The Rule of Planned Money
There is a long history of monetary experience, writes Garet Garrett. It tells us that government is at heart a counterfeiter and therefore cannot be trusted to control money, and that this is true of both autocratic and popular government. The record has been cumulative since the invention of money. Nevertheless it is not believed.
There is also a history of sound money, and if its lessons are likewise disregarded, what shall one conclude but that monetary delusions are, by some strange law of folly, recurring and incurable? There was a century of sound money. During one hundred years preceding World War I, government touched money hardly more than to establish standards of weight and measure, to lay down the laws of liability and to license bankers. In that century the wealth of the world increased more than in all preceding time of economic man. FULL ARTICLE
Comments (168)
Mike Sproul
A classic Austrian misunderstanding of money. Banks are not counterfeiters. Banks put their name on their money, hold assets against that money, and stand ready to use those assets to buy back that money.
Garrett confuses convertibility with backing. The dollar, for example, is not physically convertible into gold, meaning that the Fed will not buy back its dollars with gold. But the dollar is financially convertible: The Fed will buy back its dollars with its bonds. The Fed would not be able to do this if it did not hold assets sufficient to redeem all the dollars it has issued. Five minutes studying the real bills doctrine would make this clear.
The dollar is not fiat money. There is no such thing. If there were, it should be possible to find some central bank somewhere that holds no assets against its money, but there is no such bank.
Published: October 4, 2007 11:35 AM
Michael A. Clem
The Fed will buy back its dollars with its bonds.
In other words, it will redeem its dollars with debt. Is debt a commodity?
Published: October 4, 2007 11:40 AM
David White
Mike Sproul:
Remind me to stop by your planet sometime to get a deeper understanding of what it's like to live in fantasyland.
Published: October 4, 2007 11:43 AM
Mike Sproul
Michael Clem:
A bond is a thing of value. When the fed buys it with newly-issued dollars, the money supply rises. When the fed sells that bond and retires the dollars, the money supply falls. In both cases, the money supply moves in step with the backing held by the Fed, so there is no inflation when money is issued, and no deflation when money is retired.
I'm sure you'd agree that if the Fed issued every new dollar in exchange for an ounce of silver, then the value of the dollar would stay at one ounce of silver. The mistake Austrians make is to think that it makes a difference if a dollar is issued in exchange for a bond that can, for the trouble of crossing the street, be sold for one ounce of silver.
Published: October 4, 2007 11:49 AM
Juan
The dollar is not fiat money. There is no such thing
So, what does 'fiat money' allude to ? Why did somebody take the trouble of inventing a word for something that doesn't exist ? Is fiat money the same as unicorns ?
there is no inflation when money is issued, and no deflation when money is retired.
So, what are these two words, inflation and deflation supposed to mean ?
Published: October 4, 2007 12:15 PM
Michael A. Clem
A bond is a thing of value.
Is it? A bond is debt, right? It's only as good as the ability and willingness of the borrower to pay the money back. So money that is backed by debt, or convertible into debt, is only as good as the borrower's ability to be productive and pay the debt off. The bank isn't promising to pay gold or silver for your dollars, it's promising to pay you someone else's promise to pay. It's one step removed and runs the risk of becoming circular--after all, where does the borrower get the money to pay the debt? What happens if the debt has to be written off?
Published: October 4, 2007 12:15 PM
Fundamentalist
Mike: "A bond is a thing of value."
A bond is a fancy word for an IOU.
Published: October 4, 2007 12:17 PM
mikey
The mistake Austrians make is to think that it makes a difference if a dollar is issued in exchange for a bond that can, for the trouble of crossing the street, be sold for one ounce of silver.-------------------------------------------
This sentence perfectly summarizes the error in Prof. Sproul's thinking.For he is saying that issuing money based on the bond is not inflationary, since the bond itself is a thing of value.However, an equal amount of money is already in circulation, based on the silver.This must neccessarily be inflationary.The creditworthiness of the borrower is irrelevant.
Published: October 4, 2007 12:32 PM
Dan
The last time there was a RBD discussion here, it took perhaps 60 or so comments for it to be admitted that if everyone showed up demanding their exact deposits, right now-this very minute, it could not be done. Instead, it is explained that the banks could hand over something else, bonds being the example here, which the customer could sell for dollars if he/she wished.
But, RBDers assume that the banks customers will accept something other than what they deposited, which is fine, but it would be nice if they actually stated that that assumption is necessary. Unless this assumption is granted, there is absolutely no question that an RBD bank is a fractional reserve bank. Within this assumption of course, is an explicit agreement between the bank and the customer that the customer is handing over dollars with the understanding that he/she may not get dollars back. They may get a bag of nails, or butter, or whatever back. But, this sounds curiously like an investment firm working in a commodity market for their customers, not a bank keeping customers deposits safe.
The whole vocabulary of the RBDers sounds curiously like a deliberate attempt to blur the meaning of certain words so that they can call a bank a company which invests funds on behalf of customers in commodities or bonds etc. But, I think that even the average Joe on the street could tell you that the difference between the idea of a bank and the idea of an investment firm is that banks invest their own assets, whereas investment firms are hired to invest on behalf of their customers.
All of that being said, RBD style 'banks' seem to be ok as long as there is an explicit agreement between 'banker' and customer that when they wish to 'cash out' they may receive bonds or a stock of iron, etc in place of whatever it was they initially deposited.
Published: October 4, 2007 1:19 PM
Sag
A side note to this article. It's interesting that the son of Howard Buffett, sound money libertarian and friend of Murray Rothbard, ends up with an MA in economics from Rothbard's alma mater, multi billions and a social democratic interventionist philosophy.
Published: October 4, 2007 1:48 PM
jp
"But the dollar is financially convertible: The Fed will buy back its dollars with its bonds."
I've got a five dollar bill right now, but the Fed won't buy that from me for its bonds. Only deposit-taking institutions who can participate in open market operations get to exchange dollar bills for bonds. You call that convertability?
Published: October 4, 2007 2:02 PM
Herbert Aubrey
In the case of Howard Buffett's son, the apple fell very far from the tree, and a solid and principled tree at that. Our nation can use more individuals like Howard Buffett.
Published: October 4, 2007 2:04 PM
Mike Sproul
Juan:
Fiat money is like phlogiston, ether, and caloric: A name for something some people believe in, but which is nonexistent.
Inflation, meaning a loss of the dollar's value, results from a loss of backing.
Published: October 4, 2007 2:14 PM
Mike Sproul
Michael Clem:
It makes no difference if a thing of value is a bond (i.e., and IOU) or a square foot of land. In either case, if the Fed issues a new dollar for something worth $1, the Fed's assets rise in step with its liabilities and the dollar holds its value. By analogy, General Motors can issue new shares of stock, use them to buy an equal value of bonds, and the value of GM stock will not change. No serious economist would deny that this is true for GM stock. It is just as true of any financial security, including money.
Published: October 4, 2007 2:20 PM
Mike Sproul
Mikey:
You are assuming what you're trying to prove. An increase in the money supply, accompanied by an equal increase in bank assets, leaves the value of the money unaffected. If the value of the money fell, then a speculator could buy all the money at the low value, return it to the bank in exchange for all the bank's assets, and make a profit equal to the undervaluation of the money.
Published: October 4, 2007 2:34 PM
Kevin B
Mike Sproul,
Soooo, as the value of the dollar mysteriously drops, we should exchange our land for dollars. Then exchange our dollars for promises to print us more dollars later.
Why not beads? Why not trade our land for beads?
Published: October 4, 2007 3:49 PM
mikey
An increase in the money supply, accompanied by an equal increase in bank assets, leaves the value of the money unaffected. ---------------------------------------------------------------------
Prof. Sproul, it is the quality of these assets that I question.I don't see debt instruments as a
suitable base for issuing additional money.The borrower is spending the borrowed money on economic goods.The bank, meanwhile has issued new money, based on the debt instrument.This new money immediately enters the economy, and the supply of economic goods available has not increased at all. There is no way that this will leave the value of money unaffected, unless all of the newly created money is used only to repurchase the debt instruments,and then retired from circulation. An IOU is not wealth in the sense that land, food,cars etc are.If it was, the world could be much better off by having everyone exchange IOUs with his neighbor.
The inflation we have seen over the the last few decade stems from the fact that government monetizes its debt and this debt has grown...and grown.If this debt were to be retired,the money supply would shrink back to its hard kernel of physical notes and coins.
Published: October 4, 2007 3:58 PM
eric lansing
good work, mikey.
Published: October 4, 2007 5:14 PM
Mike Sproul
Dan:
No argument here. The real bills doctrine just says that banks and their customers care about the value of the assets backing their money, and not about the physical form of those assets. That said, the main point of the real bills doctrine is that an increase in the money supply, accompanied by an equal increase in the bank's assets, will leave the value of the money unchanged
Published: October 4, 2007 8:18 PM
Mike Sproul
JP:
The Fed will use its bonds to buy back large amounts of dollars ($100,000+, I think) at auctions conducted by licensed securities dealers. Yes; I call that financial convertibility. If the Fed refused to ever use its bonds to buy back its dollars, I'd call that financial inconvertibility.
Published: October 4, 2007 8:22 PM
Mike Sproul
Kevin B:
It's Austrians who claim that an issue of new dollars in exchange for equal-valued assets will cause the dollar to drop, not me. If the dollar did drop, speculators could make arbitrage profits by buying all the dollars at their reduced value, bringing them to the bank to claim all the assets that back those dollars, and then selling those assets for more than what they paid for the dollars.
Published: October 4, 2007 8:27 PM
Mike Sproul
Mikey:
You are assuming that inflation is caused by "more money chasing the same amount of goods". That is the very point in dispute, and you can't just assert it.
Suppose, for example, that the Fed prints 100 new dollars and buys a $100 bond with it. If that $100 displaces some other kind of money (e.g., gift certificates, foreign currency, barter, etc.), so that total spending is unchanged, then I expect you'd agree that it is not inflationary.
On the other hand, if there is no displacement of other moneys, so that people really do have an extra $100, then you have to remember that people can return that money to the bank. In a world of physical convertibility, people would take the extra $100 and return it to the bank in exchange for (say) one ounce of silver. (This is the so-called "Law of the reflux.") In a world of only financial convertibility, the extra dollars can still be returned to the bank--just in exchange for bonds, not silver.
The Fed, in conducting ordinary open-market operations, performs exactly this function. When there is extra cash in the economy, banks see their reserves rise, and this puts downward pressure on the federal funds rate. The fed reacts to downward pressure on the FFR by selling bonds, thus soaking up the excess cash.
Published: October 4, 2007 8:42 PM
Juan
Mike,
You say fiat-money doesn't exist - and then you say that 'unbacked' money somehow loses its value.
Well, I always naively thought that 'unbacked' money is also called...fiat money ?
Also the insight that if 'too much' money chases too few goods then prices will go up is not really 'Austrian' - It's a basic tenet of political economy - it is, I believe supply and demand ?
You can check out a guy called A. Smith explaining that money is commodity money - not fiat money.
Published: October 4, 2007 9:19 PM
TLWP Sam
Wow M. Sproul is there any particular website that gives an extended explanation of what you give? I admit their 'money is worthless/counterfeit because because it's paper and only gold is money' is a bit suss. But I not sure how many Libbers who have uni degrees would consider it worthless as it printed on paper and a good counterfeiter could whip up a good equivalent with the press of a PRINT button?
Published: October 4, 2007 9:23 PM
Anthony
Not an exact analogy. A better one would be if the institution decided to give everyone who passed through its hallways a degree - thus rendering it a worthless piece of paper. Similarly, the more money printed w/out an increase in goods will lead to a fall in the monetary unit's purchasing power (the analogy becomes even weaker once one stipulates that monetary expansion is non-neutral.)
Published: October 4, 2007 9:44 PM
Michael A. Clem
It just seems strange that new money can be created and backed by increased debt. Have governments found the perfect way to increase the money supply, or are you overlooking some kind of unintended consequences? Is going into debt good for the economy? With a commodity like gold, the amount of money is limited by the quantity of gold. What's the limit when it's backed by debt? And whose debt is it, anyway, that these bonds are based upon?
Published: October 4, 2007 11:06 PM
Joseph Huang
If there is no fiat money, how can there be excess cash?
Published: October 4, 2007 11:42 PM
M E Hoffer
M.A. Clem,
In Sproul's world the 'debt' the FedRes is using to 'back' its 'dollars' are U.S. Treasury obligations that demand future taxes to be made whole.
IOW, the 'dollar' holder, in short, is promising to pay future taxes to ensure the 'value' of his current 'dollar'.
see:
http://www.googlesyndicatedsearch.com/u/Mises?hl=en&submit.x=0&submit.y=0&q=debt%20as%20money
for further, better insight.
Published: October 4, 2007 11:42 PM
Marco Saba
I wonder why Microsoft just scanned and published on the Internet some books from Alexander Del Mar, here:
A history of the precious metals, from the earliest times to the present - Del Mar, Alexander, 1836-1926
Bibliography: p. xi-xxii
History of monetary systems, record of actual experiments in money made by various states of the ancient and modern world, as drawn from their statutes, customs, treaties, mining regulations, jurisprudence, history, archaeology, coins, nummulary sytems and other sources of information - Del Mar, Alexander, 1836-1926
The science of money - Del Mar, Alexander, 1836-1926
Bibliography: p. [xvii]-xxi
A history of money in ancient countries from the earliest times to the present - Del Mar, Alexander, 1836-1926
The science of money - Del Mar, Alexander, 1836-1926
Includes bibliographical references and index
http://tinyurl.com/27y878
Anyway, the best one is here:
The History of Money in America, from the History Times to the Establishment of the Constitution by Alexander Del Mar, 1899
http://www.dayspringgatherings.org/pdfs/The_History_of_Money_in_America_.pdf
Published: October 5, 2007 2:48 AM
Mike Sproul
Juan:
The point of the real bills doctrine is that the money that economists call fiat money is not fiat money at all. The dollar, for example, is backed by the Fed's assets (gold+bonds), even though economists mistakenly call it fiat money. The fact that the dollar is not physically convertible makes people think it is unbacked, but they forget that the dollar is still financially convertible.
The "too much money" story is called the quantity theory of money, which is often confused with the law of supply and demand.
Published: October 5, 2007 11:27 AM
Mike Sproul
TLWP Sam:
The best link on the real bills doctrine is
www.csun.edu/~hceco008/realbills.htm
Or just google "real bills doctrine" if I typed that link wrong.
Published: October 5, 2007 11:29 AM
Mike Sproul
Michael Clem:
It doesn't matter if new money is backed by debt, gold, wheat, or a square foot of land. It is only the value of the assets that matters to the value of the money. The Fed could easily sell $1 billion of bonds for $1 billion of farmland, and there would be no effect on the value of the dollar.
There is no point to limiting the quantity of money as long as every dollar is backed. For example, each dollar could be backed by a square foot of land. If more money is desired, people will bring the deeds to their land to banks to exchange for dollars. If people don't want more money, they will keep title to their land.
Published: October 5, 2007 11:40 AM
Mike Sproul
Joseph Huang:
If all money is backed by the assets of the bank that issued it (i.e., there is no such thing as fiat money) then banks would only issue new cash when people want new cash badly enough to hand their assets to the bank, so in this case there cannot be excess cash.
There can, however, be inflation. If the bank loses some of its assets (e.g., the Fed pays good money to maintain palatial buildings and a bloated payroll) then that will cause the value of the dollar to fall.
Published: October 5, 2007 11:47 AM
eric lansing
Mike Sproul's homepage:
http://www.csun.edu/~hceco008/realbills.htm
Published: October 5, 2007 12:36 PM
Juan
Garret says :
Since the amount of money needful to be in circulation to effect the rhythmic exchange of goods is not a fixed quantity — and this for the reason that there are tides in the volume of business — it follows that the supply of money, even gold-standard money, must be in some degree managed.
And then
During that century of sound money it was the private banker who performed that office. You may think of him sitting with his fingers on the pulse of business, saying no to the borrower when the pulse was too high, thereby curtailing the supply of credit money, or, when the pulse was low, releasing credit freely, thereby increasing the supply of money as a stimulus to business.
Now, isn't this some sort of keynesianism, this "supply of money as a stimulus" ?
I suppose that Garret is advocating free-banking but it seems he doesn't understand the weakness of system. He presesnts the counterfeiting done by bankers as something that must be tolerated - or that's even needed as a stimulus.
Is he an advocate of property rights ?
Published: October 5, 2007 12:36 PM
Juan
I should have said :
Is he a consistent advocate of property rights ?
Published: October 5, 2007 12:49 PM
Anthony
Marco, does that monetary history have any links to Austrianism, or any particular school?
Published: October 5, 2007 1:04 PM
Paul Edwards
Mike! It's good to read you again.
Question:
If i print my own money up and buy real assets with it, is this, in principle, fine?
If so, is it ok for everyone in the country to do the same, and need there be any limit on this activity? After all, this new money will all be used to buy assets, so it will all be backed by these assets of one form or another.
If it is not ok, what is the principle that makes it fine for central banks, and commercial banks, but not ok for your average joe.
Thanks!
Published: October 5, 2007 2:37 PM
Mike Sproul
Hi Paul:
Good to hear from you too!
Yes. You can print your own money as long as you hold adequate assets against it, and stand ready to use those assets to buy back the money you have issued. Anyone can do this, and there is no need for any limit to it. Any shopkeeper who issues gift certificates is doing exactly that.
I should add that the public is also free to decline to accept 'Paul dollars' if they choose.
Published: October 5, 2007 3:25 PM
Kevin B
Mike,
I just wanted to point out that in a system where people are free to refuse any currency, I would recommend against accepting paper dollars backed merely by a note promising that more paper dollars will be printed at a later date.
Published: October 5, 2007 3:32 PM
Mike Sproul
Juan:
There are many historical episodes where the issue of new money was stimulative. The explanation offered by classical economics was fairly lame, and this created an opening for Keynesians to offer their illogical explanation for it.
One strength of the real bills doctrine is that it offers a pretty good explanation for monetary stimulus: When there is not enough money in circulation for people to conduct business comfortably, the RBD says that banks can add new money to the economy and relieve the monetary scarcity, thus stimulating business. At the same time, there will be no inflation as long as the new money is adequately backed by new assets.
Published: October 5, 2007 3:34 PM
eric lansing
Mike,
I am interested in your theories...
can you critique this 3 page paper for me?
http://mises.org/daily/2504
Published: October 5, 2007 3:39 PM
Paul Edwards
Mike,
"Yes. You can print your own money as long as you hold adequate assets against it, and stand ready to use those assets to buy back the money you have issued."
Oh i would stand ready to buy back the money I issue, in principle at least, naturally. But on net, and in reality over time, i would expect the assets i would hold, and the money i issue, backed by those assets of course, to both continuously grow; just as the fed and the banks do presently. I just think that would be best for the economy – and me.
"Anyone can do this, and there is no need for any limit to it. Any shopkeeper who issues gift certificates is doing exactly that."
Do you really think so? I don't want to issue gift certificates though. I want to issue dollars that i print, and exchange them for other assets that people work for to exchange with me for my dollars.
"I should add that the public is also free to decline to accept 'Paul dollars' if they choose."
But I want to issue dollars like the commercial banks do, you know, indistinguishable from any other dollar out there. It would not be the same, nor as beneficial to me, if people viewed my dollars as distinct from or potentially inferior to other people's dollars. I want my dollars to look legitimate so people will not think twice about their value. Naturally, everyone else printing dollars would wish to do the same. But they too would agree to stand ready to buy back their dollars should they ever feel it a good idea.
Any objections to my plan?
Published: October 5, 2007 3:53 PM
Mike Sroul
Eric:
The article completely misses the mark in describing fractional reserve banking.
The real bills view of fractional reserve banking is this: Say the central bank gets 100 oz of silver on deposit and issues 100 paper receipts ("dollars") in exchange. At this point nobody would argue that each dollar is worth one ounce. Now let the bank print up another $200 and lend them to a farmer, who gives the bank his IOU (worth $200 and backed by his farm). The real bills view is that the central bank's assets have increased in step with the money supply, so there will be no inflation.
Now suppose Bank of America gets 50 of those paper dollars on deposit and issues 50 of its own checking account dollars in exchange. Every checking account dollar will be worth 1 paper dollar. Then B of A lends 150 checking account dollars to a shopkeeper, receiving an IOU worth $150 in exchange, backed by the shop. The real bills view is that in spite of the "multiplication" of the money supply, B of A's assets have increased in step with its checking account dollars, so B of A dollars keep their value. Meanwhile, B of A's actions have no effect on the assets or liabilities of the central bank, so the paper dollars are unaffected by whatever B of A does.
Published: October 5, 2007 4:32 PM
Mike Sroul
Paul:
I'd like to issue your kind of dollars too! Just print them and spend them.
But the only kind of Paul dollars that should be legal are the kind that have your name on them so that people can come to you and claim a dollar's worth of your assets.
I'd love to issue Disney dollars too, indistinguishable from the originals, but those darn counterfeiting laws get in the way.
Published: October 5, 2007 5:03 PM
Paul Edwards
Mike,
“But the only kind of Paul dollars that should be legal are the kind that have your name on them so that people can come to you and claim a dollar's worth of your assets.”
But that wouldn’t achieve for me what the fed has achieved for itself. The fed is not obligated to divest itself of treasury notes – if it does this at all, it is at its own complete discretion. In fact, since 1913, it has accumulated hundreds of billions of dollars worth of paper assets by printing and exchanging new dollars for them. Sure it occasionally buys back a billion dollars here, a billion dollars there, but on net it keeps producing and spending more and more of them. You and I want the same deal. Is there a problem with us having it – aside from the fed and the government wishing to keep its monopoly on this sweet deal?
“I'd love to issue Disney dollars too, indistinguishable from the originals, but those darn counterfeiting laws get in the way.”
Darn. That’s true – there’s a law against it. But that doesn’t answer what your view on the validity of doing this is. As long as you and I stand prepared, at our own discretion, to exchange back for dollars, the assets we buy with the dollars we print, would it would be ok and harmless from your perspective?
Published: October 5, 2007 5:24 PM
Kevin B
Mike Sproul: "At this point nobody would argue that each dollar is worth one ounce."
Fine, one dollar is worth one ounce. But the minute that an IOU or any other "asset" is taken, the same dollar is no longer worth an ounce of silver.
What kind of fool would freely (as opposed to the current state of coercion) exchange his silver for a few dollars out of a supply of dollars limited only by the imagination?
Banker: "Sorry, sir, but the only asset we have left in the vault is a certificate for a BJ from a cracked-out whore."
Customer: "...I guess I'll need directions."
Published: October 5, 2007 6:41 PM
Juan
I wonder why the concept of commodity money is so hard to grasp ?
Published: October 5, 2007 7:17 PM
JIMB
Mike Sproul - You fail to realize that the goods against which you issue new money will not remain at the old ratio of goods versus money because an increase in the supply of money will cause money to be in less value against goods than before. To believe anything else is to deny the law of supply and demand.
The only way to know with a higher degree of certainty what something is worth, is to put it at auction with all other goods using a common frame of reference, and THAT is what a universally accepted money allows.
Gift cards are *not* money. They are not universally accepted for indirect exchange.
The dollar is backed. It is ultimately backed by the goods which are produced by the U.S. and those using the currency for trade.
I note that depositing money in a bank is really a credit transaction. You give them money (cash or electronic transfer by draft or other method) and they promise to return that money on demand plus offer other services. In essentials, you have "bought" the future good of cash redeemability plus bank services.
Published: October 6, 2007 12:23 AM
JIMB
Mike Sproul - Just to make it even more obvious - what if everyone in the US decided to issue money against their house? I surmise that $50 Trillion in new money would be a tad inflationary, seeing that the monetary base is
Published: October 6, 2007 12:33 AM
JIMB
Mike Sproul ... seeing that the monetary base is less than $1 Trillion
Published: October 6, 2007 12:38 AM
Michael A. Clem
An increase in the money supply, accompanied by an equal increase in bank assets, leaves the value of the money unaffected.
I'm sure you'd agree that if the Fed issued every new dollar in exchange for an ounce of silver, then the value of the dollar would stay at one ounce of silver.
I'm not so sure that either of these statements are correct. Austrians define inflation as an increase in the money supply period, if I understand Austrian economics correctly. Any bank or government that issues new currency into the economy is increasing the money supply, whether they back it with assets or not. Even on a gold standard, new money backed by gold is still inflationary. The virtue of a gold standard is not that it prevents inflation, but that it limits the amount of inflation to the available gold stock.
A bank or government might indeed peg their currency to an ounce of gold or an ounce of silver so that it continues to buy the same amount of gold or silver, but the actual value of a dollar is its purchasing power, or how much goods and services it can buy. Even if a dollar buys the same amount of silver (because of pegging, not because it was backed by an asset), the prices of other goods and services could still change, thus changing the purchasing power of the dollar.
With debt-based money, the only real limit on inflation is the willingness of investors to loan that money to the government. The fact that a dollar is backed or convertible to a bond is not in itself a limit to inflation the way a gold or silver standard would be.
However, an interesting wrinkle in the U.S. system is that while the government itself can borrow humongous (is that a scientific term or what?) amounts of money, only the Federal Reserve can actually monetarize that debt. This is a privilege granted the Fed by the government, and it can be changed or abolished any time they want to change the law. For now, however, the Fed has a fairly high degree of independence from the government, and its interests in controlling the money supply don't quite coincide with the government's interests.
Published: October 6, 2007 1:31 AM
JIMB
Michael Clem - Mises defined inflationary money expansion as any increase of money not "needed" ... his words are:
"In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur."
Theory of Money and Credit PDF pg 242
Published: October 6, 2007 10:40 AM
Mike Sproul
Paul:
"The fed is not obligated to divest itself of treasury notes – if it does this at all, it is at its own complete discretion... Is there a problem with us having it – aside from the fed and the government wishing to keep its monopoly on this sweet deal?"
Anyone is, and should be, free to issue pieces of paper saying "IOU $1". The public is also free to accept them or reject them, and rational people would only accept them if their issuer was willing and able to buy them back with something of equal value. The better the issuer's credit, the more willing people are to accept the dollars.
But that doesn’t answer what your view on the validity of doing this is. As long as you and I stand prepared, at our own discretion, to exchange back for dollars, the assets we buy with the dollars we print, would it would be ok and harmless from your perspective?
Yes; as long as people are free to reject them, as above.
Published: October 6, 2007 12:22 PM
Mike Sproul
Kevin B
"Fine, one dollar is worth one ounce. But the minute that an IOU or any other "asset" is taken, the same dollar is no longer worth an ounce of silver."
So let the bank issue dollars that say "IOU 1 ounce, or something of equivalent value". Rational customers can choose whether or not to accept them, and the bank can offer interest as an incentive to hold those dollars. Once that's done, every new issue of dollars, accompanied by an equal increase in bank assets, will cause no inflation
Published: October 6, 2007 12:28 PM
Mike Sproul
JIMB
You'd probably admit that if each new dollar is issued in exchange for one ounce of silver, then the dollar will be worth 1 ounce no matter how many are issued. Yet you're unwilling to believe that if the dollars were issued for something worth one ounce, the same thing would be true.
You'd probably also agree that if the new dollars displaced barter or other forms of money, then new money would not raise prices. The next step is to recognize that as long as new dollars are only issued for a dollar's worth of assets, new dollars will only be issued when there is a need for them in the circulation.
I addresses a few of these issues in "Three False Critiques of the Real Bills Doctrine", which is easy to google
Published: October 6, 2007 1:27 PM
Mike Sproul
JIMB:
"what if everyone in the US decided to issue money against their house? I surmise that $50 Trillion in new money would be a tad inflationary"
The only way people would offer their house for more money is if the money was needed for trades. Once the circulation was adequate, people would stop bringing in their houses. If the circulation became excessive, the law of the reflux would come into play--in this case the bank would start selling off houses and retiring the dollars it gets for thhose houses.
Published: October 6, 2007 1:31 PM
TLWP Sam
It seem M. Sproul that the saying gold (and silver) is money is a way of saying that goldbugs don't trust the real bills doctrine. What's the point of having paper money when a mint can make more by press the PRINT button? Isn't it also more dangerous having money as electronic pulses as now someone could type whatever figure they want into a computer? History seems to show that the goldsmith who hands out receipts for gold stored immediately printed out more receipts than gold because most people didn't 'cash out' and prefer exchange the receipts until they realise was wrong then tried to get the gold causing a bank run and so forth? Undoubtedly a true goldbug would be someone who would want to exchange literal gold (and silver?) coins as there's something along the lines of 'if you can't hold it in your hand then you don't own it'.
Published: October 6, 2007 6:37 PM
JIMB
Professor Mike Sproul - No I wouldn't admit that .... it appears totally wrong ...
re: "You'd probably admit that if each new dollar is issued in exchange for one ounce of silver, then the dollar will be worth 1 ounce no matter how many are issued. Yet you're unwilling to believe that if the dollars were issued for something worth one ounce, the same thing would be true."
One ounce of silver out of circulation would reduce the effective supply of silver which *raises* the price of silver (ceteris paribus), while one more bill issued against that silver *lowers* the value of the bill. The situation has changed and it does not make sense to regard the ratio as static. That's why the example of "issuing paper against the value of houses" - unless I am misguided here - is right on the mark.
$50 Trillion issued against real estate clearly points out that it is not the "value of the backing" which determines the value of the money, it is the amount of goods available for *trade* in comparison to the *supply of money*. So we are back to supply and demand ...
Published: October 6, 2007 7:31 PM
JIMB
Prof Mike Sproul - Note I am talking about a situation in which a person cannot redeem their bills for goods ...
If a bank can buy up 1/2 the silver supply by issuing bills against silver, those bills will increase in value with the scarcity of silver and the bills will depreciate as they are redeemed (hence increasing the severity of the cycle).
I note that if the bank secretly lends the silver or sells it and maintains a fraction of the supply of it on hand, redeemability won't matter. The bills will depreciate and a run will occur at some point and the fraud discovered.
Published: October 6, 2007 7:48 PM
Mike Sproul
JIMB:
Assuming the silver was originally being used as money, then when the bank locks up one ounce as it issues one paper dollar, the paper dollars simply displace the silver and there is no effect on the value of either. You're right that if the silver were actually taken from non-money uses, it woud rise in price. That's a reason for the bank to favor locking up things like bonds, so that no actual resources are taken from the market.
Saying that issuing $50 trillion against real is inflationary is like saying that if farmers grew 10 times as much food we'd all be 10 times as fat. We don't get fat unless we eat the food, just like money doesn't act on prices unless it's spent. Furthermore, farmers won't grow food unless there's a demand for it, just like bankers won't issue a dollar unless someone comes in offering them something (bonds, land, etc.) that is worth at least one dollar.
Published: October 8, 2007 9:41 AM
JIMB
Prof Mike Sproul - Exchanging one money for another isn't what we are talking about - unless I am mistaken in reading your papers and posts here. We are talking about exchanging tradeable goods for new money, or issuing new money against collateral so that the expansion of tradable goods does not meet with a decline in prices.
Buying bonds doesn't make sense. Say a bank "buys bonds" by increasing base money. Now the value of present / future pricing in the interest rate, with all the problems associated with that, has been changed.
Published: October 8, 2007 10:30 AM
Mike Sproul
JIMB:
Yes; The real bills view is that when new money is issued in exchange for equal-valued assets, the money holds its value because of those assets, and it doesn't matter if those assets are silver, gold, land, wheat, or bonds. If I ask a banker for a loan of $100, the banker cares only that my collateral exceeds $100. He doesn't care what form it's in. As long as a banker follows this rule, his assets will keep up with his liabilities and his money will hold its value.
Published: October 8, 2007 12:26 PM
Person
No one accepts Person dollars. :'-( I hate life.
Okay, a serious question for Mike_Sproul: if the RBD implies no inflation can stem from issuing new currency as long as assets increase with the new notes issued, why has there been price inflation at all since leaving the gold standard? Hasn't the Fed only issued notes in accordance with the RBD since '71? Wouldn't that imply that the price level would follow a random walk rather than a steady upward trend?
Published: October 8, 2007 1:16 PM
Michael A. Clem
The value of money is determined by the ratio of the supply of money to available goods and services, not by the assets that back it up. Again, the value of the gold standard isn't that it makes inflation impossible and holds up the value of the dollar, it's that it puts a physical limit on the amount of inflation possible. Credit money has no such limits, or at least, has much softer limits.
A banker wants collateral for a loan, yes, but that's no guarantee that the dollar or the asset itself won't change in value during the life of the loan--it simply minimizes the risk of the loan.
Published: October 8, 2007 1:40 PM
Mike Sproul
Person:
Inflation results from a loss of backing. So the Fed issues $100 for a $100 bond. One year later, the bond has grown to $105, but the Fed has had to print another $6 to pay for printing and handling expenses, plus the cost of maintaining palatial buildings and a bloated payroll, so after 1 year the fed has $105 in bonds backing 106 paper dollars that it has issued, and the dollar falls in value by a little less than 1%.
Published: October 8, 2007 3:25 PM
Mike Sproul
Michael Clem:
The real bills doctrine works under a gold standard too. As long as the bank only issues a new dollar for assets worth 1/35 oz, then the bank can issue any number of dollars, and they will always be worth 1/35 oz. If dollars ever dropped to 1/36 oz., then anyone (including the bank) could sell one ounce for $36, redeem $35 at the bank for 1 oz, and walk away with a free lunch of $1.
Published: October 8, 2007 3:32 PM
Person
Mike_Sproul: Are you seriously arguing that long-term price inflation is due solely to the Fed's operating costs being higher than the interest on the bonds it buys? That is, inflation since '71 could have been about 0, if only the Fed had spent less on operating costs?
Published: October 8, 2007 4:24 PM
Kevin B
Mike Sproul,
Person A ands Person B have the same assets, 1 acre of land and 1 oz of gold. Each value 1 acre of land to 1 oz of gold.
A bank is started, and A & B are the only people to make deposits. Both deposit 1 oz of gold and each receive $1 stating, "IOU 1 ounce, or something of equivalent value." Each acre of land is now worth $1.
Person B offers his land to the bank as backing for a crisp new $1 stating, "IOU 1 ounce, or something of equivalent value."
A & B both build a factory on their acre. Both of them value their land and buildings equally, so that now the purchasing power of the dollar is increased. 1 acre of land now = $.5 and 1 factory = $.5
Person B uses his 2 dollars to buy back the note on his land (now worth $.5) and 1.5 oz of gold ($1.5)
Person A returns his $1 to the bank, only to receive .5 ounce of gold or something of equivalent value.
Your argument falls to pieces as soon as a relative value changes.
Published: October 8, 2007 5:22 PM
Kevin B
Of course, the bank would probably hold out on the land for $1, but if B gets the gold first then A is still stuck with land that is no longer worth 1 oz of gold.
Don't mix your drinks, and don't mix your dollar backings. ;)
Published: October 8, 2007 5:52 PM
JIMB
Prof Sproul - That is, in my view, really incorrect. The banker cannot create new money irrespective of the volume of the amount of that money that will be used in trade. Hence the very valid point that monetizing real estate values - no matter the "value of the land" - would be a huge error. As more money is issued against land financing more land speculation, the banker finds that land is rising in value against other goods, and so can issue more money against it. And if any restrain is shown, land will collapse, and with it the currency.
John Law returns ...
Published: October 8, 2007 6:46 PM
JIMB
Prof Sproul - And of course if no restraint is shown, a crack-up-boom occurs.
Published: October 8, 2007 6:48 PM
billwald
WAMPUM (beads) was useful as money to the Indian people until Europeans flooded the wampum market? To the Indian people, the beads helped to keep score in the game of life.
On the other continants gold and silver were considered hard assets before money was invented. All coining money (coins) did was to provide a visually recognizable standard weight by forming the gold and silver into official govt approved disks so that the common person didn't have to carry around a set of scales and weights in order to trade in the marketplace. Problem arose because the govts could not be trusted to manufacture honest coins.
The one common factor in 4000 years of economic history is that govts can't be trusted. The U.S. govt has never kept an honest set of books. The only way to resolve the money problem is to make cooking the books a hanging offense, starting with our elected officials and bureaucrats.
Published: October 8, 2007 7:24 PM
Michael A. Clem
If dollars ever dropped to 1/36 oz., then anyone (including the bank) could sell one ounce for $36, redeem $35 at the bank for 1 oz, and walk away with a free lunch of $1.
But all that's doing is pegging the dollar at 1/35 oz. of gold. This tells us nothing of the dollar's purchasing power of other goods and services. More dollars, even when backed by assets like gold, will still have an inflationary effect, causing the price of bread and other goods to go up, even if you can still redeem those dollars for 1/35 oz. of gold.
As I said before, the virtue of a gold standard is that it limits inflation, not that it prevents it. This virtue is not shared by monetarized debt.
Published: October 8, 2007 7:25 PM
Mike Sproul
Person:
Operating costs are only one way the dollar can lose backing. The Fed's bonds could lose value, or the Fed could just decide to maintain convertibility of the dollar at at a lower value than its assets can support.
Published: October 8, 2007 11:54 PM
Mike Sproul
Kevin B:
Of course relative value of assets can change, and if the bank's total assets are not sufficient to back the money the bank has issued, then of course the money will lose value. That's why most bankers abandon the gold peg. Once that's done, the value of the banker's money will still reflect the value of the bank's assets, except that a bank that backs its money with a diverse set of assets will have a more stable money than a bank that ties its money to gold only.
Published: October 9, 2007 12:12 AM
Mike Sproul
JIMB:
"The banker cannot create new money irrespective of the volume of the amount of that money that will be used in trade."
You were the one who said creating $50 billion would be inflationary--not me. Banks won't issue a dollar unless someone wants that dollar badly enough to offer a dollar's worth of assets for it, and once that dollar's worth of assets is received by the bank, the bank has adequate assets to buy back its dollars should they depreciate. The land inflation you mention never happens, and neither does a subsequant crash.
Published: October 9, 2007 12:19 AM
TLWP Sam
Perhap M. Sproul your analogy could be that of shares in a company? They're sorta tradable-ish and their value is represented with the company behind it, perhaps? Wait a tick, if shares are printed on paper or electronic pulses does that mean public companies are counterfeiters too?!
Published: October 9, 2007 12:23 AM
jp
Mike Sproul: "Operating costs are only one way the dollar can lose backing. The Fed's bonds could lose value, or the Fed could just decide to maintain convertibility of the dollar at at a lower value than its assets can support."
The bond market has been in a twenty-five year bull market, ever since 1980. If the bonds that back the dollar determine the dollar's value (as you maintain), why has the dollar fallen in value instead of following the bond market higher since 1980?
Also, the Fed operates far in excess of its operating costs and has so for a long time. Your argument that operating costs have helped contribute to the falling value of the dollar is not very convincing.
Published: October 9, 2007 12:27 AM
Mike Sproul
Michael Clem:
If $1 still buys 1/35 oz, then the inflation you're speaking of would be a fall in the value of gold relative to bread. This could happen--not because there are more paper dollars, but because the paper dollars reduce the monetary demand for gold. Once the monetary demand for gold is gone, the issue of paper dollars can't reduce the value of gold any more, and now the real bills doctrine will hold exactly: The issue of new dollars, in exchange for a dollar's worth of (non-gold) assets, will not affect the value of the dollar relative to gold, and neither will it affect the value of gold relative to bread.
(This is one reason why the gold standard is a bad idea. A single monetary commodity is likely to fall in value as it is displaced by paper or credit money.)
Published: October 9, 2007 12:28 AM
ktibuk
"All of that being said, RBD style 'banks' seem to be ok as long as there is an explicit agreement between 'banker' and customer that when they wish to 'cash out' they may receive bonds or a stock of iron, etc in place of whatever it was they initially deposited."
It would be OK if we werent talking about money, a medium of exchange, but another line of business.
BUt it is not ok because when it comes to money, since it is valued for its exchange value not direct use value, value of every money is interconnected.
When I counterfeit money at home and use it, I dont just defraud the person I get into exchange with. I also decrease the purchasing power of many people who hold money, thus in effect steal from them.
And what RBD doesnt understand is money debt is meaningless if there isnt some real product to buy with that credit.
You borrow money to purchase capital goods, or pay wages so laborers can buy real goods.
If there isnt a real product credibility is meaningless.
And the real products are saved in order to be lent out. Otherwise it is scam.
If you can not create a capital good for a "credible" person out of thin ait, then you can not create credit for a "credible" person out of thin air.
If you do that means you are stealing from others.
Published: October 9, 2007 5:51 AM
Jerry Lee
Mike Sproul:
Person A deposits 1 ounce of gold in bank B. Bank B issues $1 and gives it to A in exchange. One dollar is now worth 1 oz gold.
Person A now takes this $1 and deposits it in bank C. Since it counts as an asset worth of 1 oz gold, bank C issues $1 and gives it to A.
So now Person A has $1, bank C has $1 and bank B has 1 oz of gold.
Person A can do this as many times as he likes, and banks can do the same thing as well. The amount of gold stays the same, but the amount of dollars increases.
Does the value of the dollar decrease or not?
Published: October 9, 2007 6:02 AM
TLWP Sam
Suppose I pay $10 for a lotto ticket which ends up winning $10 and I use the lotto ticket as money. If people are willing to accept the ticket as a bona fide $10 note and suppose the ticket has an indefinite claim time, has the money supply likewise increased as both the note and ticket are circulating throughout the system?
Published: October 9, 2007 9:11 AM
Yancey Ward
Mike Sproul,
You really didn't answer Person's question.
What is your analysis of the history of inflation in the United States, using the real bill doctrine? What operation of the Fed has caused it?
Published: October 9, 2007 9:12 AM
TLWP Sam
If the Fed can printed legal tender and some like to call it 'counterfeiting'. In a gold-ingot economy wouldn't gold miners likewise be 'counterfeiting' as they're simply diluting the money supply? To say that gold mining takes time but then wouldn't a good real counterfeiter take a lot of time to print their own $1 million worth of notes worthy of passing as currency too?
Published: October 9, 2007 9:16 AM
Anthony
TWLP Sam, are you aware of the history of gold as money? Counterfeiting never worked well in its case, even when attempted by monarchs.
Published: October 9, 2007 9:22 AM
Person
Exactly, Yancey_Ward. To believe Mike_Sproul, you have to believe that a) US gov. bonds fell in value significantly over the past 35 years or b) the Fed deliberately caused inflation well in excess of their comfort level, because we have to reject c) that new money, even with backing, can cause inflation.
a) is clearly false, because it would imply a secular upward trend in yields. I wish!
So, you're going with b) then?
Is there a message board we can take this to so we don't have to retread the same exchanges every time?
Published: October 9, 2007 11:03 AM
jean paul
Dollar price inflation (dollar prices for the same old stuff constantly going up) is not because the amount of unbacked dollars is increasing. It's because the amount of value being exchanged - whether in dollar form or some other form - is increasing.
Say you and I each have an identical token of value. I save mine in my pocket, and you invest yours in the activities of market economy. Over time, you will realize gains to your investment, and you will have, say, 100 tokens to my one.
The bank never got involved; there was neither RBD nor fiat nor commodity currency; it was all barter from day one. Yet the demand I experience for my one token is now far less than it once was. Everyone has tokens now. Call it inflation, or just call it the rising affluence of society, but my one token now has far less purchasing power.
This is the point of RBD: not that price inflation cannot occur under RBD, but that RBD has a NEUTRAL effect on the changes in valuations of any asset versus any another as wealth is created and sometimes destroyed in the market.
Published: October 9, 2007 1:19 PM
Mike Sproul
JP:
"The bond market has been in a twenty-five year bull market, ever since 1980. If the bonds that back the dollar determine the dollar's value (as you maintain), why has the dollar fallen in value instead of following the bond market higher since 1980?"
Inflation moderated after 1980, so the dollar has fallen less. And don't forget that the real bills doctrine only puts an upper limit on what the dollar can be worth. If the Fed chooses to maintain convertibility at a lower rate than its assets can support, there will be inflation in spite of increased Fed assets.
"Also, the Fed operates far in excess of its operating costs and has so for a long time. Your argument that operating costs have helped contribute to the falling value of the dollar is not very convincing."
You are referring to the fact that the Fed earns profits? Those profits are handed over to the treasury, which is yet another drain on the Fed's assets, and another possible source of inflation.
Virtually all economists are convinced that all financial securities are valued according to their backing. The real bills doctrine says that money is valued for the same reason. I find that very convincing.
Published: October 9, 2007 1:35 PM
Mike Sproul
ktibuk:
A bank that issues money in exchange for equal-valued assets is completely unlike a counterfeiter, since the bank stands ready to use its assets to buy back any money it has issued. If I buy an apple from you and promise to pay you $1 next month, and if you then spend my $1 IOU buying something else, then my IOU is serving as money. But as long as people voluntarily accept my IOU, there is no counterfeiting, no fraud, and no inflation.
Published: October 9, 2007 1:40 PM
Mike Sproul
Jerry Lee:
"Person A deposits 1 ounce of gold in bank B. Bank B issues $1 and gives it to A in exchange. One dollar is now worth 1 oz gold.
Person A now takes this $1 and deposits it in bank C. Since it counts as an asset worth of 1 oz gold, bank C issues $1 and gives it to A.
So now Person A has $1, bank C has $1 and bank B has 1 oz of gold."
Bank B locked up 1 oz. as it issued 1 paper dollar, so the paper dollar is adequately backed, and there is no change in the money supply. Bank C then locked up the first paper dollar as it issued another. Again, no change in the money supply, and every dollar is adequately backed, so no change in the price level.
Even if bank C printed a new dollar and lent it to a farmer, so that the money supply increased, the new dollar would be backed by the farmer's IOU, so there's still no change in the value of the dollar.
Published: October 9, 2007 1:47 PM
Yancey Ward
The handing of profits to the treasury only means that the backing does not increase. It does not explain the fall in value of the dollar over time. As I understand it, every dollar is backed by a treasury note/bond, other highly liquid short term bonds, and monetary metals. To the best of my knowledge, none of the bonds the Fed holds have ever defaulted. So where has the inflation come from?
Published: October 9, 2007 1:51 PM
Mike Sproul
TLWP
"Suppose I pay $10 for a lotto ticket which ends up winning $10 and I use the lotto ticket as money. If people are willing to accept the ticket as a bona fide $10 note and suppose the ticket has an indefinite claim time, has the money supply likewise increased as both the note and ticket are circulating throughout the system?"
The money supply has increased by $10, but there is no effect on the assets or liabilities of existing money-issuing banks, and so there is no inflation. There might, however, be a reflux of $10 of Federal reserve notes to the Fed, if the $10 lottery ticket displaces an equal amount of federal reserve notes.
Published: October 9, 2007 1:54 PM
Kevin B
Mike Sproul: "Rational customers can choose whether or not to accept them..."
Hey, I am all for recognizing the right of US businesses to refuse payment in US dollars. Let private banks issue their own currency backed by marshmallow kisses for all I care.
Deregulate and let the rational customers decide.
Published: October 9, 2007 1:56 PM
Mike Sproul
Yancey:
In general, inflation happens when the amount of backing falls relative to the amount of money that the fed has issued. This can happen if:
--the fed pays $100 for a bond that is worth only $99
--the fed lends $100 at 5%, when the market rate is 6%
--the fed's bonds drop in value
--the Fed prints money to pay its expenses, and its assets don't rise
--the Fed turns over its "profits" to the treasury
There is also the possibility that the Fed has adequate assets, but simply chooses to maintain convertibility at a lower rate than its assets can support--possibly in an attempt to stimulate the economy.
Published: October 9, 2007 1:59 PM
Person
Mike_Sproul: Even when the Fed's profits are diverted to the treasury, that implicitly cancels government debt and increases the value of all of the other bonds the Fed holds (by bidding up bond prices).
The point is, everything you've argued about the RBD implies that the price level should follow a random walk, with no secular forces driving it either up or down. Please justify the inflationary history of the US Dollar since '71.
Published: October 9, 2007 2:18 PM
jean paul
Person says: "...Everything you've argued about the RBD implies that the price level should follow a random walk..."
Only if net valuation of newly created wealth versus valuation of baseline wealth follows a random walk, which it doesn't. Net gain in wealth versus baseline wealth tends to increase over time in a relatively free economy, thus the purchasing power of any particular increment of wealth falls over time.
It is sheer WEALTH inflation that you are observing. The RBD can't help it. Neither can commodity currency. It's just what happens.
Published: October 9, 2007 2:40 PM
Person
jean_paul: in a growing economy, each dollar (or unit of labor) should purchase more of the same units of what it did previously. Certainly, Mike_Sproul could argue that the net result since the 70s has been a contraction, but I don't think he believes this.
Published: October 9, 2007 2:56 PM
JIMB
Prof Mike Sproul - The idea inflation is from issuing currency against overvalued collateral sounds fantastically wrong.
Everyone borrowing $200K from their homes and spending next month would be massively inflationary, even though the collateral is worth MORE than the money issued.
The maturity of Real Bills needs to match the maturity of the goods -- but that essentially means there is *no* issuance of money, only issuance of bonds which trade at a discount to money.
I don't think it makes sense to take RBD seriously.
Published: October 9, 2007 3:39 PM
jp
Mike Sproul's reasons
1. the fed pays $100 for a bond that is worth only $99
2. the fed lends $100 at 5%, when the market rate is 6%
3. the fed's bonds drop in value
4. the Fed prints money to pay its expenses, and its assets don't rise
5. the Fed turns over its "profits" to the treasury
__________________
3. This hasn't been happening with a bond bull market since 1980.
4. The Fed doesn't print money to pay expenses, it easily covers expenses from the interest it makes on some $800 billion in bond holdings.
5. explained by Yancey Ward above
So that leaves only your 1 and 2 to explain the drop in the value of the dollar we've seen since the 70s.
The first seems to mean that the Fed would have been consistently overpaying for bonds amassed via open market operations, and thus the decline in the dollar. Two seems to mean that it lends inappropriately at the discount window.
Published: October 9, 2007 3:42 PM
jean paul
Person says: "in a growing economy, each dollar (or unit of labor) should purchase more of the same units of what it did previously."
I think that is wishful thinking more than it is truth.
If the economy consists of my one field of corn which has a constant yield, plus my neighbor who doubles his yield each year, plus some set of consumable goods, my purchasing power for those consumables in terms of corn is going to go down over time, because my neighbor can always outbid me, by an increasing margin.
You could absolutely say that corn is inflationary in this situation, but you cannot lay any kind of attack against my neighbor for any wrongdoing in inflating the corn supply.
Money is just a proxy for goods of real value. Goods of real value are naturally inflationary and deflationary. Money will refelct this.
In a growing economy, you have wealth being created out of thin air. This is wealth inflation. Money is just a proxy for wealth in other forms, and will experience the same inflation.
Published: October 9, 2007 5:01 PM
JIMB
jp - If money is the proxy for tradeable goods, money can only depreciate (i.e. inflation) if money is in excess supply compared to tradeable goods.
Published: October 9, 2007 5:07 PM
JIMB
That last post was for Jean Paul ...
Published: October 9, 2007 5:17 PM
Jean Paul
There's a JP and a Jean Paul and we are not the same :)... in fact we are arguing opposite sides of the point... confusing!
Published: October 9, 2007 5:25 PM
Jean Paul
"money can only depreciate (i.e. inflation) if money is in excess supply compared to tradeable goods."
This is precisely the point of the RBD. On a bank-transaction by bank-transaction basis, an RBD-conformant trade is not inflationary IF the pre-trade value of the money issued is not in excess of the pre-trade value of the asset retained. The pre-transaction and post-transaction valuations of any dollar against any asset will remain constant.
If the bank makes a bad trade, that means it gave away excess money for what the backing asset was worth, and the bank's money depreciates.
If the bank makes a good trade, that means it issued less money than the asset was worth, and the dollar appreciates.
Published: October 9, 2007 5:37 PM
Jean Paul
I think it's very intuitive to see that a caveman with 5 carrots is a wealthy man - king for a day among his carrotless peers. The wealth he posesses may bid away almost any other good, labor or otherwise, in the primitive economy.
Whereas today, the same man with the same 5 carrots is relatively impoverished. That's because value substitutes were created - out of thin air - in everyone's pockets around him while he clung to his precious carrots. His is no poorer than before, materially - but his economic power has shrunk, because everyone else is relatively less desperate for the marginal value gained from a carrot.
Published: October 9, 2007 5:52 PM
jp
"If the bank makes a bad trade, that means it gave away excess money for what the backing asset was worth, and the bank's money depreciates."
That's a very mechanical description which I don't think the RBD merits. Don't the users of the currency have to percieve that the backing assets are worth less than the money oustanding before they can bid the price of money down? In other words, the bank's money doesn't magically depreciate in value - a process of perception, analysis, and communication must ensue in order for depreciation to occur.
If no one notices that a bank mades a bad trade, ie. that it gave away excess money for what the backing asset was worth, than the depreciation wouldn't occur, no?
Published: October 9, 2007 5:52 PM
Jean Paul
JP,
Of course there is a latency from the point of action to the point of feeling its effects. This is true of all things. When I pull the trigger on a gun, I set into motion some course of events that will unravel in due course - inevitably, save for the willful interventions of others after the fact (e.g. dodging the bullet or pushing something in its path to intercept it, etc.)
If no one notices (yet) that I pulled the trigger and the bullet is in the air - doesn't matter. Someone will notice soon. At this point it is inevitable that something is getting hit with that bullet. It's just a question of what direction it was aimed in.
Same with the banking txn. The trajectory of the economy is either deflected or not when an RBD bank issues money. If it does its job very well, the txn will contribute a deflection toward dollar appreciation, to balance out all the times when the bank gets it wrong.
The problems is really that value is subjective and so no bank can truly have any impact on anything, whether to cause nor to cripple inflation.
Published: October 9, 2007 6:21 PM
JIMB
Jean Paul - Except, RBD stipulates not only tradeable goods, but issuing money against untraded (or less frequently traded) goods. That is inflationary.
Published: October 9, 2007 6:22 PM
Jean Paul
JIMB,
RBD stipulates that money should be issued in exact measure, value for value, in exchange for some asset, in order for the transaction to be inflation-neutral.
If more or less value is issued, the transaction will not be inflation neutral.
So the RBD is not undone because some particular trade is inflationary. The RBD states the conditions where inflationary trades occur. If inflation is observed, the RBD simply concludes that the net of millions of transactions has been to issue more money than the retained assets were worth, as valued by the market.
There are two reasons a bank today may claim to be following RBD yet be inflationary:
1. They're doing it wrong by accident
2. They're doing it wrong on purpose
The first is totally possible. Aggression introduces noise into market signals, and prevents corrections, in some cases stressing things to a breaking point. In a market befouled by aggression, the best-intentioned bank may find it difficult to invest profitably.
The second is really a consequence of the corruption aggression brings. With a monopoly currency, the values of the consuming public (the money users who desire an appreciating currency) need not be reflected in the bank's actions. Making valueless, extremely risky, or extremely long term bets is money in the pocket of the casino - the casino in this case being the political elite who set the table rules, and force you to play with their chips.
Published: October 9, 2007 6:51 PM
JIMB
Jean Paul - The first RBD stipulation is impossible. Increasing the supply of money cannot be neutral, just as increasing the supply of any other good cannot be neutral.
Further, it is not possible to predict how much error is introduced when money supply can grow because goods no longer have to compete for the a pool of money that is stable in size. So one good may "shoot to the moon" (like real estate) and that be regarded as "even better collateral" rather than deserving of even more discounted value.
Published: October 9, 2007 7:32 PM
Jean Paul
JIMB says: "Increasing the supply of money cannot be neutral, just as increasing the supply of any other good cannot be neutral."
It is neutral by definition.
If I take a carrot out of the market and put an 'identical' carrot in, that is a price-neutral operation. No prices of anything in terms of anything else change. If I take a shoe out of the market and put an 'identical' shoe back in, that is also a price-neutral operation.
Where 'identical' here means 'valued identically by the market', you can see that 'identical' substitutions are always price-neutral.
Now if money is by definition identical to the goods that back it, then swapping goods for money is simply an on-paper labelling exercise - and absolutely price neutral for any single marginal single transaction.
If the introduction of money as surrogate for existing goods is price neutral for each discrete transaction, then it is price neutral in the aggregate as well.
Depreciation, where it is observed, is purely due to the depreciation of the backing asset with respect to the bank's purchase price - this depreciation is inevitable when banks make 'bad' trades that don't cover the bank's overall loss rate.
That's what the RBD says and it is correct.
Published: October 9, 2007 8:47 PM
TLWP Sam
'in a growing economy, each dollar (or unit of labor) should purchase more of the same units of what it did previously.'
Oops, did Person cack in his own nest then? I certainly believe a better measurement for a potentially wealthier society is the labour time to personal goods ratio. That is to say, how much does working 40 hours a week, say, can convert into purchasing power at the store. So who cares if the dollar value is going down if people get paid more in line with price increases? And even this may presents problems as technology can make that which was hand-made suddenly mass produced or render certain valuable jobs invaluable as those skills aren't required much any more.
P.S. Yes, I'm pretty much agreeing with what you said Jean Paul with example about the caveman with five carrots.
Published: October 9, 2007 9:04 PM
Michael A. Clem
This is just getting weird. Carrots and work-hours both miss the point. The value of money is that it can be used for indirect exchange. Yes, if the working man's salary or wages increase proportionally to price increases, then the same amount of work-hours will buy the same amount of goods. The problem, though, is that inflationary effects don't take place immediately throughout the economy, but that they take time to propogate through the economy--Those that get the new money first benefit the most, while those that get the new money last end up paying extra or losing the value of their money.
Money has value only for its exchange value for real goods and services. A dollar may purchase a loaf of bread (or five carrots), but it is not equivalent to a loaf of bread. The dollar is of no value unless there are loaves to purchase. Putting new money into circulation by buying and storing assets does two things: it increases the money supply, and it removes an asset from the market. Instead of being an equivalent and neutral exchange, you've compounded the inflationary effect.
If the supply of money remains unchanged, then yes, an increased supply of goods and services would tend to be deflationary, and the value of the dollar would increase. One could argue that the money supply of a growing economy needs to be increased to avoid deflationary effects, but it's difficult to determine the actual quantities of goods or of money, and you'd be using the inflationary effect to counteract the deflationary effect, or at least that's what you'd be trying to do.
The actual amount of money in circulation isn't really that big a deal, almost any arbitrary amount would work. The difficulties come from making changes to the money supply and to the ratio of money to goods and services.
Published: October 9, 2007 9:58 PM
Mike Sroul
Person:
"Even when the Fed's profits are diverted to the treasury, that implicitly cancels government debt and increases the value of all of the other bonds the Fed holds (by bidding up bond prices)."
When the Fed hands $10 billion or so to the treasury, the effect on government debt (and bond prices) is negligible, while the effect on the Fed's assets is to reduce them by $10 billion, which is not negligible.
That list of 5 points explains inflation, but don't underestimate the importance of the last point--that the fed can cause inflation by maintaining (financial) convertibility at a rate below what its assets can support. That one can trump all the others.
Published: October 9, 2007 10:00 PM
Mike Sproul
JIMB:
"The idea inflation is from issuing currency against overvalued collateral sounds fantastically wrong."
If a financial security (bonds, stocks, etc) is issued against overvalued assets, it will lose value. Yet when I say that the same thing is true of a particular fianancial security that is used as money, you call it fantastically wrong.
"Everyone borrowing $200K from their homes and spending next month would be massively inflationary, even though the collateral is worth MORE than the money issued."
I repeat myself: That's like saying that if farmers grew more food, we'd all be fatter. The food must be eaten to make us fat, just like the money must be spent to act on prices. Furthermore, the farmers won't grow more food unless people pay them for it, just as the banks won't issue a new dollar unless people want that dollar bad enough to offer something worth a dollar in exchange for it. As long as every new dollar is backed by a dollar's worth of assets, there is no tendency to inflation
Published: October 9, 2007 10:08 PM
Mike Sroul
JP:
Nineteenth century note-issuing banks generally claimed that the issue of paper money was not profitable, since the expenses of printing, handling, etc. used up the interest they earned. The paper money was mostly issued as a form of advertising. If private banks broke even or lost assets from issuing paper money, it's reasonable to think the same for the Fed. Furthermore, the Fed can always maintain financial convertibility at a rate lower than what its assets can support, so inflation can result even when the fed's assets are growing.
Published: October 9, 2007 10:16 PM
jp
M Sproul said:
"If private banks broke even or lost assets from issuing paper money, it's reasonable to think the same for the Fed."
For someone who talks so much about monetary economics and the Fed, you are gravely mistaken.
Here is the most recent Fed annual report:
http://www.federalreserve.gov/boarddocs/rptcongress/annual06/pdf/audits.pdf
On page 23 is the income statement.
Revenues - $36 billion
Costs - $2.6 billion
Net income - 34.2 billion
That looks to me like a terribly profitable institution.
Mr Sproul, I'd suggest that in the future you get your basic facts right as such mistakes will cause people to doubt whatever about the RBD.
Published: October 9, 2007 10:52 PM
TLWP Sam
I beg to differ M. Clem. Doesn't your reasoning basically must mean you regard gold as the primordial money? Yet isn't technology the overall cause of the lag effect? Those who get access to a new technology or procedure benefit first and get the profit but eventually the new technology will make it throughout the system and the brief opportunity is past? Likewise, as I just mentioned, new technology can displace old jobs whilst creating new jobs. What if those in the old jobs don't automatically get one of the new jobs? Perhaps another ho-hum craptacular moment of technology - the rules keeping changing and traditional ways of doing things may be made redundant. Perhaps it's one of the times where one could look at the past with rose-coloured glasses when the economy was circular and you usually inherited your job and you could keep doing it for the rest of your life.
Published: October 9, 2007 11:33 PM
Jean Paul
M. Clem says: "Putting new money into circulation by buying and storing assets does two things: it increases the money supply, and it removes an asset from the market. Instead of being an equivalent and neutral exchange, you've compounded the inflationary effect."
The asset is not removed from the market (i.e. it is not consumed). The asset, which has value by virtue of being desired by consumers at a certain rate of exchange for dollars (invariant pre- and post-trade if the traders negotiate the price accurately), remains available to be consumed by some later purchaser.
The price of 'unbanked' assets do not increase in terms of money post-trade, because if they did, the bank would immediately sell the asset back to the market at the spontaneously inflated price, collecting more money than it had issued in the first place. If this 'pump' effect was due simply to the release of 'MORE' money, it could be repeated as needed to suck ALL the money out of circulation, while still retaining a large balance of assets.
Obviously arbitrage does not proceed unchecked in a free market, and sooner or later, before the bank could do what is suggested above, things would stabilize to a dynamic equilibrium. In equilibrium the vast majority of trades would be price-neutral at time of trade.
At any time, banked assets could be released back to market to prevent devaluation of the money - for example, if they failed to exceed some minimum rate of appreciation it would be in the bank's interest to sell the asset back to the market that values it, and retire some money.
Published: October 10, 2007 12:38 AM
Jerry Lee
I think the idea that as the amount of assets (or wealth) increases, the price of everything goes up.
The price of computers, for example, has gone down, even though people are more wealthy than they were 20 years ago. If increased wealth meant increased prices, they'd cost a lot more.
As production becomes more efficient, prices go down. Inflation (an increase in the money supply) may of course cause the price to go up.
Published: October 10, 2007 7:44 AM
TLWP Sam
Bleh. If inflation is the term used to describe more money in the system then deflation has to mean less money in the system. Talking of computers is about technical and production efficiencies and conversely the other end of the straw must technical and production inefficencies. Then there's low prices for products no one particularly wants versus highly desirable rare products with high prices . . .
Published: October 10, 2007 10:06 AM
Michael A. Clem
Doesn't your reasoning basically must mean you regard gold as the primordial money? Yet isn't technology the overall cause of the lag effect?
Weirder and weirder. Any popular commodity could be used for money as long as people accept it and use it for indirect exchange. It's just that historically, precious metals like gold and silver seemed to work the best as money. I have no particular preference for gold, I'm just trying to explain why gold was used, and what the real advantage of gold-based money was, not the mythical gold-bug version of it.
Yes, changes in technology can and does also cause changes in the economy, but in different ways than a changing money supply does. Changing technology doesn't seem very relevant to this thread, though. When the bank or government adds to the money supply, they do it at a particular point of entry, as when the Fed buys bonds from other banks, and it takes time for that new money to circulate and have an impact on other parts of the economy. It's not like the Fed could just add a dollar to everyone's pocket or bank account at the same time.
Published: October 10, 2007 10:42 AM
Michael A. Clem
The asset is not removed from the market
The price of 'unbanked' assets do not increase in terms of money post-trade, because if they did, the bank would immediately sell the asset back to the market at the spontaneously inflated price, collecting more money than it had issued in the first place.
Um, if the bank turns around and sells the asset, it then removes the money from the money supply, and thus counteracting the inflationary effect of buying it in the first place. That's no way for the bank to make money. Besides, the inflationary effect isn't immediate
Published: October 10, 2007 10:54 AM
Michael A. Clem
TWLP, "inflation" is usually used to refer to a general rise of all prices in all areas. AFAIK, only Austrians are saying that inflation is specifically an increase in the money supply, although the Chicago people admit that inflation is a monetary phenomenon. Naturally, specific goods and services can change prices due to reasons other than inflationary or deflationary effects.
Published: October 10, 2007 11:01 AM
Mike Sproul
JP:
34 billion net income on 800 billion in assets not a fantastic level of profit, especially when adjusted for inflation. And the fact that the fed turns the profit over to the treasury only makes inflation worse.
10 billion. 34 billion. Doubtless this will not be the last time I say or do something to besmirch the dignity of the real bills doctrine.
Published: October 10, 2007 12:33 PM
greg
Mike Sproul: How about providing a year-by-year graph of the amount of government securities/bonds held by the Fed since its inception? Also, notation about any government debt that was retired (by hook or by crook) while in the Feds possession would be good too.
Published: October 10, 2007 1:14 PM
JIMB
Jean Paul - You've not "taken a carrot out of the market" ... Banks lend against collateral without removing the collateral from the market. Clearly banks can only issue money for goods that are "ready for immediate purchase" as a lien againt collateral that will maintain it's value.
Example:
Issuing loans against real estate (houses are infrequently traded) can be highly inflationary ... traded goods are bought with this new supply of money, not houses. The currency then depreciates against goods-in-general (traded goods), while the house stays at the same nominal value. It's only when the income from higher nominal wages cycle back into houses that houses rise.
So then of course there's "more collateral" in houses to issue more loans against. This effect was the experience for the past 20 years until the recent housing boom in which the dollar depreciated against everything.
Published: October 10, 2007 1:15 PM
JIMB
Mike Sproul - Money is not a financial security. It is a medium of indirect exchange with immediate spendability (none of your examples have immediate spendability) and zero credit risk (all of your examples have credit risk).
You offer credit transactions and act as if they are "money". There is NO other asset that meets the function of money, that is why it is money, and it is unique.
Examples:
Deposits - Credit with the bank. There is no "money" although the bank promises redemption at par.
Check - Draft ordering the transfer of money, netted by the bank interbank settlement system.
Refinance - Payoff with new credit cleared with money, netted by the interbank settlement system.
Unless I've missed what you are saying, I believe you need to do some thinking on what money is.
"...As long as every new dollar is backed by a dollar's worth of assets, there is no tendency to inflation."
Entirely incorrect in my view. Issuing currency against assets of reliable value can still lead to inflation if those assets are not *traded*. Issue 1 Trillion against real estate, even if highly collateralized, will result in massive inflation against 'goods-in-general' because real estate isn't normally traded in the same volume the money is issued.
I've got to say that this sounds like it is straight from the John Law book of economics. Have you read http://mises.org/books/inflationinfrance.pdf ?
The arguments John Law made were remarkably like those in support of RBD.
Published: October 10, 2007 1:30 PM
eric lansing
according to RBD, a bank takes an asset (say an IOU from a farmer backed by his farm and issues money against it. Why should the farmer issue an IOU in exchange for money? Because he wants to borrow.
Now, say I open a bank in RBD world... I need no capital to do so - all I am doing is accepting assets and issuing Lansings which (curiously this has gone much undiscussed) people will presumeably use as payment for goods and services.
What the farmer wants?... he wants purchasing power to secure for himself goods and services, perhaps to expand his farm and hence his future production. If the farmer cannot pay his IOU, the money obviously becomes worthless. (btw Antal Fekete is an RBDer who advocates only 91 day self liquidating bills as proper backing for money.)
What I believe has gone overlooked here is the fact that my lansings represent nothing. I have not saved anything. What the farmer wanted was *savings* to sustain himself while he expands his farm... he wanted bread, shoes, etc.
Assuming (as I don't) people would accept bank money (Lansings) then Mr Farmer will be engaging in consumption that is not backed by production. Even if prices don't rise, the capital structure of the economy is being consumed.
Published: October 10, 2007 1:54 PM
jp
"34 billion net income on 800 billion in assets not a fantastic level of profit, especially when adjusted for inflation. And the fact that the fed turns the profit over to the treasury only makes inflation worse."
The Fed's retun on assets is 4.3%, which compares favorably to commercial banks Royal Bank (0.92%), Bank of America (1.54%) and Citigroup (1.27%). Again, you are speaking without an eye to the data.
And by returning profit to the treasury, the Fed still maintains the same amount of backing for each dollar, not less. That's because existing dollars are already backed by bonds and don't need the profits from those bonds as additional backing.
You're theory is interesting, but you seem unable to use it to explain the real world. For instance, you still haven't explained how the tremendous drop in the purchasing power of the dollar since 1980 has occurred in the face of the tremendous bond bull market over that same time (bonds being what back the dollar).
Here is a better real world question:
I'm sure we can all agree that since 1996, the value of the dollar has fallen. The CPI has risen from 155 to 210. The Dow has risen from 5,000 to 14,000. The Case-Shiller Housing Price index has gone from 50 to 160 or so. Any argument here?
According to your theory, this can only be because the amount of backing for each dollar has declined.
Yet according to the Consolidated Statement of Condition of All Federal Reserve Banks, here are the numbers.
Dec 1996
backing assets: $462 billion
circulating currency: $424.5
each dollar is x% backed: 108.9%
Oct 2007
backing assets: $832
circulating currency: $777
each dollar is x% backed: 107.1%
note: backing assets include gov't issued and guaranteed securities, foreign currency, gold, SDRs, repos, and discount loans
Yes, the amount of backing has declined slightly, but is it enough to explain why the dollar's purchasing power has dropped by 30-50% (very approx) since 1996? I don't think so.
Greg's suggestion that you provide a year-by-year graph of the amount of government securities/bonds held by the Fed since its inception is a good one. Funny enough, I am in the midst of compiling circulating currency and backing data (including not only gov't securities but gold, disc loans, repos, etc from 1940 to present) and will make this data available to anyone interested. Will you go out on a limb and predict that the value of the assets backing circulating dollars has declined over that time frame?
Published: October 10, 2007 3:21 PM
jp
"And the fact that the fed turns the profit over to the treasury only makes inflation worse."
I just realized that the main problem with this statement is that profits can't back anything.
The Fed earns a dollar profit from its bond portfolio. On the asset side of its balance sheet you'd see these profits appear. But how can these profits back anything? They are dollars. And dollars cannot back dollars.
So its irrelevant what the Fed does with its profits. Your belief that sending Fed profits to the treasury causes inflation is wrong since profits, or cash, simply cannot back cash.
Published: October 10, 2007 4:19 PM
Jean Paul
Yes, cash can back cash, provided the backing cash is itself backed, which it has to be because its original issue occured in exchange for genuinely valued backing.
Cash backing cash, of all things, must be seen to be the ultimate uncertainty-free inflation-neutral situation.
Published: October 10, 2007 5:55 PM
Mike Sproul
Greg and JP:
If you want empirical studies, see
Thomas Cunningham: "Some real evidence on the real bills doctrine vs. the quantity theory"
Bruce D. Smith: Several articles on american colonial currency
Thomas Sargent "The Ends of 4 big inflations"
A little poking around should convince you that since central banks are run by quantity theorists, they collect only data that quantity theorists would be interested in: Tons of data on various measures of the money supply, and almost nothing on the value of the central bank's assets.
Let me emphasize again that the RBD only sets an upper bound on the value of the dollar. If the fed chooses to maintain financial convertibility at a low level, then the value of the dollar can be much less than the Fed's assets would lead you to think.
Published: October 11, 2007 2:20 PM
Mike Sproul
JIMB
It doen't matter if you call a thing money or not. It's spent just the same.
In 1710, people denied that paper money was actual money, since every paper pound had ultimately to be paid off in coins
In 1845, people denied that checking account pounds were money, since every checking account pound had ultimately to be paid in paper or coins
Since 1950, people have denied that credit card dollars are money, since every credit card dollar must ultimately be paid with a check, paper note, or coin.
I'm going to predict that by the year 2050, credit card dollars will finally be counted as money, but there will be some newer kind of money that economists will refuse to recognize.
Published: October 11, 2007 2:26 PM
Mike Sproul
Eric Lansing:
If your lansings are backed by nothing and people know it, then they will have no value. If they are backed, and people know it, they will have value. If enough people know it, they might actually be used in trades, but since you have to hold enough assets to buy them all back, you won't get the free lunch you might have hoped for.
Published: October 11, 2007 2:30 PM
eric lansing
Mike,
that wasn't my point. Even if the Lansings are backed by assets and accepted on the market, the RBD you describe is not borrowing & lending. People borrow *money* (or savings) so they can secure for themselves real goods & services to sustain themselves (say... to improve their capital structure - they must halt production to spend time & resources on this expansion).
In my example, the Lansings are backed by an IOU which is backed by a farm, but I have not facilitated the transfer of savings from saver to borrower, so if my Lansings are used they will be used to consume (steal) capital.
What the farmer wants is food, clothes, services etc. For him to borrow those he must find someone willing to lend those. My RBD bank does not have those. Fractional banking results in consumption that is not backed by production.
Published: October 11, 2007 2:55 PM
Michael A. Clem
Why do you people keep wanting to make things complicated? The simpler economics can be explained, the easier it will be to explain it to mainstream people.
Essentially, money is simply anything that most people will accept and use for indirect exchange. Cigarettes in jails are essentially money, but in limited circumstances, since most other people not in jail don't accept cigarettes as a medium of indirect exchange. Credit cards, on the other hand, are not money, because people don't trade cards, they use cards to manage money transactions without having the money in hand. When I pay with a credit card, I'm not giving the seller a quantity of cards, just a convenient way of handling the transaction. The credit card company gives the seller the money, and then I pay the credit card company in return. Paper currency wasn't originally considered money because people didn't trust it, but as its use became more common and more acceptable, it became money, and not merely a money substitute.
Asset-backing doesn't assure the value of money, that's determined by good old supply and demand, demand being based on how much money people want for indirect exchange. As I've already said, using precious metals like gold or silver for backing money helped reassure people that the supply of money doesn't go wildly out of whack.
The history of the Fed has given Americans a certain amount of confidence in the dollar, but without something like the gold standard, that trust is more precarious than it needs to be. Bonds for backing provide no real limits on the money supply. Greenspan had a reassuring effect (why do you think people were so darned worried about what Greenspan would say?), but another Volcker as Fed Chair would probably cause increased insecurity. Bernanke doesn't want to upset the current apple cart, but it's not clear that he can do as well as Greenspan. And so it goes.
The backing of money is more of a psychological factor rather than any real economic factor in the value of money.
Published: October 11, 2007 4:26 PM
Jean Paul
Supply and Demand are not about quantity alone. You cannot forget the subjective valuation people place on wants satisfied. This is an aspect which cannot be separated from supply and demand. If quantity goes up, but subjective valuation per unit remains constant, then there is no depreciation due to quantity.
The backing of money represents money's ability to satisfy wants. To the extent that the backing satisfies wants, the money that stands as proxy for the backing will satisfy wants, and thus it attains approximately equal subjective value as the share of backing assets that it represents (many would value the money more than the concrete backing asset, until point of consumption, due to the portability, longevity, and transaction convenience the money provides prior to an act of consumption).
It has nothing to do with quantity.
What the RBD says is: if you issue money at the appropriate rate of exchange SUCH THAT there is no inflationary effect, and there will be none. It's somewhat tautological. The key thing is getting the exchange rate correct. If the bank gets it right and the asset-seller gets it wrong, the consequence is neutral or positive appreciation of the money relative to its prior value. If the bank gets it wrong and the asset-seller gets too much money for the stuff he sold, then the money depreciates.
You don't need to make it a personal mission to track the value of the backing if you don't want to. You just need to have faith that the other market participants, acting in concert, will provide enough pricing signals to track the value of the backing.
It's as simple as it can possibly be.
Some examples about IOUs, since they seem a popular gripe:
If IOUs have, and sustain, a certain market value, then the IOU can be used in trade directly on the market. Thus it can EQUIVALENTLY be exchanged for some inflation-neutral quantity of money. I don't know what that quantity is, but the market does, and if the bank can figure it out, they can safely retain the asset and issue that much money.
If the IOU has zero value in the market, then inlation-neutral exchange rate is zero dollars per IOU, and every issue of a nonzero quantity of money for this IOU will be inflationary at the time of issue (the effects of which will be felt after some elapsed latency).
If the IOU has some nonzero market value on the transaction date, then the issue of money will be non-inflationary on the transaction date. However if the value of the IOU changes as some point, the money will adjust its value sympathetically (with some latency while the innate intelligence of the market discovers what has happened).
The RBD is absolutely sound. Under free banking this would quickly become apparent. The inflationary nature of the current system has two causes: wealth inflation occurs at the rate of wealth production and is refelcted in prices; also an ineptly-managed monopolist currency will significantly underperform a well managed RBD currency in a competitive currency market.
Published: October 11, 2007 6:40 PM
eric lansing
Jean Pierre, I just can't take you seriously... it's like you're high on cocaine.
Clem, I don't buy the "reassurance" theory either. Inflation is not bad because it causes prices to rise. It is bad because it causes a boom and then a bust, and the bust commeth...
http://mises.org/article.aspx?Id=1480
Published: October 11, 2007 7:53 PM
Mike Sproul
Eric Lansing:
Say I'm a farmer with 100 bushels of wheat in my barn, ready to sell. I need to buy lunch, which I can pay for with 1 bushel. But I find it more convenient to pledge 1 bushel to the bank in exchange for 1 checking account dollar lent into my account. This transaction does not increase my net worth, and creates only a negligible increase in my ability to buy goods. There is no more demand than there used to be, and so no effect on prices. Furthermore, the newly created dollar is backed by a bushel of wheat, so the dollars hold their value. If the new dollar wasn't wanted in the circulation, then someone would bring the dollar back to the bank in exchange for a dollar's worth of the bank's assets.
Published: October 11, 2007 8:48 PM
JIMB
Mike Sproul (and others) - Those historical securities gained their value by being connected to gold, i.e. money. In my view, the analysis really needs to stick with the facts of human action.
Money is defined by its unique economic function.
Today, a U.S. transaction is ultimately settled in actual electronic money (reserves of the banking system through the Fed) or in cash, and direct trades of financial assets are only possible using either as a money-substitute: their value depends on being exchangeable into money, not the reverse.
Said another way: money substitutes always depend on their being convertible into money. If they were unconvertible, those substitutes would have no value. Hence the very real difference between "any financial asset is money" and what the market regards as money.
It doesn't sound to me like you are making the necessary distinctions to have an informed opinion about the validity of RBD.
Published: October 11, 2007 9:21 PM
Jean Paul
Eric Lansing, thank you for the kind words.
Anyway, it would be nice if we had free banking, then we wouldn't have to argue about it, we could just see it and shrug.
Published: October 12, 2007 12:21 AM
Michael A. Clem
Clem, I don't buy the "reassurance" theory either. Inflation is not bad because it causes prices to rise. It is bad because it causes a boom and then a bust, and the bust commeth...
I would agree that the boom/bust is the bigger problem, but it's the result of the inflation, and higher prices are always a problem for the consumer with lagging wages. I'll keep thinking about this, but as it stands now, I don't see how the backing of currency has all that much to do with its actual spending power, except as it reassures the consumer that the money supply won't vary wildly.
Any commodity that's acceptable to people could be used as money, and the important thing is how the money supply is controlled. Backing by precious metals has been the historical method of controlling the supply, but other ways are possible.
Published: October 12, 2007 8:41 AM
Michael A. Clem
Supply and Demand are not about quantity alone. You cannot forget the subjective valuation people place on wants satisfied.
Since money is only valued for its ability to be used in indirect exchange, that is for its ability to satisfy wants, then the demand for money is directly related to the subjective valuation people place on wants satisfied. Supply, of course, is done by the bank or government that provides money.
I'm not convinced that the backing of money represents money's ability to satisfy wants. Money's ability to satisfy wants depends primarily upon other people accepting the money, and how much they value the money. Backing may reassure people that the money has value, but as a true economic phenomenon, I don't see how backing actually gives the money any value. You could say, for example, that a dollar represents 1/35 oz. of gold, but its real value is its purchasing power, which is based upon people accepting the dollar and how much people value that dollar. In other words, its real value is based upon subjective valuation, like any other commodity.
Published: October 12, 2007 8:53 AM
Michael A. Clem
Anyway, it would be nice if we had free banking, then we wouldn't have to argue about it, we could just see it and shrug.
Agreed. I would be satisfied with money derived from a free market process.
Published: October 12, 2007 8:56 AM
eric lansing
Mike,
if the farmer wants to borrow lunch & is willing to go into debt, pay interest and pledge a bushel as collateral, he will surely find a willing lender - someone who, for argument's sake, has an extra lunch lying around (savings) that they're looking to lend at interest. Only if everyone in the economy was consuming all they produced & saving nothing would he be unable to borrow.
The RBD bank, however, does not have this lunch to lend. It could only lend the lunch if someone had saved & deposited a dollar with it.
Published: October 12, 2007 10:29 AM
Mike Sproul
JIMB:
Those arbitrary distinctions about what is money and what is not are what lead quantity theorists astray. Are checking account dollars money? Are savings account dollars money? Are gift certificates money? How about overdrafts, certificates of deposit, US bonds, shares of GM stock, foreign currency? I could use any of those things to buy certain items. The fact is that there are degrees of moneyness, but once you recognize that the value of any given financial security--from federal reserve notes to gift certificates--is determined by the assets and liabilities of its issuer, and not by the money substitutes available, all that tortured reasoning about "What is money" can be seen as just a case of people asking the wrong questions.
Published: October 12, 2007 10:52 AM
Mike Sproul
Michael Clem:
If you're OK with free market money, you should be OK with (say) Disney dollars or Mike dollars. Quantity theorists, however, would say that those "money substitutes" would reduce the demand for "real" money and thereby reduce the value of the dollar. Murray Rothbard once told me that it should be illegal for a bank to issue dollars that are convertible into 1/35 oz of gold, and then, with customer consent, swap their gold for an equal value of silver. Are you a libertartian or a quantity theorist? You can't be both, unless you're Rothbard.
Published: October 12, 2007 10:59 AM
Mike Sproul
Eric Lansing:
"The RBD bank, however, does not have this lunch to lend. It could only lend the lunch if someone had saved & deposited a dollar with it."
A bank gets 10 oz. of silver on deposit and issues 10 paper receipts ("dollars"). The farmer then pledges one bushel of wheat (or a square foot of land, for that matter--anything worth at least 1 ounce of silver) and the banker willingly prints another dollar and lends it to the farmer. The bank does indeed have the dollar to lend, and the dollar is adequately backed by the wheat or the land, so it causes no inflation. Someone "saved" a lunch to offset the farmer's borrowing, or you could say that the farmer sold his wheat forward to pay for his lunch today, but that is irrelevant to the quantity of dollars issued.
Published: October 12, 2007 11:11 AM
JIMB
Mike - The definition isn't arbitrary at all and I believe you are in denial of the facts. Money is the ultimate settlement for indirect exchange for immediate spending - that's observable and logical. In fact, Yen wouldn't be money at all in the international market if it weren't convertible to DOLLARS, one way or another. (Perhaps someday we will see dollars demonetized by the market). The "ultimate settlement item" IS money and everything else has value primarily in respect to it's ability to command that ONE main medium of indirect exchange. Credit is not a reliable money substitute and isn't money (obviously, factually).
Clearly dollars, either electronic money at the Federal Reserve or cash dollars ARE money and nothing else is. You see, you accuse "Austrians" of getting it wrong but you haven't defined what money is in the first place (and it seems you are operating under some severe miscalculations) - You need to define money according to factual observable human action. If you don't, it's not economics, its fantasy.
How about you put forth a definition and we can talk about what the real issue is.
Published: October 12, 2007 11:54 AM
jp
“If you want empirical studies, see…"
Alright Mike, I’ll take it from your reading suggestions that you don’t feel up to answering my questions about the real world applications of the RBD and want me to scram.
"They collect only data that quantity theorists would be interested in: Tons of data on various measures of the money supply, and almost nothing on the value of the central bank's assets."
That’s a bad exaggeration. A simple trip to the library and I found a record of all the Fed's assets (broken into categories by type) from 1914 to present, as well as currency issued. These numbers are published every week by the Fed. I’m surprised that as someone interested in the backing behind dollars that you seem to have made no effort to acquire these numbers.
“If the fed chooses to maintain financial convertibility at a low level, then the value of the dollar can be much less than the Fed's assets would lead you to think.”
Can you explain this further? Are you saying there is no point in looking at the Fed’s assets? The Fed maintains convertibility through open market operations and discount lending (points 1 and 2 on your list from earlier on), but you keep on bringing up this last point as if it is something magical and different from point 1 and 2. If not than how is it different? Please use actual Fed examples for clarity.
"Yes, cash can back cash, provided the backing cash is itself backed, which it has to be because its original issue occurred in exchange for genuinely valued backing."
Ok. But the Fed cannot back cash with cash. See it's note 3g to financial statements.
http://www.frbsf.org/publications/federalreserve/annual/1997/footnotes.html
If I may, the problem with you and Jean Paul is you wax theoretic, but completely sidestep any attempt apply your theory to the reality of the last century or so. I'd suggest you work on that. If we can't use your theory to explain reality then why should we believe you? The good thing about the quantity theory is that a lot of effort has been made to apply it to reality, and the correspondence between increased money supply and a decreasing purchasing power of the dollar is very much apparent.
Published: October 12, 2007 11:54 AM
Michael A. Clem
Sure, I'd be okay with the existence of Disney dollars or Mike dollars, assuming that they were, in fact, money in their own right, and not merely a money substitute. Even so, I wouldn't want to use them unless I thought their value (purchasing power) would remain stable or increase.
In free banking, I would, of course have more than one option for money, and this competition itself would help ensure that Disney or you didn't devalue your currency through inflation of the supply, although you could also try other ways of ensuring me that the money would be stable, such as a gold standard. If you tell me your money is backed by "assets", I'd need to know more about these assets and their nature to know if I'm assured or not of its stability. Of course, at that point, I could also look at the history of your currency and see how stable it's been in the past. Counterfeiting, too, would be an issue to consider, and I would expect issuers to take reasonable anti-counterfeiting measures.
Published: October 12, 2007 1:09 PM
eric lansing
Mike,
the silver that was deposited with the bank represents, say, 10 loaves of bread that have been saved by the baker. In receiving his 10 paper dollars, he retains his claim to those loaves. If the RDB bank issues an additional paper dollar backed by the farmer's IOU (which is backed by the farm... lets drop the bushels of wheat since these are essentially saleable & liquid, whereas the farm is not), then there will be 11 paper dollars competeing for the same 10 loaves, no? If the farmer buys a loaf with his IOU dollar and then the baker tries to buy back his 10 loaves he will find that 10 dollars can only buy 9 loaves.
If the baker were to lend one of his paper dollars to the farmer, savings would support the farmer's consumption.
Published: October 12, 2007 1:22 PM
Mike Sproul
JIMB:
I can buy a loaf of bread with one ounce of silver, with a bank note promising to deliver one ounce of silver, with a check that promises to deliver one bank note, with a credit card that promises to deliver one checking account dollar, with yen, etc. Trying to define what is money and what is not is just trying to draw lines where nature didn't put any. But every one of those moneys that I mentioned is the liability of its issuer, and is valued according to that issuer's assets and nothing else.
Published: October 12, 2007 6:46 PM
Mike Sproul
JP:
I don't want you to scram; I just want you to listen to reason.
The Fed's balance sheet tells us, for example, that they issued $100 and acquired $100 of bonds in exchange. We already knew that. Data that is relevant to the RBD would tell us whether those bonds have since risen or fallen in value, and that data is harder to find. I should add that Thomas Tooke, probably the most data-oriented economist of the nineteenth century, concluded that the real bills view was correct and the quantity theory was wrong. (As long as you're scolding me about my lack of data, did you do what I suggested and look up those empirical articles?)
About maintaining convertibility at a low level: A bank could have 100 oz of silver backing $100, but if the bank chooses to maintain convertibility at $1=0.6 oz (which is an effective default) the value of the dollar will be less than the value of the bank's assets would lead you to believe. The same is true if the bank backs dollars with bonds and maintains only financial convertibility. If the Fed uses its bonds to buy back dollars only when the dollar drops below .6oz, then the dollar will be worth .6 oz even if the Fed's assets could justify a higher value. Needless to say, this creates empirical difficulties.
Published: October 12, 2007 7:01 PM
JIMB
Mike - Well you've already agreed with the Austrian position here although you appear not to have noticed it ... You say financial securities have degrees of moneyness. So I must ask in reference to what? Clearly you are comparing securities to an actual existing money ...
You see, you (accidentally) blur the lines between money and credit and money substitutes because you've not considered what money is and it's unique service in trade. Until you do, you cannot provide an analysis that makes sense, and you run the risk of large errors in logic.
Austrian economics provides a theory of money which is empirically verified, observable, logical, and known apriori all wrapped into one! So far I've haven't anything that even approaches that in RBD.
Published: October 12, 2007 8:47 PM
renato
The Federal Reserve Notes are not counterfeit. They are inflationary, government-monopoly imposed money. But it is the Federal Reserve's money to make.
I guess there are ways in which a real-bills bank could act to mantain the value of their notes. Offering their assets for sale against their notes and burning the proceeds will both cause monetary deflation and provide instant exchange-value for the noteholders.
There is nothing wrong with making your own money and profiting from it. What is wrong is forcing (or frauding) people to use it.
Published: October 12, 2007 9:41 PM
Mike Sproul
Eric Lansing:
The farm can, of course, be sold. Otherwise the farmer couldn't have borrowed against it. The farmer's net worth is not affected by the loan, so he has no more demand for loaves with the loan than without it. If not for the loan, the farmer could have sold a square foot for 1 loaf. You say there are now $11 chasing 10 loaves, but before the loan there were $10 plus 1 square foot chasing the loaves, so the price of the loaves is unaffected. It's the same with the silver. When the 10th ounce is deposited, there is one more paper dollar chasing the 10 loaves, but also 1 less ounce of silver. It's the value of the item that matters--not its physical form.
Borrowers are not made richer by loans, so the overall demand for goods is unaffected by loans of newly-issued cash. If I have a $100,000 Tbill, I can buy a house with it, and the Tbill can trade from hand to hand after that. If I sell it to the fed for $100,000 in green paper, I can still buy the same house, and the green dollars can trade from hand to hand after that. If for some reason the additional $100,000 were not needed for circulation, the law of the reflux would take hold and the $100,000 would return to the fed.
Published: October 13, 2007 11:06 AM
jp
"Data that is relevant to the RBD would tell us whether those bonds have since risen or fallen in value, and that data is harder to find."
How about this data:
http://www.newyorkfed.org/markets/soma/tnotes.html
This page basically lists every security the Fed holds by CUSIP number and par value. Most securities have risen over the last year, so according to RBD the backing of each dollar would have risen too.
By following this data over time one should get a good idea for backing, no?
I have read the suggested articles, interesting stuff, thank you. Those are old examples though and I am more interested in applications to the present. Incidentally, the Sargent paper relied on central bank balance sheet data to arrive at its conclusions and wasn't concerned whether the bonds had risen or fallen in value.
Your comparison of dollars to GM stock is interesting. GM stock is equalized to its backing not through some mechanical process, but a psychological process whereby hundreds of thousands of traders arrive at conclusions about GM backing and act on these conclusions by buying or selling accordingly. Methods such as fundamental analysis and value investing help bring GM stock to the same level as it's backing (or at least close to it).
According to you, the same occurs with dollars. Fed backing is analyzed by a large number of traders, the dollar falling or rising according to these trader's perceptions of backing.
But in order for the backing theory to play out, people must be aware of what backs the dollar and able to price it. Ask the man on the street about what backs the dollar, and they won't be able to tell you. How can they participate in this process of valuating backing?
According to you, there are many empirical difficulties as well as problems with data availability when it comes to analyzing backing. If it is so difficult (impossible?) to figure out backing, who is doing it and how? There seems to be no method such as fundamental analysis (which analysts of GM stock use) available to the Fed analyst. How is the process of dollar-devaluation- due-to-declining-backing occurring if no one can actually learn what backing is worth to begin with?
Published: October 13, 2007 1:10 PM
Jean Paul
"Ask the man on the street about what backs the dollar, and they won't be able to tell you. How can they participate in this process of valuating backing?"
Individual participants in the market do not keep track of the value of the money's backing in money terms, NOR do they keep track of the quantity of money issued (so I'm not sure how the point is relevant?)They don't need to know either, because price signals tell them all they need to know.
...Not very related, but under free banking, you'd soon see appreciating dollars outcompeting depreciating ones, I am sure.
Published: October 13, 2007 8:31 PM
JIMB
Mike - This is just fiction: "If I have a $100,000 Tbill, I can buy a house with it, and the Tbill can trade from hand to hand after that."
You can't count on one hand the number of "houses that settled in T-Bills".
Trade is settled in cash, rarely with money substitutes, and those substitues (such as T-bills) are always discounted against cash (i.e. they must bear a positive rate of interest or they will not trade at par). Again, you appear not to properly connect RBD with any relevant facts of human action.
Had I the time, I'd love to take your class on money and banking (if you are still teaching it). I've been in the business for nearly 20 years. It would be an interesting run.
As an aside, even the T-accounts in banking are messed up. An asset is something owned. The bank doesn't own anything but the currency. If the bank buys 100 oz of silver by issuing new currency, the asset is the currency, the liability is the silver (the bank owes the silver to any person who wishes to redeem the currency for the silver).
And if the bank issues $100 in exchange for $110 IOU whose present value is $100, the $100 is the asset, the IOU is a liability (the bank owes the IOU asset back to the borrower upon presentment of payment).
Banking appears purposefully designed to deceive depositors into believing the loans the bank has are the bank's assets when in reality, the primary asset is the power to issue currency, which in the U.S. the Federal Reserve possesses, at the service of the 12 regional and many member banks.
Published: October 14, 2007 12:40 AM
Mike Sproul
JP:
Thanks for the link. My hat's off to your data-finding ability. If the Ded's bonds rise in value, then certainly the fed's assets rise, and the dollar would either rise or fall by less. If, for example, inflation had been running at 4%, and the fed's assets started rising at 1%/yr, then inflation should drop to 3%.
As I said, the real bills doctrine puts an upper limit on the value of the dollar, but not a lower one. If any currency were valued above the assets held by the issuing bank, you'd see a speculative attack like in Thailand, Korea, Mexico, etc. But if a central bank chose to conduct its open market operations at a rate below what its assets could support, it has effectively defaulted on its obligations, and can use open-market operations (aka "financial convertibility") to maintain the value of the currency at a selected level. This can make investors' opinions about assets and liabilities less relevant, though I think Jean-Paul makes a good point about security pricing. It takes surprisingly few informed investors to price a security
Published: October 14, 2007 11:42 AM
Mike Sproul
JIMB:
My point was that issuing $100,000 cash for a $100,000 Tbill does not change anyone's net worth, and so does not change anyone's demand for goods because a person who owns a $100,000 Tbill can, for the trouble of crossing the street, use it to buy things.
I'll leave you to argue with the accounting profession about why silver deposited in a bank is the bank's asset, while the paper or credit dollars it issues in exchange are the bank's liability.
Published: October 14, 2007 11:49 AM
JIMB
Mike - Yes it does. T-bills are not used to settle trades, money is. So creating new money against a T-bill means an increase in immediate spendable funds rather than a transfer of funds from the buyer to the seller, which would occur without the creation of new money. There is an increase in demand as opposed to a shift in demand from one economic actor to another.
This has the obvious effect of lowering the rate of interest (buying bonds with new cash will lower the interest rate on the bond), and discoordinating the prices of goods because the value gotten to buy the bond came from the existing holders of the currency - the new issuance of currency diluted the value of the existing currency to those that hold the currency. Hence the currency is actually the asset of the bank because the bank can take from it at will (by issuance).
This is really basic stuff, Mike. I suggest you think through the mechanism step by step before proposing that Austrians are wrong about their view of money.
Published: October 14, 2007 2:15 PM
eric lansing
Mike,
"It's the value of the item that matters--not its physical form."
would you agree that there is such things as capital goods and consumer goods? The 10 loaves were savings... the baker sacrificed consumption so that he could draw on the savings in the future... the square foot of land cannot be consumed - it does not contribute to the pool of available savings. It is just capital which can be used to produce svings in the future.
Published: October 16, 2007 9:43 AM
Mike Sroul
Eric Lansing:
Frank Knight had some interesting things to say about the fallacious distinction between productive goods and unproductive goods. I don't remember a citation, but basically it comes down to saying that goods I approve of are productive and goods I don't approve of are unproductive. I think the same could be said of capital goods and consumer goods. I might eat the bread to get energy to do my work, and I might use the square foot of land to grow flowers for my own enjoyment.
Published: October 16, 2007 11:34 AM
eric lansing
Mike,
apart from the Real Bills authors you have cited, can you share your economic influences? You mentioned you knew Murray Rothbard... did you ever read Man Economy & State or Human Action? Keynes? Friedman? Samuelson? Also, what role does the central bank play in real bills? It would seem there is no need for one.
What are you?
Published: October 16, 2007 1:17 PM