be judges by its definitions, not yours. Different definitions can make the theory irrelevant, but not incorrect.
Yancey: “…you don’t believe the deflation that occurs on extinguishment of the bills ever cancels out the inflation from the initial issuing of notes- that the inflation just keeps ratcheting upwards with each cycle.”
That’s a very good point. Technically, I guess you could say that some dollars are removed from circulation when the borrower pays back the loan, especially if the paper money isn’t used as reserves. If only one borrower existed, then the money supply would jump when he spent his borrowed money, then fall back to the previous level when he paid it back. As a result, inflation would also jump as a result of the increased money supply, then deflation would set in when the money supply shrank. Does that sound familiar? Wouldn’t that be the Austrian business cycle?
In reality, there is an unlimited demand for borrowing money. So for every borrower paying back his loans, two or more are taking out new loans. Also, individual borrowers repeatedly take out the short term loans, possibly several times a year. As a result, the supply of IOU’s grows faster than the pay back of the loans. Interest rates fall, spurring further borrowing. So the money supply continues to grow for years and price inflation increases as a result. However, at some point malinvestment shows up and some borrowers can’t pay back loans. Bankers tighten credit, issue fewer loans and call in some. The growth in the money supply lessens, causing prices to fall. Then the recession hits. This should sound very familiar to Austrians: it’s the ABCT. And it’s caused by RBD, which is just a type of fractional reserve banking. Yes, RBD tries to place restrictions on loans, but as Germany and the US in the 1920′s learned, those restrictions are insufficient to stave off disaster.
Another good example were the bills of exchange used in the late middle ages. Bills of exchange were nothing but short term IOU’s based on production. They were traded just like paper money. Gold and silver were the only money. But the total amount of bills of exchange often came to 20 times the total amount of gold and silver in circulation. These bills of exchange would cause business cycles just like paper money or fractional reserve banking does. In fact, they worked exactly as proponents of RBD say their theory should work.
RogerM,
Yes, that all sounds right. Thank you, your description really helps clarify my view of things.
Jesse:
“I conceded that RBD is correct given its definitions and precondition, but only because it then says nothing at all. A theory which claims nothing is technically correct.”
The RBD says, for example, that if a bank issues $100 in exchange for 100 oz. of silver, and then issues another $200 in exchange for IOU’s with a current market value equal to 200 oz. of silver, then the dollars will remain equal in value to one oz. If the IOU’s rise in value the dollars rise too (to an upper limit of 1 oz, depending on the deals made by the banker), and if they fall in value the dollars fall too. This is not a theory that claims nothing. It is a theory that claims that the value of money is determined by its backing. Any stock market analyst will say that the same thing is true of corporate stock. Would you say that they “claim nothing” too?
MV=PQ. Money spent=money received. Now there’s an empty theory!
Peter: Which two? I only counted one, Jean Paul.
Mike Sproul (who always pops up in these threads to support RBD and beg people to read his about how fiat money doesn’t exist…at least his RBD stuff is in a useful format, unlike the no-such-thing-as-fiat thing)
RogerM: “V is irrelevant to this discussion (and usually a constant), so let’s change the equation to simple M=PQ. If the money supply increases, either P, Q or both must increase. Since Q is generally fixed in the short run, P rises.”
!
P = M V / Q
The most important thing you need to defend here is why V and Q are unchanged before and after the issue of money.
Since the RBD is correct (as conceded by some here), the conclusion is that V and Q move as needed to maintain P constant before and after issuing money IN EXCHANGE FOR SUFFICIENT SECURITY. There’s no conflict here, except maybe over the definition of the word inflation, but who cares about that. What’s important is the value of P denominated in bank notes, before and after the money is issued, and the fact that it doesn’t change if you obey the RBD.
I’m sure someone can speculate why V might drop or why Q might rise or why both might do such things. It probably has to do with the diappearance of the big pile of backing assets from the market, which can no longer be traded for until sufficient money is returned to the bank to release those assets.
The assumption of static V and Q is plainly the problem here.
RogerM,
No good Austrian believes in the quantity theory of money. Our monetary theory is based on writings of Mises and Wicksell.
MV=PQ is professor Fisher’s theory (and accounting identity as Mike stated).
Trygve Haavelmo has actually very nice presentation of Wicksells theory in mathematical form in his Probability Approach in Econometrics (Econometrica, 1944 supplement). That could be usefull.
In a free society, it is possible that privately run RBD banks would compete with private fractional reserve banks and private full reserve banks, all issuing their own currencies running the gamut from paper to commodity backed.
Customers would have to inform themselves on the relative merits of each one. Banks would need to explain their methods. Third parties would add criticism and advice. Competition would weed out the weak and determine which banks and monies survived. It is interesting to speculate who would win out, but in the end it is the market place that would decide, no?
adi,
I was under the impression that RogerM was addressing the alterations in the exchange ratios between money and commodities caused by changes in the monetary base. I didn’t think Austrians had objections to this part of the quantity theory of money, but rather to that theory’s inability to explain how the exchange ratios arose in the first place.
JP: I fully agree with your position, in support of free banking in general.
I do think the quantity theory of money is much less informative than the backing theory, because no one seems to be able to describe how Q and V actually behave (I’ve been searching – I can’t find any literature on it, other than allusions that their behaviour is clouded in controversy).
Quantity theory, while based on the obviously true exchange equation, seems a poor theory versus the backing theory (which actually does have some predictive merit). I do disagree with the suggestion the RBD is irrelevant.
Wow, this is a long-running thread… and it barely even references Zimbabwe…
Jean Paul,
When monetary metals actually served as money, what was their backing?
adi:”No good Austrian believes in the quantity theory of money. Our monetary theory is based on writings of Mises and Wicksell.”
I realize that Austrians don’t believe that the quantity theory can solved as an equation because Q can’t be quantified, since you can’t add differing products such as apples and steel. But in concept, I can’t see any difference between it and Mises/Wicksell. Please enlighten me.
Jean Paul:”The most important thing you need to defend here is why V and Q are unchanged before and after the issue of money.”
V, velocity, is historically doesn’t change much, excpet in periods of high inflation when people don’t want to hang on to paper money because it is deprreciating so rapidly. The V accelerates and acts as an increase in M. Q is fixed only in the short run. As the money supply increases and P increases as a result, Q will tend to rise. But the competition for resources and malinvestments will cause firms to go bankrupt.
In a free society, it is possible that privately run RBD banks would compete with private fractional reserve banks and private full reserve banks, all issuing their own currencies running the gamut from paper to commodity backed. … Competition would weed out the weak and determine which banks and monies survived. It is interesting to speculate who would win out, but in the end it is the market place that would decide, no?
It depends. In your hypothetical scenario, what currency does the government accept in payment of taxes and such? What does it decree to be legal tender for all debts public and private?
Or does the proviso that this is a “free society” preclude the existence of such things?
Jean Paul: What predictive merit does RBD have, exactly? The inputs to the theory (whether or not the trades were good) are unknown until after the outcome has been observed (i.e. the notes have been redeemed). By the time you can actually make predictions, those predictions are no longer needed.
George Gaskell: Yes, “free society” means no taxes and no legal tender laws, among other things. What else could it mean?
Yes, “free society” means no taxes and no legal tender laws, among other things. What else could it mean?
It could also mean “no fractional reserve banks,” but he included them in his question, so I wanted to clarify.
Jesse: “The inputs to the theory (whether or not the trades were good) are unknown until after the outcome has been observed.”
I don’t know what my dice will show until after they have stopped rolling. But I do know that in the long run I will hit snake-eyes about once in every thirty six rolls.
Probability theory, as well as an understanding of the possible things dice might do, and the likelihood of those things happening, gives me a great deal of predictive power.
Likewise – the RBD lets me translate predictions about the performance of a backing asset directly into predictions about inflation.
Specifically it tells me that to run a successful bank with stable or appreciating money relative to the market, I need to issue money for assets with an average rate of devaluation less than the average interest rate charged.
How is this not a valuable insight?
… it also tells me that the quantity of money in circulation is a red herring with respect to the purchasing power of the money, and illustrates the microeconomic mechanics of why.
Contrast with the strictly empirical claims about what V and Q tend to do over time on a macro scale.
I don’t know about you but I will take a micro versus a macro explanation every time.
Yancey Ward: “When monetary metals actually served as money, what was their backing?”
All exchange, without exception, is at the most fundamental level a barter in means to satisfy wants.
The ‘backing’ of any asset is simply a function that regresses through the most efficient known chain of asset exchanges, subtracting the subjectively valued transaction and asset holding costs from the subjective value of the most desired want which can be satisfied.
The backing of every asset is ultimately measured in ‘subjective value of wants satisfiable’.
That’s true for gold, potatoes, oil, notes, etc.
Monetary metals arose as money, not valueless out of the blue, but because they were already assets with value attached to them due to their ability in exchange to satisfy wants. The market observed the relative stability of the value of the asset relative to the market (i.e. the stability of the ‘backing’ of the asset), and tended to the most cost minimizing technology available, which was precious metal coinage, or wheat, or receipts, or whatever.
(This is Mises’ explanation of the origin of money, and I find it to be sound. Do we disagree?)
The point is, money isn’t anything special. It’s just another asset. It can be any asset. It’s value is due to its ability to secure means to satisfy wants, which is the only definition of ‘backing’ that makes any general sense.
I have a question for the RBD proponents: is there an issue in the RBD debate about whether the non-metal notes should be designated as such? In other words, what would be the significance of designating these paper currencies on their face as “potato notes,” “oil notes,” etc.? Corporate stock certificates are certainly specific as to their “backing,” and corporate shares are generally traded in some circles as though they were a kind of money.
I could see where post-issue changes in the exchange ratios of the commodities behind the non-metal notes might affect the notes’ market value.
I ask because I am reminded of the gold notes and silver certificates of yore, where the bills themselves were noted as redeemable only in specific monies.
Jean Paul: “… it also tells me that the quantity of money in circulation is a red herring with respect to the purchasing power of the money, and illustrates the microeconomic mechanics of why.”
The quantity theory of money has proven itself even in barter. If in barter a standard rate of exchange exists between bread and apples, and the supply of one increases relative to the other, one will become cheaper in relation to the other. So if the supply of apples doubles, the exchange rate of apples for bread will fall to one half its original rate.
And the quantity theory has proven itself with gold and silver. In fact, the Scholastics who discovered the quantity theory did so by observing steady price increases in Spain in the 16th century as Spain shipped boat loads of gold and silver from the Americas.
The quantity theory of money is the most well-established theories of economics, in a priori terms and empirically. Why would it seem so strange that it works with paper money as it does with barter and gold?
George,
You have identified the key issue- disclosure.
If you have followed many of these debates, you will notice one consistent theme whenever RBD proponents talk about backing- they start off with the claim that the bank issued notes are backed with monetary metals, but whenever pressed as to what happens when the reserves are not there, then say that they will exchange their notes for whatever assets are at hand- IOUs, deeds to land, potatoes. Of course, in the past, people used gold and silver as money, and certificates that represented these metals. Given a choice between accepting a certificate in payment for my bread, I will prefer one that is 100% exchangeable for gold to one that may or may not be depending on the banks balance sheet. To get me to take the other certificate, you will have to give me a discount on its face value. And on my next transaction, I will have to give my trading partner a discount, and on and on. Given freedom, people will choose to trade in the most money like commodity. Only fraud and government coercion can prevent the market from reaching this state.
Note Jean Paul’s answer to my earlier rhetorical question about what was gold’s backing. RBD proponents are clueless what this means in regards to RBD in a completely free market for money, absence coercion, and with full disclosure of the backing a bank note actually has.
“The quantity theory of money is the most well-established theories of economics, in a priori terms and empirically. Why would it seem so strange that it works with paper money as it does with barter and gold?”
You are confusing the law of demand with the quantity theory. The law of demand says that when the quantity of an actual consumable good rises, its price will fall. It’s true for apples and for gold and silver.
Paper and credit money are not consumable goods. There is no production function by which labor and capital are transformed into checking account dollars. They are financial securities that can be created and destroyed at the stroke of a pen. The law of demand is not a meaningful model in this case, and it is a mistake to say that the law that applies to apples and oranges can be extended to apply to bookkeeping entries.
I also note that in the equation MV=PQ, the Q term does not refer to the economy’s aggregate output of goods. It refers only to the quantity of goods bought with the particular kind of money designated by M. For example, if M is the quantity of green paper dollars, then Q is the quantity of goods bought with green paper dollars. It might happen that on one day, 10% of the economy’s goods are bought with green dollars. On the next, the quantity of green dollars might double, and 20% of the economy’s goods might be bought with green dollars. The aggregate output of goods need not have changed at all, but Q would have doubled as M doubled, and there will be no change in V or P.
Mike: “You are confusing the law of demand with the quantity theory. The law of demand says that when the quantity of an actual consumable good rises, its price will fall. It’s true for apples and for gold and silver. Paper and credit money are not consumable goods.”
The quantity theory of money is nothing but the general theory of value applied to money. In barter, if an good, not just consumable goods, becomes more abundant relative to other goods, it’s value relative to other goods will fall. If a good becomes more scarce, it’s value will rise. This applies to land, gold, human beings, bread, anything. Gold is not a consummable good and the law of value applies to it. Human beings are not consumable goods, but the value of their labor varies with scarcity and abundance relative to other goods. Services dominate our economy and the more abundant a service, the lower its price relative to other services and goods. Why would paper money be exempt from this universal principle? The only difference with paper money is that it can be easily created and destroyed, which means that its value is much more volatile relative to other goods and services than any other form of money.
Mike:”I also note that in the equation MV=PQ, the Q term does not refer to the economy’s aggregate output of goods. It refers only to the quantity of goods bought with the particular kind of money designated by M.”
That’s simply inaccurate. Q not only refers to goods, but to services as well. M refers to all money, whether in the form of green paper bills or just accounting entries.
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