Comments (75)

• Or it will print the difference!!!

  Guess which avenue the Fed will take? There is no other way out. Do you think Hillarobamamccain will sit there and take on hundreds of billions of deficit or have to raise taxes to bail out the Fed? Funny how the bail out hot potato keeps getting closer and closer to tax payers?

  Neither the Fed, nor the banks, nor the investment banks, nor the big 8 accounting firms, nor the SEC, nor Freddie Mae, nor Freddie Mac, nor Congress, nor anybody else knows the true value of these mortgage backed securities.

  I personally think it is sick that the banking RESERVE now stores reserves in derivatives.

  Special thanks to Wilson, FDR, Nixon, Carter, Reagan, Bush, Clinton and Bush for this fine mess.

  Published: April 4, 2008 8:31 AM

• Mike Sproul

  ""None of this would have happened had the politicians left money and banking to the private sector."

  Austrians are one of the few groups that recognize this simple truth. Now if only they'd recognize that there's no such thing as fiat money, that banks are not equivalent to counterfeiters, and that all money is backed by the assets of its issuer.

  Published: April 4, 2008 8:39 AM

• Yancey Ward

  Robert Murphy,

  I am no banking expert, but is it a reasonable interprettion that the net fall in reserves, despite the Fed's actions, is simply reflecting the stupendous losses banks are suffering now?

  Published: April 4, 2008 8:56 AM

• fundamentalist

  I'm thinking along Yancey's line: is the Fed reducing reserves, or allowing them to decline, and the decline is caused by defaults on loans?

  Published: April 4, 2008 9:38 AM

• Alton Parker

  We have no money, it's all ledger entrys!

  Published: April 4, 2008 9:53 AM

• Bradford Young

  If demand for loans is declining, then perhaps we are not in a liquidity crunch. Perhaps we are in a deleveraging period. Wouldn't it be expected that price of the commodity would decline as it sought an equilibrium point? Perhaps the Fed just lowers its Target rate to reflect the market rate?

  Our liquidity crunch is not necessarily a lack of loanable funds but a lack of counterparties for tradeable securities. In an over-the-counter market, there is no bid if the counter-party won't answer his phone. Perhaps the mark-to-market accounting, which would use the most recent trading data, contributes to the unwillingness to trade. Sellers only go to the market to demand liquidity under the most dire situation, which buyers exploit to get assets at a terrific price. Each "under some duress" trade gets printed and goes into the appraisal process that underlies the mark to market accounting for these lightly traded securities.

  Does that make sense?
  

  Published: April 4, 2008 10:08 AM

• billwald

  Money has been ledger entries at least since the Crusades. Cooking the books should be a hanging offense. Even the Mafia needs honest book keeping.

  Published: April 4, 2008 11:44 AM

• eric lansing

  yay! Sproul is back... someone argue with him, please...

  Published: April 4, 2008 12:06 PM

• mikey

  Robert Murpy writes:

  
  "In that case, the Fed will either have to eat large losses and pass them along to the taxpayers, or it will print up the difference"

  
  Would this newly printed money be infationary? It seems as if we would have the same amount of fiduciary media, but in a different form.

  Published: April 4, 2008 12:52 PM

• Mike Sproul

  mikey:

  "Would this newly printed money be infationary? It seems as if we would have the same amount of fiduciary media, but in a different form."

  The Fed's loss of assets would mean less backing per dollar, so that alone would be inflationary. If the Fed then printed another billion paper dollars, it would use them to buy a billion dollars worth of bonds, so backing would rise in step with the quantity of money and there would be no inflation.

  Published: April 4, 2008 2:38 PM

• Peter

  Would this newly printed money be infationary? It seems as if we would have the same amount of fiduciary media, but in a different form.

  In the instant, yes; but what would happen to those newly printed bills? They'd quickly find their way into bank deposits...fractional reserve bank deposits, that become the reserves behind even more loans; every newly printed dollar will become ten or twenty or thirty dollars. Hell yes, it'd be inflationary!

  Published: April 4, 2008 4:30 PM

• Michael A. Clem

  Now if only they'd recognize that there's no such thing as fiat money, that banks are not equivalent to counterfeiters, and that all money is backed by the assets of its issuer.
  
  I'm working on my arguments, Eric! ;-) In the meantime, I'd say that it's not impossible to have fiat money, although I'm not prepared to convincingly say whether or not the U.S. dollar as it exists now is fiat currency or not.
  
  Essentially working from the model of a 100% gold standard and extrapolating out, the issue of redeemability seems very important to the value of the currency. If a currency is redeemable in the backing asset of the issuer, then the value of the currency is necessarily equal to the value of that asset.
  
  However, if a currency is not redeemable, then the value of the currency has no relation to the value of the asset, and fluctuates merely on people's subjective valuation of the money, i.e. the supply and demand of the money itself. In such cases, the asset serves only as a limiting factor in the issuance of new currency, and we essentially have a fiat money situation.
  
  Note that this means we could have a fiat money, even if gold is the asset, if the money is not redeemable in gold.
  

  Published: April 4, 2008 8:19 PM

• quincunx

  "If the Fed then printed another billion paper dollars, it would use them to buy a billion dollars worth of bonds, so backing would rise in step with the quantity of money and there would be no inflation."

  So what you are saying is that if the FED continued doing what it has been doing since 1933, swapping bonds for cash, there would be no inflation?

  Well, I hate to break it to you but there has been inflation in the last 75 years.

  The FED doing ONLY as you say would mean that treasury debt == cash. We would still have a debt-as-money system. A government deficit would cause inflation.

  Published: April 4, 2008 9:21 PM

• Bruce Koerber

  As I began to grasp from reading a recent article by Gary North, we are in a deflationary period. Just like the paradox of high unemployment and inflation (referred to as stagflation) we are entering a time of inflation of the money supply and deflation!

  This whirlpool event pulls everything into itself and it is easy to see how destructive a depression of the magnitude of the 30's (or even greater) can be. The temptation is to try to fix it by intervention which only intensifies and prolongs the destruction.

  The correct policy is non-intervention which is like getting oneself out of the water before the currents builld so much momentum. Then the equilibrium forces that allow resources to become freed up disrupt the vortex thoughout its structure, dissipating the energy, lessening the swirl velocity, breaking into smaller eddies, and making the economy safe for entrepreneurs to re-enter, set their sails, and forge a new direction. That new direction is non-interventionism!

  Published: April 4, 2008 9:43 PM

• Michael A. Clem

  The Fed's loss of assets would mean less backing per dollar, so that alone would be inflationary. If the Fed then printed another billion paper dollars, it would use them to buy a billion dollars worth of bonds, so backing would rise in step with the quantity of money and there would be no inflation.
  
  You mean that there would be no monetary inflation. But the value of the dollars (assuming redeemabillity) would be based upon the value of those bonds, or rather the value of all dollars would be based upon a ratio of the value of those bonds compared to the value of other assets that the previous currency was based upon. If those bonds decrease in value, then the dollar decreases in value, too.

  Published: April 4, 2008 10:12 PM

• Matt

  "As the Fed itself has discovered, the conventional tools aren't working the way the textbooks say they should."

  The conventional tools of course worked many times in the past. A recession was in the works, interest rates were lowered, more debt was created, the banks were happy and the taxpayer footed the bills, more inflation of goods and services were the results.

  Now things look like they are different, why? For the first time the banks don't trust each other anymore
  they know what they pulled off in the past was dishonest but at taxpayers expense. The debt problems now are so great that they just can't simply be borne by the taxpayer alone. The thieves don't trust each other anymore...What a revolting situation. Hyperinflation here we come.

  Published: April 4, 2008 11:41 PM

• Mike Sproul

  "If a currency is redeemable in the backing asset of the issuer, then the value of the currency is necessarily equal to the value of that asset.

  However, if a currency is not redeemable, then the value of the currency has no relation to the value of the asset, and fluctuates merely on people's subjective valuation of the money, i.e. the supply and demand of the money itself."

  Convertibility can be instant or delayed, certain or uncertain, physical or financial. The fact that the fed will not buy back its dollars with 1/35 oz of gold is irrelevant as long as it will buy back its dollars with bonds or other assets that are worth 1/35 oz. If there is such a thing as fiat money, there should have been some bank somewhere that issued money and held no assets, but there have never been such banks. And when money-issuing banks lost all their assets, their money lost all value, just as the real bills doctrine predicts.
  Furthermore, if the peso is fiat money, then the Mexican government can print a peso, buy a lunch with it, and never have to answer for that peso. In other words, it can get a free lunch. This free lunch would attract other banks to issue rival moneys in Mexico in order to get a share of that free lunch. But as that happens, the demand for the peso would fall, and would keep falling as long as there is any free lunch to be had--that is, as long as the peso has any value at all.

  "So what you are saying is that if the FED continued doing what it has been doing since 1933, swapping bonds for cash, there would be no inflation?"

  Inflation can happen if the Fed's issue of money outruns its assets, or if its assets lose value, or if it reduces the rate at which it maintains (physical or financial) convertibility.

  "If those bonds decrease in value, then the dollar decreases in value, too. "
  Agreed. The value of the Fed's money equals the value of the assets backing that money.
  

  Published: April 5, 2008 1:30 AM

• Guess where the money went?

  My guess :It went to profits for foreign investment banks. This is similar to what happend in Japan 15 years ago.

  Currency speculators, who assume a giant risk of currency valuations going against them, loan money from the US at an artificialy low rate. They then make short term loans to German, Arabic, Chinese, Indian, etc governments at slightly higher rates.

  This is a great scheme as long as the US and the other governments group together in a Pro-Keynes race to lowest currency value.

  It also makes sence with the comment that the Fed could make the rate zero and pump forever. What was the lowest rate in Japan? What about during the Saint Greenspan Fed?

  Published: April 5, 2008 9:48 AM

• fundamentalist

  Mike: "If the Fed then printed another billion paper dollars, it would use them to buy a billion dollars worth of bonds, so backing would rise in step with the quantity of money and there would be no inflation."

  Not if the bonds it purchased were mortgage-backed that were totally worthless. That would be true even under RBD.

  But the RBD, or the Banking School, as Mises called it and fought against it from the time he was a young scholar, confuses cause and effect. The Fed deliberately lowers the value of bonds backing dollars by inflating the money supply. That's how it lowers interest rates. But the Banking school thinks price inflation results from the lower bond values. It doesn't. It results from the greater money supply. The lower bond values result from the increased money supply. The RBD/Banking School gets this wrong because its dogma was established about 400 years ago and its class members refuse to read any economics that has come out since then.

  Published: April 5, 2008 10:34 AM

• fusgerm

  Sproul contends that the Fed's banknotes are backed by the Fed's assets, and that the fiduciary media issued by the private banks are backed by the assets of those banks.

  If those assets were gold (or perhaps some other form of commodity-money) then no Austrian economist would object.

  But, in fact, the Fed's assets are mainly US bonds, and a private bank's backing for its fiduciary media consists mainly of secured loans owed to the bank by its customers.

  To Sproul, it does not matter that the money is backed by debt, even if banknotes are convertible to (say) a fixed weight of gold, PROVIDED that the gold-value of the debt is maintained.

  But that proviso simply cannot be satisfied. One of the requirements of money is scarcity. Debt is not scarce. It can be created on demand, in potentially unlimited quantities. It is therefore totally unsuitable as backing for money. Money backed by debt would soon have a nominal value greater than the whole world's stock of gold. That has already happened. Irredeemability was inevitable.

  Sproul's RBD will be non-inflationary only if money is backed by something which is limited in supply. Austrian economists are right to scoff at a dollar-note which is backed by nothing more than a promise to pay future dollar-notes.

  Published: April 5, 2008 10:52 AM

• fundamentalist

  If anyone is seriously tempted by Mike's Real Bills Doctrine economics, you should read the current article on the web site "Valuation without Calculation" by Mises. Here's an important section:

  "A serious blunder that owes its origin and its tenacity to a misinterpretation of this imaginary construction was the assumption that the medium of exchange is a neutral factor only. According to this opinion the only difference between direct and indirect exchange was that only in the latter was a medium of exchange used. The interpolation of money into the transaction, it was asserted, did not affect the main features of the business. One did not ignore the fact that, in the course of history, tremendous alterations in the purchasing power of money have occurred and that these fluctuations often convulsed the whole system of exchange. But it was believed that such events were exceptional facts caused by inappropriate policies. Only "bad" money can bring about such disarrangements. "

  This is another area in which the RBD/Banking school goes wrong: it assumes that money (whether paper, digital or gold) is neutral in its effect on prices, in other words it is not a commodity. Mike has always insisted that paper/digital money is not a commodity and does not have the effects of a commodity. Mises demonstrates that all money, regardless of the form it takes, is a commodity and has the same effects in the marketplace on prices as any other commodity.

  Published: April 5, 2008 10:53 AM

• newson

  to mike sproul:
  on page 7 of your paper - "THERE'S NO SUCH THING AS FIAT MONEY", you write:

  "Just as the value of an American option is equal to that of a European call option, the value of a convertible dollar must be equal throughout the year to the value of an inconvertible dollar."

  but there are some situations where early exercise has value, and so the american option will be worth more than its european analogue. wikipedia lists some of these possible situations:

  "*An in the money (ITM) call option on a stock is often exercised just before the stock pays a dividend which would lower its value by more than the option's remaining time value
  *A deep ITM currency option (FX option) where the strike currency has a lower interest rate than the currency to be received will often be exercised early because the time value sacrificed is less valuable than the expected depreciation of the received currency against the strike.
  *An American bond option on the dirty price of a bond (such as some convertible bonds) may be exercised immediately if ITM and a coupon is due."

  valuation differences between the two would option types increase with the duration of the option contract.

  besides, to get back to the us dollar's value, the erosion of the asset-backing of the dollar is a bit like the strike price of the underlying constantly shifting. early exercise may well pay off, indeed it's hard to think of any other reason why convertibility (dollars-to-gold) was barred, were it not attractive.

  Published: April 5, 2008 11:00 AM

• Walt D.

  Centralized bureaucracy has a long and distinguished track record of failure. Why should banking regulation be any different? In my opinion 99% of the mortgage crisis can be explained by the Fed lowering rates to 1.25% and then raising them 0.25% at a time to over 5%. This is what screwed up the 5-1ARM's and negative amortization interest only and the so called chooser option mortgages (which assumed that housing prices would (or could) increase ad infinitum - the chooser option drops the payment below the interest only amount, assuming that the increase in the market value of the house will take care of the difference.
  
  Why would we expect the Fed to be able to come up with a solution to a problem that was caused by their own action. The Austrian model is the only long term viable, albeit painful, solution. Let the market clean up its own mess, move away from fiat money, and have the Fed stop interfering.

  Published: April 5, 2008 11:41 AM

• Mike Sproul

  "One of the requirements of money is scarcity. Debt is not scarce. It can be created on demand, in potentially unlimited quantities. It is therefore totally unsuitable as backing for money. Money backed by debt would soon have a nominal value greater than the whole world's stock of gold. That has already happened. Irredeemability was inevitable."

  If my house is worth $100,000, I can't borrow more than $100,000. The amount of debt in the world is limited by the amount of goods that can be offered as collateral. Given that collateral, the debt is as valuable as the goods backing it.
  You'd have no problem allowing gold certificates to be issued up to the quantity of gold that exists. I'd have no problem allowing additional gold certificates to be issued, as long as they are issued in exchange for goods worth 1 ounce (and as long as people understood the risk of the goods falling relative to gold). Taking it one step further, I'd have no problem with additional gold certificates being issued in exchange for bonds worth 1 ounce, since those bonds are ultimately backed by goods. This is discussed in my paper "Three False Critiques of the Real Bills Doctrine", which you can find by clicking on my name.

  "the erosion of the asset-backing of the dollar is a bit like the strike price of the underlying constantly shifting. early exercise may well pay off, indeed it's hard to think of any other reason why convertibility (dollars-to-gold) was barred, were it not attractive."

  Only a bit. It's more like the option writer losing assets and becoming unable to perform on his option. And one very big advantage to inconvertibility is that the bank becomes immune to a bank run.

  (I should have said that the value of an American call option is normally equal to a european option, with exceptions made because of dividends, etc. My point was that a convertible dollar is like an american call, and an inconvertible dollar is like a european call. So convertible dollars will normally be worth the same as inconvertible dollars. (This explains why, for example, currencies do not normally fall when convertibility is suspended.))

  "Austrian economists are right to scoff at a dollar-note which is backed by nothing more than a promise to pay future dollar-notes."

  If a bank issues 100 paper dollars in exchange for a bond worth $100, it can just as well retire those dollars by selling off a $100 bond. You can back a dollar with something denominated in dollars. In the same way, GM can issue new stock and sell it for call options on GM--GM stock would then be backed by something denominated in GM stock.

  Published: April 5, 2008 2:19 PM

• Mike Sproul

  "One of the requirements of money is scarcity. Debt is not scarce. It can be created on demand, in potentially unlimited quantities. It is therefore totally unsuitable as backing for money. Money backed by debt would soon have a nominal value greater than the whole world's stock of gold. That has already happened. Irredeemability was inevitable."

  If my house is worth $100,000, I can't borrow more than $100,000. The amount of debt in the world is limited by the amount of goods that can be offered as collateral. Given that collateral, the debt is as valuable as the goods backing it.
  You'd have no problem allowing gold certificates to be issued up to the quantity of gold that exists. I'd have no problem allowing additional gold certificates to be issued, as long as they are issued in exchange for goods worth 1 ounce (and as long as people understood the risk of the goods falling relative to gold). Taking it one step further, I'd have no problem with additional gold certificates being issued in exchange for bonds worth 1 ounce, since those bonds are ultimately backed by goods. This is discussed in my paper "Three False Critiques of the Real Bills Doctrine", which you can find by clicking on my name.

  "the erosion of the asset-backing of the dollar is a bit like the strike price of the underlying constantly shifting. early exercise may well pay off, indeed it's hard to think of any other reason why convertibility (dollars-to-gold) was barred, were it not attractive."

  Only a bit. It's more like the option writer losing assets and becoming unable to perform on his option. And one very big advantage to inconvertibility is that the bank becomes immune to a bank run.

  (I should have said that the value of an American call option is normally equal to a european option, with exceptions made because of dividends, etc. My point was that a convertible dollar is like an american call, and an inconvertible dollar is like a european call. So convertible dollars will normally be worth the same as inconvertible dollars. (This explains why, for example, currencies do not normally fall when convertibility is suspended.))

  "Austrian economists are right to scoff at a dollar-note which is backed by nothing more than a promise to pay future dollar-notes."

  If a bank issues 100 paper dollars in exchange for a bond worth $100, it can just as well retire those dollars by selling off a $100 bond. You can back a dollar with something denominated in dollars. In the same way, GM can issue new stock and sell it for call options on GM--GM stock would then be backed by something denominated in GM stock.

  Published: April 5, 2008 2:20 PM

• fundamentalist

  Mike: "Given that collateral, the debt is as valuable as the goods backing it."

  And, you would add that the value of the debt would decline only when the value of the asset declines. But what causes assets to rise and fall in price? For the most part, it's the volume of money in circulation. Again, you're confusing cause and effect.

  Published: April 5, 2008 2:46 PM

• Mike Sproul

  "And, you would add that the value of the debt would decline only when the value of the asset declines. But what causes assets to rise and fall in price? For the most part, it's the volume of money in circulation. Again, you're confusing cause and effect. "

  If a bank issues 300 gold certificates, backed by 100 oz. of gold plus bonds worth $200, (and denominated in dollars), then in order for assets to equal liabilities, it must be true that 100+200E=300E, where E is the value of a dollar (oz./$). Solving, we get E=1. Now let the bank issue another $400, for an IOU worth $400. Then 100+200E+400E=700E. Again, E=1 oz./$. The volume of money does not affect its value.

  Now, as you say, if assets did fall in price--say the IOU's that were worth $600 fall to $550, then the equation becomes 100+550E=700E, for E=.67 oz/$. We have inflation, but it was caused by a loss of assets, not because of more money.

  Published: April 5, 2008 3:42 PM

• Michael A. Clem

  If a bank issues 100 paper dollars in exchange for a bond worth $100, it can just as well retire those dollars by selling off a $100 bond. You can back a dollar with something denominated in dollars.
  
  But this makes no sense, or perhaps it's a case of circular logic. If the value of the bond is denominated in dollars, then how do you tell what the value of the bond is, and thus the value of the dollar? By seeing how much goods the bond will buy? Who accepts bonds as payment?
  
  The value of the dollar is equal to 1/100th of the value of $100 bond, which is equal in value to $100. Is that not circular?

  Published: April 5, 2008 8:18 PM

• Michael A. Clem

  Now, as you say, if assets did fall in price--say the IOU's that were worth $600 fall to $550, then the equation becomes 100+550E=700E, for E=.67 oz/$. We have inflation, but it was caused by a loss of assets, not because of more money.
  
  I suspect that there's something missing in what you say, and I'm going to figure it out. Obviously, using a bad or unstable asset for the issuing of currency creates an unstable currency, which is one reason why a commodity like gold would be better than bonds. But in this particular example, your IOU's went from being worth $600 to $550. Why? Who placed the value on the IOU's? And how did they value the IOU's, if not in the very dollars that were issued on those IOU's? Is it merely that the currency isn't equal to an ounce of an IOU (since such a thing doesn't exist), or is it that subjective valuation changed the value of the currency?

  Published: April 5, 2008 9:18 PM

• Mike Sproul

  "The value of the dollar is equal to 1/100th of the value of $100 bond, which is equal in value to $100. Is that not circular? "

  Remember that these dollars are defined as gold certificates, each worth 1 ounce. Only after this has been established do we start talking about issuing additional dollars in exchange for dollar-denominated assets.

  "your IOU's went from being worth $600 to $550. Why? Who placed the value on the IOU's? And how did they value the IOU's, if not in the very dollars that were issued on those IOU's? "

  When IOU's drop in value, it is normally because the borrower is having trouble repaying them. Besides, it's actually not necessary to the argument that those IOU's be denominated in dollars. They could just as well be denominated in gold. I introduced dollar-denomination just to cover the added complication that the currency becomes more unstable when backed by dollar-denominated assets. For example: the IOU's lose value, which makes the dollars lose value, which makes the bonds fall still more, etc. This complication is nicely handled by the equations I wrote.

  Published: April 5, 2008 9:40 PM

• Mike Sproul

  "The value of the dollar is equal to 1/100th of the value of $100 bond, which is equal in value to $100. Is that not circular? "

  Remember that these dollars are defined as gold certificates, each worth 1 ounce. Only after this has been established do we start talking about issuing additional dollars in exchange for dollar-denominated assets.

  "your IOU's went from being worth $600 to $550. Why? Who placed the value on the IOU's? And how did they value the IOU's, if not in the very dollars that were issued on those IOU's? "

  When IOU's drop in value, it is normally because the borrower is having trouble repaying them. Besides, it's actually not necessary to the argument that those IOU's be denominated in dollars. They could just as well be denominated in gold. I introduced dollar-denomination just to cover the added complication that the currency becomes more unstable when backed by dollar-denominated assets. For example: the IOU's lose value, which makes the dollars lose value, which makes the bonds fall still more, etc. This complication is nicely handled by the equations I wrote.

  Published: April 5, 2008 9:40 PM

• Michael A. Clem

  Remember that these dollars are defined as gold certificates, each worth 1 ounce. Only after this has been established do we start talking about issuing additional dollars in exchange for dollar-denominated assets.
  
  Okay, I see that now. But If a bank issues 300 gold certificates, backed by 100 oz. of gold plus bonds worth $200, (and denominated in dollars), then in truth, the value of the currency is actually worth 100 oz of gold plus the value of the bonds, not 300 oz. of gold. Each $1 certificate is equal to 1/3 oz of gold, and 1/200 of the value of the bonds. I know you say that financial convertibility renders physical convertibility moot, but you point out that the bank has to maintain a certain amount of activity, and the right kind of activity, to avoid physical convertibility. So, it's not moot, and the value of the currency is made more unstable by being backed by unstable assets.
  
  It might also be a point of fraud if there are 300 gold certificates that state that they are all redeemable in gold, when there are only 100 oz. of gold. If the certificates were simply a generic currency "backed by the assets of the bank", that would avoid the fraudulent issue, but invite closer scrutiny of the bank's assets.
  
  Last but not least, I still don't see how RBD explains historical phenomena such as the continuous inflation we have had since the creation of the Fed. Have the Fed's assets been continually declining in value all this time?

  Published: April 5, 2008 11:14 PM

• newson

  mike sproul says:
  "My point was that a convertible dollar is like an american call, and an inconvertible dollar is like a european call. So convertible dollars will normally be worth the same as inconvertible dollars. (This explains why, for example, currencies do not normally fall when convertibility is suspended.)"

  hmm, this is counterintuitive, where are your examples? when a country suspended convertibility in isolation, the currency did fall. in wars involving numerous countries, one country's suspension was rapidly followed by chain-reaction suspensions by many others. but this was a political decision aimed at avoiding a haemorrhage of its gold reserves, had a single country remained convertible in this circumstance, its currency would have been revalued upwards.

  i believe valuation difference between american and european options would be huge if we're talking about inconvertibility of over seventy years (the closure of the public gold window).

  Published: April 5, 2008 11:37 PM

• fusgerm

  fundamentalist: "Mike has always insisted that paper/digital money is not a commodity and does not have the effects of a commodity."

  Mike Sproul's view on the irrelevance of the quantity of money is supported by von Mises insofar as money is 100% backed by reserves:

  "If the debtor - the government or a bank - keeps against the whole amount of money-substitutes a 100% reserve of money proper, we call the money-substitute a money-certificate...

  "If the money reserve kept by the debtor against the money-substitutes issued is less than the total amount of such substitutes, we call that amount of substitutes which exceeds the reserve fiduciary media...

  "While the quantity of money-certificates is indifferent, the quantity of fiduciary media is not. The fiduciary media affect the market phenomena in the same way as money does. Changes in their quantity influence the determination of money’s purchasing power and of prices and - temporarily - also of the rate of interest..."

  (Human Action)
  

  Published: April 6, 2008 12:39 AM

• fusgerm

  Sproul: "The amount of debt in the world is limited by the amount of goods that can be offered as collateral." The problem is that there is practically no limit to such goods - land, houses, stocks, works of art ... and therefore no limit to the creation of money in the form of fiduciary media. This fails the "scarcity" qualification for money.

  Gold would be equally useless as money in the unlikely event that a seam of pure gold was discovered of almost unlimited quantity. Spain's seizure of New World gold was responsible for inflation which would have totally discredited gold as money if the new supply had not come to an abrupt halt.

  Sproul: "GM can issue new stock and sell it for call options on GM -- GM stock would then be backed by something denominated in GM stock." Well, I hope GM doesn't get carried away, selling most of its assets in exchange for call options on its own stock. The leverage would make for interesting share-movements.
  

  Published: April 6, 2008 12:41 AM

• jp

  "The problem is that there is practically no limit to such goods - land, houses, stocks, works of art ... and therefore no limit to the creation of money in the form of fiduciary media."

  If there was no limit to houses why are they trading on the market for hundreds of thousands of dollars instead of for nothing? Why does it cost me $30 for a share in Microsoft and not $0? I think it's because these goods, assets etc are indeed scarce. There are only so many great paintings worth collateralizing because only so many great painters exist.

  Published: April 6, 2008 12:51 PM

• Mike Sproul

  " Each $1 certificate is equal to 1/3 oz of gold, and 1/200 of the value of the bonds. I know you say that financial convertibility renders physical convertibility moot, but you point out that the bank has to maintain a certain amount of activity, and the right kind of activity, to avoid physical convertibility."

  Yes; if the bank wants its dollars to trade on the market for 1 oz. of gold, then it must maintain convertibility--financial or physical or both. To accomplish this, the bank must have assets worth at least 300 oz as backing for $300, but 100% physical gold is not necessary--and not even a good idea.

  "I still don't see how RBD explains historical phenomena such as the continuous inflation we have had since the creation of the Fed. Have the Fed's assets been continually declining in value all this time?"

  Either that, or the fed's money has outrun the fed's assets, or the fed has (perversely) chosen to maintain (physical or financial) convertibility at a lower level than its assets can support

  "currencies do not normally fall when convertibility is suspended.)"

  hmm, this is counterintuitive, where are your examples?"

  Two examples are (1) the English suspension of 1797, which is covered in my "Three False Critiques of the RBD" paper, and (2) the American suspension of 1933, which caused no significant change in the value of the dollar.

  "i believe valuation difference between american and european options would be huge if we're talking about inconvertibility of over seventy years (the closure of the public gold window)."

  As explained in my "no Fiat Money" paper, the cost of issuing paper money (printing, handling, etc.) approximately burns up the interest it would have earned, so a delay of convertibility does not force dollars to sell at a large discount.

  "GM stock would then be backed by something denominated in GM stock." Well, I hope GM doesn't get carried away, selling most of its assets in exchange for call options on its own stock. The leverage would make for interesting share-movements."

  Yes it would. That's why it's a mistake for the fed to back its dollars with bonds that are denominated in dollars. You get a feedback effect, where if the bonds fall in value, the dollars backed by those bonds will lose value. But since those bonds are denominated in dollars they will lose still more value, etc.

  Published: April 6, 2008 1:50 PM

• newson

  mike sproul says:
  "So convertible dollars will normally be worth the same as inconvertible dollars. (This explains why, for example, currencies do not normally fall when convertibility is suspended.)"

  
  The table(s) present the price of one United States Dollar.
  Switzerland, 1932 - 1935
  1932 5.1533 Franc
  1933 4.0265 Franc
  1934 3.0896 Franc
  1935 3.0772 Franc

  The table(s) present the price of one United States Dollar.
  France, 1932 - 1935
  1932 25.4610 Old Francs
  1933 19.8760 Old Francs
  1934 15.2230 Old Francs
  1935 15.1490 Old Francs

  in april 1933, fdr's executive order made it obligatory for us citizens to hand over their gold @ $21-67oz. he then devalued the dollar to $35-00oz (for overseas gold-holders).

  the above currency samples would seem to contradict your assertion that suspension caused no significant change in the dollar's value. indeed, it looks as though people foresaw what was going to happen as early as 1932, and i gather this is corroborated by the fact that circulating gold coin dropped by 35% in the 3 months leading up to the april confiscation.

  the punishment on forex markets may have been mitigated because the dollar remained convertible for foreigners until nixon closed the gold window definitively in 1971.

  as for 1797, i'll have to read your piece first. so far, i'm unconvinced.

  Published: April 6, 2008 9:59 PM

• fusgerm

  JP: "If there was no limit to houses why are they trading on the market for hundreds of thousands of dollars instead of for nothing? Why does it cost me $30 for a share in Microsoft and not $0? I think it's because these goods, assets etc are indeed scarce. There are only so many great paintings worth collateralizing because only so many great painters exist."

  
  Let me clarify. There is a vast untapped supply of houses, shares etc which are NOT pledged as collateral and which are therefore available to be monetized. It is just as New World gold used to be.

  Suppose, for example, that the money supply doubled due to a big increase in the amount of borrowing for house/land.

  If the dollar were redeemable in gold, then the bonanza of extra dollars would have the effect of a huge (but fraudulent) gold discovery. The extra supply of new "gold" would lower its price, i.e. raise the dollar-price of goods & services.

  Eventually gold redemption would be suspended. There is actually not enough gold to honor the dollar-notes which are masquerading as gold-equivalents.

  And that is what did happen, over a longish timeframe due to the reserve and capital constraints on the banks.

  And the inflation goes on, with the irredeemable dollar-note as the new target ...
  

  Published: April 7, 2008 1:25 AM

• Mike Sproul

  I tried to post replies to the above, but only got a message saying my posting will be reviewed by the blog owner. This has happened a few times, so I'll give up posting on this blog until the apparent software bug is fixed. Anyone who wants to know my replies is welcome to email me by clicking on my name above.
  

  Published: April 7, 2008 4:13 PM

• jp

  Fusgerm: "Let me clarify. There is a vast untapped supply of houses, shares etc which are NOT pledged as collateral and which are therefore available to be monetized. It is just as New World gold used to be."

  I dunno about that comparison.

  In a world in which say gold certificates are the medium of exchange, a previously unknown supply of gold from the new world will cause a large drop in the gold price. In reaction to this gold certificates will fall too.

  But houses and shares aren't "discovered" in the same sense. We don't venture down to Florida and suddenly stumble upon a city of spontaneously formed empty houses or stock markets for the taking, this sudden new supply forcing prices down. If we DID find an uninhabited island with a million houses fit for use than I agree with you, this would probably push world housing prices down.

  But in reality, houses are formed within society through time preference - people consuming less today to invest in projects like houses and companies for tomorrow. These houses etc. are not on undiscovered islands and have already been priced into the markets for houses and stocks.

  To make the analogy to the gold certificate world, say a number of jewellers, hoarders etc. decide to convert previously saved gold hidden in vaults into fresh certificates. One might say that this gold was previously “undiscovered,” or “uncollateralized”, much like houses that have no mortgages you speak of. The sudden collateralization of all this new gold doesn’t hurt the gold price as there has simply been a swap for gold and certificates. Wouldn’t the same happen when already-built houses are collateralized too?

  Mike: I was hoping you could comment on fundamentalist’s points about money neutrality. Is the RBD indeed a neutral-money theory in that money has no influence on real factors like production, employment, etc?
  

  Published: April 8, 2008 9:25 AM

• Mike Sproul

  "the above currency samples would seem to contradict your assertion that suspension caused no significant change in the dollar's value."

  Here's the English CPI around the period of the 1797 suspension:
  Table 1. British Price Index (1782=100)
  Year Price Year Price
  1792 93 1807 132
  1793 99 1808 149
  1794 98 1809 161
  1795 117 1810 164
  1796 125 1811 147
  1797 110 1812 148
  1798 118 1813 149
  1799 130 1814 153
  1800 141 1815 132
  1801 153 1816 109
  1802 119 1817 120
  1803 128 1818 135
  1804 122 1819 117
  1805 136 1821 106
  1806 133 1821 94

  And there's this:
  “Looking back from the safety of 1798, ‘A Proprietor of Bank Stock’ thus summarized the transition: ‘In this desponding state, when all men dreaded, with the utmost anxiety, the event that was seen to be inevitable, and not far distant, and which it was supposed would involve the kingdom in general bankruptcy and intire ruin, the 26th February, 1797, was the crisis that gave the happy turn, and almost instantly dismissed all the horrors and fears that surrounded us; restored complete confidence…’” (Horsefield, 1944, quoted in Ashton and Sayers, 1953, p. 19).

  And this link gives the American CPI around 1933, which also shows no significant change as a result of the 1933 suspension.
  http://www.economagic.com/em-cgi/data.exe/var/cpiu-long

  "Suppose, for example, that the money supply doubled due to a big increase in the amount of borrowing for house/land.

  If the dollar were redeemable in gold, then the bonanza of extra dollars would have the effect of a huge (but fraudulent) gold discovery. "

  This ignores what is usually called the "Law of the Reflux", which says that when an economy is already well-stocked with cash, any additional paper money will simply reflux to the bank that issued it, in exchange for silver, bonds, etc. The fact that we have a large stock of houses that COULD be used to borrow new money doesn't mean they WOULD be used to borrow new money. If I have a house and I want to borrow money, then if the economy is well-stocked with cash, I will find that I can borrow some of that EXISTING cash. I have no need to go to the bank and ask them to create new cash. Only when money is in short supply would I have to go to a bank and ask them to create new money for me to borrow.

  "I was hoping you could comment on fundamentalist’s points about money neutrality. Is the RBD indeed a neutral-money theory in that money has no influence on real factors like production, employment, etc?"

  The RBD says that money is neutral in the sense of having no effect on prices. The theory itself doesn't have much to say about production and employment, but there are many historical examples of money being introduced into cash-starved economies and producing economic miracles in production and employment (The French playing card money of 1685 and the Massachusetts paper shillings of 1690 come to mind, but of course there are many others). The RBD helps to clarify why this happens, but I wouldn't say it's a direct implication of the theory. The quantity theory, on the other hand, leaves people thinking that a 10% increase in the money supply would only cause prices to rise 10% without affecting employment and production, so of course they're left scratching their heads when they see new money causing a real economic boom. This leaves people vulnerable to nonsensical theories like Austrian busines cycle theory and Keynesianism.

  Published: April 8, 2008 11:16 AM

• eric lansing

  so we banning Sproul from debating on mises now? WOW!!!!!!!!!!!!! F&%$#*& DISGRACE!!!!!!!!!!!!!!!

  Published: April 8, 2008 12:36 PM

• jeffrey

  Eric, in all my years of tech work, the #1 mistake that people make is to assume admins are banning people and reviewing comments and otherwise interfering with the exchange of ideas -- when in fact it is (99.9% of the time) a software issue. It is so in this case.

  All people everywhere: do not assume that you are being picked on personally when the software doesn't quite work the way you want it to.

  Now checking for comments flagged as spam etc. By the way, moderating forums like this takes a fantastic amount of time away from the zillion other things there are to do in this world. Just a bit of good sense about reality would tell you that glitches are software related, not decisions by admins.

  Published: April 8, 2008 1:19 PM

• jeffrey

  Sure enough, Sproul's comment was flagged (by software) as spam because it had an abundance of links combined with numbers that put it over the top for the software. I just approved the comment.

  Can others here please take notice of this case? No one is being censored or slapped around because of their opinions.

  Published: April 8, 2008 1:30 PM

• eric lansing

  thanks Jeff,

  sounded like he was being censored. Hate to admit it, but I like reading him. Bring a Keynesian, Monetarist or any gov't economist to a debate here and it's a no contest, but Sproul makes me think. Anyway, sorry for the outburst.

  Published: April 8, 2008 2:20 PM

• fundamentalist

  Mike: "The RBD says that money is neutral in the sense of having no effect on prices."

  Mises: "A serious blunder that owes its origin and its tenacity to a misinterpretation of this imaginary construction was the assumption that the medium of exchange is a neutral factor only. According to this opinion the only difference between direct and indirect exchange was that only in the latter was a medium of exchange used. The interpolation of money into the transaction, it was asserted, did not affect the main features of the business. One did not ignore the fact that, in the course of history, tremendous alterations in the purchasing power of money have occurred and that these fluctuations often convulsed the whole system of exchange. But it was believed that such events were exceptional facts caused by inappropriate policies. Only "bad" money can bring about such disarrangements."

  "In addition people misunderstood the causes and effects of these disturbances. They tacitly assumed that changes in purchasing power occur with regard to all goods and services at the same time and to the same extent. This is, of course, what the fable of money's neutrality implies. The whole theory of catallactics, it was held, can be elaborated under the assumption that there is direct exchange only. If this is once achieved, the only thing to be added is the "simple" insertion of money terms into the complex of theorems concerning direct exchange. However, this final completion of the catallactic system was considered of minor importance only. It was not believed that it could alter anything essential in the structure of economic teachings. The main task of economics was study of direct exchange. What remained to be done besides this was at best only a scrutiny of the problems of "bad" money."

  "Complying with this opinion economists neglected to lay due stress upon the problems of indirect exchange. Their treatment of monetary problems was superficial; it was only loosely connected with the main body of their scrutiny of the market process. About the turn of the nineteenth and twentieth centuries, the problems of indirect exchange were by and large relegated to a subordinate place. There were treatises on catallactics which dealt only incidentally and cursorily with monetary matters, and there were books on currency and banking which did not even attempt to integrate their subject into the structure of a catallactic system. At the universities of the Anglo-Saxon countries there were separate chairs for economics and for currency and banking, and at most of the German universities monetary problems were almost entirely disregarded.[4] Only later economists realized that some of the most important and most intricate problems of catallactics are to be found in the field of indirect exchange and that an economic theory which does not pay full regard to them is lamentably defective. The coming into vogue of investigations concerning the relation between the "natural rate of interest" and the "money rate of interest," the ascendancy of the monetary theory of the trade cycle, and the entire demolition of the doctrine of the simultaneousness and evenness of the changes in the purchasing power of money were marks of the new tenor of economic thought. Of course, these new ideas were essentially a continuation of the work gloriously begun by David Hume, the British Currency School, John Stuart Mill and Cairnes."

  from Valuation Without Calculation, Daily Article | Posted on 4/5/2008 by Ludwig von Mises.

  In short, the RBD/Banking School of money utterly ignores advances in economics of the past century.

  
  

  Published: April 8, 2008 2:40 PM

• Inquisitor

  I'll agree that even though I disagree with Mr Sproul he does make a good effort to present his case.

  Published: April 8, 2008 5:30 PM

• Mike Sproul

  "In short, the RBD/Banking School of money utterly ignores advances in economics of the past century."

  Well, at least we agree that the quote from Mises needed shortening.
  As for those advances, it was 1810 when David Ricardo "defeated" Charles Bosanquet in the bullionist debates, and the quantity theory has been the mainstream view of economists ever since. Starting from that incorrect theory, economists have built an amazing tangle of awkward scaffolding and bailing wire upon the foundation of the quantity theory. So when I was developing the real bills doctrine, I did indeed ignore the so-called advances of the last two centuries, in the same way that modern astronomers ignore all the advances made by Ptolemy's followers in their attempt to assert that the sun orbits the earth, instead of the other way around.
  For anyone who is interested, I recently posted a handwritten journal that I started in 1989, which contains my random observations about monetary theory. You might find it an interesting chronicle of how I changed from a quantity theorist to a real bills'er. Click on my name above to see it.

  Published: April 8, 2008 6:12 PM

• eric lansing

  I saw that, Mike. 6 months ago I would have laughed at someone who said that Keynesians are more libertarian than monetarists.

  You are a badass (I think... would be nice to see someone come out and make you look foolish so I could start wearing my Rothbard t-shirt again).

  Something is not clicking... I used to take for granted that increases in the money supply caused prices to rise. I never thought about the "value of the dollar" as such.

  Are they mathematical identities? Or is it possible that banks can expand the money supply by issuing $ 100 Bank of America dollars against a bushel of wheat valued at $100... have the value of te "dollar" unchanged, but have prices of goods and services rise nonetheless? Am I being stupid? Is it really a mathematical identity?

  Published: April 8, 2008 6:34 PM

• Mike Sproul

  Eric Lansing:

  "Are they mathematical identities? Or is it possible that banks can expand the money supply by issuing $ 100 Bank of America dollars against a bushel of wheat valued at $100... have the value of te "dollar" unchanged, but have prices of goods and services rise nonetheless? Am I being stupid? Is it really a mathematical identity?"

  If E=the value of the dollar (bushels of wheat/$), then the inverse ($/bushel) is the price of wheat, so yes, it's a mathematical identity. The relation gets slightly fuzzier when we're talking about the price of a bundle of goods as opposed to the price of a single good, but saying that P=1/E is still a perfectly good first approximation. You can look up various elaborations of this by googling "paasche index" and "Laspeyres index", but it's only an elaboration.
  

  Published: April 8, 2008 9:52 PM

• newson

  mike sproul says:
  "So convertible dollars will normally be worth the same as inconvertible dollars. (This explains why, for example, currencies do not normally fall when convertibility is suspended.)"

  here's another of the currency series that shows the devaluation leading up to, and following the 1933 fdr executive order dishonouring convertibility for us citizens. i think the dutch were the last on the continent to suspend gold convertibility.

  The table(s) present the price of one United States Dollar.

  Netherlands, 1932 - 1935
  1932 2.4817 Guilder
  1933 1.9334 Guilder
  1934 1.4841 Guilder
  1935 1.4768 Guilder

  i've used exchange rates to question your contention, and you've given me cpi, the wrong measure. cpi doesn't react to money supply changes with any immediacy or predictability, as the austrians are constantly emphasizing (not following the quantity theory in a purely mechanistic way). besides the us was in a deflation, so cpi was going to be depressed.

  paper currencies have always failed over differing time-spans, but convertibility at least ensures a choke-leash is always around the note-issuer's neck.

  Published: April 9, 2008 1:04 AM

• fusgerm

  JP: "If we DID find an uninhabited island with a million houses fit for use than I agree with you, this would probably push world housing prices down."

  The point that I was trying to make was not about house-prices but about inflation, in the event that the money-supply doubled due to a huge increase in borrowing for houses. I queried how Sproul could deem this to have no effect on prices. Sproul's reply:

  "This ignores what is usually called the "Law of the Reflux", which says that when an economy is already well-stocked with cash, any additional paper money will simply reflux to the bank that issued it, in exchange for silver, bonds, etc..."

  This law will be true if the paper money is 100% backed by gold or silver. But otherwise the issue of fiduciary media will be inflationary, and then any subsequent "reflux" will be deflationary - which in a nutshell is the Austrian business cycle.

  According to Mises, people may be short of cash, but not an economy. Even if the stock of gold or silver is fixed, then it will simply rise in value to accomodate any additional demand for cash holding due to population growth etc.

  Published: April 9, 2008 9:35 AM

• jp

  newson/mike:
  I don't know how relevant this is to your conversation but modern day convertible bonds might provide some insight into how non-convertibility would affect the value of a currency.

  If two bonds are similar in all respects but one is convertible into stock at a certain price, the convertible bond will have a higher price and lower yield than the plain bond. If a firm were to somehow cancel that bond's convertibility, I am sure it would fall in value. I'm no expert on converts though.
  

  Published: April 9, 2008 10:57 AM

• jp

  mike:
  Let me ask a better question on money neutrality.

  An Austrian would say that money is non-neutral because any increase in the money supply occurs at a certain point in the economy. Those near the initial point benefit at the expense of those at the end since the prices of their goods rise first. This redistribution is uneven, ie non-neutral. In a system with fiduciary money, when the money rate of interest is set below the natural rate, all sorts of projects that would be unprofitable are suddenly profitable. The business cycle erupts resulting in all sorts of non-neutralities.

  We all know what you think about increases in the money supply. But with your theory, what happens from the point at which the money rate of interest is set below the natural rate? ie. from the point at which the Fed chooses to pay less for assets than they are worth? We are talking the Fed here, where competition and therefore reflux are muted, if existent at all.

  Would price increases, ie the devaluation of the dollar, be uniform for all goods, assets, and services, given the above interest rate policy?

  Would there be any impact on capital structure, the stock market, employment, etc given the above? Would a cycle appear?

  Published: April 9, 2008 11:33 AM

• Mike Sproul

  "i've used exchange rates to question your contention, and you've given me cpi, the wrong measure. ..

  paper currencies have always failed over differing time-spans, "

  I sense the approach of an endless debate over the merits of the cpi vs. exchange rates. Let me see if I can short-circuit the debate by saying that the suspension of convertibility normally has only small effects on the value of money. I think we can agree to that.
  Here's the way I see the issue: Suppose, for example, that a private bank issues paper dollars that will be convertible into 1 oz. of silver at the end of one year. In a world of 5% interest rates, we expect those dollars to be worth .95 oz at the start of the year, .975 oz. at mid-year, and 1 oz. at the end. In other words, the value of those inconvertible dollars is equal to 1/(1+R). Now suppose another bank issues paper dollars that are convertible into 1 oz. throughout the year. These dollars will sell for 1 oz. throughout the year.
  Now we have a problem: The issuer of convertible dollars is getting a free lunch of (up to) .05 oz./year. He sells the dollar for 1 oz at the start of the year, and lends (almost) the whole ounce at 5%, so at the end of the year he gets (up to) 1.05 oz. from his loan, while buying back his dollar for only 1 oz. The issuer of the inconvertible dollar gets no such free lunch. He sells his dollar for .95 oz at the start of the year, lends the silver at 5%, and at the end of the year he gets back 1 oz. from his loan, but has to buy back his dollar for 1 oz.
  The most obvious way to solve the free lunch problem is for the issuer of the convertible dollar to pay interest on it. He should maintain convertibility of the dollar at .95 oz at the start of the year, .975 at mid year, and 1 oz. at the end of the year. That way there's no free lunch. Note, however, that if he suspended convertibility at mid year, his formerly convertible dollar will remain at .975 oz. That's what I mean when I say that suspension normally does not affect value.

  We can elaborate on this by supposing that the cost of issuing either kind of paper dollar (printing, handling, etc.) is .05 oz/year. Then the value of the inconvertible dollar will be 1/(1+R-C), where C=cost of issue). If R=C=.05, then both the convertible dollar and the inconvertible dollar will be worth 1.0 oz. throughout the year, and suspension, again, will not affect value. (This is discussed in my "No Fiat Money" paper.)

  "but convertibility at least ensures a choke-leash is always around the note-issuer's neck."

  It assures that if the bank loses assets, it will also suffer a disastrous run. Suspension of convertibility makes a run impossible, and only results in a small drop in the value of money, commensurate with the loss of assets. A choke leash is only helpful if it doesn't kill the dog.

  "This law (of the reflux) will be true if the paper money is 100% backed by gold or silver."

  No; paper can reflux to the bank in exchange for gold, but it can also reflux to the bank in exchange for bonds. The law of the reflux works as long as the bank maintains either financial or physical convertibility.

  "If two bonds are similar in all respects but one is convertible into stock at a certain price, the convertible bond will have a higher price and lower yield than the plain bond."

  Yes, the same is true of money and options. The difference is normally small, and in principle it can be negligible.

  Published: April 9, 2008 11:49 AM

• Mike Sproul

  jp:
  "what happens from the point at which the money rate of interest is set below the natural rate?
  Would price increases, ie the devaluation of the dollar, be uniform for all goods, assets, and services, given the above interest rate policy?"

  I'm afraid I'll have to continue to disappoint you on that one. The RBD just doesn't say much on that subject, but my kneejerk reaction is that there's no reason to expect the effects on prices to be non-uniform.

  I find that most questions of this nature can be understood with a stock market analogy: If GM issued new shares of stock in exchange for assets of insufficient value, or lent those shares at below-market rates, would you expect non-uniformities in the price of GM? Well, the people who first get that underpriced stock might gain, (unless they had to expend resources searching for that gain), but in a world of well-informed investors, the price of GM stock will just fall across the board and that's that.

  Published: April 9, 2008 11:59 AM

• Michael A. Clem

  in a world of well-informed investors, the price of GM stock will just fall across the board and that's that.
  
  Sounds suspiciously like the flaw of the "perfect knowledge" crowd. In the real world, there are plenty of less-well-informed investors, so you'd have people who got the undervalued stock first benefit the most, people who were watching closely and guessing correctly benefitting a little, and so on to the last clueless investor who finally notices the change in stock prices.
  
  Furthermore, what bothers me about these stock analogies is the idea that issuing new stock, at whatever price, is going to have a uniform effect on the value of the stock. Stocks are valued based upon a number of factors, quantity of stock and company assets being only two, and not necessarily the most important two. Extra cash for the company by issuing more stock might have a positive or negative impact on the value, depending upon how they put that cash to use. Simple, mathematical calculations can't answer those types of questions for the investor.
  

  Published: April 9, 2008 10:52 PM

• fundamentalist

  Michael: “Furthermore, what bothers me about these stock analogies is the idea that issuing new stock, at whatever price, is going to have a uniform effect on the value of the stock.”

  Good point! Sproul’s use of the stock analogy is way off base. Issuing stock is nothing at all like issuing money. When issuing stock, the company exchanges an asset for money. In issuing money, the gov exchanges money for assets, so the analogy is bass-ackwards. But Sproul makes it worse by focusing on just the issuance of one unit of stock and its effects on the price of the stock. Of course issuance of one unit of stock won’t change anything, just as the issuance of one dollar in a trillion dollar economy won’t have any measurable effects. Finally, Sproul wants us to focus on the transaction: exchaning one unit of stock does not change the value of the stock. But neither does selling one car change the price of that car or any other car, nor does selling one house change the value of that house or any other house. In other words, Sproul wants us to focus on the exchange of just one unit of something and its effect on its value.

  The money supply is an aggregate measure of all money in the system. Small changes won’t have much effect. So to make Sproul’s stock analogy appropriate for the money supply, we have to look at all stock issued at once. Do changes in the total supply of stocks change the value of stocks? Of course. Analysts watch the supply of new issues entering the market, among other things, to help them determine the direction the stock market will take. When the stock market is low, many companies repurchase their own stock in an effort to raise its price. So Mike’s stock analogy, when properly understood in the aggregate instead of focusing on just one unit of stock, reinforces the Austrian theory of money.
  

  Published: April 10, 2008 9:00 AM

• fundamentalist

  PS, It should be clear to anyone who has invested in stock that the value of any stock fluctuates wildly, yet the assets of the companies who issued the stock don't fluctuate much at all. If the RBD/Banking school were correct, the value of stocks would change only with the value of the underlying assets of the issuing companies, which means they wouldn't change much. Instead, we witness almost daily very large changes in the prices of all stocks.

  Published: April 10, 2008 9:09 AM

• newson

  to jp:
  yes, of course convertible bonds are always going to be worth more than plain vanilla bonds, because you've got a call option embedded. the call option's value depends on the conversion price, the underlying equity's volatility, the bond's duration, and the dividend stream (and to a lesser extent, the volatility of the underlying equity's dividend stream), and also the probability of other unknowable good things that management may direct towards shareholders, to the detriment of bondholders.

  mike sproul's example of the incentives shaping convertibility deal with private banks, where paper money printing does have a meaningful cost. in central banking, which is what we're arguing here, all costs of issuance are meaningless. (think of the forests to supply zimbabwe with constantly changing denominations).

  i also can't see the gm stock and the gm derivative market as useful for thinking about the fed. i mean gm is really a convertible security. first, i can sell gm shares and any of its derivatives for dollars. gm has no control over the value of these dollars. second, i could buy all of the gm shares and convert the gm assets into dollars.

  Published: April 10, 2008 10:38 AM

• newson

  to mike sproul:
  the example you've given, as i said to jp, illustrates what might happen in a free-banking scenario. in the central banking model, all costs of note-issuance are irrelevant. here's the real value of money told through the "art" of british punk band, the k foundation:

  "In a bizarre simultaneous sideshow, KLF nailed £1,000,000 of their own money to an art installation. When they dismantled the installation and returned the million to the Bank of England, pierced with nail-holes, the Bank declared the money unusable and fined the K- Foundation £9000 for damaging it and charged them £500 to print a new million.

  finally, what about the disastrous collapses of pegged currencies? these are convertible, too. what about the argentine peso several years back?

  Published: April 10, 2008 10:58 AM

• jp

  It seems to me that neutral-money RBD leads to the conclusion that the Fed's setting of rates below the natural rate is benign. Yes, the currency loses value. But price changes under neutral RBD are uniform, so no one benefits or is hurt by redistribution. A business cycle does not erupt. It puts one in the unlibertarian position of not being able to critique central banking. Neutral RBD gives no reason why free banking should be the best choice, since central banking creates no harmful distortions to begin with.

  Fusgerm: "This law will be true if the paper money is 100% backed by gold or silver. But otherwise the issue of fiduciary media will be inflationary, and then any subsequent "reflux" will be deflationary - which in a nutshell is the Austrian business cycle."

  What if the paper money is 100% backed by houses?

  Fundamentalist: You have good point about the aggregate supply of stock, though I think you're forgetting the corresponding aggregate demand. A supply of new issues can simply be a manifestation of a strong underlying demand and needn't result in lower stock prices.

  Mike: "Yes, the same is true of money and options. The difference is normally small, and in principle it can be negligible."

  I don't think I could find a single convertible bond trader who would agree with you that the effects of cancelling the convertability feature of their bonds is small to negligible. It would seem to me that convertability has value and probably shouldn't be ignored.

  Published: April 10, 2008 10:59 AM

• Mike Sproul

  "In the real world, there are plenty of less-well-informed investors, so you'd have people who got the undervalued stock first benefit the most, people who were watching closely and guessing correctly benefitting a little, and so on to the last clueless investor who finally notices the change in stock prices."

  This misses the forest for the trees. The more uncertainty there is, and the less information there is, the more imprecise is the relation between the value of money and the value of the assets backing it, and the same is true of stock. The point of the RBD is that the value of money is equal to the value of the assets backing it. The quantity theory, in contrast, says that the value of money is determined by how much money is chasing how many goods in the economy. The RBD makes sense, and the QT doesn't. As long as every econ textbook presents only the QT, as if there were no other theory, and doesn't even mention the RBD, then I'm going to focus my attention on the fundamental proposition that the value of money is determined by backing, and I'll leave questions about uniformity of effects to be addressed in their own time.

  "Of course issuance of one unit of stock won’t change anything, just as the issuance of one dollar in a trillion dollar economy won’t have any measurable effects."

  Not at all. The RBD says that if we issue 1 new dollar in exchange for assets worth $1, or a billion dollars in exchange for assets worth $1 billion, then in both cases the dollar will hold its value.

  "in the central banking model, all costs of note-issuance are irrelevant."

  In the context of the dollars I mentioned above, where they start the year at .95 oz, rise to .975 at mid-year, and finish at 1 oz., I think it's clear that a mid-year suspension would not affect value in the case of a costlessly-issued currency. I think it's also clear that if those dollars cost .05 oz./year to issue, they will be worth 1 oz throughout the year, suspension or not. Is this what you're arguing with? Otherwise I don't see your point.

  "what about the disastrous collapses of pegged currencies? these are convertible, too. what about the argentine peso several years back?"

  If a bank holds $100 of assets as backing for 100 pesos, then a peso will be worth a dollar, convertible or not. If assets fall to $99, and the peso is inconvertible, then the peso will fall to $.99, but there will be no run. If the bank maintains convertibility at $1 per peso, even though the bank only has enough assets to support $.99/peso, then there will be a disastrous bank run, as nobody wants to be stuck with the last peso. This is what happened in Argentina.

  "I don't think I could find a single convertible bond trader who would agree with you that the effects of cancelling the convertability feature of their bonds is small to negligible. It would seem to me that convertability has value and probably shouldn't be ignored."

  As above, this is a forest/trees thing. I think in the case of the dollars starting the year at .95, rising to .975, and then to 1 oz., my "negligible difference" between convertible and inconvertible dollars is a good approximation.
  

  Published: April 10, 2008 7:38 PM

• newson

  mike sproul says:
  "The point of the RBD is that the value of money is equal to the value of the assets backing it. The quantity theory, in contrast, says that the value of money is determined by how much money is chasing how many goods in the economy. The RBD makes sense, and the QT doesn't.

  trying to make sense of the above, if the fed has $1 billion of gold (say) as its note backing, obviously the value of that gold is informed by the existing gold stocks off the fed's balance sheet (say $10 billion). the rbd seems to be saying it's possible to quarantine these two gold stocks, and examen each one separately. this cannot be.

  Published: April 11, 2008 4:22 AM

• fundamentalist

  Mike: "The point of the RBD is that the value of money is equal to the value of the assets backing it."

  Using your stock analogy, the RBD is clearly wrong. Otherwise, the prices of stocks wouldn't fluctuate as wildly as they do. They should remain at the value of the underlying assets of the company, that is, the book value. But very few stocks trade at book value. Most trade at various multiples of book value.

  Newson: "the rbd seems to be saying it's possible to quarantine these two gold stocks, and examen each one separately."

  Not only that, but the RBD argues that if you have gold backing each dollar, you can still print more dollars as long as you get an asset in exchange for the new dollars. Then the dollars would be backed by a combination of gold and other assets, such as land.

  Published: April 11, 2008 7:55 AM

• Mike Sproul

  "if the fed has $1 billion of gold (say) as its note backing, obviously the value of that gold is informed by the existing gold stocks off the fed's balance sheet (say $10 billion). the rbd seems to be saying it's possible to quarantine these two gold stocks, and examen each one separately. this cannot be."

  That's not what the RBD says. What it does say is that if the Fed owns 1 billion ounces of gold, which it holds as backing for 1 billion paper dollars, then each paper dollar will be worth 1 oz.
  Naturally, the value of the gold owned by the Fed will be affected by the world's total gold stock, so if the world's gold stock were to increase from 10 billion ounces to 11 billion ounces, then one ounce of gold, which previously could have bought 1 ton of wheat, will afterwards be able to buy (say) 0.9 tons. Likewise the paper dollars, being backed by gold, will fall in value by the same amount.
  I don't know what you're thinking when you say "quarantine". Are you talking about the fact that the Fed owns 1 billion in gold, while the other 9 billion is in private hands? I suppose that's a quarantine in some sense, but you seem to be carrying the meaning way beyond that.

  "Using your stock analogy, the RBD is clearly wrong. Otherwise, the prices of stocks wouldn't fluctuate as wildly as they do. They should remain at the value of the underlying assets of the company, that is, the book value. But very few stocks trade at book value. Most trade at various multiples of book value."
  Stock prices fluctuate because people's opinions about future profits fluctuate. If it were possible to accurately count future profits on the asset side of a balance sheet, then we wouldn't see discrepancies between a firm's book value and its market value. Stock prices reflect a firm's assets in the same way that a bathroom scale reflects the weight of a person who is always moving on the scale: The reading will never be perfectly accurate, but you'll still see bigger average numbers for a fat man than for a thin one.

  Published: April 11, 2008 10:12 AM

• fundamentalist

  Mike: "Stock prices fluctuate because people's opinions about future profits fluctuate."

  Exactly! And the purchasing power of money reflects its future value as well.

  Mike: "If it were possible to accurately count future profits on the asset side of a balance sheet, then we wouldn't see discrepancies between a firm's book value and its market value. Stock prices reflect a firm's assets in the same way that a bathroom scale reflects the weight of a person who is always moving on the scale: The reading will never be perfectly accurate, but you'll still see bigger average numbers for a fat man than for a thin one."

  If that's true, then what assets do the .com companies, like Google and Yahoo have that keeps their stocks at something like 100 times earnings?

  Many things influence the price of stocks and the value of assets is only one of many and one of the least important ones. But you're straying from your point, which is that the issuance of stock (or the quantity of stocks in circulation) does not affect the price of stocks and that's where you're wrong. Every analyst knows it has a very strong effect, much stronger than the value of the underlying assets. Some stocks will sell below the asset value while others sell at multiples of 3 times assets. Your defense of the RBD depends completely on the relationship between assets and stock prices and that relationship is very small.

  Published: April 11, 2008 12:23 PM

• newson

  mike sproul says:
  "Naturally, the value of the gold owned by the Fed will be affected by the world's total gold stock, so if the world's gold stock were to increase from 10 billion ounces to 11 billion ounces, then one ounce of gold, which previously could have bought 1 ton of wheat, will afterwards be able to buy (say) 0.9 tons."

  - isn't this just the same as the quantity theory of money? that is, the more plentiful gold (and also gold-dollars) is chasing after the same goods and services, and so commands a lesser wheat price.

  when iraq swapped from the swiss dinar to the saddam dinar after the first gulf war, the kurds continued to use the obsolete currency as money. there was no more being printed (unlike the saddam dollar, which was printed at a brisk pace), and it was hard to counterfeit.

  from the top of my head, tsarist bonds were used as money long after the heads had rolled, following the bolshevik revolution.

  these examples seem to favour the qvm theory. supply of paper fixed, no asset backing of the notes. in other words, i believe the us dollar's value in theory could be stabilized without convertibility as long as the money supply could be kept constant. the only "asset backing" would be the legal tender laws. history has shown this never happens except when the monetary regime is dead (in the tsarist and swiss dinar examples).

  re: convertibility, i'm flogging a dead horse, but i see your example as flawed. here's my view of how things would pan out:

  scenario #1: i hand over my 100oz silver for paper, convertible in year's time. not only have i locked in an interest rate (thereby potentially exposing myself to opportunity loss should rates increase), i am also at counterparty risk for the entire time. i am therefore conferring large benefits on my bank, and will demand a commensurate reward for the risks, demanding to be paid more, or to having to pay less, as the case may be.

  scenario #2: i hand over my 100oz to my convertible bank, and get my paper bills. now my bank doesn't know when i may choose to convert, and so bears all the risk of mismatched durations between my deposit and the loan it makes with my silver. the counterparty risk is less because i can whisk the silver out at short notice if i suspect there are prudential issues. these are benefits to me and i'm going to demand less return (or accept to pay more, as the case may be).

  i don't think you can just compare npv of like interest streams to judge this case. because of the inherent riskiness of fractional reserve banks, the option value of convertibililty must be high.
  

  Published: April 12, 2008 3:50 AM

• Mike Sproul

  Newson:

  "isn't this just the same as the quantity theory of money? that is, the more plentiful gold (and also gold-dollars) is chasing after the same goods and services, and so commands a lesser wheat price."

  You've hit on the difference between the law of demand and the quantity theory. The law of demand says that when more gold is dug out of the ground its price will fall. The law of demand does not say that the creation of gold certificates will affect the price of gold, but the quantity theory does say that. (The RBD says that the creation of gold certificates will not affect the value of gold.)

  
  "when iraq swapped from the swiss dinar to the saddam dinar after the first gulf war, the kurds continued to use the obsolete currency as money. there was no more being printed (unlike the saddam dollar, which was printed at a brisk pace), and it was hard to counterfeit."

  There's a similar story from WWII, where some Navy sailors bought food from islanders using monopoly money. When they visited the island years later, they found the monopoly money still being used. My answer is that this can happen out of ignorance. In the same way, if the GM factory blew up tomorrow, and investors on an island didn't hear about it for awhile, they would continue to value GM stock even when it was worthless in the rest of the world. Unfortunately, I've never heard enough information about these cases to make a systematic study, but I'd be willing to bet that these kinds of money always lose value once people learn that the money issuer is defunct. That's certainly what happened to the privately-issued paper money of frontier days.
  (Before I forget: A bank run is less like a choke chain and more like a bomb strapped to the dog.)

  "i don't think you can just compare npv of like interest streams to judge this case. because of the inherent riskiness of fractional reserve banks, the option value of convertibililty must be high."

  Adding in factors such as counterparty risk, mismatched duration, and being locked in will certainly change the numbers, but I don't see where it would change the fundamental result. In a world where these factors are neglibible, the difference in price between convertible and inconvertible dollars will be negligible. When those factors become significant, then convertibility will make a significant difference to the value of the two kinds of money.
  

  Published: April 12, 2008 1:03 PM

• fundamentalist

  Mike: "The law of demand does not say that the creation of gold certificates will affect the price of gold, but the quantity theory does say that."

  The quantity theory says no such thing. You will not find any advocate of the general quantitative theory, especially Mises, Hayek or Rothbard, who have said anything similar. The quanity theory says that if you increase the supply of gold certificates, and the volume of gold remains the same, the value of the gold certificates will fall relative to gold, but the certificates will not affect the value of gold in exchange for other goods.

  Published: April 12, 2008 3:50 PM

• fundamentalist

  Mike: "The law of demand does not say that the creation of gold certificates will affect the price of gold, but the quantity theory does say that."

  The quantity theory says no such thing. You will not find any advocate of the general quantitative theory, especially Mises, Hayek or Rothbard, who have said anything similar. The quanity theory says that if you increase the supply of gold certificates, and the volume of gold remains the same, the value of the gold certificates will fall relative to gold, but the certificates will not affect the value of gold in exchange for other goods.

  Published: April 12, 2008 3:51 PM

• Mike Sproul

  Fundamentalist:

  You're probably thinking of gold certificates issued on 100% reserves. I don't know of anyone, myself included, who has ever claimed that those are inflationary. I was talking about gold certificates issued on fractional reserves. The writings of Austrian economists are saturated with claims that fractional reserve certificates would be inflationary.

  Published: April 12, 2008 10:42 PM

• fundamentalist

  Mike: "The writings of Austrian economists are saturated with claims that fractional reserve certificates would be inflationary."

  That's true. But Austrians don't claim that the certificates change the price of gold relative to goods, but the price of gold relative to the certificates. An increase in gold certificates, without a corresponding increase in gold reserves, will cause the certificates to lose value relative to everything. But the value/price of gold won't change. Gold will continue to purchase the same volume of goods as before the increase in certificates. For example, assume an acre of land sold for an ounce of gold, or one gold certificate. If the number of gold certificates doubles, an acre of land will still sell for one ounce of gold, but two gold certificates because gold certificates would now be worth just half an ounce of gold.

  Published: April 13, 2008 2:11 PM

• fundamentalist

  PS, The price of gold relative to goods changes very slowly, only with the increase of the supply of gold, or about 2-3% per year. That's why many Austrians compare the price of a commodity, such as oil, with how much gold it's worth in order to determine the real inflation that has taken place. The price indices are too unreliable and leave out asset price inflation and the devaluation of the dollar against other currencies. Gold's stability provides an excellent benchmark for measuring the increase in the supply of paper money and credit.

  Published: April 13, 2008 2:15 PM