Inflation Is a Policy that Cannot Last
To Austrian economists, the so-called international credit market crisis is a prima facie case of the inherent destructive tendency of government-controlled paper money: it is the consequence of an excessive expansion of credit and money, which encourages uneconomic investment and leads to unsustainable debt burdens.
Once the inflation-fueled boom (the time span in which malinvestment occurs) is about to turn into bust (the period in which malinvestment is corrected), the government-sponsored central bank steps in and lowers the interest rate, in an effort to reverse the economic downswing into a boom.
Mises was aware that an inflation policy could not go on forever, but must break down sooner or later: "the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears." FULL ARTICLE
Comments (139)
newson
good article. the french 1796 and the weimar republic hyperinflations were relatively brief thanks to competition from sound monetary regimes. in the universal fiat system, the time for total collapse would likely be much longer. the various central banks will close ranks and fight this one to the grisly end.
as you and mises have said, the collapse will occur "eventually". in the case of zimbabwe, i'm dismayed and astounded how long "eventually" can actually be.
Published: March 14, 2008 10:58 AM
lee cruz
So quick question since I'm new to the whole monetary thing. What would happen if the Gov legally put a stop to the printing of Federal Reserve notes for say... 10 years? Someone told me deflation is bad for people with loans or something to that effect. Anyone wanna help me out?
Published: March 14, 2008 11:01 AM
Ron
Lee,
I think the perception is that it would be bad, but in fact if the rate of deflation equaled the rate of inflation over the same number of years, it would come out the same.
For instance, a $100,000 home bought in 1997 would have to be sold in 2007 for $130,921.61, all other things being equal, in order to keep up with inflation. What the seller would see is a perceived profit of $30,921.61.
At the same rate of deflation, a home bought for $100,000 in 1997 would sell for $78,520.27 in 2007, resulting in a perceived loss of $21,479.73. If the homeowner hadn't paid off enough of the mortgage to bring its principle balance below $78,520.27, he would be upside-down on the loan.
In either case, though, the relative buying power of the dollar is what is important, as in the second case the seller could then turn around and spend the original sum of $100,000 and afford a larger home, rather than having to fork over a larger sum of money for the same size home.
Where deflation really shows its value is in terms of savings. Even without any growth resulting from payment of interest, dividends, etc. associated with savings and investment, $100,000 saved now would be worth over $130,000 later, even though the actual number of dollars wouldn't have increased.
Someone smarter than me can feel free to correct my assumptions or calculations, of course. :-)
Published: March 14, 2008 1:03 PM
fundamentalist
lee cruz: "What would happen if the Gov legally put a stop to the printing of Federal Reserve notes for say... 10 years? Someone told me deflation is bad for people with loans or something to that effect."
You're right. With a fixed money supply, prices would fall at about the rate of increase in production plus population increase, or about 3% annually. That would make money worth more each year by the same amount. So in real terms, the principal of the loan would increase in value by that amount, also.
In the short run, borrowers would be devastated, because their nominal income would fall and they would find it harder to pay back loans. But in the long, interest rates would fall because fewer people would borrow to purchase consumer goods and people would save more. People should become wealthier and make paying off old loans easier.
Published: March 14, 2008 1:12 PM
Mike Sproul
Lee Cruz:
Before you get sucked in to the Austrian view of money, you should read about the real bills doctrine by clicking on my name below. The real bills view is that the dollar is backed by the gold and bonds held by the federal reserve. This means that if the Fed prints $10 billion and uses it to buy $10 billion worth of bonds, then the fed's assets will have risen in step with the money supply and there will be no inflation. If the fed stopped printing, then the value of the dollar would be unaffected, since the Fed's assets and liabilities would both be frozen at current levels. There would, however, be a period of tight money, followed by the emergence of some substitute form of money.
Published: March 14, 2008 1:37 PM
Matt
"Inflation Is a Policy that Cannot Last"
It would have been better said that Theft is a policy that cannot last. The Federal Reserve
and Government are in this together, both gain from this dishonest Fractional Reserve System. When one can create paper money and then loan it out as if it had real goods backing it and then charge interest, which are derived from real goods on that fictitious loan what else can it be called except Theft. The banks and the government are in this together in which they are sure winners and the public at large are sure losers.
What a racket.. The moral implications are nauseating.
Published: March 14, 2008 2:33 PM
fundamentalist
Mike: "This means that if the Fed prints $10 billion and uses it to buy $10 billion worth of bonds, then the fed's assets will have risen in step with the money supply and there will be no inflation."
Sadly, Mike still clings to the idea money is not a commodity and therefore does not act like a commodity. It is not subject to the laws of supply and demand. Even though money was purely a commodity for over 6,000 years when it was gold and silver, the "magic" of paper money transforms it into a super-commodity, with the ability to defy gravity, travel faster than the speed of light, and completely ignore all of the laws of economics. If you like economic fiction, you'll love the RBD.
Published: March 14, 2008 3:02 PM
fusgerm
Mike Sproul is partly right. The US currency is not a fiat currency, which can be expanded at will. It is an irredeemable but backed currency, It is backed by the assets of the Fed, which consists mostly of US bonds. Look at the Fed's balance sheet if you are in doubt.
Therefore the US currency, if it collapses, will not do so because its quantity is increased without limit. It will do so because the assets of the Fed lose value (relative to something of relatively stable purchasing power, such as gold).
In the past week we have seen the Bernanke Fed accept $200bn of mortgage debt as collateral. The message is clear. The Fed will be prepared to dilute its assets with ANY amount of mortgage-debt to protect the banking system. That is why the fall of the $US is intensifying.
The depreciation of the dollar (in terms of gold) in turn reduces the gold-value of US bonds, since a US bond is merely a promise to pay future dollars. That in turn reduces the value of the dollar, which is mostly backed by bonds. Coupled with doubts over US solvency (e.g. future funding of SS), the whole circular edifice could snowball into just the kind of monetary collapse that von Mises described.
Published: March 14, 2008 4:44 PM
fundamentalist
fusgerm: "The US currency is not a fiat currency, which can be expanded at will."
The Fed can expand the currency at will by simpling buying US government debt. The available supply of such debt is around $20 trillion. So you're saying that if the Fed bought up all of the available US debt, bonds and notes, and thereby dumped trillions of dollars into the economy, no prices would change? The dollars would still be backed by US bonds. If you believe that, I have a bridge in Brooklyn I like to sell.
Published: March 14, 2008 4:56 PM
lester
slightly OT- i was just at Twisted Village, a record store (they still have those!) in Cambridge Mass. The proprieter, who is an ancap though he doesn't know it, said he just doesn't have any imports from europe anymore because even if he made zero profit the cd's would be like 20 dollars a piece. it's an avant garde reecord store, so it's not like we are all shipping magnates with euros to spare, most purchases are probably about 20 dollars.
they also have a record label and I asked if "exports" to europe were up. he said not really.
of course, a few years ago when the euro was 80 cents the shelves were overflowing with all sorts of fun stuff
Published: March 14, 2008 5:02 PM
fusgerm
fundamentalist:
The US currency is not a fiat currency, in the commonly understood sense. This definition is from http://financial-dictionary.thefreedictionary.com/Fiat+currency:
"Money that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves."
The Fed could also expand the currency at will by buying up all the gold it could lay its hands on - and issue corresponding amounts of paper dollars. But that would not lower the value of the $US. On the contrary!
The value of a backed currency like the $US is determined not by the quantity of paper dollars on issue, but by the quality of each paper dollar's backing.
Published: March 14, 2008 5:43 PM
Michael A. Clem
I think the problem with RBD is that money backed by debt is inherently untrustworthy and unstable. Debt doesn't provide the kind of backing that a commodity like gold or silver provides. And I think Fundamentalist is also right--money itself is a commodity, the supply and demand of which affects its value.
If the currency is irredeemable, then the value of the assets backing the currency doesn't have much effect on the value of money, only on the ability of the bank to issue new currency. If the currency is redeemable, then the value of the asset backing the money also comes into play in the supply and demand of that money.
Published: March 14, 2008 6:08 PM
André Dorais
Excellent article! It reminded me of Rothbard's Mystery of Banking. I had to crunch the numbers! Just enough to keep it pleasant. Thanks!
Published: March 14, 2008 7:04 PM
Mike Sproul
Michael Clem:
There are many meanings of "redeemable". A currency can be instantly redeemable, redeemable after a delay of a weekend or a delay of 75 years, and it can be physically redeemable (the issuer will buy it back with an ounce of silver, a bushel of wheat, etc.), or the currency can be financially redeemable (the issuer will buy it back with an equal value of bonds or other securities). The US dollar is financially redeemable, and physical redeemability has been suspended for 75 years, but the fed's assets are still there, and the dollar is backed by those assets.
Money, incidentally, can be pieces of paper, bookkeeping entries, or computer blips, all of which can be created or destroyed instantly and costlessly. Check any microeconomics book and you'll find that the laws of supply and demand apply to actual goods, actually produced using scarce resources, and actually consumed by real people. The laws of supply and demand can't just be carelessly applied to computer blips as if those blips were ordinary commodities.
Published: March 14, 2008 7:08 PM
Kevin B
Fusgerm: "Money that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves."
I believe that the author of that line meant physical reserves, such as gold or silver. If you notice, that definition is drawn from investopia's website, which provides more detail.
Still, wikipedia would be a better source:
"fiat money is money that has value primarily because a government demands it in payment of taxes, and that government has credible enforcement of its demand."
Published: March 14, 2008 7:34 PM
fusgerm
Michael Clem: "If the currency is irredeemable, then the value of the assets backing the currency doesn't have much effect on the value of money"
That is not necessarily true. The central bank can actively intervene to maintain the value of its currency. If its asset-backing is adequate, then it can actually make a profit by buying its currency when it is undervalued, and selling it when it is overvalued.
Even in the absence of central bank intervention, forex markets can keep currencies in alignment, even though (as markets do) they tend to veer from one extreme to the other.
I quite agree that money is a commodity, but a 100% backed redeemable currency is not so much "money" as a money-certificate. As long as the issuing bank is trusted, the commodity that is subject to supply and demand is not the money-certificate but the underlying backing.
The $US issue is clouded by irredeemability, but the Fed's assets, including over $700bn of bonds and $200bn of gold, could be used in a dollar-buyback, and this would lift the value of the dollar just as a share-buyback lifts the value of shares.
But that will not happen. The Fed will weaken its asset-quality rather than strengthen it. The depreciating $US helps protect home-owners from falling into negative equity, AND reduces the real value of the US overseas debt. The US government and the private banks benefit at everyone else's expense.
Published: March 14, 2008 7:42 PM
Kevin B
I mean "investopedia."
Also, the wikipedia link is http://en.wikipedia.org/wiki/Fiat_currency
Sorry about that.
Published: March 14, 2008 7:42 PM
Eric
When you or I borrow money from a non-counterfeiter, the total amount of money circulating does not change. Wealth is simply transferred from one party to the other. When the FED is involved, the amount of money in the system increases. Comparing prices today with those of 1913 prove this.
One difference is that I can’t write an IOU and force everyone to accept it as legal tender. The government, via the FED, can do this. Then they are able to keep increasing the supply of money so that previously existing money becomes worth less than before. And the government getting the new money early, is able to pass off this money as though it had the same value as money created earlier.
So, if you want to believe that the FED has assets backing it’s money, I say show me the physical assets. All there are is worthless promises backing up the US dollar. Any other debtor who never pays back a loan is not lent money forever. But the FED never minds that its debtor is a deadbeat. This is because the FED can keep creating money at will to buy the government’s worthless promises. It’s simply a huge ponzy scheme.
Published: March 14, 2008 8:18 PM
Inquisitor
I agree with Fundamentalist.
Published: March 14, 2008 8:54 PM
newson
to ron: regarding your assumptions - whether the mortgagee has a fixed rate or a variable rate mortgage is going to make a lot of difference to the outcome of the home purchase in a monetary deflation.
in a true deflation, bond prices soar as the fixed coupons are increasingly more valuable. in your example i assume you're looking at a fixed interest rate mortgage. in that case the the borrower is penalized by locking in interest rates in a declining rate market (this would be disastrous if for some reason refinancing were impossible).
were the mortgage a variable rate, at least the interest payment would be declining over time, though the purchase would still be a loser.
how bad the opportunity loss caused by unexpected changes of interest to a loan-subscriber will depend on the size and timing of the loan repayments.
in a deflation, bonds are king, cash is queen, and everything else is pain.
Published: March 14, 2008 8:56 PM
fusgerm
Kevin B:
According to the OED, the term "fiat money" was first used in 1880, of money "which is made legal tender by a 'fiat' [i.e. command] of government, without having an intrinsic or promissory value equal to its nominal value".
What comes to mind is currencies in the middle ages which were clipped by the government, or reminted with more base metal, and then debtors were compelled by decree to accept it The end result, of course, was monetary inflation, and a gift to existing debtors (notably the government) at the expense of existing creditors.
Again, in recent times, Roosevelt decreed that all contracts which called for payment in gold be honored in US dollars.
But today, when most currencies, gold and silver are freely traded, no Western currencies are fiat in the original sense.
Nor is the US dollar a fiat currency in the "gold reserves" sense, since it is backed over 20% by gold (and the remainder by mostly liquid assets).
Nor is it a fiat currency according to the biased Wikipedia definition, since if the US government demanded taxes in gold then the gold-backing of the $US would rise due to an increase in monetary demand for gold.
Published: March 14, 2008 10:40 PM
Michael A. Clem
Money, incidentally, can be pieces of paper, bookkeeping entries, or computer blips, all of which can be created or destroyed instantly and costlessly. The laws of supply and demand can't just be carelessly applied to computer blips as if those blips were ordinary commodities.
Money is something used for indirect exchange, and is valued precisely because it can be used for indirect exchange. Sure, money can be bookkeeping entries or credits maintined on computers, but the fact that it can be created or destroyed instantly and costlessly makes it more suspect and harder to trust without strong assurances that it *won't* be created and destroyed haphazardly, or worse, with the design of enriching some people at the cost of others while producing nothing of value to society.
The point of backing the money is precisely to provide such assurances. Real, physical commodities like gold and silver were valued precisely because they could not be created or destroyed instantly and costlessly. Currency backed by debt can be destroyed instantly, but not costlessly, because it causes some people to get a free ride at the expense of others.
If you can't trust money to be a store of value, then you can't trust money. So how trustworthy is money backed by debt? Ask anyone who is paying higher nominal prices because of the debt-backed dollar inflation that continues to happen year after year. Or ask why the value of the dollar is depreciating compared to other currencies. Can RBD explain these things?
Published: March 14, 2008 11:08 PM
TLWP Sam
Quite frankly why should deflation be any better than inflation? Ideally, I'd reckon it should be 'zero-flation', with neither side getting any free rides. How does deflation at '3%' really make much difference than inflation at '3%? - Some parties get a little extra for nothing but not enough to make a huge difference. On the other hand, a shift of 100000% will make a big difference regardless in which direction in goes. Then again how is shortages that deflation implies necessarily noble either - it's akin to someone with a huge stockpile of food and water become rich and powerful during famine and drought?
Published: March 15, 2008 12:06 AM
Kevin B
Fusgerm,
The only "value" backing US dollars is the threat of force. If the force involved to back the dollar were removed, how long do you think it would take for the dollar to be abandoned?
Published: March 15, 2008 12:21 AM
Inquisitor
Systematic exhaustion of savings and erosion of purchasing power should be worse than deflation for obvious reasons... neither is optimal, but still.
Published: March 15, 2008 12:42 AM
newson
to fusgerm:
your figures on the gold-backing of the usd are suspect.
in august 2005, the official gold holdings of the us stood at
8 113.5 tonnes or 261.5 million troy oz, whilst money supply (m3) stood at $9 873.9 billion. so at that time for $37 831 in "money", there was one troy ounce of gold backing (http://fms.treas.gov/gold/05-08.html).
Published: March 15, 2008 2:25 AM
Mike Sproul
Michael Clem:
"Ask anyone who is paying higher nominal prices because of the debt-backed dollar inflation that continues to happen year after year. Or ask why the value of the dollar is depreciating compared to other currencies. Can RBD explain these things?"
The RBD says that inflation is caused when the supply of paper money issued by the fed outruns the fed's assets, so yes, the RBD can explain inflation as being caused by a lack of backing
Published: March 15, 2008 7:18 AM
Mike Sproul
Kevin B.:
"The only "value" backing US dollars is the threat of force. If the force involved to back the dollar were removed, how long do you think it would take for the dollar to be abandoned?"
Paper money can have value either because people know that its issuer will give them something of value for it, or because people know that its issuer will accept it in lieu of something else. For example, if the tax man has the power to take one ounce of silver from me, but then declares that he'll accept one paper dollar instead of silver, then one dollar will be worth one ounce. If the government loses that power to tax, then in that case the dollar will lose value. But remember that the fed holds assets against the dollar, and stands ready to use those assets to buy back its dolars. If the fed loses its assets, then the dollar will lose value as well. In this very limited sense, the dollar is backed by force, but it is more correct to say that the dollar has value because it is backed by the fed's assets.
Published: March 15, 2008 7:28 AM
Mike Sproul
Newson:
Fusgerm is correct about gold-backing. He is talking about the assets and liabilities of the Federal Reserve, not the US as a whole. If you check the balance sheet of the federal reserve, you will see that the Fed has about $200 bn in gold, plus $700 bn in bonds, as backing for $900 bn in green paper dollars issued by the fed.
M3 consists of checking and savings dollars issued by private banks, and backed by the assets of those private banks. Since the fed did not issue those dollars, the fed does not back them.
The green paper dollars issued by the fed are backed by the fed. The checking account dollars issued by private banks are backed by those private banks--not by the fed, and not by US gold reserves.
Published: March 15, 2008 7:38 AM
Eric
For those that think the dollar is not money by fiat, try competing with it. Look where the liberty dollar is now. And you don't pay tax when you ask for change for a $20, while you do if you exchange gold for cash. The $US is money because it is in demand. As Mises said, it has value today because in the immediate past it has had value. Trace that back far enough over time (recursively as MIses would say) and you will find that our money had backing by gold. It was FIAT that severed that connection, so today's dollar is fiat money.
Published: March 15, 2008 12:58 PM
noncoercive
The two graphs on U.S. Monetary History near the beginning of the article confuse me. The orange line in both is supposed to be the money stock.
The problem is that the orange lines in the two graphs are completely different.
One of them must be something other than the money stock.
Published: March 15, 2008 1:41 PM
jp
Good conversation folks.
Michael Clem: In regards to the convertability/inconvertability argument, any Federal Reserve annual report says that "in the event that collateral is insufficient [to cover notes issued], the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks."
This means that, in the event of a Federal Reserve windup, FRN holders have seniority to all Fed assets over and above shareholders, government, & unpaid suppliers and employee pension claimants. This is the same sort of convertability a non-voting publicly traded stock has, indeed it is better, and as we all know stocks do have value.
Mike Sproul, I was wondering if you could elaborate on your comment: "Check any microeconomics book and you'll find that the laws of supply and demand apply to actual goods, actually produced using scarce resources, and actually consumed by real people. The laws of supply and demand can't just be carelessly applied to computer blips as if those blips were ordinary commodities."
You often compare currency to stocks. If the laws of supply and demand can't be applied to currency, then they don't apply to stocks like GOOG or IBM either. But everyone knows stock prices are driven by supply and demand, and to claim otherwise would a tough bridge to defend.
So when you say s & d doesn't apply, do you mean that it is a different sort of s & d than that for goods? Or does it flat out not exist? Or simply that other forces counteract s & d? You've got me stumped.
Published: March 15, 2008 1:46 PM
Mike Sproul
Eric:
"For those that think the dollar is not money by fiat, try competing with it."
Checking account dollars compete with the fed's paper dollars. So do credit card dollars, disney dollars, eurodollars--heck, even the peso in some border towns. If you think the dollar is fiat money, youprobably think the peso is too. So how does a currency like the peso keep any value at all when mexico gets invaded by dollars? Simple: The peso, like every other so-called fiat money, is backed by the assets of the central bank that issues it, and that is what gives it value.
Published: March 15, 2008 4:08 PM
Mike Sproul
jp:
"So when you say s & d doesn't apply, do you mean that it is a different sort of s & d than that for goods? Or does it flat out not exist? Or simply that other forces counteract s & d? You've got me stumped."
For example, suppose that the assets of some corporation, call it GM, consist of nothing but a $60 million bank account, and its only liabilities are 1 million shares of GM stock. Assuming everyone knows this, GM stock will sell for $60. If GM sold for $61, then demand for it would fall to zero, while GM would eagerly offer infinite quantities of newly-issued stock for sale. Conversely, if GM stock sold for $59, demand for shares would be infinite. Meanwhile, GM would offer no new shares, and even repurchase its old shares. Supply would drop to zero. The upshot is that both demand and supply of GM stock are horizontal lines at the price of $60. In this case it is meaningless to say that the price of GM stock is determined by supply and demand. It would be more correct to say that supply and demand are determined by backing, but there is no reason to even mention supply and demand. It is enough to say that the value of GM stock is determined by its backing, period.
Next, let's allow for some uncertainty about how much money GM has in the bank. In that case, differences of opinion among investors could lead some to think GM was worth $70, while others would think it's worth $50. You have the makings of a downward-sloping demand curve, in direct proportion to the ignorance of investors. Similarly, uncertainty on the part of the corporation can lead to an upward-sloping supply curve of GM stock. Thus it becomes somewhat meaningful to speak of supply and demand for a stock.
But now go back to the microeconomics books. I have never seen a microeconomics text that applied the notion of demand and supply to anything but actual goods. (Macro books are another matter!) They correctly start with the laws of consumer preference and the fact of scarcity, and then they derive demand and supply curves for GOODS--not pieces of paper that are claims to those goods.
We all know that stock traders speak of supply and demand for stocks, and those words do mean something. But we should make up some new words to distinguish supply and demand of actual goods from supply and demand of pieces of paper and computer blips.
Published: March 15, 2008 4:30 PM
Nima
The RBD makes one fundamental flaw: It misconstrues the term "backing".
Any money produced by the money-issuing authority and used to purchase something has "backing" in Mike Sproul's sense. Whether the FED prints/creates new money to purchase $1000 in loafs of bread or $1000 in Treasury Bonds in order to obtain FUTURE loafs of bread from the interest it receives does not matter.
In the first example the loafs of bread would have to appear on the FED's balance sheet as inventory obtained, valued at its purchase price. It could either be sold at a profit or distributed to the bank's owners.
In the second example the bonds would appear on the balance sheet at face value. The fact that the bread perishes over a shorter period of time does not matter in the slightest. The treasury bond, too, is redeemed over a certain period of time, it's interest payments count towards the profit of the federal reserve bank, which is distributed to it's owners so they can go out on the market and buy bread or whatever else they desire to buy.
The fundamental problemof fractional reserve banking remains: It shifts wealth from those people who get to use the new money last to those who get to use it first.
The RBD immediately breaks down once the author tries to answer one question: How could the FED ever inject money WITHOUT backing?
Published: March 15, 2008 5:55 PM
Nima
The RBD makes one fundamental flaw: It misconstrues the term "backing".
Any money produced by the money-issuing authority and used to purchase something has "backing" in Mike Sproul's sense. Whether the FED prints/creates new money to purchase $1000 in loafs of bread or $1000 in Treasury Bonds in order to obtain FUTURE loafs of bread from the interest it receives does not matter.
In the first example the loafs of bread would have to appear on the FED's balance sheet as inventory obtained, valued at its purchase price. It could either be sold at a profit or distributed to the bank's owners.
In the second example the bonds would appear on the balance sheet at face value. The fact that the bread perishes over a shorter period of time does not matter in the slightest. The treasury bond, too, is redeemed over a certain period of time, it's interest payments count towards the profit of the federal reserve bank, which is distributed to it's owners so they can go out on the market and buy bread or whatever else they desire to buy.
The fundamental problemof fractional reserve banking remains: It shifts wealth from those people who get to use the new money last to those who get to use it first.
The RBD immediately breaks down once the author tries to answer one question: How could the FED ever inject money WITHOUT backing?
Published: March 15, 2008 6:24 PM
Eric
Checking account dollars are just receipts for dollars, and I don't have to accept your check as money. I can demand that you pay me in actual currency.
Published: March 15, 2008 8:18 PM
Mike Sproul
Nima:
"The fundamental problemof fractional reserve banking remains: It shifts wealth from those people who get to use the new money last to those who get to use it first."
On real bills principles the new money (adequately backed) does not cause inflation, so there is no shift of wealth.
"The RBD immediately breaks down once the author tries to answer one question: How could the FED ever inject money WITHOUT backing?"
The Fed prints $100 and tosses it into the street. New money has just been injected without backing, and it will cause inflation, just like the RBD says.
Published: March 15, 2008 8:19 PM
Nima
Mike:
But the scenario that I just explained already shows the shift of wealth: Bread is withdrawn from the market and its price will go up, those marginal buyers who would have bought the bread via offering a service in exchange, can no longer afford it. The officials at the federal reserve benefit because they obtained the bread before its price goes up.
If the fed prints money and tosses it onto the streets nothing happens. No money is injected into the economy. It does not enter economic circulation and remains completely irrelevant. The whole act would be a useless pastime without any effect on society. The example does not answer the question: "How could the FED ever inject money WITHOUT backing?".
Published: March 15, 2008 9:13 PM
Mike Sproul
Nima:
I own a $100 bond, which I could use to buy bread, although at some minor inconvenience. Instead, I hand the bond to the fed, in exchange for 100 paper dollars, with which I buy the same bread. There is no effect on the price of bread, and neither I nor fed officials have any change in our net worth.
When I said the money was tossed in the street, there was an unstated assumption that people would pick it up and spend it. In that case there is more money, but the fed gets no additional backing, so inflation results.
Published: March 15, 2008 9:26 PM
Nima
Mike:
By omitting the fact that people pick up the money and spend it you left out a crucial event.
The central bank is that group of people who print paper out of nothing and purchase assets. The use of that money is enforced by that organization which controls the police and the military.
This does not change in the slightest if the central bank decides to involve junior partners (those people who find the money and pick it up) who are made responsible for spending that money. Again, the goods purchased would initially have to be added as backing to the bank's balance sheet and then distributed as profit share to the individuals who picked up the money. This process can be accelarated by allowing the people who purchased the goods to obtain those goods immediately and add them as "backing" to their balance sheet. However, this does not at all change the catallactic character of the whole operation.
If you admit that this whole exercise causes inflation, then you have already admitted .
Again, wealth is transferred from the free market to the owners of the central bank whose money is enforced by a violent apparatus.
Regarding your first example: It is simply wrong to believe that you can purchase bread with a government bond. But feel free to try and do it tomorrow. I look forward to the photographic evidence :)
Published: March 15, 2008 10:39 PM
Nima
I am sorry I did not finish one sentence. I meant to say "If you admit that this whole exercise causes inflation, then you have already admitted that any money injection by the FED causes inflation"
Published: March 15, 2008 10:45 PM
Eric Andersen
Fusgerm, Fundamentalist, Eric, Mike Sproul et al . . . Are each of you economic professors? Boy, I wish I could grasp this subject and articulate it as well as each of you do. I am new to this field. Yes, I did have some economics in college but simply took the course becuase I had to. I have been trying to learn this subject on my own for the past few months reading all that I can get my hands on but lack the access to a teacher who can quickly get me past the ideas I am not comprehending that are steps to understanding the subject matter better. Any of you living in San Diego?
Thanks for the great discussion you are having. I am devouring your exchange :)
Published: March 15, 2008 11:38 PM
newson
mike sproul says:
"Fusgerm is correct about gold-backing. He is talking about the assets and liabilities of the Federal Reserve, not the US as a whole. If you check the balance sheet of the federal reserve, you will see that the Fed has about $200 bn in gold, plus $700 bn in bonds, as backing for $900 bn in green paper dollars issued by the fed.
M3 consists of checking and savings dollars issued by private banks, and backed by the assets of those private banks. Since the fed did not issue those dollars, the fed does not back them."
the flaw in this argument is in this last line. since its inception, the fed has show an increasingly strong inclination to rescue failing banks and thrifts, thereby breaking down any hypothetical "firewall" between its dollars and the dollars included in m3. indeed, it was the regular and periodic collapse of fractional reserve banks that was used to justify the establishment of the fed in 1913.
were the fed only responsible for the little pieces of green paper, there would have been massive waves of bank collapses every business cycle, this one included. this has not occurred on any scale.
as for the bonds in the fed's balance sheet, these are only worth the confidence investors have in the management of the united states government. as others have pointed out, the quantity of bonds issued by the government is not fixed, and is potentially unlimited. but there is a real limit to the extent the us government can tax to cover its debts. so the backing to these bonds is, again, uncertain.
here's my question to you: why the creation of the fed, if not to bail out errant banks?
Published: March 15, 2008 11:49 PM
Mike Sproul
Nima:
"The central bank is that group of people who print paper out of nothing and purchase assets. The use of that money is enforced by that organization which controls the police and the military."
If the fed printed 100 paper dollars "out of nothing" and bought an equal value of gold, silver, land, wheat, or whatever, and if the fed stood ready to buy back its dollars with those assets, I suspect you'd agree it would not be inflationary, since the fed's assets would rise in step with the money issued. The next step would be for you to recognize that if the fed issued another $100 and used it to buy an equal value of GM stock, private IOU's, government bonds, etc., and stood ready to use those assets to buy back its dollars, then that would also not be inflationary. You might also recognize the irrelevance of the police in maintaining the value of the dollar. Currencies have lost value even when people have been beheaded for refusing to accept it.
"This does not change in the slightest if the central bank decides to involve junior partners (those people who find the money and pick it up) who are made responsible for spending that money. Again, the goods purchased would initially have to be added as backing to the bank's balance sheet and then distributed as profit share to the individuals who picked up the money. This process can be accelarated by allowing the people who purchased the goods to obtain those goods immediately and add them as "backing" to their balance sheet."
The goods purchased become the assets of the people who found and spent the money. They are not the fed's assets. The point of this exercise was to show that the fed can issue money without getting additional backing, and in that case, those dollars will lose value.
"Regarding your first example: It is simply wrong to believe that you can purchase bread with a government bond. But feel free to try and do it tomorrow. I look forward to the photographic evidence :)"
That bond is part of my wealth, so my net worth, and my net ability to buy goods, is not changed if I take it to the fed and exchange it for dollars, Next time I use a $100,000 T-bill to buy real estate, I'll be sure to take a picture.
Published: March 16, 2008 8:25 AM
Mike Sproul
Eric Anderson:
I live in LA, and as far as I know I'm the only econ professor anywhere who teaches the real bills doctrine. Click on my name below if you want to learn about it. Unfortunately, you probably learned nothing but Keynesianism and monetarism in college, but studying the real bills doctrine might begin to repair some of the damage that's been done.
Published: March 16, 2008 8:37 AM
Mike Sproul
newson:
To the extent that the fed uses its $900 billion in assets to try to back the $10 trillion that is M3, the fed will have less assets backing the $900 billion of green paper for which it is legally and correctly responsible, and there will be inflation, as the RBD implies.
There is nothing noteworthy about the fact that the Fed's bonds have an uncertain value. Name one financial security that doesn't.
You should note, however, that the fed can mitigate bank runs either by directly bailing out failing banks, or by issuing new paper dollars to offset the checking account dollars destroyed when a private bank collapses.
Published: March 16, 2008 8:53 AM
newson
to mike sproul:
using your own logic, the fact that inflation does exist is proof that indeed the fed doesn't only answer to the bits of green, george washington paper, but to the broader money of m3.
a company's bond is denominated in dollars, and is valued according in accordance with its risk. a company can affect only the mix of its assets, not the denomination thereof. the fed, by virtue of its control over the currency, can also affect the value of the tbonds on its balance sheet (irrespective of the government's fiscal policy setting).
i'm still waiting for you to explain the rationale behind the federal reserve system, if not to institutionalize inflation.
Published: March 16, 2008 9:52 AM
TLWP Sam
I'll take a blind stab at 'why a central finance institution'. I'm guessing it's to have one currency and expand it to go with goods and services. To say more money automatically means inflation is bunk unless there's no change in good or services (or worse - declining goods and services). Or it's like comparing a world food production that can feed 4 billion people - in the year 1800 it would be far too much food and lead to wastage whereas nowadays it'd lead to large-scale famine.
Published: March 16, 2008 10:41 AM
Inquisitor
And why would it be necessary for this?
Published: March 16, 2008 11:02 AM
Eric Andersen
Thank you Mike. I will begin reading. I have never heard of RBD. In simply terms where does it depart from Austrian and Chicago? My economics class was taken in 1983 there in Los Angeles as well. Loyola Univ. What school would you say Bernanke and Paulson currently adhere to? Keynes?? I thought FDR proved his ideas ineffective. Still learning.
Published: March 16, 2008 11:18 AM
Mike Sproul
newson:
"using your own logic, the fact that inflation does exist is proof that indeed the fed doesn't only answer to the bits of green, george washington paper, but to the broader money of m3."
Inflation is proof that the fed has less backing per dollar now than it used to. That could happen because of the fed's misguided attempt to back dollars it did not issue, or for hundreds of other reasons.
"a company's bond is denominated in dollars, and is valued according in accordance with its risk. a company can affect only the mix of its assets, not the denomination thereof. the fed, by virtue of its control over the currency, can also affect the value of the tbonds on its balance sheet (irrespective of the government's fiscal policy setting)."
The fed is no different that a private company in that respect. For example, GM might purchase some hypothecated shares on GM stock (think call options). Those hypothecated shares are denominated in GM stock, even though they weren't issued by GM. Thus GM can have the same effect on its assets that the fed does.
"i'm still waiting for you to explain the rationale behind the federal reserve system, if not to institutionalize inflation."
The RBD says little or nothing in the way of a rationale for the federal reserve system. The RBD says that the value of money is equal to the value of the assets backing it. In equation
form: E=M/A, where E=exchange value of the dollar (oz./$), M=quantity of dollars issued by a
particular bank, and A=the value (oz.) of the assets owned by that particular bank. So if M rises
relative to A, there will be inflation ( E falls), but if M and A rise together, E is unaffected.
Whether those dollars are issued by a central bank or by a private bank is irrelevant, though
personally I see no reason why the central bank should be the only bank allowed to issue paper
dollars, or why it should have any authority over how many checking account dollars are issued
privately. In this area the RBD is much more libertarian that the QT--a definite sticking point
for Austrians.
Published: March 16, 2008 3:00 PM
Mike Sproul
Eric Andersen:
In simple terms, the RBD says that the value of money is equal to the value of its backing. The QT says that the paper dollar is unbacked, so it has value for the same reason that a rare postage stamp has value--limited supply, together with the fact that people demand those dollars for use in trade.(BTW: I taught at Loyola in 1983, but back then I was a quantity theorist who had never heard of the RBD.)
As for Bernanke and Paulson: Like all mainstream economists, they believe the quantity theory of money, but they also use Keynesian concepts like aggregate demand and aggregate supply. Personally, I think this is because mainstream economists are uncomfortable with the quantity theory, so in places where it doesn't seem to make sense, they are taken in by the (even less sensible) ideas of Keynesian economics.
Published: March 16, 2008 3:08 PM
Nima
Mike:
"If the fed printed 100 paper dollars "out of nothing" and bought an equal value of gold, silver, land, wheat, or whatever, and if the fed stood ready to buy back its dollars with those assets, I suspect you'd agree it would not be inflationary, since the fed's assets would rise in step with the money issued."
This is not true. If the FED bought up the entire corn supply, the price of corn would rise significantly. No matter whether or not it stays ready to buy back the money at some point or not.
Imagine you yourself are the central bank. You print money and buy up the entire corn supply in the world. Every time you place an order for corn you will have to pay more than the highest marginal bidder is currently paying.
Please let me know if you seriously doubt this? Have you read about the theory of relative value preferences and the theory of marginal utility?
"The goods purchased become the assets of the people who found and spent the money. They are not the fed's assets. The point of this exercise was to show that the fed can issue money without getting additional backing, and in that case, those dollars will lose value."
Please let me know if you don't understand the catallactic relevance of the term "central bank" in our example, as I just explained it to you and you did not address it.
"You might also recognize the irrelevance of the police in maintaining the value of the dollar. Currencies have lost value even when people have been beheaded for refusing to accept it."
Legal tender laws, the requirement to pay taxes in paper dollars, and the taxation of capital gains on gold and silver are the primoridal instruments for the government to ensure the broad usage of a paper currency. The currency can still lose value of course, I never denied this fact, so I am not sure why you brought it up.
"That bond is part of my wealth, so my net worth, and my net ability to buy goods, is not changed if I take it to the fed and exchange it for dollars, Next time I use a $100,000 T-bill to buy real estate, I'll be sure to take a picture."
I assume you have agreed that you cannot go to the bakery and but bread with a government bond. (Please let me know if anything is still unclear regarding this.)
Published: March 16, 2008 5:33 PM
fundamentalist
RBD supporters will try to kick up as much dust as possible to obscure the issue and make themselves sound erudite, but the truth is that history proves that an increase in the supply of gold money causes price inflation. All you have to do to see it is look at times and places that have experienced gold rushes. In the late 1800's, silver lost its value as money because it became too plentiful. Paper, or digital, money do not have any magical properties that enable them to escape the laws of economics. Any increase in them will cause prices to be higher than they would have been without the increase. Regardless of the smoke the RBD people blow, they can't escape these fundamental truths.
Published: March 16, 2008 5:53 PM
TLWP Sam
Good point F. When money is made from a certain commodity such as gold then the value of the money is left to the vagaries of gold finds and seizures as well as losses. If gold mining were fairly random especially if it were accidently found when mining something else then I could imagine an economy having sudden random bursts of inflation and deflation. Perhaps M. Sproul a big question is if money can be released with new good and services how does the money supply contract if the goods and services are not available any more? Does this imply a ratchet-style increase?
Published: March 16, 2008 6:54 PM
newson
mike sproul says:
"Inflation is proof that the fed has less backing per dollar now than it used to. That could happen because of the fed's misguided attempt to back dollars it did not issue, or for hundreds of other reasons."
i would agree with you on this point, but can't think of any of the hundred other reasons you've hinted at. misguided? i think this was nothing more than a deliberate attempt to trade off localized banking failures for institutionalized, and systemic inflation.
you've pointed out how gm could purchase a security like its own call options (or some synthetic security derived from gm stock). first, i'm not sure that the sec would allow this, there are regulations on share buy-backs and such. second, any derivative security still has to deliver gm stock on exercise - it cannot be willed into existence by the derivative producer.
gm, even if it did have a derivative product on its balance sheet, could not devalue its stock and therefore the derivative by issuing more stock in the way the fed can do with money. if gm wished to make a preferential stock placement at 1c/share, doubling the number of shares on issue, this would have to be put to the current stockholders. presumably they would be upset by this devaluation and vote it down.
the fed could/can devalue the fixed interest securities on its balance sheet by its very own actions in money creation, and there is no possible veto by anyone.
finally, you'd be aware that the austrians are split between the free bankers, and the 100% reservers. i fall into the latter camp, but would far prefer free banking to the present system.
even the regular bank failures that the fractional reserve system occasioned pre-1913 served to make the public extremely wary of banks. this public vigilance has sadly waned. the risk hasn't magically vanished, just gone from local to systemic.
Published: March 16, 2008 9:01 PM
Don Lloyd
If a convenience store will accept my $1 bill for a candy bar, it is money, period. There is no requirement for money to be backed in any shape or form. All backing is an attempt to limit the increase in the supply of money, to oppose the inherent incentive for any producer of money to increase its supply for his or its own benefit.
When Mike claims that price inflation will be minimal or non-existent if FED assets track the supply of money, he has it almost exactly backwards. FED assets have no function except to serve as a largely unrealized potential capability to reverse the increase in the supply of money.
An effective absence of price inflation would loosely require the supply of money to track, not FED assets, but rather the supply of goods and services that can be purchased with money.
Regards, Don
Published: March 17, 2008 7:13 AM
Mike Sproul
"If the FED bought up the entire corn supply, the price of corn would rise significantly."
The RBD doesn't talk about what the central bank could do to the price of corn by buying corn, it asks what the fed does to the value of the dollar by printing dollars and using them to buy bonds and other assets. The answer to that is that as long as the fed's assets rise in step with the quantity of money it has issued, the value of the dollar is unaffected.
"In the late 1800's, silver lost its value as money because it became too plentiful. Paper, or digital, money do not have any magical properties that enable them to escape the laws of economics."
What would be magical is if a piece of paper that lays claim to one ounce of gold were subject to the same laws as the gold itself.
"i would agree with you on this point, but can't think of any of the hundred other reasons you've hinted at."
The Fed's assets can fall relative to its liabilities if it overpays for bonds, blows money on overpaid managers, gets robbed, loses a building to an earthquake, etc.
"first, i'm not sure that the sec would allow this, there are regulations on share buy-backs and such. second, any derivative security still has to deliver gm stock on exercise - it cannot be willed into existence by the derivative producer."
If there are SEC regulations, they would be easy to get around. For example, a corporation could just make an off-the-books bet with someone that pays a dollar every time GM stock rises $1, and loses $1 every time GM falls by $1. That would amount to GM owning one derivative share of its own stock.
Genuine stock does not have to be delivered at exercise. The two parties can agree to deliver the cash equivalent of a share of GM instead. In any case, any bad event that happens to GM would then cause its stock price to fall, and the fall would be exaggerated by GM's ownership of derivative shares--exactly the same as when the Fed issues money.
"the austrians are split between the free bankers, and the 100% reservers. i fall into the latter camp,"
So customers who prefer to put their money in fractional reserve banks, knowing that they pay higher interest, but might not always have cash available, should be prohibited from doing so? And you would prefer a 100% reserve bank, even though that kind of bank is more vulnerable to robbery? That's a vary unlibertarian position, but it's in line with the self-contradictory position of many Austrians.
Published: March 17, 2008 11:30 AM
fundamentalist
Mike: "What would be magical is if a piece of paper that lays claim to one ounce of gold were subject to the same laws as the gold itself."
What a strange assertion! The paper derives its value from the gold. Otherwise, the paper is no more valuable than toilet paper. All derivatives respond to the value of the underlying asset. If you don't understand that, please don't invest in futures or options, which are other forms of derivatives.
The value of paper money backed by gold will respond to the changes in the supply of gold. If gold suddenly gushes into the market place, its value will fall. As a result, the value of the paper backed by gold will fall as well, because the paper derives its value from the gold that backs it.
So what happens if paper is not backed by gold, but by bonds? In the same way, if the supply of bonds increases, their value will fall, and the value of the paper derivative will fall as well.
So, in a sense, the RBD is correct that the value of paper (or digital) money is tied to the value of the asset backing it. Or in more modern terms, paper (or digital) money is a derivative of the underlying asset. If the supply of the underlying asset increases, the value of the derivative will fall. This is very, very basic finance.
At the same time, if the supply of derivatives increases relative to the underlying asset, the value of the derivatives will fall. This happens in fractional reserve banking when the volume of gold, or bonds, backing money remains the same but the volume of money increases through credit expansion. If the volume of money doubles while the stock of assets remains the same, you will have multiple units of money with claims on one unit of asset. That's fractional banking.
So even though the "claim" remains the same, that is, my $1 thousand bill may still lay claim to one ounce of gold, there may be another 20 people with $1 K bills who have a legal claim to the exact same one ounce of gold. So the expansion in the volume of claims has created a situation of fraud. But also, the increase in the number of derivatives laying claim to the same underlying asset will have the same effect on prices as if the volume of the underlying asset has increased. Either way, prices will eventually rise in response to the greate supply of money.
Published: March 17, 2008 12:01 PM
Inquisitor
Where did he say it should be outlawed? I think you're leaping to conclusions...
To the extent that some Austrians have called for the outlawry of fractional banking, it has been on account that it is fraudulent. That doesn't make them inconsistent, though it does make them wrong IMO, if the bank is clear enough on what it is doing.
Published: March 17, 2008 12:05 PM
fundamentalist
Mike: "If the fed printed 100 paper dollars "out of nothing" and bought an equal value of gold, silver, land, wheat, or whatever, and if the fed stood ready to buy back its dollars with those assets, I suspect you'd agree it would not be inflationary, since the fed's assets would rise in step with the money issued."
You may be right on that point, but that’s not what the Fed or its banks do. If the Fed did what you claim, I think it would be a major improvement over the current system. This is what the Fed, and banks, do: They print money and use it to buy assets, such as bonds. No problem so far. But then the people who receive the money deposit it in a bank. Then the bank loans out those deposits to 50 other people. No more paper dollars have been printed, but deposits in bank accounts, which are digital money, have grown by a factor of 50. So now you have a mix of paper and digital money with a total value 50 times greater than that of the original asset the bank purchased. In other words, you have 50 claims to the same asset. That growth in digital money devalues it and the paper money originally issued.
Published: March 17, 2008 1:21 PM
Nima
Mike said: "The RBD doesn't talk about what the central bank could do to the price of corn by buying corn, it asks what the fed does to the value of the dollar by printing dollars and using them to buy bonds and other assets. The answer to that is that as long as the fed's assets rise in step with the quantity of money it has issued, the value of the dollar is unaffected."
So you agree that the price of corn would rise if the federal reserve bank bought up the entire supply of corn with newly printed money. Please let me know if anything is still unclear regarding this as it is an important stepping stone in understanding the effects of credit expansion.
Also, it seems like you agreed that you cannot purchase a loaf of bread with a treasury bond, but I did not yet receive any specific reply on this. This is important in understanding the importance of the meaning of what a medium of exchange, money, actually is.
Published: March 17, 2008 3:13 PM
jp
Fundamentalist said: "No problem so far. But then the people who receive the money deposit it in a bank. Then the bank loans out those deposits to 50 other people. No more paper dollars have been printed, but deposits in bank accounts, which are digital money, have grown by a factor of 50. So now you have a mix of paper and digital money with a total value 50 times greater than that of the original asset the bank purchased. In other words, you have 50 claims to the same asset."
Remember, when the commercial bank creates these digital deposits, it will only do so upon taking proper collateral. This might be a lien on a house, a car, whatever. These count as assets on the banks balance sheet. So yes, you may have 50 times the money out there (paper dollars and digital deposits), but as long as the banker does a good job he'll have 50 times the assets backing that money.
Published: March 17, 2008 4:03 PM
Mike Sproul
jp is right about the backing of privately-issued money. The paper dollars issued by the fed are backed by the fed's assets, and as long as the fed's assets rise in step with paper money, the paper dollar will hold its value. The checking account dollars issued by private banks are backed by the assets of those private banks, so when private banks issue more checking account dollars, not only are the assets and liabilities of the fed unaffected (and the value of the paper dollar), but the value of the checking account dollars is unaffected as well.
"So you agree that the price of corn would rise if the federal reserve bank bought up the entire supply of corn with newly printed money."
Well, the fed could buy all the world's farmland, but the land would probably still be there, still being farmed, so the fed could buy all the farmland without affecting its value. But this is beside the point of what happens to the value of the dollar when the fed issues more dollars for miscellaneous assets that it does not actually consume.
"Also, it seems like you agreed that you cannot purchase a loaf of bread with a treasury bond."
I could buy 10,000 loaves. I could buy a car or a house. If the treasury issued them in small denominations, then I could buy single loaves. The point is that when I exchange my T-bill for paper dollars from the fed, my purchasing power is substantially unchanged, so there is no upward pressure on prices.
Published: March 17, 2008 5:14 PM
fundamentalist
jp: "So yes, you may have 50 times the money out there (paper dollars and digital deposits), but as long as the banker does a good job he'll have 50 times the assets backing that money."
Not at all. Check out the related post on this site from Henry Hazlitt. Suppose the bank loaned money only on gold. Would an increase in the supply of gold cause the value of money to fall? Of course it would, because the digital money is a derivative of the underlying asset, gold, the supply of which has increased relative to the supply of goods. If the supply of any good increases relative to other goods, its value will fall in relation to other goods. This is kingergarten econ. If you don't understand this, you'll never understand anything about economics and will be a sucker for every con scheme like the RBD. In addition, the derivative instrument, in this case digital money, will follow the underlying asset and lose its value. If that happens with gold, what do you think will happen if the underlying assets are cars or homes?
Mike: "The paper dollars issued by the fed are backed by the fed's assets, and as long as the fed's assets rise in step with paper money, the paper dollar will hold its value."
History proves you wrong. I recently read that when Alexander returned from his conquests in the east with mountains of stolen gold and silver, prices in Greece skyrocketed. The increase in prices caused by an increase in the supply of gold and silver is extremely well documented and it would be silly to deny it. If that can happen to gold and silver, what do you think would happen to paper/digital money that is backed by gold and silver? Or worse, by bonds, cars and homes? If the supply of the underlying asset increases relative to goods, the value of the asset and its derivatives will fall.
You problem is that you don't take the next step in the analysis. All you look at is the backing behind the created money. But to be a good economist, you must look at what happens next: if assets can be turned into money, the supply of those assets will automatically increase at a rapid rate. As with gold, an increased supply translates into a lower value.
Published: March 17, 2008 6:36 PM
newson
to mike sproul: your gm analogy is completely inappropriate to understand the fed. the gm synthetic security you've described could be constructed through the simultaneous purchase both put and call options - whether or not that transaction can stay off balance sheet is something for a securities lawyer, not me. but enron suggests you're probably right!
anyway, let's run with your scenario: any change in gm's outlook will be mirrored by the derivative. if gm, however, wished to place zillions of their shares at 1c to the stearn bears company, the law requires that existing shareholders be able to vote on this dilution of their capital. disenfranchised shareholders will turn the proposal down, as its transfers their wealth to stearn bears' shareholders.
by devaluing the dollars over which it has control, the fed can also collapse the value of the fixed interest treasuries in its portfolio. a fed preferential rights issue to the stearn bears company (read bail-out), for example, doesn't get put to the shareholder base (ie. all dollar holders). that's the difference between the fed and an ordinary corporation.
the other possible reasons you've advanced to explain the inflation we experience are inconsequential. fed wages are disclosed - greenspan earned $180k in his final year - his salary was decided by congress. some of the regional fed governors earn double that figure. nor is their real estate anything flash. we could multiply the fed's buildings and personel one hundred fold and not make a dent in their balance sheet.
i'd like to hear more about how the fed would be able to overpay for t-bonds (one of the deepest markets in the world), without word getting out! and it would have to be overpaying countless billions. in short, ockhams razor applies here - we have inflation because the fed answers to the broad money dollars, not just the narrow money ones.
as far as the free-banking vs 100% reserve argument goes, i make no representations for anyone but myself. but you're a regular here, and you'll have noticed the austrians do not have uniform opinions on this.
my two bobs' worth - free-banking is superior to the current regime, but inferior to the 100% reserve bank. you'd be aware of the rothbardian view of free-banking as a fraud on its depositors, so there's no point going over this.
what concerns me about free-banking (and this is an utilitarian, not an ideological argument) is the political backlash that bank collapses cause. small depositors are unfamiliar with the mechanics of fractional reserve banking (regardless of how many pages the pds runs to), and history is full of episodes where the smart money placates the retail base of a failing institution, whilst exiting via the back door, capital intact.
which historical examples of free-banking do you use in championing the cause?
with the exception of inflation, nothing foments social unrest as efficiently as bank collapses.
Published: March 17, 2008 9:26 PM
jp
I agree with a lot of what you write, except for "if the supply of any good increases relative to other goods, its value will fall in relation to other goods." Demand is important. The supply of apples may be growing briskly compared to stable orange supply. But if apple demand is at the same time exploding while orange demand dwindling, than apple prices could be rising faster than oranges, even though apple supply is rising relative to that of oranges.
If you want to rephrase your statement: "If the supply of any good increases relative to other goods, its value will fall in relation to other goods." and add "demand for all goods staying constant", then I agree that "the derivative instrument, in this case digital money, will follow the underlying asset and lose its value." I don't know if you'll admit it but what you wrote above is very RBDish.
Published: March 17, 2008 9:41 PM
Mike Sproul
"The increase in prices caused by an increase in the supply of gold and silver is extremely well documented and it would be silly to deny it."
The RBD doesn't deny that an increase in the supply of an actual commodity like gold will reduce its value. The RBD says that the value of money is equal to the value of its backing, so that if a bank issues another $100, while simultaneously acquiring $100 worth of new assets, the value of the dollar will not change.
"the gm synthetic security you've described could be constructed through the simultaneous purchase both put and call options"
The right combination would be a call bought and a put written. The combination you described is a V straddle.
"if gm, however, wished to place zillions of their shares at 1c to the stearn bears company, the law requires that existing shareholders be able to vote on this dilution of their capital."
Correct, and consistent with the RBD view that when liabilities outrun assets, the value of liabilities--be they shares of stock or money, will fall. This can happen when corporations are badly run, and when the Fed is badly run. The accounting principles are the same in each case.
"the other possible reasons you've advanced to explain the inflation we experience are inconsequential. fed wages are disclosed - greenspan earned $180k in his final year"
OK. Now multiply $180k by 10,000 or so and you'd have a ballpark figure for the Fed's payroll. Then there are printing costs, etc. I could go on, but it might be enough to mention that in the 1800's, when private banks were allowed to issue paper money, most bankers said that the cost of issuing paper dollars was high enough to make them unprofitable--except for their usefullness as advertising for the bank. Now if privately-run banks with a profit motive couldn't turn a profit by issuing paper dollars, it's unlikely that the Fed, with no profit motive, could do better. So there's a big reason why the Fed might lose assets over time. Now for the clincher: The Fed must pay its "profits" (interest earned on bonds minus expenses) to the treasury each year. This effectively guarantees that the Fed will always lose assets over time, and thus guarantees inflation.
"nothing foments social unrest as efficiently as bank collapses"
If a 100% reserve bank holds 100 ounces of silver against 100 paper dollars issued, and if it is robbed of 1 ounce, then that bank will face a run just like a fractional reserve bank.
Published: March 18, 2008 6:25 PM
fundamentalist
jp: "I don't know if you'll admit it but what you wrote above is very RBDish."
You mean the idea that paper money is a derivative of the underlying asset? Of course, not everything in the RBD is wrong, otherwise no one would accept it. There has to be an element of truth in false theories in order to attract believers. On the other hand, half-truths are the most dangerous lies.
Mike: "The RBD doesn't deny that an increase in the supply of an actual commodity like gold will reduce its value. The RBD says that the value of money is equal to the value of its backing..."
Yes, but you deny that an increase in the supply of the asset backing the derivative paper money will cause the paper money to lose value, which is nonsense. If the asset loses value, the derivative must lose value as well. The assets backing the derivative will lose value when their supply increases relative to goods and services. It doesn't matter whether the asset backing the derivative is gold, bonds, land, water, apples or beans.
Published: March 18, 2008 8:35 PM
Don Lloyd
Mike,
"...The RBD says that the value of money is equal to the value of its backing, so that if a bank issues another $100, while simultaneously acquiring $100 worth of new assets, the value of the dollar will not change..."
This absurd claim would seem to say that all the monies used down through history, seashells for example, were really worthless if they were unbacked.
Regards, Don
Published: March 19, 2008 1:49 AM
newson
to mike sproul:
touche! i concede your point that the written put/long call structure is the appropriate structure for our gm vs. fed analysis.
printing costs are insignificant compared to the size of the fed's balance sheet, and these days most transactions are effected electronically. besides, this argument is circular - countries experiencing hyperinflation necessarily have to re-denominate their bills (with increasing frequency) due to heightened inflationary expectations occasioned by the previous flood of paper. catch 22.
the fed is a not-for-profit entity, so payroll expenses are met from bond income, and net revenue is devolved to treasury. personnel costs and printing costs,therefore, are irrelevant in this "value-leaching" process.
bottom line - i believe the operating costs of the central bank are a miniscule part of the inflation picture. the fed's fixed costs have remained fairly stable (costs compared to balance sheet) over time. the big jump in inflation from the seventies on can only be explained by the fact that the fed answers for broad money (m3), and not the narrow money definition as per its charter.
the lack of banking collapses in a climate of high price volatility (post 1970's) would be inexplicable without the fed's overt/covert interventions.
Published: March 19, 2008 2:48 AM
Mike Sproul
"you deny that an increase in the supply of the asset backing the derivative paper money will cause the paper money to lose value, which is nonsense. If the asset loses value, the derivative must lose value as well. The assets backing the derivative will lose value when their supply increases relative to goods and services."
Are we talking about the same thing? If the supply of gold increases, the value of gold will fall, and the value of gold certificates (derivatives) will fall in step. The dispute is (or should be) about this: If there are 100 gold certificates backed by 100 oz. of gold, and then 200 new certificates are issued in exchange for miscellaneous assets that have a market value equal to 200 ounces, will that make a gold certificate worth less than one ounce? The QT says yes. The RBD says no because, for one thing, those miscellaneous assets could be sold for 200 ounces of gold, and then there would be 300 oz. backing 300 certificates, so each certificate must still be worth 1 ounce.
"This absurd claim would seem to say that all the monies used down through history, seashells for example, were really worthless if they were unbacked."
Seashells were as much a commodity as gold or silver. They were not a token money, and so they required no backing to have value.
The RBD does recognize that if a commodity like silver is partly valued because people demand it for use as money, then as paper money is substituted for silver, the price of silver will fall to its "use value" as the substitution occurs. Once silver has been driven down to its use value, further issue of (adequately backed) paper money can't drive the silver any lower, so the RBD will be fully satisfied.
"i believe the operating costs of the central bank are a miniscule part of the inflation picture. the fed's fixed costs have remained fairly stable (costs compared to balance sheet) over time. the big jump in inflation from the seventies on can only be explained by the fact that the fed answers for broad money (m3), and not the narrow money definition as per its charter."
The Fed's operating costs only have to amount to 1% of its total assets in order to account for an inflation rate in the neighborhood of 1%, and the fact that the Fed's "profit" is handed to the treasury guarantees an annual loss of a significant part of the Fed's assets. Furthermore, if the fed is lending at 3% in a world where the market rate is 5%, that will also be a source of inflation. Finally, there is the problem that I call "inflationary feedback" (In There's No Such Thing as Fiat Money"), which will exaggerate any inflation.
Published: March 19, 2008 10:25 AM
TLWP Sam
Interestingly it could be argued that gold, silver, seashells, food, water, etc., are all worthless until people give them value.
Published: March 19, 2008 10:45 AM
Inquisitor
Sam, what, if anything at all, do you know about Austrian economics? Why do you even post here? It could be argued? Well, sorry to have to inform you of this, but Menger did in fact argue that, say over 100 years ago, in his Principles of Economics. That is essentially the marginal-utility and subjective theories of value imputation. Nothing has value other than through the eyes of the person valuing it. Gold just has those properties that make it highly likely to be valued.
Published: March 19, 2008 12:58 PM
fundamentalist
Mike: "If there are 100 gold certificates backed by 100 oz. of gold, and then 200 new certificates are issued in exchange for miscellaneous assets that have a market value equal to 200 ounces, will that make a gold certificate worth less than one ounce? The QT says yes."
That's not true. The QT would say that the gold certificates are still worth an ounce of gold. However, the increase in the supply of gold relative to goods/services has made the cold less valuable with respect to goods/services. At the same time, the gold certificates have become less valuable in relation to goods/services because they derive their value from the gold. The flip side is that prices have risen, which is price inflation. You claim that RBD would not ignite price inflation, but it's clear that it would if the supply of the underlying asset increased relative to goods/services.
Now what do you think would happen in a society such as ours where paper money isn't backed by anything, but banks can exchange if for assets? The supply of paper/digital money would increase relative to goods/services and lose value, which means that prices would rise.
Just curious, but do you think anyone should be able to print paper money and exchange it for assets, such as cars and homes? Why should that power be limited to just banks? Shouldn't every individual have the right to print money and exchange it for assets is the value of the paper is as good as the asset it is exchanged for? If the government didn't require by law that people accept paper/digital money, do you think they would?
Published: March 19, 2008 1:27 PM
jp
Just to quantify Mike Sproul and Newson's comments with some stats.
In its 2006 annual report, Fed assets came out to $873 billion. The Fed earned $36.5 billion in revenues, this from its bond portfolio. It paid $3.95 billion in expenses. Net income was $34.5 billion. $29.1 billion of this was returned to the Fed under the column... "Payments to U.S. Treasury as interest on Federal Reserve notes." The last is a bit odd, since the rest of us don't make interest off the notes we hold.
As for the Fed answering for broad money (m3), I see FDIC as being the answerable party. By insuring commercial bank deposits, FDIC sets up a moral hazard dynamic that lets commercial banks expand M3 irresponsibly. In a world without FDIC, if a bank collapses the value of the money it has issued falls to nothing since there is not enough to back it. In the real world, if a bank fails FDIC pays off a depositors from its cash holdings.
In the case of a grand collapse, FDIC wouldn't have enough money to pay despositors, in which case the Federal government would have to increase taxes or raise more money via bonds to top FDIC up. The Federal government's credit would go bad, hurting bond prices, and this would impair the value of the Fed's bond portfolio. The currency would lose value. In this way I can see the Fed being answerable to M3. But it is only because of FDIC.
Published: March 19, 2008 3:15 PM
Don Lloyd
Mike,
"...The RBD does recognize that if a commodity like silver is partly valued because people demand it for use as money, then as paper money is substituted for silver, the price of silver will fall to its "use value" as the substitution occurs. Once silver has been driven down to its use value, further issue of (adequately backed) paper money can't drive the silver any lower, so the RBD will be fully satisfied."
The sequence is as follows :
1. Silver is money. It also has non-monetary uses. The monetary demand to hold in individual cash balances and the non-monetary demand for industrial and other uses combine to work against the total supply of silver to determine the market price of silver, ultimately in terms of the supply of all other goods and services that can be purchased with money.
2. Part, and eventually all, of the monetary supply of silver may be withdrawn and allocated to paper (or electronic) claims on silver which may serve as a more portable form of money, without generally affecting the market price of silver. This particular silver is NOT available for non-monetary uses.
3. Claims to silver are repudiated and new pseudoclaims are issued as they become money and silver is de-monetized. The pseudoclaims are now money and are now what are demanded by individuals to hold in cash balances. The market value of the money (pseudoclaims) is determined by the supply and demand of and for the pseudoclaims.
Silver now has a new demand category, a speculative, investment demand. This replaces the demand to hold silver in the cash balances of individuals, but need not bear any necessary relationship to it. The market price of silver depends on the supply of silver and the new combined demand for silver.
Regards, Don
Published: March 19, 2008 4:01 PM
Mike Sproul
"The QT would say that the gold certificates are still worth an ounce of gold. However, the increase in the supply of gold relative to goods/services has made the cold less valuable with respect to goods/services. At the same time, the gold certificates have become less valuable in relation to goods/services because they derive their value from the gold. The flip side is that prices have risen, which is price inflation. You claim that RBD would not ignite price inflation, but it's clear that it would if the supply of the underlying asset increased relative to goods/services."
Now I know we aren't talking about the same thing. I'll leave it to any interested Austrians to answer whether they believe that the QT says the gold certificates will still be worth 1 oz. What I want to emphasize is the question of what happens when 200 new gold certificates are issued in exchange for miscellaneous (non-gold) assets that can be sold on the market for 200 ounces of gold, but THE QUANTITY OF GOLD THAT EXISTS IS UNCHANGED.The RBD says that each gold certificate will still be worth 1 ounce, and furthermore, the value of gold relative to other goods will be unchanged, except for any transitory drop in gold's value that results as people stop using it as money.
"3. Claims to silver are repudiated and new pseudoclaims are issued as they become money and silver is de-monetized. The pseudoclaims are now money and are now what are demanded by individuals to hold in cash balances. The market value of the money (pseudoclaims) is determined by the supply and demand of and for the pseudoclaims."
If a bank holds 100 ounces of silver against 100 silver certificates, and then sells 90 oz for bonds worth 90 oz, the demand for silver really is reduced, especially if it makes a deal with its customers where the bank can deliver an ounce's worth of bonds in lieu of silver.
Yes; I do think anyone should be able to issue token money. I might try to get local stores to accept Mike Dollars, but so far, I haven't developed good enough credit for them to circulate. Disney, on the other hand, has good enough credit that its Disney dollars can and do circulate, and I approve.
"Now what do you think would happen in a society such as ours where paper money isn't backed by anything, but banks can exchange if for assets?"
Disney dollars are backed by Disney's assets. Mike dollars are backed by my assets, and the Fed's dollars are backed by the Fed's assets. There is no such thing as fiat money.
Published: March 19, 2008 9:18 PM
newson
to mike sproul:
i'll have to read your essay before i make any judgement.
i should also have been more clear about broader money, which i've labelled as m3. there's considerable discussion about which aggregate best accomodates the austrian view of money, but they are all broader that the narrow money the fed is supposed to stand behind.
whilst you offer structural reasons for the fed's inflationary bias, there seems to be no explanation as to why the inflationary pressures should vary so greatly over time. why was it roaring in the seventies (coinciding with the shutting of the gold-window), and not in the fifties?
after all, the devolution of interest revenue to treasury is a given, personnel and other fixed costs are known and reasonably predictable.
Published: March 19, 2008 9:46 PM
Don Lloyd
Mike,
"If a bank holds 100 ounces of silver against 100 silver certificates, and then sells 90 oz for bonds worth 90 oz, the demand for silver really is reduced,..."
As long as every silver certificate corresponds to an equivalent amount of silver, either the silver certificates, or the silver, but not both, count as money. However, simplifying, the public holds the certificates and the bank holds the silver.
As soon as the first ounce of silver is sold out from under the certificates, with or without the knowledge of the public, the certificates become money on their own, and all of the 100 ounces of silver are converted from monetary to non-monetary uses.
This is an increase in the supply of non-monetary silver, and a reduction (to zero) in the demand for monetary silver, and the market price of silver will fall.
However, both the supply of certificates and the demand to hold them are largely unchanged, leading to no price inflation for as long as no new certificates are produced.
It makes no difference what the silver is exchanged for, if anything.
Regards, Don
Published: March 19, 2008 10:43 PM
Michael A. Clem
Yes, but you deny that an increase in the supply of the asset backing the derivative paper money will cause the paper money to lose value, which is nonsense. If the asset loses value, the derivative must lose value as well. The assets backing the derivative will lose value when their supply increases relative to goods and services. It doesn't matter whether the asset backing the derivative is gold, bonds, land, water, apples or beans.
It seems we're dangerously close to agreeing with RBD, since Mike S. is saying that the value of the currency is the value of the backing asset. So if the value of the asset goes down, the value of the currency goes down. And since the current U.S. dollar is backed by debt, and the amount of debt has grown dramatically, guess what's happened to the U.S. dollar?
So is RBD really saying anything worthwhile, or is it, in fact, saying something trivial?
Published: March 19, 2008 11:09 PM
fundamentalist
Mike: “Now I know we aren't talking about the same thing. I'll leave it to any interested Austrians to answer whether they believe that the QT says the gold certificates will still be worth 1 oz.”
Yes, we are talking about the same thing. You simply refuse to accept advances made in economics over the past 400 years.
Mike: "What I want to emphasize is the question of what happens when 200 new gold certificates are issued in exchange for miscellaneous (non-gold) assets that can be sold on the market for 200 ounces of gold, but THE QUANTITY OF GOLD THAT EXISTS IS UNCHANGED.The RBD says that each gold certificate will still be worth 1 ounce, and furthermore, the value of gold relative to other goods will be unchanged, except for any transitory drop in gold's value that results as people stop using it as money.”
I assume you’re adding to your previous analogy, and that instead of the original 200 ounces of gold backing 200 gold certificates, you now have 200 ounces of gold backing 400 gold certificates. You’re right that most people would consider the certificates to be worth an ounce of gold. But that’s because of the illusion caused by your small numbers. Add a trillion to the figures. You’ve essentially doubled the money supply, the certificates, without adding any to your gold reserves. History is against you. Banks have tried that hundreds of times since paper money became popular over 400 years ago. Such an increase has cause enormous price inflation every single time without exception. Why does that happen? Because people believe the gold certificates still represent an ounce of gold, so they respond as if the supply of gold has doubled, and doubling the supply of gold has generally caused prices to double in every case for the past 6,000 years without exception.
Michael: “It seems we're dangerously close to agreeing with RBD, since Mike S. is saying that the value of the currency is the value of the backing asset. So if the value of the asset goes down, the value of the currency goes down.”
That part of RBD is true, since paper money is just a derivative of the underlying asset.
“And since the current U.S. dollar is backed by debt, and the amount of debt has grown dramatically, guess what's happened to the U.S. dollar?”
And unlike gold, the supply of debt is infinite, so the expansion of the money supply is infinite, although the Fed can reduce the money supply by selling debt back to the public or to banks.
“So is RBD really saying anything worthwhile, or is it, in fact, saying something trivial?”
Something trivial. RBD is basically a denial of every advance in monetary theory in the past 400 years. It makes a similar mistake to that of classical economists who wanted to fix an objective value to everything; RBD wants to fix an objective value to money. But like any other commodity or service, the value is in the eye of the beholder and strongly affected by supply and demand. In addition, the true value of gold-backed money is not in fact that it is gold-backed, but in the fact that the supply of gold changes very little. Since the supply of gold changes little, the supply of paper dollars backed by it should change very little, but with fractional reserve banking that’s not the case. FR banking expands the supply of paper against fixed reserves so that you end up with a ratio of paper money to gold of about 50:1. RBD says that won’t matter because banks exchange newly printed paper for assets, but it does matter because the supply of paper dollars relative to goods has changed, and kindergarten econ teaches that if the supply of anything, services, goods or ideas, increases relative to other services/goods/ideas, it will lose value in the eyes of the public (demand remaining the same) because it is less scarce. That’s the subject theory of value developed by Austrians in the late 1800’s which chaps the RBD.
If all that happens with gold-backed money, you can imagine the mischief paper/digital money can cause when it’s backed only by government/corporate IOU’s. There is no limit to the volume of IOU’s that either can issue. In addition, with FR banking the ratio of paper/digital money to assets (debt) expands at about 50:1, so the money supply can grow to infinity. The only thing that stops the Fed from expanding the money supply infinitely is the price inflation it causes.
Published: March 20, 2008 9:30 AM
jp
Fundamentalist, you focus too much on supply. If demand and supply are equally important, why do you mention supply 15 times and demand only twice in your last post?
For instance, you say the supply of debt is infinite so the money supply grows infinitely. But if people have no new demand for debt at current interest rates and are happy with their situation, how can both debt and money supply grow? How is debt foisted on these people? You speak as if money is simply pushed out into the public indiscriminately. But money can also be drawn out by the public through their demand.
If supply is infinite, why can't I go get a million dollar loan right now? Banks only issue on good credit and sufficient collateral, and will not lend infinitely since their is no such thing as infinite collateral.
Another example in which you neglect demand: "RBD says that won’t matter because banks exchange newly printed paper for assets, but it does matter because the supply of paper dollars relative to goods has changed, and kindergarten econ teaches that if the supply of anything, services, goods or ideas, increases relative to other services/goods/ideas, it will lose value in the eyes of the public (demand remaining the same) because it is less scarce."
You qualify this statement by saying "demand remaining the same". But when banks exchange newly printed paper for assets, they can only do so because demand for that paper by the public is increasing. If there was no demand for new paper, the banks couldn't create it. Now if the supply of paper is increasing with the demand for paper, you can no longer say paper money is losing value in the eyes of the public.
From the tone of things most of you guys have agreed with (at least parts) of Mike Sproul's backing theory, you just don't want to admit it.
Published: March 20, 2008 10:40 AM
Inquisitor
What does Mr Sproul have to say about current interest rates? Does he admit that the Fed is meddling with them?
Published: March 20, 2008 11:40 AM
Don Lloyd
JP,
"... But when banks exchange newly printed paper for assets, they can only do so because demand for that paper by the public is increasing. If there was no demand for new paper, the banks couldn't create it. Now if the supply of paper is increasing with the demand for paper, you can no longer say paper money is losing value in the eyes of the public."
This is a misunderstanding. When an individual accepts money, either new or old, for an asset or a service or whatever, this does NOT represent a demand for money, but rather a judgement that the good or service given up is of less value than one that can be expected to be available in the near future in exchange for the money acquired.
If the money is new, the only difference is that the judgement of relative values would, in theory, have to include the dilution in the value of money. However, the significance of the dilution of this transaction is miniscule as it depends on the size of the transaction vs the total supply of money.
Regards, Don
Published: March 20, 2008 11:58 AM
fundamentalist
jp: "...you focus too much on supply. If demand and supply are equally important, why do you mention supply 15 times and demand only twice in your last post?"
You’re confusing a couple of terms in your argument—demand for money and demand for loanable funds. Demand for money is the demand to hold cash balances, which stays fairly constant. Demand for loanable funds is the demand to borrow money to invest in new ventures and is highly erratic, virtually unlimited, and depends on the interest rate. If banks want to make more loans, they only have to lower their interest rate. When businessmen spend the money they borrowed, it becomes cash and increases the money supply. Also, lower interest rates encourage consumers to buy consumer durables, such as cars, with borrowed money and the loans become cash quickly.
Demand for money (cash holdings) is constant if the money supply is constant. It may grow with the population increase. But the demand for money tends to be the inverse of its supply. This is especially true in periods of high inflation as people try to exchange worthless money for goods as quickly as possible. So the demand for money depends on the value of money. As the supply of money increases through loans, the value of money falls and the demand for it falls.
So why does the value of money fall when the supply increases? Because the output of goods and services hasn’t changed. Now you have more money chasing the same amount of goods/services. The value of money relative to goods has to fall. This is a basic, iron-clad law of economics, and the backing behind the money won’t prevent this law from operating. As money falls in value (or what people see is rising prices) they want to hold less money.
You’re right that if interest rates remain the same, banks can’t expand the money supply beyond the demand for loanable funds at that interest rate. And the money supply tends to fall with higher interest rates. But it’s very easy to increase the money supply beyond the levels at which people want to hold money by simply lowering the interest rate for loanable funds.
Published: March 20, 2008 12:06 PM
Inquisitor
Don, you're alluding to exchange value, correct?
Published: March 20, 2008 12:21 PM
Don Lloyd
fundamentalist,
Just a nitpick -
"...As money falls in value (or what people see is rising prices) they want to hold less money..."
Since the demand for money is a demand for cash balances, but valued in purchasing power, people must actually increase their demand for (nominal) money to hold. (And the new increased supply of money must be held by everyone in aggregate) This is not normally a major problem since most peoples' desired cash balances are much less than their net worth. The problem is the holding of assets that do not resist the falling exchange value of a money that is increasing in supply.
Regards, Don
Published: March 20, 2008 12:30 PM
fundamentalist
Don,
You're right. In the aggregate people are forced to hold all of the new money whether they want it or not. Prices simply adjust so that the value of the cash holdings relative to goods is the same as before the new cash infusion.
Published: March 20, 2008 1:37 PM
Mike Sproul
"there seems to be no explanation as to why the inflationary pressures should vary so greatly over time. why was it roaring in the seventies (coinciding with the shutting of the gold-window), and not in the fifties?"
Inflation will rise during periods where the fed is lending below the market interest rate, or when the government bonds held by the fed lose value, or when the fed overpays for the bonds it buys. Also, there is a section in my "No Fiat Money" paper that explains that the fed can, if it wants to, reduce the rate of physical convertibility from 1 oz/$ to .5 oz./$. That's not relevant to the fed since the dollar is not physically convertible, but the dollar is financially convertible, and the fed can also reduce the rate at which financial convertibility is maintained.
"However, both the supply of certificates and the demand to hold them are largely unchanged, leading to no price inflation for as long as no new certificates are produced."
The certificates were previously backed by 100 oz. of silver. Now they are backed by assets worth 100 oz. of silver. And if the fed then issued another 200 certificates, in exchange for assets worth 200 oz., the value of the certificates would still be 1 oz., since there are now 300 certificates laying claim to assets worth 300 oz.
"So is RBD really saying anything worthwhile, or is it, in fact, saying something trivial?"
Yes; definitely trivial. The same is true of double-entry bookkeeping ("The greatest invention of the human mind" or words to that effect). You can only appreciate the RBD once you've closely looked at the train wreck that is the quantity theory of money.
"I assume you’re adding to your previous analogy, and that instead of the original 200 ounces of gold backing 200 gold certificates, you now have 200 ounces of gold backing 400 gold certificates."
No; starting from 200 oz backing 200 certificates, you issue 200 new certificates in exchange for misc. assets worth 200 oz, for a total of 400 oz. worth of stuff backing 400 certificates
"the value of the currency is the value of the backing asset. So if the value of the asset goes down, the value of the currency goes down.”
That part of RBD is true, since paper money is just a derivative of the underlying asset. "
That PART?? That IS the rbd.
"What does Mr Sproul have to say about current interest rates? Does he admit that the Fed is meddling with them?"
Of course. Forcing the fed funds rate down to the 1% range and then up to the 5% range is an obvious case of meddling. It is made possible by the fed's unjustifiable monopoly on the issue of paper money, together with its unjustifiable authority to enforce reserve requirements on private banks.
"If the money is new, the only difference is that the judgement of relative values would, in theory, have to include the dilution in the value of money."
The simplest answer to this--and there are many more, is provided by the Law of the Reflux--the proposition that if new money is not wanted in the circulation, then it will either reflux to its issuer or else displace an equal amount of substitute moneys. But given that backing per dollar is unchanged, one thing that the new money cannot change is the value of the dollar.
Published: March 20, 2008 2:35 PM
fundamentalist
Mike: "Inflation will rise during periods where the fed is lending below the market interest rate, or when the government bonds held by the fed lose value, or when the fed overpays for the bonds it buys."
According to RBD why would those things cause prices to rise? If the Fed lowers the interest rate, money is still backed by the same bonds. Why would lower interest rates cause prices to rise, which is the same thing as money loses its value? And how would you know if the Fed pays more for bonds than it should? The only determinant of the value of a bond is what it sells for in the open market. And why would the value of Fed bonds lose value?
Published: March 20, 2008 4:23 PM
Mike Sproul
If the fed lends $100 for one year at a 3% interest rate, when the market rate is 5%, the fed will be repaid $103 in 1 year. But the present value of $103, discounted at the market rate of 5%, is just $98. So the fed loses $2 on the loan, and the dollar loses value.
If a bond sells at auction at $100, and the fed steps in and starts buying bonds in a big way, then the bonds might be bid up to $101. The fed thus overpaid for the bond. Also, if a government has financial troubles, the value of its bonds will fall. If those bonds back the currency, the currency will fall too.
Published: March 20, 2008 9:49 PM
fundamentalist
Mike: "So the fed loses $2 on the loan, and the dollar loses value."
That doesn't make any sense. Why would the Fed loan money at 3% when the market rate is 5%? The gov auctions its notes and bonds in a free market. I suppose you're saying that the value of the notes backing the currency has fallen in value and so the currency falls in value, too, but I don't see that the Fed ever does such a thing.
Mike: "If a bond sells at auction at $100, and the fed steps in and starts buying bonds in a big way, then the bonds might be bid up to $101. The fed thus overpaid for the bond."
No it didn't. Anything sold at auction obtains the correct value for it.
Mike: "Also, if a government has financial troubles, the value of its bonds will fall. If those bonds back the currency, the currency will fall too."
But the US government has never experienced the kind of financial trouble that causes bonds to lose their value. It has the best credit rating in the world.
I don't see the mechanisms you cite working in the real world, yet the value of the US dollar has fallen about 99% in the past half century. Must be something else causing it.
Published: March 20, 2008 10:26 PM
newson
to mike sproul:
recognising the fed has created inflation, at what point above mere paper value does the dollar become fiat money, according to rbd?
would the rbd doctrine regard the zimbabwean dollar as not being a fiat currency? after all, it's backed by their treasury's bonds, and the full taxing powers of the republic.
i think the real crux of the matter is the redeemability of the dollar. after all, in the end-18th century assignat/mandat currency madness, the confiscated property of the catholic church was used as collateral to back the currency. and still the the paper ended worthless, thanks to over-issuance.
Published: March 21, 2008 5:02 AM
fundamentalist
Mike: "If the fed lends $100 for one year at a 3% interest rate, when the market rate is 5%, the fed will be repaid $103 in 1 year."
Why would the Feds have to pay 5% on an issue of bonds when the market rate had been 3%, say a week before? The only reason I can think of that happening is because the Fed wants to buy more bonds than sellers want to sell at 3%. If the Fed buys bonds, it's pumping cash into the economy. If the interest rate goes up on those bonds, that means that people don't want the cash the Feds are trying to unload, so the Fed has to pay a higher interest rate to get them. But that doesn't mean that the Fed has paid more than the market rate; it has paid exactly the market rate. But the Feds drove up the interest rate by trying to buy more bonds than people wanted to sell. It's amusing to me that you can't see the quantity theory at work here. The determining factor in the price (interest rate) of the bonds is the VOLUME of bonds the Feds want to buy. Or to see it from the flip side, the Feds want to stuff the economy with a huge volude of cash, more than people want to take, so the Feds have to pay more for the bonds they want to buy because the value of the cash has fallen.
Published: March 21, 2008 8:44 AM
Mike Sproul
"at what point above mere paper value does the dollar become fiat money, according to rbd?"
Since all money is worth its backing, money without backing has no value. There is no such thing as fiat money. The same is true of seignorage, since fiat money is money whose whole value is seignorage
"would the rbd doctrine regard the zimbabwean dollar as not being a fiat currency? after all, it's backed by their treasury's bonds, and the full taxing powers of the republic."
It's not fiat money. It's backed by the very shaky Zimbabwean government, which is why it's losing value.
"i think the real crux of the matter is the redeemability of the dollar. after all, in the end-18th century assignat/mandat currency madness, the confiscated property of the catholic church was used as collateral to back the currency. and still the the paper ended worthless, thanks to over-issuance. "
The National Assembly sold off those confiscated landsover the next few years, at the same time that it paid its bills with newly-printed money. The money supply rose relative to the government's assets, and so the value of the Assignats fell.
Published: March 21, 2008 9:12 AM
jp
"That doesn't make any sense. Why would the Fed loan money at 3% when the market rate is 5%"
I was curious about that too when I first heard Mike's claim.
I've done some digging around and I think I can give you a good example of the Fed overpaying. If you go to http://www.newyorkfed.org/markets/omo/dmm/temp.cfm
and follow the link "show last 25 operations" you can see the actual repos conducted by the Fed.
On March 20, the Fed conducted an open market operation in MBS. (The Fed is restricted to purchases of agency-backed MBS ie. issued by Fannie Mae or Freddie Mac). On that day it accepted, or bought, $14.45 billion MBS at an average rate of 2.337%.
In the open market, benchmark Fannie Mae MBS are trading at yields of 4% or so. On March 20 the Fed dramatically overpayed for the agency MBS it purchased. After all, the lower the yield (2.337 vs 4%), the higher the price paid.
It also bought $9.55 billion of agency debt (bonds issued by Fannie Mae and other agencies) for which it paid 2.257% per annum on average. Right now Fannie Mae debt is trading at least 2% higher than treasuries, so in the market yields would be more like 3-4% on Fannie Mae debt. Again the Fed overpaid.
Why does the Fed overpay? That is how it keeps the overnight federal funds rate in line with its target. When the Fed engages in a repo it buys a security from one of the 20 or so primary dealers, printing up cash in exchange. It sells the security back the next day at a slightly higher price. The profit the Fed makes is similiar to the interest a bank collects on overnight loans. Right now the difference between the Fed's buying and selling prices are about 2.25% per annum, or the level of the target for the Fed funds rate. When it bought MBS on March 20, the Fed should have contracted to sell the MBS the next day at a higher price than it did, if it were to take market prices and yeilds of +3% as a guide. But it sold it at lower price, a price implying a yield of 2.257%.
How does this keep the ff rate in line? Prime dealers usually exchange overnight funds in the federal funds market. The rate at which they lend to each other is the federal funds rate. The Fed never actively participates in that market, it only enforces its own target for that rate by conducting repos that in a way compete with the fed funds rate. These repos are alternative sources of funding for the primary dealers. By accepting bids for repos, the Fed draws participants away from the fed funds market and thereby relieves pressure, lowering the fed funds rate to its target.
If you look at the history of the fed funds rate, it has been below the market yield on two year government bonds for most of this time. The average duration of the Fed's bond portfolio is two years, that is why I use two years as my example. This means that in general the Fed undervalues the bonds it is purchasing. I think that helps illustrate Mike's point.
Published: March 21, 2008 10:24 AM
fundamentalist
jp: "This means that in general the Fed undervalues the bonds it is purchasing."
I see your point. The Feds aren't engaging in free market exchange, but deliberately losing money in order to pump cash into the system. Here's the reason I don't think that will cause inflation: the Feds do that only when trying to pump money into the system. Sometimes they pump money in at a greater rate, sometimes at a lesser rate, but when they want to raise interest rates, they do the opposite of what they're doing now; they make money on the bonds.
So the Feds alternate losing money and making money on bonds in order to influence the interest rates. But shouldn't they cancel each other out and inflation stay around zero? Instead, in best of times we see the inflation reported by the indexes at 2%, with an average around 3%. But the indexes understate the inflation rate. To get close to the real rate, you have to factor in the rise in assets and the decline of the dollar.
Price inflation exists even when the Feds are trying to raise interest rates and are buying bonds for less than they're worth. How can that happen? The answer is again QUANTITY. Even though the Fed pays less for the bonds than they're worth (the Feds make a profit), they still buy a sufficient quantity of bonds to increase the money supply. The rate of increase in the money supply never falls to zero, regardless of the price of bonds. The money supply always increases, sometimes slower, sometimes faster.
Published: March 21, 2008 2:08 PM
Don Lloyd
Backing and silver certificates --
Let's say we have a $10 silver certificate which can be redeemed for one ounce of silver or used to purchase $10 in goods at retail. For a combination of reasons, retailers will accept silver certificates in payment, but not silver itself. Assume to start that the market price of silver is $10 an ounce.
What we have is money and all is right with the world.
What happens if the market price of silver changes?
If the market price of silver doubles to $20 an ounce, no rational consumer will use a $10 silver certificate to buy $10 worth of goods at retail, but will instead redeem or exchange it for an ounce of silver with a market price of $20.
The rise in the market price of silver has effectively destroyed money, converting it into silver.
If the market price of silver halves to $5 an ounce, nothing happens. The silver certificate will still purchase $10 worth of retail goods. The quantity of money has not changed and neither has the supply of non-silver goods.
As we can see from this example, the backing of money is a threat, not a benefit for the day-to-day operation of money. The benefit of backing comes only from its ability to restrain the producers of money from costlessly increasing the supply of money, IFF the backing is 100%.
Regards, Don
Published: March 21, 2008 4:18 PM
newson
to jp:
i'm thinking like fundamentalist here, re: fed "open market" operations. when the fed overpays for securities in order to pump liquidity into the system, surely when it changes tack and drains liquidity from the system to raise interest rates, the same process occurs in reverse. by withdrawing its bidding for securities, or bidding less aggressively, the fed is going to make back (in opportunity profit) what it sacrificed in the tightening cycle.
unless they have a long-term loose-money bias, would not the two interventions effectively cancel each other out?
to mike sproul:
i see your point about fiat money, but it seems little more than semantics. without convertibility, there is no restraint on the dilution of the money's underlying worth. history shows the inevitability of paper currency to approximate its wood pulp value over time, by virtue of political expediency.
going back to the assignat example, even had the properties not been disposed of, excessive note issuance could still have rendered the land backing of the paper infinitesimal.
the only historical examples of non-inflationary episodes have been accompanied by popular redeemability of the currency. the more articulated the redeemability process, the more the tendency to inflation.
Published: March 21, 2008 7:56 PM
Mike Sproul
"If the market price of silver doubles to $20 an ounce, no rational consumer will use a $10 silver certificate to buy $10 worth of goods at retail, but will instead redeem or exchange it for an ounce of silver with a market price of $20."
You get that result by making the certificates convertible into TWO things: silver and dollars. The same thing happened with silver coins after 1964.
If certificates were convertible only into silver, they would buy twice as many dollars. If they were convertible only into dollars, they would buy half as much silver. Even if money is convertible into only one thing, there is a risk of a bank run when the assets backing the money lose value. It is the maintenance of physical convertibility that is the problem--not backing.
Published: March 22, 2008 9:39 AM
Mike Sproul
"without convertibility, there is no restraint on the dilution of the money's underlying worth. history shows the inevitability of paper currency to approximate its wood pulp value over time, by virtue of political expediency."
You're forgetting that money can be physically convertible OR financially convertible, and there have been some periods where inflation of physically inconvertible currencies has been at or near zero for a few years
"going back to the assignat example, even had the properties not been disposed of, excessive note issuance could still have rendered the land backing of the paper infinitesimal."
This is consistent with the real bills view that inflation results when money increases, but backing doesn't
"the only historical examples of non-inflationary episodes have been accompanied by popular redeemability of the currency. the more articulated the redeemability process, the more the tendency to inflation."
Those have also tended to be periods of bank runs. We have two choices: (1) Issue paper money that is physically inconvertible. The bank's loss of assets over time--reulting mostly from the cost of issuing paper money--will cause inflation, but no bank run. (2) Issue physically convertible paper money. The bank's loss of assets will show up as a bank run.
Published: March 22, 2008 9:47 AM
jp
fundamentalist and newson:
Regarding the Fed compensating its losses with gains, I don't think that happens. This may be a bit long, but I think you'll find it interesting. First of all, let's qualify this by saying that when the Fed loses, for the most part it is still making a gain. But its gain is less than the gain it would have made if it had bought at the market clearing price.
To simplify this argument, let's say that the Fed buys homogenous units of government bonds with a set duration. In reality it buys bills and bonds, 3 month all the way to 30 year, MBS, agency debt, etc and there are all sorts of interest rates for these securities. But let's make it easy on ourselves.
Our homogenous government bonds yield 3%. They trade for $100. The Fed is keeping the federal funds rate at 2%. At 2%, they are paying approx $101 for bonds ie they are overpaying.
The Fed decides to raise the ff rate to 2.5%, government bonds still yielding 3%. How does it do this? It accepts less bonds that are submitted to it for purchase, letting their price drop to $100.50 or so from $101. More dealers return to the ff market, and with that market less slack than before, rates rise. The Fed is still overpaying though. Fundamentalist - note that in this example the Fed is tightening (from 2% to 2.5%) but is still overpaying for bonds. ($100.50 vs 100) In other words the Fed can raise interest rates, doing the opposite of what they're doing now; and lose money on the bonds relative to the market.
Now the Fed decides to raise the ff rate to 3%. It offers to pay 100 for government bonds, ie. it offers the market rate. Primary dealers are indifferent to this price as they can sell in the open market at 100, or they can sell to the Fed. If the Fed offers 100.0001 it can still attract bids and influence the ff rate to fall to 2.99999%, which is close enough.
Now the Fed wants to raise the ff rate to 3.5%, above the bond rate of 3% and $100. It offers to pay $99 for bonds worth $100. This is the situation both of you brought up, the possibility that the Fed might make money on its bonds by paying less than the market, ie. it might make outsized profits relative to what market participants might make. But if the Fed offers $99, the primary dealers will just laugh at them. Why sell for $99 what can be sold for $100 in the market? The Fed will get NO offers, and the ff rate will stay at 3%. This means that the Fed cannot possibly make above market rates on its purchases of bonds. The market will not let them.
How does the Fed force the ff rate up to 3.5%, above the market rate for bonds of 3%? It must start to sell bonds, ie. conduct REVERSE repos. The Fed offers to sell its bonds at $99 and 3.5% while the market price is $100. The primary dealers will jump at this opportunity for free profit, withdrawing money from the ff market to purchase $99 bonds. The ff market is now much tighter and the ff lending rate will rise to 3.5%. But as before, the Fed loses money by transacting at prices below market. The only difference is that now it is selling rather than buying.
So my point is that no matter if the Fed is raising rates or dropping them, no matter if the ff rate is above the market rate or below, and no matter if it is conducting repos or reverse repos, each trade it makes is below the market, ie. it is losing relative to all other market participants.
Another interesting observation is this. To keep the ff rate BELOW the bond rate (or the natural rate, that determined by time preference) the Fed engages in open market purchases, ie repos. When the ff rate is ABOVE the bond rate, it must keep it locked there with open market sales, or reverse repos. As http://mises.org/daily/2676 says, "The Fed has only engaged in 16 reverse repos since late 2000, versus 1247 repurchases". What this means is that not only does the Fed always overpay, but since late 2000 (as far as the data goes) is has consistently kept its market rate below the bond, free market, or natural rate. Interesting, eh?
Published: March 22, 2008 11:09 AM
Don Lloyd
Mike,
"...You get that result by making the certificates convertible into TWO things: silver and dollars. The same thing happened with silver coins after 1964.
If certificates were convertible only into silver, they would buy twice as many dollars. If they were convertible only into dollars, they would buy half as much silver. Even if money is convertible into only one thing, there is a risk of a bank run when the assets backing the money lose value. It is the maintenance of physical convertibility that is the problem--not backing."
But silver certificates (or a bank account that records deposits and withdrawals of silver certificates) are the only independent existing embodiment of dollars. They ARE dollars. If the silver certificates can be easily employed for ANY purpose for which they have a higher value than as money, then the entire category of money has been destroyed.
Regards, Don
Published: March 22, 2008 2:28 PM
Mike Sproul
"But silver certificates (or a bank account that records deposits and withdrawals of silver certificates) are the only independent existing embodiment of dollars. They ARE dollars."
Compare this to what you said earlier:
"If the market price of silver doubles to $20 an ounce, no rational consumer will use a $10 silver certificate to buy $10 worth of goods at retail, but will instead redeem or exchange it for an ounce of silver with a market price of $20."
And of course there's this:
"Let's say we have a $10 silver certificate which can be redeemed for one ounce of silver or used to purchase $10 in goods at retail."
This is quite a tangled web.
Published: March 22, 2008 4:35 PM
Michael A. Clem
If the market price of silver doubles to $20 an ounce, no rational consumer will use a $10 silver certificate to buy $10 worth of goods at retail, but will instead redeem or exchange it for an ounce of silver with a market price of $20.
Don, let's not make this harder than it is. In your example, you say that $10 = 1 ounce of silver. If the value of silver increases, $10 will STILL equal 1 ounce of silver, but that $10 will now buy more goods. If the money is backed by silver, then the value of the money is equal to the value of silver. It's impossible in your scenario for 1 ounce of silver to go up to $20 unless the banks specifically change that ratio. Silver IS the money, and the certificates simply represent a quantity of silver.
I'm not saying that RBD is right, but that's the logic that's been presented.
Published: March 22, 2008 8:05 PM
newson
mike sproul says:
"We have two choices: (1) Issue paper money that is physically inconvertible. The bank's loss of assets over time--resulting mostly from the cost of issuing paper money--will cause inflation, but no bank run. (2) Issue physically convertible paper money. The bank's loss of assets will show up as a bank run."
and here we have total agreement. i'm certainly in favour of #2. #1 has the problem of transforming localized and circumscribed risk (geography, time-frame etc) into long-term systemic risk. periodic bank-runs and collapses make the public very wary of banks, and less likely to entrust their entire capital thereto. the boom-bust cycle is likely to be much shorter under #2, malinvestments purged at more regular intervals. inflation neutralized over the course of the boom-bust cycle.
besides, "bank-run" scenario allows the possibility of 100% reserve banks to arise and thrive even during bank-run episodes.
not all banks collapsed during depressions, and it's likely the survivors would enjoy a competitive advantage in terms of perceived deposit security.
i think the theft issue is a red herring, an entirely insurable contingency. a fraud/theft would have to first consume shareholders equityentirely before insolvency became a possibility. ratings agencies would fill information gaps with respect to these risks.
short of the law requring that banks be 100% reserved, i believe "bank-run" scenario to be much more benign (though politically fraught), than the institutionalized inflation scenario (our lot), with its masked and lagged downside.
Published: March 22, 2008 8:13 PM
Michael A. Clem
To carry the scenario farther, though, may prove interesting. Silver would become more valuable if some more valuable use was found for it. However, silver would become less valuable if a greater quantity of silver was found and mined, and thus, the value of the silver certificates themselves would be devalued. Regardless of how much silver the banks actually hold, it is the total quantity of silver that affects the certificates.
Now, if Mike S. is right, our current currency is backed by debt. Thus, like the silver example, the total quantity of debt affects the value of our money, regardless of the amount of debt that the banks hold. The largest debtholder is the U.S. government, and its debt has greatly increased over the 20th century till now. The more the government borrows, the less the value of our currency. Per RBD. Right, MIke?
Published: March 22, 2008 8:29 PM
newson
to jp:
point taken. this perfectly illustrates what i said to mike sproul, the institutionalized inflation model has a complexity that the old bank-run model didn't. the fraud on depositors is still there, just more opaque.
and yes, the number of repos vs. reverse-repos is less cryptic that the other points, and very revealing. thanks for the leg-work.
Published: March 22, 2008 8:39 PM
Mike Sproul
"short of the law requring that banks be 100% reserved, i believe "bank-run" scenario to be much more benign (though politically fraught), than the institutionalized inflation scenario (our lot), with its masked and lagged downside."
That's a scary thought. Would you at least give people the choice of which kind of bank they get to keep their money in?
"The more the government borrows, the less the value of our currency. Per RBD. Right, MIke?"
Well, yes--as long as we attach a very big "Other things the same" qualifier. The dollar is backed by T-bonds owned by the Fed. If those T-bonds lose value, then the fed's dollars will lose value. And one thing that COULD reduce the value of T-bonds is for the government to go deeper into debt.
Published: March 22, 2008 9:14 PM
fundamentalist
jp, Interesting analysis, and I think you're right to some degree. In order to force money into the economy below the existing market rate, the Feds do have to lose money on its sale of notes/bonds. But the whole purpose of losing money is to pump huge quantities of dollars into the economy. How can you tell whether the inflation that follows is a result of loss of value in the bonds or the quantity of dollars pumped into the economy? In statistics, they call those "confounded effects." They're confounded because they're correlated with each other as well as with the result--rising prices. How is it possible to tell which affect produces the result? Only by means of reason and observation of what actually happens.
No objective, automatic mechanism causes dollars to lose value. Valuation is always and at all times subjective. Dollars don't lose value simply because the Feds buy bonds at a loss. Participants in the marketplace must decide that dollars are worth less. Do business people follow Fed sales and say to each other "The Fed is overpaying for bonds again. Let's raise prices." I don't think so. What happens today is what has always happened since the days when the Spanish brought back boat loads of gold from the Americas. Merchants experience an increase in sales from the new dollars entering their stores and raise prices in order to keep limited inventory from disappearing too quickly and to profit from the increased demand.
But I have to admit that if the RBD means nothing more than that the Feds should always charge market rates for their notes/bonds, I would have to agree completely. The RBD can attribute the rise in prices to the man in the moon and I wouldn't care, because the Feds couldn't pump money into the economy without artificially lowering interest rates, which in your terms means losing money on the transaction. Austrians have always agreed on that. With respect to the Fed, the RBD would be a great improvement on how the bank operates.
But RBD means more than that. It defends fractional reserve banking, which is the second method by which the money supply expands and contracts. This expansion and contraction of the money supply causes booms and busts, destroys vast amounts of wealth, and persuades the people to accept greater state control of their lives and economy. It impoverishes the lower and middle classes at the expense of the wealthy and increases inequality of incomes and wealth.
I have no problem with banks offering loans on collateral or without collateral, but the money loaned should come from the savings of businesses and consumers. In that way, savings regulates how much can be loaned and maitains a fairly constant money supply. But the RBD insists that restricting loans to savings in unecessary. Banks should be able to print paper and loan it out at will. And to some degree, that would be fine if the government didn't force people to accept dollars as payment. In other words, if we returned to a state of free banking where each bank issued its own notes and people were free to accept, reject or discount them, then the RBD might work just fine.
But you know, we've been there and done that. for most of the 19th century we did that. The result was regular booms and busts, business cycles, every ten years on average with all of the evil results I described above. In the end, the people begged for protection from banks and the government gave us the super bank. So proponents of the RBD are doing nothing but asking us to repeat the 19th century because it was so much fun.
Published: March 22, 2008 9:26 PM
newson
to mike sproul:
mandatory 100% reserve banking is defensible even from a libertarian perspective along rothbardian lines (frb is inherently fraudulent etc.).
bank-runs are scary, yes, but in comparison to what? i don't think we can yet judge how the secular inflationary trend post-1930's is to play out. my thoughts are that in the next few years we are going to pay for the structural weaknesses and the accumulated misallocation of resources dating back to the 1930's, and then some.
maybe in few years time, facing massive economic disorder and hyperinflation, we'll be more kindly disposed towards bank-runs.
Published: March 22, 2008 9:44 PM
newson
to fundamentalist:
i'm not sure that the nineteenth century is that bad, when you compare it to the twentienth. sure, the road was rocky, but the foundation for economic success was sound, and the inflation cycle's duration was less (so less damaging).
last century we swapped the periodic, small runs for what will be the twenty-first century international monetary collapse.
i gather you, too, are a supporter of 100% reserve banks?
Published: March 22, 2008 10:36 PM
Don Lloyd
Mike S,
"This is quite a tangled web."
All of the statements that you quoted are still valid for the different contexts under which they appeared. It's not worth untangling this web now.
Regards, Don
Published: March 22, 2008 10:38 PM
Don Lloyd
Michael A. Clem,
"Don, let's not make this harder than it is. In your example, you say that $10 = 1 ounce of silver. If the value of silver increases, $10 will STILL equal 1 ounce of silver, but that $10 will now buy more goods. If the money is backed by silver, then the value of the money is equal to the value of silver. It's impossible in your scenario for 1 ounce of silver to go up to $20 unless the banks specifically change that ratio. Silver IS the money, and the certificates simply represent a quantity of silver."
No, money is the medium of exchange. It is the certificates that have a number of dollars embossed on them. The retail goods are priced in dollars, and only dollars are accepted for them. Silver COULD be money, but only if a dollar is a measure of weight for silver.
Money has value if and only if people and stores almost universally accept it in exchange for goods and services.
If you are about to hand a cashier a piece of paper embossed with '$10' for bread and candy and another customer comes along and offers you silver with a market price of $9, this new backing of the paper money increases its value not one iota.
Regards, Don
Published: March 22, 2008 11:00 PM
Michael A. Clem
Silver COULD be money, but only if a dollar is a measure of weight for silver.
In your example, you specifically said that a $10 certificate is equal to an ounce of silver. Now, even though you said that stores wouldn't take silver for some reason, just the silver certificates, you still have a situation of 100% silver backing. Thus a $10 silver certificate is always going to equal an ounce of silver, no matter how the value of silver changes. A $10 silver certificate is always going to buy more than $9 worth of silver, because $9 worth of silver is simply 9/10 of an ounce of silver. This relationship can only change if the banks (or government) specifically state that a $10 silver certificate is no longer equal to an ounce of silver, because this ratio is arbitrarily chosen.
If people are willing to exchange silver certificates, then they are de facto exchanging silver, since that's what the certificates represent, even if they prefer the certificates over the actual silver.
Obviously, the dynamics change if you don't have 100% silver backing of the certificates, but that's a different scenario.
Published: March 22, 2008 11:45 PM
Michael A. Clem
Or, for example, look at the current price of gold. It's over $1000 per ounce. If the dollar were still backed by gold, then the value of the dollar would be tied to the value of gold. The "value" of gold would always be equal to the dollar ratio that had been established ($32/ounce wasn't it?), even if the value of gold increased in relation to other goods. Under such a gold standard, it would have been impossible for gold to reach $1000/ounce, no matter how much the value of gold increased, because the currency would be pegged to the gold. Gold can only increase to $1000/ounce because our currency is not backed by or pegged to gold, thus allowing us to value gold with a monetary price, instead of by how much goods gold can buy.
Published: March 22, 2008 11:58 PM
Don Lloyd
Michael A. Clem,
"In your example, you specifically said that a $10 certificate is equal to an ounce of silver. Now, even though you said that stores wouldn't take silver for some reason, just the silver certificates, you still have a situation of 100% silver backing...."
No, I said 'Assume to start that the market price of silver is $10 an ounce.'
"...Thus a $10 silver certificate is always going to equal an ounce of silver, no matter how the value of silver changes. A $10 silver certificate is always going to buy more than $9 worth of silver, because $9 worth of silver is simply 9/10 of an ounce of silver. This relationship can only change if the banks (or government) specifically state that a $10 silver certificate is no longer equal to an ounce of silver, because this ratio is arbitrarily chosen...."
No, a $10 silver certificate will always yield a pre-determined weight of silver, assuming the redemption promise is still in effect. This may be less or greater than $10, where dollars are the monetary unit of account. It will always (?) buy goods and services whose prices sum to $10.
If the market value of the goods and services whose prices sum to $10 exceed the market price of the silver backing, then we still have money, a medium of exchange. If not, the silver and its certificate is worth more than $10 and it is no longer money because it is not now a medium of exchange. And if the certificates are the only money, money no longer exists.
If the market price of silver is $20 for the certificate weight, nobody will give you 2 $10 certificates because it would be like giving you 2 ounces of silver for 1, and if they did, you would end up with the original problem, only twice as bad, having certificates too valuable to serve as a medium of exchange.
Regards, Don
Published: March 23, 2008 12:25 AM
newson
to mike sproul:
here's a snippet that jp highlighted in another mises blog-post. alan greenspan in a speech to the university of leuven, belgium:
"That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the one we have today, can produce such claims without limit. To be sure, if a central bank produces too many, inflation will inexorably rise as will interest rates, and economic activity will inevitably be constrained by the misallocation of resources induced by inflation."
perhaps it was just a lapsus, or perhaps the whole fiat-money/unconvertible money polemic is just semantics, as i'd thought?
in fact, it's an amazingly frank admission from one whose style was deliberately gobbledegook.
Published: March 23, 2008 7:34 AM
newson
here's the link for the above-cited, january 1997 greenspan speech:
http://www.federalreserve.gov/Boarddocs/Speeches/1997/19970114.htm
Published: March 23, 2008 7:48 AM
newson
to jp:
regarding the constant erosion of fed assets in its open market operations, there are some things fathom with what you're saying. take a look at this, for example:
"In going back to 1946 the market has lead the Fed at every major turn in interest rates. Yes, the market leads and the Fed follows. The latest example of this occurred during the 2000 to 2004 timeframe. In November 2000 the 3-month T-Bill was at 6.22% and the Discount Rate was sitting at 7.50%. By January 2001 the T-Bill rate had fallen to 5.70%, which widened the spread between the Discount Rate and the T-Bill rate from 1.28% to 1.80%. It was at that time that the Fed began cutting the Discount Rate and they continued cutting the Discount Rate as they followed the rates lower as was being set by the market. The 3-month T-Bill rate finally hit bottom in June 2003 at .82%."
this is the link for a more extensive treatment -
http://financialsense.com/Market/wood/2007/0907.html
why does it follow that the fed loses on its on-market activity? i mean it's trailing the market, not leading. also, from a cursory glance at the fed's site, they impose a "haircut" on those using the repo facility.
Published: March 23, 2008 8:33 AM
newson
to jp:
it should read as - "...some things i can't fathom with what you're saying..."
Published: March 23, 2008 8:41 AM
Mike Sproul
"How can you tell whether the inflation that follows is a result of loss of value in the bonds or the quantity of dollars pumped into the economy?"
This question has been examined by Thomas Cunningham, Bruce Smith, Bomberger and Makinen, and a few others, all of whom are cited in my paper "There's No Such Thing as Fiat Money", at www.csun.edu/~hceco008/realbills.htm. Cunningham, for example, concludes that his results provide "clear support for the real bills doctrine".
"But RBD means more than that. It defends fractional reserve banking, which is the second method by which the money supply expands and contracts. This expansion and contraction of the money supply causes booms and busts,"
If I pay for my groceries with my own paper IOU, and if the grocer uses that IOU to buy supplies, and if that IOU circulates a while before I finally pay it, then that IOU is money, backed by fractional reserves. Exactly what about that process should be illegal? One of the biggest complaints of the nineteenth century was that the currency was "inelastic"--that it failed to grow and shrink with the needs of business. That's why the Fed's first duty, as stated in its charter, is to provide an elastic currency. The quantity theory held sway in the nineteenth century, just as now, and quantity theorists always favored "tight money". When they prevailed, the money supply was restricted and recessions followed. If fractional reserve banking is allowed to work, the money supply can grow and shrink to ACCOMMODATE booms and bust, without causing them.
"mandatory 100% reserve banking is defensible even from a libertarian perspective along rothbardian lines"
I repeat my question about my circulating IOU.
"A fiat money system, like the one we have today,"
No argument there. Alan Greenspan, like virtually every other reputable economist on earth, is a quantity theorist who believes that there is such a thing as fiat money. A few hundred years ago, those same people would have sworn the sun orbits the earth.
Published: March 23, 2008 10:27 AM
jp
Fundamentalist: "But the whole purpose of losing money is to pump huge quantities of dollars into the economy."
On the flip side, don't forget that, assuming my hypothesis about the Fed is right, the Fed also has to lose money to withdraw quantities of dollars from the economy. To withdraw it must offer to sell its bonds above the market rate. The primary dealers see this, divert funds from the fed funds market, and buy the bonds. Money supply goes down. The Fed loses money. So the whole purpose of losing money is to pump AND withdraw dollars from the economy.
As I see it this is one of the major differences between Mike's backing theory and traditional quantity theory, as applied to today's Fed. Under Mike's backing theory, the Fed loses money even when it contracts the money supply since it is mispricing its assets sales. With less backing, the purchasing power of the dollar declines even as money supply is shrinking.
Quantity theory would see a shrinking money supply and conclude that the purchasing power of the dollar is actually rising. With less notes out there, they have more value.
"No objective, automatic mechanism causes dollars to lose value. Valuation is always and at all times subjective. Participants in the marketplace must decide that dollars are worth less. Do business people follow Fed sales and say to each other "The Fed is overpaying for bonds again. Let's raise prices." I don't think so."
I agree. This sort of analysis should proceed using marginal utility, just as Mises set out to do. Mind you, some participants in today's market place may indeed follow esoteric Fed data, I'm thinking speculators. But you're right, the average person on the street doesn't.
Substituting commercial banks for the Fed in your point, I think its more likely that anyone who has deposited large chunks of their cash at a certain bank will pay close attention to what that bank is purchasing with their money. If the bank is lending too much out for excessively risky assets (ie. relaxing lending standards or setting lower interest rate than the market) depositors will get antsy and worry.... are our dollars still at the bank? and... if the bank sells its assets, will their be enough to cover our deposits?
This will be more common in a world without depository insurance, not our present world. Some will go back to the bank and withdraw their money, redepositing it in a safer bank. If for some reason convertability/redeemability is suspended by the bank, rather than withdrawing customers will spend their chequing account money as quick as possible, forcing the price of the issuing bank's money down to the presumed level of its backing.
But I am still confused on this topic. Both the backing theory and quantity theory have so much intuitive appeal that I feel they both have to be right in some way. Even Mike accepts the quantity theory holds for commodity money. Why would it suddenly disappear as an explaining factor?
"...the money loaned should come from the savings of businesses and consumers. In that way, savings regulates how much can be loaned and maitains a fairly constant money supply. But the RBD insists that restricting loans to savings in unecessary."
What about collateral? If the bank lends me money to buy a car, they'll ask for the car as collateral. That car is already in existence, GM made it and the bank will not lend to me if I don't have good collateral. In that respect, the amount of money the bank lends is regulated by the amount and subjective value of collateralizable assets in existence.
Published: March 23, 2008 2:47 PM
jp
Newson:
Your 2000-2001 example is a good point. Let me summarize to make sure we're on the same page. If the Fed was keeping the federal funds rate (not the discount rate, that's a different thing) at 6.5% in 2000 (not 7.5% as per the article), significantly above the t-bill rate of 6.22% (indeed, it fell as low as 5.3%), then it would have been buying those t-bills at a discount to the market, after all buying at a higher yield implies a lower price. That means that in 2000-2001 the Fed should have been making profits in excess of what it would have made had it bought at market prices. Furthermore, the Fed was not keeping the ff rate above the t-bill rate via open market sales since the Fed has hardly engaged in any of these since 2000. Therefore, the Fed had to have been keeping the ff rate above the t-bill rate using open market purchases and presumably making money. End summary.
In my earlier example I simplified the analysis into a comparison of the ff rate to the rate on homogenous government bonds. The reality is that the Fed buys all sorts of securities with differing maturities and from different issuers. Unpack these and the picture broadens.
In your example t-bills were trading at yields below the ff rate. Given this criteria, when the Fed announces an open market operation, no primary dealer would willingly offer to sell t-bills as it would result in a loss to them. But there might be other bonds like the 5, 10, 20 or 30 year bonds that are still trading above the Fed funds rate, even though the 3 month isn't (long term yields are often slower to react than near term ones). The primary dealers can thus keep their 3 month bills and sell these longer maturity assets instead to the Fed, continuing to earn outsized profits at the Fed's behest.
In other words, dealers will substitute some assets for others depending on what relative interest rates are. The Fed rate may indeed be trailing market rates down, but there will often be some bond classes that are still above the ff rate.
In 2001, the ff rate was actually set above all maturities of government bonds, 3 month all the way to 30 year. But the Fed also buys agency-guaranteed MBS. This is a new power and was only allowed in 1999 (see http://mises.org/daily/2676 for the story). Back in 2000-2001, the average Fannie Mae issued MBS was yielding around 7.5%. With the ff rate at 6.5%, the only assets the primary dealers could profitably sell to the Fed would have been MBS. By overpaying for MBS, the Fed lured primary dealers away from borrowing in the ff market to buying from it, thereby keeping the ff market tight and at the 6.5% target.
What do the numbers show? There was a big jump in MBS as a % of total open market ops, from 0% in 1999 to 20% in 2000, confirming the possibility that these operations were relatively more popular. Even though MBS sales to the Fed grew, there were still transactions in government bonds too. These would have been losing propositions for the primary dealers, and gains for the Fed. I have no idea why the dealers would have taken these trades and that does weaken my case. There could be some form of moral suasion by the Fed on primary dealers to take losing trades, but I have no evidence for this. It is also difficult to properly analyze Fed open market ops as the maturities of bonds bought and sold are not included, nor does the data series go back beyond 2000.
As for haircuts, the Fed does claim to apply them to open market ops, but I don't think they make the actual rates public. The way I see it the haircut the Fed applies cannot bring the purchase price of bonds lower than the market rate for those bonds. If the haircut was onerous, the primary dealer would simply sell those same bonds in the market where haircuts are not applied, then transfer the cash into their reserves to meet requirements.
In the end, if the Fed doesn't dangle some sort of carrot in front of the primary dealers, then it will lose the ability to control the fed funds rate. While it might be able to earn abnormal profits for a few months, at some point it'll lose its ability to do so. I can't see its abnormal profits ever outweighing its losses. While the 2000-2001 period does show evidence of some Fed profits amongst MBS losses, from 2002-2006 the ff rate was WAY below almost every market rate, resulting in what must have been pretty big losses.
Published: March 23, 2008 4:42 PM
newson
to jp:
i've got to sit down and have a good think about the main body of your comments, but one reflexive comment on this:
"What about collateral? If the bank lends me money to buy a car, they'll ask for the car as collateral. That car is already in existence, GM made it and the bank will not lend to me if I don't have good collateral. In that respect, the amount of money the bank lends is regulated by the amount and subjective value of collateralizable assets in existence."
i've got a credit card with a pretty amazing limit with one partcular financial institution with whom i've got no offsetting credits, nor have i presented financials for years. i'm sure there are lots in the same situation. the unsecured loan market is pretty large, and secured only by the creditor's desire to avoid the stigma/costs of bankruptcy. is reputation part of your collateralizable assets?
Published: March 23, 2008 6:33 PM
newson
"...debtor's desire to avoid the stigma/costs of bankruptcy."
low caffeine alert.
Published: March 23, 2008 7:13 PM
Mike Sproul
"Both the backing theory and quantity theory have so much intuitive appeal that I feel they both have to be right in some way. Even Mike accepts the quantity theory holds for commodity money. Why would it suddenly disappear as an explaining factor?"
Because the laws of supply and demand, which apply perfectly well to commodities, don't do so well when applied to pieces of paper that are claims to those commodities. The last piece of the puzzle, to my mind, has to do with the fact that the RBD places a maximum value on the value of money, but no minimum value (see my "No Fiat Money" paper) This means that the fed can maintain financial convertibility at a rate below what its assets can support, and it can do so by printing too much money--which makes it look a lot like what the quantity theory says.
Published: March 23, 2008 9:14 PM
Michael A. Clem
Because the laws of supply and demand, which apply perfectly well to commodities, don't do so well when applied to pieces of paper that are claims to those commodities...This means that the fed can maintain financial convertibility at a rate below what its assets can support, and it can do so by printing too much money--which makes it look a lot like what the quantity theory says.
Not making sense. Why wouldn't supply and demand apply to claims on those commodities? Or rather, since supply and demand apply to the commodities, why wouldn't the claims be treated the same as the commodities that they represent?
And how can they print too much money, as long as they're being backed by assets? Only if they engage in fractional reserve banking or some other fraudulent means, as far as I can see, but never with 100% backing.
Published: March 23, 2008 10:06 PM
Michael A. Clem
No, I said 'Assume to start that the market price of silver is $10 an ounce.'
No, a $10 silver certificate will always yield a pre-determined weight of silver, assuming the redemption promise is still in effect. This may be less or greater than $10, where dollars are the monetary unit of account. It will always (?) buy goods and services whose prices sum to $10.
Okay, I'm really not understanding you, Don. The only way that the monetary price of silver can vary is if it is not the backing asset of the currency, i.e., you are NOT using silver certificates, and banks are not holding silver. If you are using silver certificates, the certificates are necessarily defined as a certain weight of silver, and thus vary in lockstep with the value of silver.
I suppose there could be two different currencies on the market, silver certificates and something else. Then silver could have a monetary value that varies in the non-silver certificate currency. But that's a much more complicated scenario, and I didn't get the impression that you were setting it up that way.
Published: March 23, 2008 10:14 PM
Don Lloyd
Mike S,
DL: No, I said 'Assume to start that the market price of silver is $10 an ounce.'
No, a $10 silver certificate will always yield a pre-determined weight of silver, assuming the redemption promise is still in effect. This may be less or greater than $10, where dollars are the monetary unit of account. It will always (?) buy goods and services whose prices sum to $10.
MS: Okay, I'm really not understanding you, Don. The only way that the monetary price of silver can vary is if it is not the backing asset of the currency, i.e., you are NOT using silver certificates, and banks are not holding silver. If you are using silver certificates, the certificates are necessarily defined as a certain weight of silver, and thus vary in lockstep with the value of silver.
I suppose there could be two different currencies on the market, silver certificates and something else. Then silver could have a monetary value that varies in the non-silver certificate currency. But that's a much more complicated scenario, and I didn't get the impression that you were setting it up that way.
A silver certificate has two properties which are only sometimes coincidently in alignment.
First it is a claim which can be redeemed for a specified weight of the commodity silver.
Secondly, it is embossed with a given amount of dollars, which determines how valuable it is as money, a medium of exchange, universally accepted.
At any particular point in time, the certificate will be more valuable used as money, or the reverse. It can't be both at once unless they happen to be equal in value.
At present, if I pull a $10 bill out of my wallet, I can buy a total of $10 of priced goods and services with it, including silver at its market price.
However, it is not a claim to any particular weight of silver. If it were, the specified weight of silver claimable might be very large, or very small. If the claimable weight of silver is sufficiently large, the highest value use of the $10 bill will be as a silver claim. If the claimable weight of silver is sufficiently small, then the highest value use of the $10 bill will be as a medium of exchange, money.
The exact same mechanism is true of actual silver coins as well. A few years ago Canadian 1 oz Silver Mapleleaf coins, marked with a face value of $5 CDN had less than $5 CDN worth of silver content. At that time, they were actual Canadian money, and $5 CDN served as a price floor no matter how low the market price of silver might go. As the market price of silver rose above $5 CDN (ignoring dealer markups) the coins tracked the price of silver due to their increased melt value, and no rational holder of a coin would spend it like it was just worth $5 CDN as money.
Regards, Don
Published: March 23, 2008 11:11 PM
Don Lloyd
Sorry, wrong Mike.
Regards, Don
Published: March 23, 2008 11:14 PM
newson
to jp:
ok, tim wood has used the discount rate by way of example, but as he says, the same applies for ffr. for week ending november 24, 2000 the ffr was 6.5%, the 3mth bills were trading @ 6.18%. come week ending jan 26, 2001 ffr is 6% and bills trade @ %5.1. now fast forward to the lowest point for yields in this cycle - june 2003, ffr stands @ 1.25%, but the 3month bills are yielding between 20-40 basis points lower. so the fed has been out of the market over this whole cycle, as far as this part of the yield curve is concerned. now this i find confusing, as i had always believed that the fed's interventions were mainly at the short end of the yield curve. and yet over this period, to deal with the fed would have been a losing proposition. any transactions with the fed would have strengthened the feds balance sheet at the time of the operation. or am i going crazy?
p.s. i don't know where tim wood gets his figure of 5.7% for 3month bills in january 2001. all the figures i quoted are from the ny fed's site.
Published: March 24, 2008 12:10 AM
newson
to mike sproul:
one final thing before i dig into your paper, are you a supporter or an opposer of central banking, or does it vary from case to case, according to the reserve bank's track record? thanks for an interesting blog.
Published: March 24, 2008 5:41 AM
Mike Sproul
Newson:
I don't think the central bank should have a monopoly on the issue of paper money, and given free banking, I don't think the central bank serves any purpose that couldn't be handled by the private sector. Standardizing the look of paper money comes to mind as an advantage of central banks, but I doubt that private banks would have much trouble with that. Given the ubiquity of central banking, I can't quite rule out the possibility that they serve some unknown useful purpose, so I don't favor abolition, but if private banking were freed of constraints, I'd expect that people would soon have no use for a central bank.
Published: March 24, 2008 10:18 AM
Mike Sproul
Michael Clem:
I wasn't making sense to jp awhile back either, so I re-posted my reply to him about supply and demand.
jp:
"So when you say s & d doesn't apply, do you mean that it is a different sort of s & d than that for goods? Or does it flat out not exist? Or simply that other forces counteract s & d? You've got me stumped."
For example, suppose that the assets of some corporation, call it GM, consist of nothing but a $60 million bank account, and its only liabilities are 1 million shares of GM stock. Assuming everyone knows this, GM stock will sell for $60. If GM sold for $61, then demand for it would fall to zero, while GM would eagerly offer infinite quantities of newly-issued stock for sale. Conversely, if GM stock sold for $59, demand for shares would be infinite. Meanwhile, GM would offer no new shares, and even repurchase its old shares. Supply would drop to zero. The upshot is that both demand and supply of GM stock are horizontal lines at the price of $60. In this case it is meaningless to say that the price of GM stock is determined by supply and demand. It would be more correct to say that supply and demand are determined by backing, but there is no reason to even mention supply and demand. It is enough to say that the value of GM stock is determined by its backing, period.
Next, let's allow for some uncertainty about how much money GM has in the bank. In that case, differences of opinion among investors could lead some to think GM was worth $70, while others would think it's worth $50. You have the makings of a downward-sloping demand curve, in direct proportion to the ignorance of investors. Similarly, uncertainty on the part of the corporation can lead to an upward-sloping supply curve of GM stock. Thus it becomes somewhat meaningful to speak of supply and demand for a stock.
But now go back to the microeconomics books. I have never seen a microeconomics text that applied the notion of demand and supply to anything but actual goods. (Macro books are another matter!) They correctly start with the laws of consumer preference and the fact of scarcity, and then they derive demand and supply curves for GOODS--not pieces of paper that are claims to those goods.
We all know that stock traders speak of supply and demand for stocks, and those words do mean something. But we should make up some new words to distinguish supply and demand of actual goods from supply and demand of pieces of paper and computer blips.
"And how can they print too much money, as long as they're being backed by assets? Only if they engage in fractional reserve banking or some other fraudulent means, as far as I can see, but never with 100% backing."
Once the bank has peoples' deposits of silver, it can lower its rate of physical convertibility from (say ) 1 oz/$ to .5 oz./$. It would be robbing its customers, but say the bank does it anyway. Now suppose the bank suspends physical convertibility, but uses financial convertibility to maintain the dollar at 1 oz/$. Then one day the bank decides to reduce the rate of financial convertibility to .5 oz./$. This is the same kind of robbery, and the bank accomplishes it simply by failing to use its bonds to buy back dollars it has issued--until the dollar falls to .5 oz/$. Further explanation is in my "No Fiat Money" paper.
Published: March 24, 2008 10:43 AM
Nima
Mike:
"Well, the fed could buy all the world's farmland, but the land would probably still be there, still being farmed, so the fed could buy all the farmland without affecting its value. But this is beside the point of what happens to the value of the dollar when the fed issues more dollars for miscellaneous assets that it does not actually consume."
Please just stick to my specific qustion: How can you think that an additional demand for something, ceteris paribus, will not result in an increase in prices. If the fed buys assets it exercises an upward pressure on those assets' prices. It is simple economics 101. On another note: the federal reserve does ultimately consume the assets. It earns a profit via the interest payments on the assets. The profits are disbursed to its shareholders and used for consumption on the open market.
"I could buy 10,000 loaves. I could buy a car or a house. If the treasury issued them in small denominations, then I could buy single loaves. The point is that when I exchange my T-bill for paper dollars from the fed, my purchasing power is substantially unchanged, so there is no upward pressure on prices."
Same here, my simple question again: It seems like you agreed that you cannot purchase a loaf of bread with a treasury bill? Yes or No? But for your own arguments sake I will address your car example: It is wrong. Plain and simple. Your car dealer is not going to accept treasury bills as means of payment. If you believe otherwise, feel free to prove it.
I have written a post as to what is and what is not to be included in the money supply http://nimamahdjour.blogspot.com/2008/03/money-supply-watch.html
I have not read all of your posts regarding free banking, but I do agree that a fractional reserve system could be maintaned with very little inflation and price changes. But this is not contingent upon the money supply rising in step with the banks assets. It is contingent upon the money supply rising in step with its demand. And it is completely out of the question in an unfree, compulsory legal tender money system.
Published: April 8, 2008 12:17 PM
watchelephan
with my become in the adventures. then. raspberries, other things is still caught it A huge the wild
Published: June 19, 2008 9:42 PM