Paper, considered as a material whereof to make money, has none of the requisite qualities in it. It is too plentiful, and too easily come at. It can be had anywhere, and for a trifle….Paper money appears at first sight to be a great saving, or rather that it costs nothing; but it is the dearest money there is.
The only proper use for paper, in the room of money, is to write promissory notes and obligations of payment in specie upon. A piece of paper, thus written and signed, is worth the sum it is given for, if the person who gives it is able to pay it, because in this case, the law will oblige him. But if he is worth nothing, the paper note is worth nothing. The value, therefore, of such a note, is not in the note itself, for that is but paper and promise, but in the man who is obliged to redeem it with gold or silver. FULL ARTICLE
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David Hillary
Perhaps we have been talking at cross-purposes.
By “cash holding” or “gold holding” I have been talking of individuals (or corporate entities), whereas it seems that you have been talking of bank-reserves. Hence your reasoning made as little sense to me as mine did to you. Even when you spoke of “social holdings” I assumed that you meant the collective holdings of all members of society.
Yet even allowing for that, we are still at odds.
Certainly gold has non-monetary value. When it became adopted as a medium of exchange, it acquired additional value due to the additional demand for monetary purposes. If gold becomes more common, while demand for cash holding remains the same, then the monetary value of each oz of gold will decline, while its industrial utility will be unimpaired, and so its industrial use will increase. If gold became as common as sand, then the monetary component would vanish, because it would be no better as money than sand.
You say of a closed economy “If the stock of gold coin is more than ample …” But any amount of gold will serve the purpose of money, as long as it is not low that the coins fall through the holes in our pockets, nor so high that we need a knapsack to carry it. If the gold stock doubles overnight, then once the dust has settled in the credit markets, we shall eventually have to get used to carrying around almost twice as much gold in our pockets. But no one will be richer or poorer (in terms of purchasing power) as a result of the extra weight.
You suggest that the additional gold might be redeployed, let us say as jewellry. In that case the value of money would be unaffected, But I find it inconceivable that everyone would agree to do this except by government decree. The temptation to use it as money would be too great. You might as well ask why half of the gold stock was not converted to jewellry the previous year, for the worthy purpose of lightening everyone’s pockets.
You say:
“I can’t follow why you are objecting to the conclusion that the opportunity cost of holding gold coin reserves is the interest foregone on holding interest bearing securities. If the interest rate isn’t the opportunity cost of holding coin, what is it?”
As a definition of interest rate, this is circular. As a “conclusion”, it is a tautology. The “market” interest rate is not set by a bank or government or issuer of securities, but is formed by the relative preferences for consumption or saving by all market players. It is the rate at which the total supply of savings will fill the total demand for borrowing. In other words, the market interest rate (for any term) is the outcome of the supply and demand for credit (for that term).
The practice of debt-monetization (fractional reserve banking) reduces the bank’s demand for savings deposits and so tends to depress interest rates below the market rate.
Cheers
Inquisitor: As far as schools of thought go, concerning banking and money, White outlines three schools: the currency school, the banking school, and the free banking school (Free Banking in Britain). He says that the currency school held that commercial banks or central banks could over-issue paper money, the banking school held that neither commercial nor central banks could over-issue paper money, and that the free banking school held that only central banks could over issue paper money. Now, as far as I understand this question, so long as all paper money is not legal tender, and is convertible to gold coin, and in a small open economy, then the banking school was right: the interest rate is fixed at the world interest rate, the demand to hold money is determined by the demand to hold it, the price of money is determined by the world purchasing power of gold, and therefore no over-issue can occur, and if it did occur it cannot influence prices or interest rates. Thus it appears my position is closest to the banking school, not withstanding my support for free banking. Incidentally I believe White provides the best contemporary theory, analysis and exposition of banking and money available today. However I do think he has not correctly understood the analysis of money in a closed economy, and it is here that it appears my theory is novel — so far I have not found any other academic that has developed this theory concerning the exchange rate of and interest rate on commodity money in a closed economy. My own attempts to fully write up my own theory are also incomplete, although I have got as far as to derive my results both numerically and analytically.
LanceH: When a commodity becomes a selected medium of exchange, it does not, ultimately, add to its price: the demand to use the commodity as a medium of exchange is not a demand to consume it, but a demand to hold it: after a period of an elevated price, the stock of the commodity will have expanded sufficiently to meet the demand to hold it, and its price can return to where it was before. Supply and demand are flows, the demand to hold money is the demand for a stock, not a flow. So, the price of the monetary commodity should settle at that price that makes supply and demand flows equal, and maintains that stock of the commodity people wish to hold, under conditions of equilibrium in both goods markets and asset markets, other things being the same.
It is also a tautology that the stock of a commodity can only increase or decrease, other things being equal, by running surpluses or deficits in the market for that commodity, and that surpluses can only be run by having a price that is above equilibrium, and deficits by having a price that is below equilibrium.
The additional complexity of commodity money is that it is both a produced and consumed good, and an asset in asset portfolios (and part of the capital stock). Confusion between stocks and flows is the greatest barrier to understanding commodity money economics.
The adequacy of the stock of the monetary commodity is a very real question: one amount is not as good as another. If the commodity’s relative price is ultimately anchored by primary market supply and demand functions, and disequlibrium is only temporary, then an inadequate stock of the commodity in society’s capital stock will make commerce more difficult and increase transaction costs — the society could enjoy substantial marginal benefits from an increased stock of the commodity. Conversely an excessive stock of the monetary commodity would come at a cost of fewer buildings etc. and for little marginal benefit.
Your analysis of my contention that excess gold can be worked off appears to misunderstand somewhat the proposed scenario. The scenario is that the gold price will fall temporarily, the gold market will go into deficit temporarily, and then the gold price will rise to its former value, and the equilibrium price and stock will be restored. I.e. any disequlibrium resulting from the excess of gold is only temporary.
You are correct that the introduction of fractional reserve banking will reduce the interest rate (in a closed economy), other things being equal. To consider this let us construct a closed economy and then introduce a banking system.
Annual output (GDP) 100,000 tonnes gold by value/year
Capital stock 200,000 tonnes gold by value, consisting of 10,000 tonnes in gold coin and 190,000 tonnes in gold value of other forms of non-financial capital (buildings etc.), at depreciated historical cost.
Suppose the interest rate on interest bearing securities was 6% p.a. and that 100,000 tonnes of interest bearing securities were issued.
So, wealth is held in the form of:
gold coin: 10,000 tonnes
interest bearing securities: 100,000 tonnes (yield to maturity valuation)
equities: 90,000 tonnes (depreciated historical cost less debt owed)
Total: 200,000 tonnes
Now introduce a banking sector that issues 5,000 tonnes in bank notes, 5,000 tonnes in cheque account balances, 5,000 tonnes in term deposits, and 5,000 tonnes in share capital. Thus total liabilities plus net worth is 20,000 tonnes. Assets is 18,000 tonnes in interest bearing securities and 2,000 tonnes in gold coin. Society’s wealth is now held by non-banks as follows:
gold coin: 8,000 tonnes
Bank notes: 5,000 tonnes
Cheque account balances: 5,000 tonnes
Term deposits: 5,000 tonnes
interest bearing securities: 82,000 tonnes
equities (including bank shares):95,000 tonnes
Total 200,000 tonnes
So, the total wealth (book value) is the same, however the stock of money is increased from 10,000 tonnes to 18,000 tonnes. Since cheque account balances pay interest, the demand to hold money will have increased — it is not more attractive to hold money that pays interest — however, overall demand to hold gold coin will have decreased: bank notes are competing with coin to supply money in bearer form, and cheque accounts are also offering a substitute. The interest rate on money will therefore fall.
Suppose that, for some reason, this causes a bout of inflation. This will reduce the gold price and suppose this results in a deficit in the gold market of 500 tonnes/year. After 10 years the gold stock is reduced to 5,000 tonnes, suppose this restores equilibrium, and a bout of deflation returns the gold price to equilibrium. From here on, notwithstanding the introduction of fractional reserve banking, the interest rate and exchange rate on the monetary commodity are the same as they were before, and society has less gold than before, and correspondingly more buildings. Thus any reduction in the interest rate may be only temporary.
Interesting thread. Much better than the normal arguments that always seem to come up.
Lance H:
“The practice of debt-monetization (fractional reserve banking) reduces the bank’s demand for savings deposits and so tends to depress interest rates below the market rate.”
If you can find a copy of Jack Hirshleifer’s “Investment, Interest, and Capital”, or “Price Theory and Applications”, or even Irving Fisher’s “Theory of Interest”, you’ll see the equilibrium real interest rate determined as the rate that equalizes the slopes of each individual’s intertemporal production-possibilities curve with the slopes of everyone’s intertemporal indifference curves. That interest rate is determined independently of the existence of money, and thus is not affected by the practice of fractional reserve banking. Fractional reserve banking can be viewed as an efficiency-improving practice that reduces the spread between the borrowing/lending rates, but not as a practice that systematically leads to lower interest rates overall.
Mike,
Interest rates are interest rates on MONEY, not on inter-temporal production/consumption possibilities and the desire for them. Time preference is as meaningless to the money market as is speed preference for the market for automobiles. People don’t desire, in economics, abstract goods, and preferences for them are economically meaningless — preferences are for bundles of particular goods or assets, not for abstracts like time, space, love or power. The interest rate is determined in the money market, where loans or securities are bought and sold, issued and redeemed.
If the capital stock is small, according to the law of diminishing marginal returns, the interest rate should be high, as a rationing device to ration the small amount of available capital into the most profitable investments, even though society as a whole (or the median agent) might find that under such rewards it is better to save rather than spend. Perhaps over time the capital stock can grow and stable equilibrium reached, however at any one time the market clears at some price.
Zooming into the microscopic level of the monetary commodity market, it is the marginal rate of return on that form of capital (the stock of the commodity) that determines what the interest rate on the monetary commodity will be. As above, the larger the stock of the commodity, the lower its marginal rate of return, and therefore the lower the interest rate will be in order to make that stock willingly held.
Otherwise, how can you explain the motivation to hold stocks of the monetary commodity?
See White’s Free Banking in Britain for a theoretical model that shows the bank’s demand to hold specie in its portfolio. His model shows that the bank will, at the margin, equalise the rate of return from holding specie with the rate of return from holding bills (interest bearing assets (risk adjusted, of course)) and the rate of cost of obtaining funding from deposits and notes. I.e. the marginal rate of return on specie is the interest rate. If you can accept his model — and it is sound — and generalise it and apply it to all bank and non-bank agents in a closed economy, the conclusion that the interest rate is a decreasing function of the gold stock necessarily follows.
David Hillary:
In a world without money, people would still lend 100 bushels of wheat today, and be repaid 105 bushels next year. Maybe we are talking at cross purposes about the difference between real and nominal rates?
“As above, the larger the stock of the commodity, the lower its marginal rate of return, and therefore the lower the interest rate will be in order to make that stock willingly held.”
That’s a pretty mixed up statement. Normally I’m not one to fall back on higher authority, since the higher authorities in monetary theory are more confused than the rest of us. But the theory of interest, in the tradition of Irving Fisher, is well-developed and non-controversial, and it implies that the real interest rate is determined by the slopes of intertemporal production-possibilities curves and intertemporal indifference curves.
Mike,
Yes, we are talking at cross purposes, at least somewhat.
It is reasonably well known that the interest rate on different currencies and commodities differ. The question here is about the interest rate on one particular commodity: the monetary commodity in a closed economy on a commodity monetary standard.
The interest rate on money is of course the nominal interest rate, not the real interest rate. Other than inflation indexed bonds, the money market works on a purely nominal basis.
I guess the criticism of the Fisher theory of interest would be that it is not a monetary theory but a real theory, and concerns the real interest rate, but the interest rate is the interest rate on money, i.e. the nominal interest rate.
To get from the real market to the nominal market requires a theory of inflation or inflation expectations or similar. Which theory to use is far from obvious, which makes Fisher’s theory of limited use.
The rates returns on different forms of capital need not be identical: the capital stock at any point in time may not be in equilibrium between any two or more forms of capital. How the capital market allocates and re-allocates capital between the monetary commodity and buildings etc. under a commodity money standard in a closed economy is presently lacking a coherent theory. This is where my theory comes in.
The connection between the interest rate and the size of the stock of the monetary commodity is actually quite evident and demonstrable.
Necessarily agents who hold the monetary commodity forego contractual interest available from lending it and holding an interest bearing security instead. This is almost self evident, a fairly trivial economic theory. Given no one is obliged to hold the monetary commodity, the fact that it is held demonstrates some benefit from holding it. When agents optimise their portfolios, their marginal rate of return on holding the monetary commodity must be equated to that on other assets in the portfolio (risk adjusted), including interest bearing securities.
The consequences of, other things being equal, the monetary commodity increasing, is not so obvious. How much one is wedded to the quantity theory of money is very important here: quantity theorists would expect inflation as a result of the increased stock of money and could expect that after prices rose equilibrium would be restored with the enlarged stock of the monetary commodity. Those who think, in principle, that the quantity theory of money is misguided, could come to a very different conclusion: that the increased stock of the monetary commodity would result in a diminished rate of return on that form of capital, in accordance with the law of diminishing marginal returns.
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