Comments (128)

• David A. Singhiser

  HOLY SH*T!

  Sorry, I'm not capable of civil and intelligent right now.

  I'm only now just getting it and trying to understand how this fraud has lasted so long.

  And why aren't more people mad? Mad? That's not strong enough - outraged, furious. Where's the mob with pitchforks?

  My God!

  Published: June 14, 2008 10:31 AM

• Matt

  David,
  "And why aren't more people mad? Mad? That's not strong enough - outraged, furious. Where's the mob with pitchforks?"

  Welcome to the club of an economic knowledgeable minority.
  This counterfeiting game has been deliberately obfuscated such that very few of the public can or are able to understand what is happening, therefore no revolt, just great frustration about what is happening and finger pointing in all directions except at the real cause of inflation more rationally known as theft on a grand scale.

  Not worry though, thievery can not be extended indefinitely, the Federal Reserve and their cohorts the Congress are on a spending/thieving binge that will end as all binges must end, unfortunately there will be a lot more pain and suffering by the innocents. Someone has to pay for these grand injustices and if the Guilty don't pay then the innocent must. Justice like the law of Gravity can be overcome temporarily, but eventually it is in charge. As I see it we are closer to the end than to the beginning.

  Published: June 14, 2008 3:09 PM

• John Or

  Hi

  A very interesting article.

  I like Rothbard's ideas and I hope they are implemented.

  Now, let us visualize that all of Rothbard's recommendations are implemented world wide.

  So now we all use gold coins or notes representing 100% warehoused gold.

  The total amount of worldwide gold will increase a relatively small percentage each year as more gold is mined.

  The total amount of world wide wealth is not static. It grows as a result of human endeavors. A shiny shoe is worth more than a dull one. A 3GHz CPU is worth more than a 200MHz CPU

  In other words, worldwide wealth will increase at a much higher percentage each year as human technological advances continue.

  From this I conclude that the value of gold will increase over time.

  This fact would motivate some people to simply hoard their gold since it increases in value over time. Gold Hoarding would reduce the amount of gold in circulation which in turn would further accelerate gold's increase in value.

  I could be wrong, but I think this would be a disincentive towards capital formation for other industries in the long run.

  Comments, please.

  John Or

  Published: June 14, 2008 4:43 PM

• Mike Sproul

  David and Matt:

  If the Fed operated like a counterfeiter, and if Austrian economics gave a correct view of money, then your outrage would be justified. But the Fed is not a counterfeiter, and Austrians are wrong about money. The paper dollars issued by the fed were issued in exchange for things of value--mostly gold and government bonds. The fed stands ready to use part of those assets (the bonds) to buy back the dollars it has issued. That is not the act of a counterfeiter.
  Once you recognize that paper dollars are backed by the fed's assets, the next step is to see that if the fed issued another billion dollars, and received a billion dollars' worth of assets in exchange, then the fed's ratio of assets to money would be unchanged, so the value of the dollar would be unaffected. Thus, the issue of new paper dollars does not reduce the value of existing dollars, and no robbery occurs.
  You can click on my name above for further reading.
  

  Published: June 14, 2008 4:45 PM

• Matt

  Mike,
  To make more clear my point on counterfeiting.
  Just about everyone now working is going to receive in the mail or credited to their bank account $600.

  Where is this new money coming from?
  If you were to issue money it would be called counterfeiting, when the treasury does it it's called deficit spending if not enough taxes ( labor/goods wealth) are collected.
  This new money is not wealth but a future claim on wealth, i.e. real goods or services which are wealth. This new money is more debt on the already Billions of debt.
  The savings of millions of people will again be depreciated as a result of this new money (debt) also known as higher prices at the grocery store etc.
  Money issued by the FED is not wealth it is a claim on wealth.
  Then there is the issue of Fractional Reserve Banking, this is more theft on top of theft.

  Banks will not credit to your account Gold or anything of value for the IOU's it issues it will instead give you another IOU, if this is not counterfeiting I don't know what is.
  The price of Gold on the free market is another telling sign that the public is catching on to the surreptitious theft in progress since the Roosevelt Administration.
  

  Published: June 14, 2008 8:45 PM

• TLWP Sam

  And Libertarians complain when words are given arbitrary definitions on a whim! Counterfeiting means to present a fake object as a real object - a fake dollar note, a fake Mona Lisa, a gold-plate lead coin being presented as a pure gold coin. I've said before and I'll say it again - if the Fed's a 'counterfeiter' then a gold miner's counterfeiting because he's diluting the gold supply (which unlike a diamond miner gold is fungible) and making each gold ounce worth less. Or Rembrant was counterfeiting every time he created another painting. Not to mention big time counterfeiters and destroyers of wealth were Charles Martin Hall and Paul Héroult - they figured out to mass produce aluminium from bauxite causing it to go from a metal more valuable than gold to a common metal certainly making the Capstone of the Washington Monument of laughing joke of an investment.

  Published: June 14, 2008 9:38 PM

• Mike Sproul

  Matt:

  Those stimulus checks might be a bad idea, but they are not counterfeiting--just taking wealth from one pocket and putting it in another. The checks could cause inflation IF they increase government debt enough to reduce the value of govt bonds, but they are not inherently inflationary.
  Fractional reserve banking is not inflationary either. When wells fargo issues a checking account dollar, it always gets a dollar's worth of assets in return. So checking account dollars are backed by the assets of the private banks, while paper dollars are backed by the assets of the fed.
  It's natural for anyone who has studied economics to lean toward the quantity theory of money, as you do. But the more you study the quantity theory, the more its inconsistencies will slap you in the face. The real bills doctrine, on the other hand, is a remarkably airtight theory of money.

  Published: June 14, 2008 11:38 PM

• newson

  to mike sproul:
  if frb is not inflationary, and the fed's backing the currency, how can you possibly explain the loss of 95% of the dollar's value since the creation of the federal reserve?

  Published: June 15, 2008 12:02 AM

• P.M.Lawrence

  John Or, what you are describing would only happen over the medium term on going back to a bullion standard (this also works with silver etc.), and even then only if gold or silver was released at prices that turned out to be very far from what the market eventually settled on. As people developed their own bullion holdings, Pigou's real balance effect would start to operate, leading to an equilibrium in holdings and an undistorted market driven flow of capital resources to investment opportunities. In fact, private bullion holdings would provide the very stabilising of the economic cycle that Keynesians claim needs government intervention.

  Published: June 15, 2008 2:31 AM

• fundamentalist

  John Or: "This fact would motivate some people to simply hoard their gold since it increases in value over time. Gold Hoarding would reduce the amount of gold in circulation which in turn would further accelerate gold's increase in value."

  Not necessarily. You're thinking of a static supply of gold. Gold production increases the supply of gold at roughly the same rate that most economies grow, around 3%. So as Reisman points out in his book "Capitalism" the price of gold would stay relatively the same. And if you look at the history of prices in the 19th century, that's pretty much what happened except for periods of excessive use of paper money and wars. During gold's heyday in the 19th century, huge amounts of gold for investing in new ventures poured into the US.

  But even if the supply of gold was static and its value constantly increasing, that increase would be about 3% annually. Entrepreneurs would offer much higher rates of return on other investments, so few people would hoard.

  Published: June 15, 2008 8:17 AM

• fundamentalist

  David: "And why aren't more people mad? Mad?"

  Good point. My experience is that people don't believe me. They have so much confidence in the goodness of their beloved state that they simply refuse to believe that the state would allow such blatant fraud.

  Published: June 15, 2008 8:20 AM

• fundamentalist

  Mike: "Once you recognize that paper dollars are backed by the fed's assets, the next step is to see that if the fed issued another billion dollars, and received a billion dollars' worth of assets in exchange, then the fed's ratio of assets to money would be unchanged, so the value of the dollar would be unaffected."

  For those new to this site, you should know that Mike's theory of money violates every principle of value and pricing that economists have learned in the past 150 years, including the subjective theory of value, marginal value, quantity theory of money and how fractional banking works.

  Of course, Mike will argue that money is not like other commodities. It exists in a world of its own immune to the laws of economics. But history shows that it isn't. It obeys all of the above laws just like any other commodity. Mike longs to restore the economics of the 15th century.
  

  Published: June 15, 2008 8:28 AM

• Artisan

  What I don't quite see is how a single country going back to 100% redeemability would manage to keep its gold...?

  In act, if you look at Nixon and the Vietnam war, you could argue: America tried and failed.

  Wouldn't gold reserves (and the legal tender) quickly flow out of the borders because of exchange rate issue and rising monetary inflation in other countries? Soon, that money (alias Gold) would indeed have to land in foreign hands because of its security and practicability, while no more could be issued, people would be forced to trade most probably with substitutes (silver notes? Or even "more volatile" underlyings?)

  Published: June 15, 2008 10:04 AM

• Mike Sproul

  Newson:

  "if frb is not inflationary, and the fed's backing the currency, how can you possibly explain the loss of 95% of the dollar's value since the creation of the federal reserve?"

  The value of the paper dollars issued by the fed is determined by how much backing the fed holds per dollar. So if there has been inflation, it is because the fed now holds less backing per dollar. This can happen, for example, if the fed lends at below-market interest rates, overpays for bonds, bails out bankrupt homeowners, is forced to hand a portion of its interest earnings over to congress, overspends on printing, buildings, staff, etc.

  Fractional reserve banking creates only checking account dollars, and those checking account dollars are a call option on paper dollars, with a strike of zero and no expiration. Just as call options do not reduce the value of the underlying security, checking account dollars do not reduce the value of paper dollars. Naturally, if paper dollars themselves lose value, then checking account dollars, being claims on paper dollars, will lose value as well.
  

  Published: June 15, 2008 10:21 AM

• Alex

  I agree that the inflationary operations of the Federal Reserve in the creation of money by buying big pieces of paper (government bonds) is badly understood. And of course inflation, even if fully anticipated, imposes taxes on the citizenry. The difference between counterfeiters, however, and the Fed is that the Fed does not hide the fact that it creates money. The amount of money it creates is published and known widely. And if the public wishes, the Federal Reserve can be abolished through the democratic process. Counterfeiters on the other hand operate outside the law and hide their operations from the public. They pretend that they are not creating money when in fact they are.

  If a bank has $100 of 5-yr fixed term deposit liabilities backed by $100 worth of 5-yr term loans, I would guess that no-one would argue that there is any fraud involved here.

  But, if instead a bank has $100 of demand deposit liabilities backed by $10 of Fed notes and deposits at the Fed, and $90 in 5-yr loans, some people argue that this situation involves fraud. I'm not sure why this is so. At any time, the bank can repay all depositors by borrowing Fed notes from the Federal Reserve. These loans from the Fed are essentially backed by the borrowing bank's 5-yr loan assets. The only possible loss the Fed exposes itself to here is the default loss on the bank's loans. But if the bank is prudent, and has set aside appropriate loan loss provisions, there will be no loss to the Fed (or cost to taxpayers) in these Fed loans. Naturally, imprudent banks should be allowed to fail.

  There would clearly be fraud involoved if the bank stated to depositors that for each $1 on deposit the bank keeps $1 in its bank vault. But the banks don't say this, and only very stupid depositors would believe this.

  Published: June 15, 2008 11:27 AM

• Mike Sproul

  Alex:

  "a bank has $100 of demand deposit liabilities backed by $10 of Fed notes and deposits at the Fed, and $90 in 5-yr loans, some people argue that this situation involves fraud. I'm not sure why this is so."

  It obviously is not fraud, and the fed is obviously not a counterfeiter. It takes years of Austrian 'education' to make people think otherwise.

  Mainstream economists do not help matters when they advocate the quantity theory of money in textbooks. The quantity theory clearly implies that the fed's issue of money, and fractional reserve banking, are inflationary. Mainstreamers won't take the next step and accuse the fed and the banks of fraud, since they don't want to sound crazy. Austrians, however, are quite comfortable being called crazy, and so they do call it fraud.

  The quantity theory is the heart of the problem. It is wrong. All money is backed by the assets of its issuer, so the issue of money, by the fed or by private banks, is not inherently inflationary, and therefore not fraudulent. Unfortunately, economists rejected the real bills doctrine in favor of the quantity theory almost 200 years ago, and have been on the wrong track ever since.

  Published: June 15, 2008 12:03 PM

• Alex

  Mike:

  Surely you agree that the creation of money by a central bank causes general price increases. If not, what do you think has caused, for example, Zimbabwe's current inflation?

  Published: June 15, 2008 1:07 PM

• fundamentalist

  Alex: "But, if instead a bank has $100 of demand deposit liabilities backed by $10 of Fed notes and deposits at the Fed, and $90 in 5-yr loans, some people argue that this situation involves fraud. I'm not sure why this is so."

  It's fraud because if the state didn't give the bank the authority to create the $90 out of thin air, it would be illegal. If you or I tried to do what the bank does without a license from the state, we would go to jail. Essentially, the state licenses fraud. Proof that it's fraud is that if everyone who claimed to have money in the bank decided to withdraw it all at once, the bank would fail and $10 would have to be split between all of the customers.

  Pyramid schemes are illegal, and just like banks, they can operate for years without going broke. If banks are fraudulent, then at best they're pyramid schemes. But no one goes to jail for bank pyramids because the state sells bankers a license to create their pyramids.

  The other fraud in fractional banking is the price inflation it creates. The people who receive the first issue of new money can purchase assets before prices rise. The last people to receive the money get it after prices have risen, so fractional banking transfers wealth, without letting people know this is happening, from the late receivers of money to the early receivers of money.

  Published: June 15, 2008 3:01 PM

• Mike Sproul

  Alex:
  "Surely you agree that the creation of money by a central bank causes general price increases. If not, what do you think has caused, for example, Zimbabwe's current inflation?"

  No; I don't. I used to, and I even taught it in my money and banking classes from 1981-89. But I was always bothered by questions like how to define money, why fractional reserve banking would be inflationary, what happens when money crosses borders, etc. You can click on my name above for a more complete discusion of the real bills doctrine, and how I arrived at it.

  Just for starters, suppose the Fed accepts 100 oz of silver on deposit, and then issues 100 paper receipts (dollars) in exchange. Anyone would agree that the issue of those dollars is not inflationary. And I think most people would also agree that if the bank accepted another 200 oz and issued another $200, that would not be inflationary either.
  Now, having issued $300, suppose the bank prints another $300 and lends them to a farmer, and the farmer agrees to repay 330 oz next year (assuming 10% interest) and posts his farm as collateral. That 330 oz IOU is worth 300 oz today. Does that extra $300 cause inflation? I say no, since if the dollar fell to (say) 0.9 oz, then everyone would rush to the bank to redeem for 1 full ounce. Is the bank capable of redeeming all $600 for 600 oz.? Yes; it is. All the banker has to do is sell his 300 oz. IOU for 300 of his own dollars, and then burn them. Then there are $300 left in public hands, which the banker can redeem for the 300 oz. in his vault. So at no time would the dollar fall below 1 oz.

  Your next question will probably center on what happens if the currency is inconvertible, like the US dollar. That's a longer story, but I'll start by saying that there are at least two kinds of convertibility: (1) physical convertibility, where the bank agrees to buy back its dollars with silver, and (2) financial convertibility, where the bank agrees to buy back its dollars with bonds. In many cases, if not most, financial convertibility makes physical convertibility irrelevant.

  The Zimbabwe currency is losing value because the amount of backing per unit of currency is falling. Either the issue of money is outrunning backing, or the bank is losing backing, or some of both.
  
  

  Published: June 15, 2008 10:35 PM

• newson

  mike sproul says:
  "Fractional reserve banking creates only checking account dollars, and those checking account dollars are a call option on paper dollars, with a strike of zero and no expiration. Just as call options do not reduce the value of the underlying security, checking account dollars do not reduce the value of paper dollars."

  but with an equity call option, the options written cannot exceed the number of shares on issue (and typically call options can only be written against a figure far short of 100%), so no dilution takes place.

  the checking account dollars, on the other hand, outweigh the dollars on issue. so if they are exchanged for little green pieces of linen, the numbers of said linen must rise, or some of the contracts will fail to be honoured. so either default or dilution.

  as an aside, on safehaven,com there another rbd exponent called antal fekete, are you aware of him?

  Published: June 16, 2008 1:45 AM

• P.M.Lawrence

  Artisan, the most likely scenario if one country were on a bullion standard while its trading partners were not is that they would buy its assets with bullion from their reserves and extracted from their people, basically exporting their inflation while they could. That would be self limiting in the long term, since they would run out of bullion. Bullion would flow out if other countries had better terms of trade and allowed their people to hold it and/or if they wanted to put it into their own reserves - but that would effectively mean that they too were bullion oriented. It has happened in the past, but it doesn't match your concerns. Either way - bullion flowing in or bullion flowing out - there can be huge problems over quite a long period, but those are best addressed by looking at the trade side, not the money side.

  Published: June 16, 2008 3:45 AM

• Silverleaf

  While being admittedly dumb as a box of rocks and spending most of my time relying on horse sense, it just seems so that I need to be able to trade my little green pieces of linen (as someone said) in for something that has real, inherent value. Government bonds are only good for as long as the government issuing them a) continues to exist and b) is willing to buy the little green pieces of linen back. I'm not interested in trading one piece of paper for another, as it were. I would much rather be able to trade my little pieces of linen in for something of real, inherent value that I can use to sustain myself when this whole thing collapses of what appears to be grandiose overthinking to the point of departure from common sense. I used to think that my grandmother was crazy for keeping her money in 15 separate banks. Grammie was onto something...

  Published: June 16, 2008 7:17 AM

• Mike Sproul

  Newson:
  "but with an equity call option, the options written cannot exceed the number of shares on issue (and typically call options can only be written against a figure far short of 100%), so no dilution takes place."

  That might be the way securities laws are written, but except for that, the number of calls can exceed the number of shares on issue. If investors become worried about a possible squeeze when calls exceed shares, then each call can have some fine print that says "redeemable either for 1 share of stock, or the equivalent in cash." Checking account dollars can have a similar feature, specifying that checking account dollars can be redeemed for paper dollars, or an equivalent value of euros.
  (BTW There is dilution even when the number of calls is less than the number of shares, since option writers don't have to hold 100% reserves of stock against calls written.)
  I've seen Fekete's work. He advocates the issue of money only for productive purposes, while the backing version of the rbd says that money can be safely issued for any purpose, as long as sufficiently valuable collateral is received in exchange.

  Published: June 16, 2008 9:36 AM

• newson

  mike sproul says:
  "(BTW There is dilution even when the number of calls is less than the number of shares, since option writers don't have to hold 100% reserves of stock against calls written.)"

  this doesn't figure to me. naked call sellers either must deliver stock or must buy back their positions before expiry. there is no dilution of earnings per share by this procedure, merely a change in ownership of underlying.

  as regards your cash settlement as alternative to delivery, this would destroy the call market's function. how could i hedge a position on the underlying if i couldn't guarantee that i would receive stock? how could you possibly cash settle if there is a surplus of unsatisfied call holders? you couldn't use the expiry price because that wouldn't incorporate the uncovered deals (ie unsatisfied demand for stock).

  Published: June 16, 2008 10:52 AM

• newson

  mike sproul says:
  "Checking account dollars can have a similar feature, specifying that checking account dollars can be redeemed for paper dollars, or an equivalent value of euros."

  this is where i have trouble with rbd. when the vastly bigger checking account dollars are presented for swapping to either euros or pieces of green, there will only be enough fed assets to cover the early-birds. so either the fed turns the late-arrivers away, or it prints up a fresh batch of green, and dilutes the cover of existing linen-holders.

  i would say the fed has been busy doing the latter for the past 70+ years, and the evidence would be the lack of widespread banking collapses since the depression, when they were a regular, periodic feature of frb prior to central banking. the fed happily accepting toxic sub-prime paper as perfectly good collateral for loans (and who knows that these loans won't be rolled over forever) makes a good case for dilution, i would have thought.

  Published: June 16, 2008 11:14 AM

• Michael A. Clem

  it just seems so that I need to be able to trade my little green pieces of linen (as someone said) in for something that has real, inherent value.
  
  Absolutely, and it works both ways. You 'earn' those pieces of linen/paper by giving someone else something of value (labor, product, etc.), and in return, other people give you something of value when you give them those pieces of paper. But if there is an ever-increasing number of those pieces of paper (inflation), then the value of the decreases. Mr. Sproul likes to tell us that the value of the assets that backs the issuance of those pieces of paper is what gives them value, but what is the value of debt? And it is a striking coincidence, as Newson likes to keep pointing out, that the value of those pieces of paper has decreased so dramatically since the creation of the Federal Reserve back in 1913. Either RBD can explain this, or it can't.
  
  Either way, getting rid of the government monopoly on currency sounds like a good idea to me.
  
  I'm not sure that fractional reserve banking is fraudulent if depositors agree to it, but of course, what depositors have agreed to it under the current system? The Federal Reserve Notes in my pocket say nothing about fractional banking or convertibility, financial or otherwise. In fact, about all they do say is that they are legal tender for all debts, public and private.
  

  Published: June 16, 2008 11:28 AM

• Mike Sproul

  Newson:

  "this is where i have trouble with rbd. when the vastly bigger checking account dollars are presented for swapping to either euros or pieces of green, there will only be enough fed assets to cover the early-birds."

  The fed does not back checking account dollars. Those are backed by the private banks that issued them. The fed backs only the paper dollars that the fed issued. The fed's balance sheet shows something like $900B in paper dollars in the hands of the public, while the fed holds something like $200B in gold, plus $700B in bonds. If the public stopped wanting to use paper dollars, the fed could first sell off its bonds and retire the $700B in paper dollars received, then it could sell off its gold, and retire the last $200B of paper.
  It's the same with private banks. Assuming they have issued $5 Trillion in checking account dollars, backed by $100B in paper plus $4.9 T in bonds, then if people all wanted to redeem their checking account dollars, the private banks could first sell $4.9T in bonds, and retire the checking account dollars received. Then the banks could sell off their last $100B in paper dollars, which would retire the last of the checking acocunt dollars.

  Everyone is paid off--not just the earlybirds.
  

  Published: June 16, 2008 11:33 AM

• Michael A. Clem

  If the public stopped wanting to use paper dollars, the fed could first sell off its bonds and retire the $700B in paper dollars received, then it could sell off its gold, and retire the last $200B of paper.
  
  Assuming that the Fed was willing to redeem the paper currency (a big assumption, I think), why would people want to buy their bonds, which are denominated in U.S. dollars? What value would they have if no one is using those dollars???
  

  Published: June 16, 2008 11:52 AM

• Person

  Mike_Sproul: Correct me if I'm wrong, but your analysis seems to go something like this:

  Austrian: The Fed is causing price-inflation by printing new dollars, which the government then treats as free money.
  Mike_Sproul: No, the Fed isn't causing inflation, because it buys and holds assets of equal value when it issues new dollars.
  Austrian: That can't be true, because obviously, there has been price inflation.
  Mike_Sproul: Right, because the fed doesn't actually back all of its dollars -- it throws off most of the interest as free money for the government, which then causes price inflation.
  Austrian: *falls out of chair*

  Published: June 16, 2008 11:56 AM

• Mike Sproul

  Michael Clem:

  The fed redeems paper dollars for bonds every day. It's called an open market sale of bonds. If the day ever comes when the fed has used up all of its bonds buying back paper dollars, then it will start to matter whether the fed redeems the rest of the dollars for gold. If it does, the paper dollar will hold its value. If it doesn't, the paper dollar will lose its value.
  The fact that the bonds are denominated in dollars is beside the point. Imagine that we started in a world where the only dollars were silver coins. Then the fed started basing paper dollars on those coins, eventually issuing billions of them in exchange for bonds, denominated in dollars. There is no reason why this can't work in reverse. The dollars that were issued for bonds can be just as easily retired for those bonds.

  Person:
  If that's what you think the rbd says, then no wonder you are skeptical. Austrians say the fed is no different from a counterfeiter. I say no, because the fed stands ready to use its assets to buy back those dollars. IF the fed loses assets (to the government or to anyone else) then there is less backing per dollar and there will be inflation. If the fed's assets move in step with the issue of dollars, then there will be no inflation.
  Austrians hold that inflation is caused by more money chasing the same goods. The RBD holds that inflation is caused by more money laying claim to the same assets. Big difference.

  Published: June 16, 2008 1:03 PM

• Michael A. Clem

  The fed redeems paper dollars for bonds every day...The fact that the bonds are denominated in dollars is beside the point.
  
  It's not beside the point if the point is to STOP using U.S. dollars, as your previous post suggested. It highlights the very flaw of calling a spade a shovel and thinking that they are two different things. Debt is a poor form of asset-backing, since it obviously doesn't prevent inflation.

  Published: June 16, 2008 1:14 PM

• jp

  "The fed redeems paper dollars for bonds every day. It's called an open market sale of bonds."

  Mike, you're misrepresenting the Fed. It does not conduct open market sales every day. The Fed almost exclusively conducts open market purchases, not open market sales ie. it buys bonds rather than selling bonds. The ratio of purchases to sales is about 1000:1. It conducts the sales you talk about maybe once or twice a year.

  Even if you were a dealer looking to trade your dollars for bonds, you can't just initiate the conversion. You'd have to wait for the Fed to set up a formal auction. Your characterization of convertability as being effortless is a bit weak.

  Published: June 16, 2008 1:49 PM

• Person

  Mike_Sproul: Yet you completely agree (with Austrians) that the existing Fed's practices, taken as a whole, do cause inflation; you only disagree about how much inflation any given issue will cause.

  So why the pretense that the Fed is backing all of its dollars when it clearly isn't? (i.e. in the sense that it throws off some of its assets to cover expenses and give freebies to the government)

  Published: June 16, 2008 2:46 PM

• Joe Stoutenburg

  Mike Sproul:

  I'd like to follow through your example regarding the issuance of $300 for which an IOU on a farm was accepted as collateral. I'd like to know your reaction as I continue the example. I'll welcome correction wherever you deem appropriate.

  Before continuing the example, some important groundwork is in order. Implicit in your example is that $1 is convertible for 1 oz of silver. Here, I'll place Austrian and rbd theories aside and rely strictly upon principles of voluntary contract. Given the choice, I insist that every paper dollar that I own be backed by something tangible. I would prefer to receive an ounce of silver though I might be persuaded to accept a share in the farm as long as I was confident that I could exchange the share for an ounce of silver in the future.

  Those are my terms. There will be no debate on this.

  Now to review, the bank issued $600 in paper money. As backing, it claims 300 oz of silver and an IOU on the farm. I'll consider a number of scenarios:

  1) The farmer repays his loan by returning $300 in paper money. In this instance, the bank tears up the IOU. Thereafter, it is fully backed by silver. No one should have a problem with this.

  2) The farmer repays his loan by returning 300 oz in silver. This time, the bank leaves $600 in paper money circulating. All of it is backed by silver. Again, there should be no problems from anybody.

  3) The farmer defaults on his loan. The bank forecloses on his farm and is able to sell it in exchange for at least 300 oz of silver. The bank now has $600 in paper money circulating with 600 oz backing it. Still, no problem.

  4) The farmer defaults on his loan. The bank forecloses on his farm but discovers that it is only able to sell it in exchange for 100 oz of silver. The bank made a poor loan and is consequently insolvent. It has $600 of paper money circulating with only 400 oz of silver. It is liquidated and the silver split between the holders of the paper money. Assuming this was the only bank in the economy, each dollar is now 1.5 oz of silver. More likely, this was one of multiple banks. The exchange rate only increases slightly. Inflation has occured since the paper money was insufficiently backed. At least though, the bank responsible for the inflation has suffered the consequences.

  5) The loan to the farmer is still outstanding. He is abiding by its terms. Meanwhile, I produce $600 of paper money to the bank that I wish to exchange for 600 oz of silver. What happens?

  This one is a little trickier. This is where you may have to wriggle a little to justify your theory. I don't think that you're going to come up with anything that will get me to accept it. The farmer, being a guy like me, expected that each of his dollars would be backed by an ounce of silver. Did he know that rather than borrowing a claim on 300 oz of silver that he was selling his farm short? Whatever the case may be, I won't let the bank force him to buy back his farm to cover the fraudulent short position. The banker is in big trouble in my book.

  Another point requires review. In scenario 2, the farmer managed to obtain 300 oz of silver to repay the loan. Yet the paper money that was originally unbacked (don't tell me it was backed by the farm - he had already exchanged 300+ oz to buy it!) remains in circulation. The amount of paper money in circulation has increased with no increase to the real assets backing it. In other words, your bank has caused inflation.

  This may be the point at which you try to pull out some kind of financial convertibility on me. I'll tell you now, I'm highly skeptical that it'll work on me. At this point, I'm dead set against your banking system. The only way that I'll live with it is if coercion is employed to force me.

  We have a more basic problem there.

  Published: June 16, 2008 3:16 PM

• joe b.

  Federal Reserve notes aren't counterfeit but they also aren't backed by any promise of anything but more of the same. Money created by commercial banks is inflation unless the bank loans only deposits. If deposits are used as a base upon which to pyramid loans, the money thus created is inflationary regardless of any collateral "backing." As the loan is repaid the inlationary liability is deflated, assuming more loan money is not created to replace it. Adding new capital or new deposits used as reserves, branch banking, new banks etc. increase the opportunity for more inlation.
  Using property as collateral for a loan doesn't make the loan more or less likely to be inflationary. But if that collateral (usually not a fungible good) were used to back the money supply, either alone or in conjunction with other goods of any sort, then, there would be no consistent standard of value to bring coherence to the information contained in prices. Recent experience with collaterized debt obligations might suggest as much.

  Published: June 16, 2008 4:12 PM

• Mike Sproul

  Michael Clem:

  The point that matters is that paper dollars that were issued in exchange for bonds can be retired in exchange for bonds. No need to worry about stopping the use of dollars

  JP:
  Let me rephrase: The fed redeems dollars for bonds on a regular basis. Period. Sometimes it happens as an open market sale of bonds, but more often the bonds held by the fed mature, the fed becomes the owner of so many dollars, and (usually) those maturing bonds are rolled over into new bonds, and the dollars return to the public.

  Person:
  "So why the pretense that the Fed is backing all of its dollars when it clearly isn't?"

  You might as well ask why the pretense that GM backs its stocks, when profits are down and the stock is faling. The point is that the value of money, like the value of stock, DEPENDS on backing. If backing is maintained there will be no inflation. If not, there will be inflation. Austrians say the value of money depends on the fact that the government limits the quantity of those pieces of paper, while their usefulness as money creates a demand for them. Which theory is more believable: the one that says a piece of paper has value because it is a claim to something of value, or the one that says the paper has value even though it is a claim to nothing?

  Joe S:

  No disagreement on items 1-4, except the dollar is worth 400/600=.67 oz, not 1.5 oz. Also your point about the other banks is unclear.
  On #5, I assume you mean that you collected all 600 paper dollars that were in circulation, and presented them to the bank, demanding silver. The bank has 300 oz, plus the farmer's IOU that, by assumption, is worth 300 oz. So the bank first pays out its 300 oz, then sells the IOU for 300 oz and then redeems the remaining 300 paper dollars. You can come up with some scenario where the banker is unable to sell the IOU for 300 oz., and in that case, the banker would have had to put some fine print on his paper dollars, specifying that they are redeemable for 1 oz, or for the farmer's IOU. The farmer is only obligated to pay back his IOU on the original terms, and the banker simply pays out an IOU worth 300 oz, rather than 300 oz itself. (I have just pulled out some kind of financial convertibility.)

  And about your point on scenario #2: The bank, according to your story, is in possession of 600 oz, and there are 600 paper dollars in circulation. No problem.

  Joe B:
  Show me the bank that issues money without taking assets of at least equal value, and I'll send them more business than they can handle. Every dollar that is issued on these terms is matched by an equal increase in bank assets, so the dollars hold their value

  Published: June 16, 2008 6:22 PM

• Mike Sproul

  Newson:

  "this doesn't figure to me. naked call sellers either must deliver stock or must buy back their positions before expiry. there is no dilution of earnings per share by this procedure, merely a change in ownership of underlying."

  I meant that if there are 100 shares of the underlier in existence, and 60 calls are issued, then it will appear to investors that there are now 160 shares available to buy. Now, this is not really dilution, since the 100 shares are claims against the corporation that issued them, and the 60 calls are claims against the call writers. The calls and the underlier are different things. Note that the issue of calls will not reduce the value of the underlier. Austrians make a mistake when they say that the issue of checking account dollars (calls on paper dollars) reduces the value of the underlying paper dollars. That's why I brought up calls and underliers--to point out this error.

  "as regards your cash settlement as alternative to delivery, this would destroy the call market's function. how could i hedge a position on the underlying if i couldn't guarantee that i would receive stock?"

  I believe most calls end with a cash settlement. Apparently, it's not a big deal, since most investors are content with cash instead of stock.On the other hand, this problem might set some kind of limit on the issue of call options. If 1% of call holders actually do want stock instead of cash, the issue of calls couldn't exceed 100 times the number of underlying shares. I don't know of any actual examples of this.

  "how could you possibly cash settle if there is a surplus of unsatisfied call holders? you couldn't use the expiry price because that wouldn't incorporate the uncovered deals (ie unsatisfied demand for stock)."

  I think you're right that the price would be corrupted. I also think, as above, that it's a rare enough case that it hasn't caused major problems.

  Published: June 16, 2008 7:15 PM

• Alex

  Mike Sproul:

  Suppose that there are no commercial banks and that Federal Reserve notes are the only legal form of money, as declared by the government.

  Suppose the Fed on its balance sheet has $700 billion of government bonds as assets "backing" (to use your term) $700 billion of Fed notes circulating as money.

  The first thing to note is that the almost all the interest on the government bonds is remitted back to the Treasury, and, that to the extent the Fed's government bond portfolio grows over time, the $700 billion held by the Fed are rolled over but never paid off. This fact means that the $700 billion of government bonds held on the Fed's balance sheet represent interest-free perpetual public debt, or, in other words, a cumulative amount of taxes that the government has extracted via the Fed.

  Now, suppose the Fed decides to suddenly purchase another $1 trillion of government bonds presently in the public's hands (on the open market). This action will, naturally, reduce interest rates and increase the amount of money in the public's hands by $1 trillion. The question is what will the public do with the extra $1 trillion of fed notes that they have bought with the bonds they sold to the Fed. The view that you (Mike) dispute is that this is would be a disequilibrium situation concerning the demand for goods and services, financial assets, real assets and money, and that at least some of this "excess" money would find its way to increase the demand for goods and services thereby driving up their prices. If you think not, what's your story in the re-establishment of equilibrium between money and goods and services?

  Published: June 16, 2008 7:20 PM

• Mike Sproul

  Alex:

  If you hadn't specified that there are no commercial banks, I would have had two answers about the effects of the extra $1 trillion: 1) $1 trillion of checking account dollars would have refluxed to the commercial banks, or (2) the extra $1 trillion would sit idle in people's drawers.
  I would also point out that the public now holds an extra $1 trillion of green paper, where they used to hold $1 trillion of bonds, so the public's spending power is not much affected.
  Of course the basic problem is your assumption that the fed forces money into circulation with no attention paid to its economic effects.
  

  Published: June 16, 2008 7:49 PM

• P.M.Lawrence

  Michael A. Clem, a spade and a shovel are two different things. A spade has a digging action, so it needs a long lever arm and a narrow blade with no raised sides with their resistance. A shovel has a scooping and lifting action, so it needs a short lever arm that keeps the weight close to the effort and a wide blade with raised sides to reduce spillage.

  Published: June 16, 2008 11:06 PM

• newson

  to mike sproul:

  i think only difference between the rbd and the austrians is that the latter insist on a money whose stock is as close to constant as possible. that way the function of money as a yardstick is stable over time.

  with rbd, the backing of the money is a moving target, with loans to particular sectors having a positive feedback on valuation of the backing assets.

  so in the sub-prime case, banks loaned on property valuations which were pumped up by the vast amounts of credits already destined towards the sector. dog chases tail.

  Published: June 17, 2008 12:59 AM

• Joe Stoutenburg

  Mike:

  Yes. You're right. I flipped my ratio. My point about other banks would only apply in the presence of a central bank that required all branch banks to use the same notes. If the bank used its own notes, then the exchange rate on its notes would be 0.67 oz per dollar. If it used notes common to other banks, then there would be a less significant dilution to the value of the dollars. I think that this is tangential to the primary discussion though I'll certainly carefully consider a response if you think it's worth pursuing.

  On #5, it is possible for the bank to contract with its note holders to accept either silver or a share of the IOU. If the farm is worth far less than 300 oz of silver, then it seems that the scenario is reduced to something like #4. The real value of the assets backing the notes is not what the bank initially claimed it to be. It seems to follow that inflation is the result. Since you didn't object to #4, can I infer that you agree that inflation can occur in this manner?

  The financial convertibility of the IOU is troubling to me. It seems like you could quickly lose track of the collateral. The bank could sell its IOU not for silver but for notes from another bank. The bank receiving the IOU might then conceivably issue another $300 with the IOU backing it. A determined observer might discover the practice and call it out, but it seems likely to me that banks might get away with trading these financial assets and issuing money with multiple claims on the same assets. It has kind of the same feel as the sub-prime mess. Debt has been repackaged and sold so many times that it is difficult to sort out who is holding the empty bag.

  When it comes down to it, here is where I am starting to land on your real bills doctrine. It is not necessarily at odds with my economic philosophy (most strongly influenced as it is, by the Austrian school). While it may be true that most Austrians are gold-bugs (or at least advocates of commodity money), I don't read anything in basic Austrian principles that requires money to based upon precious metals. Rather, a central tenant of the school is that exchange is subjective. People do not intrinsically quantify their desires. They can only order their desires in a cardinal manner. It is only the introduction of money that makes economic calculation possible.

  There is no economic law prohibiting competing currencies. Neither is there law prohibiting issuing money that may have multiple convertibility - silver, gold, an IOU or other financial asset. If people voluntarily agree to an exchange, then it can not be found in conflict with Austrian economic principles.

  Now all that being said, I deeply distrust the notion of backing money with other financial assets. As I explained in connection with my original scenarios, I believe that such backing will quickly become obscured and that the money supply will inflate beyond control. I remain an advocate of defining money as a commodity that is stable in quantity. Such a money is much less prone to manipulation than any other that I could conceive.

  In any case, surely you must agree that the U.S. dollar has been subject to significant inflation. Would you be willing opine on how that has happened? Do you have no problem with that inflation? And do you not agree that there have been wealth transfers as its result?

  Published: June 17, 2008 8:42 AM

• Mike Sproul

  Newson:

  On RBD principles, keeping the money stock constant would not assure that the amount of backing per unit of currency is constant, so it would not prevent price inflation. What it would do is leave the public with too little money during booms, and too much money during busts. The RBD allows elasticity of the money supply, where the money supply can grow and shrink according to the needs of business. Sometimes there will be speculative bubbles, but you'll have those under any system. We'll have bubbles until we get better crystal balls.

  Published: June 17, 2008 8:48 AM

• Michael A. Clem

  Thanks for the correction, P.M., but I still wonder what Mr. Sproul is shoveling.
  
  The point is that the value of money, like the value of stock, DEPENDS on backing. If backing is maintained there will be no inflation. If not, there will be inflation. Austrians say the value of money depends on the fact that the government limits the quantity of those pieces of paper, while their usefulness as money creates a demand for them. Which theory is more believable: the one that says a piece of paper has value because it is a claim to something of value, or the one that says the paper has value even though it is a claim to nothing?
  
  A piece of paper has value because other people are willing to accept it in exchange for something of value, that's the claim currency has. Why they are willing to accept it is more complicated, perhaps even psychological. A dollar used to be a certificate representing a quantity of gold, and now it represents a 'financial asset' like a Treasury bond. The psychological difference should be obvious: gold is a very real, physical substance with weight and mass. A bond is a debt--a promise that the seller will come up with money in the future and pay it back. You tell me which is more secure.
  
  Nonetheless, people DO take U.S. dollars, in spite of the lack of commodity backing. Supply and demand still apply to dollars, just like any other commodity. All other things being equal, the supply of dollars DOES make a difference to the value of the dollar. The real question is, are all other things equal? I don't think debt-backed dollars have the same weight as gold-backed dollars, but either way, backing only affects the value of dollars to the extent that people trust the backing, and are thus willing to accept dollars.

  Published: June 17, 2008 9:05 AM

• Alex

  Mike Sproule:

  The debate is whether or not increases in money cause increases in the general level of prices of goods and services. Let me give a second example, which probably should have been my first, then deal with your above comments.

  President Mugabe has a $1 trillion Zimbabwean (face value) government bond printed up (big piece of paper) and has it carted over to the Zimbabwean central bank. The Zimbabwean central bank in return for this bond, sends back to Mugabe 1 trillion Zimbabwean dollars currency. Mugabe then spends this money on Zimbabwean goods and services. Do you argue that these actions have no effect on the Zimbabwean price level?

  Though not so dramatically, the above is exactly what happens between the Treasury and the Fed. The Treasury has big pieces of paper (T-bonds) printed up and lots of them are purchased by the Fed. If, say, $1 billion worth is purchased directly from the Treasury by the Fed, the Fed simply creates a $1 billion Treasury deposit at the Fed, which the federal government then spends on goods and services. Though $1 billion is not as large as $1 trillion, qualitatively the government-Fed transaction would have the same effects on U.S. spending and the price level as would Mugabe's diddling.

  Now, in a more roundabout way. Suppose the public has $1 billion of money and purchases $1 billion of newly issued government bonds. Then the Fed engages in a $1 billion open market purchase of these bonds to get them onto its balance sheet. The net effect is exactly the same as if the Treasury had sold the bonds directly to the Fed.
  
  Now, if when the Treasury sells its bonds to the fed (either directly or in two steps), the government doesn't spend the money it has raised from the bond sale, then there will be no increase in the general price level. (If you like, the demand for money holdings (by the government) has increased by exactly the same as the increase in money supply.) But, of course, if the newly created money is spent by the government on goods and services, this will drive up prices.

  Now to your comments:

  Not sure what "refluxed to the commercial banks" means. Anyway, there were no commercial banks in my example.

  "or (2) the extra $1 trillion would sit idle in people's drawers. I would also point out that the public now holds an extra $1 trillion of green paper, where they used to hold $1 trillion of bonds, so the public's spending power is not much affected."
  
  These statements assume unrealistically that people are completely indifferent to the amount of money and other assets that they hold. For example, they don't care whether they hold $1 trillion of interest bearing government bonds or $1 trillion of cash earning no interest.

  "Of course the basic problem is your assumption that the fed forces money into circulation with no attention paid to its economic effects."

  My example was extreme to demonstrate a point. I believe there would be large price level effects from such a Fed action, but I thought you said there would not be any economic effects for the Fed to worry about by such an action.

  Published: June 17, 2008 9:40 AM

• newson

  mike sproul says:
  "What it would do is leave the public with too little money during booms, and too much money during busts."

  but the primary purpose of money is as a measuring stick of value. just as distance, to be measured accurately must be denominated in widely understood and accepted units, so to must money stock remain constant in order to accurately price different goods over different times.

  if i choose to measure a cricket in inches, i still can use the same unit to measure a football field. people don't ever need more money, only the stuff it represents. inches don't grow to measure football fields.

  Published: June 17, 2008 10:42 AM

• Joe Stoutenburg

  I've never understood what people meant by statements such as Mike's:

  What it would do is leave the public with too little money during booms, and too much money during busts.

  I've always figured that it was because the statements don't make sense. newson's post seems reasonable and only reinforces my figuring. But I'd like to ask Mike (who seems more thoughtful than the typical arm-chair economist) to back up the statement. Focusing on the boom side of your statement, if "too little money" is a bad thing, can you explain just what would be the consequences of having "too little money"?

  I can see having too little or too much money from the standpoint of the function of money (for instance, using water as money in an area dotted by lakes). But that is an entirely different matter.

  Published: June 17, 2008 11:12 AM

• fundamentalist

  Mike: “…keeping the money stock constant would not assure that the amount of backing per unit of currency is constant, so it would not prevent price inflation. What it would do is leave the public with too little money during booms, and too much money during busts.”

  Exactly! Booms should be based on savings, so there should be a break on booms. RBD completely ignores the capital structure that is the foundation of Austrian econ. Booms go bust when too much money chases too few capital goods. Because capital goods are scarce and take time to produce, the plans of many businessmen must fail. But when growth is financed by savings, the limited amount of savings causes balanced, sustainable growth that prevents too much money chasing scarce capital goods.

  Austrian econ would produce counter-cyclical movements in the money supply. The Fed follows a version of the RBD which cause a pro-cyclical money supply, and its history proves. In other words, the money supply feeds booms and starves busts. Mike’s statement demonstrates that his RBD doctrine not only violates established theories of value and the Austrian theory of money, but the Austrian Business Cycle Theory as well.

  Mike’s RBD says that money is neutral, or in econo-speak, “endogenous.” In other words, money does not cause changes to the real economy, it responds to them, the view of mainstream econ, too. If that’s true, then what causes the business cycle? In technical terms, random shocks. In plain English, acts of God. In other words, neither mainstream econ nor Mike’s RBD have a theory.

  Austrian econ predicts that RBD will cause the money supply to grow first, and the boom will follow. Then, when businesses start going broke from malinvestments, they will be unable to pay back loans and the money supply will shrink. In some cases it will shrink so fast due to failing business confidence that the Fed can’t catch it even using RBD. Austrian econ predicts that under the Fed’s RBD the money supply will be too high during booms and too low during busts, as history shows.
  

  Published: June 17, 2008 11:16 AM

• fusgerm

  Mike Sproul:

  I find the RBD helpful in explaining how money maintains its value. I don't think that the QT adequately explains why money supply growth is often associated with a RISING currency value - e.g. the Yuan or Aus Dollar in recent years.

  But I disagree with many of your conclusions. In particular, I think that the Austrian version of the QT is actually consistent with the RBD theory of monetary backing.

  1. I don't find periodic bond sales a reassuring form of convertibility. Bonds are claims to future dollars, and dollars are backed by bonds, so they rise and fall in value together. Maintaining backing in terms of Treasuries is therefore no check on inflation.

  It would be more reassuring if the Fed had conducted periodic gold trades to keep gold at $40/oz. That's the only kind of financial convertibility that's worth a crumpet.

  2. You say that a call option does not affect the value of the underlying stock, and that is broadly true. But money is no ordinary stock. Money is the medium of exchange, ergo the means of payment. If a claim to money is itself generally accepted as payment then it too is money in its own right, by definition. It is as if a call option to a share of stock itself automatically becomes a share of the stock. This doesn't prove that the QT is true, or that the RBD is false, but that the effect of issuing a "call option" on money might not be neutral.

  3. Suppose the currency is redeemable in gold, and then the bank fills half of its vaults with silver by value. If the gold-price of silver falls too much, then your bank will be in trouble. Likewise if it buys too many bonds: if interest rates rise, it will be in trouble. Little wonder that you prefer a currency which is not physically convertible, since I doubt that a bank could hedge against this. Even FDIC depends on taxpayer largesse.

  4. The MECHANISM by which an inconvertible currency maintains its value seems unstable to me. An RBD bank is like a fixed-income mutual fund, with capital-guaranteed shares which are used as money. According to you, the market-value of each share may be expected to trade at its net asset value (NAV). But what mechanism will ensure this? Mutual fund shares often trade way above or below their NAV for extended periods. The Austrian business-cycle can be seen as an instance of the market-value of money being pushed below its NAV (inflation) during booms, only to spring part-way back explosively (deflation) during busts.

  5. How might this come about? If banks are free to create fiduciary media with no reserve-limit or Basel-limit, then one would expect interest-rates to be lower than if the banks draw exclusively on time-deposits to make loans. The proof of that does not rely on the QT, but may be explained by a reduced demand for time-deposits. This gives rise to the mismatch between savings and investment at the heart of the ABCT.

  6. Alternatively, if we accept a mild form of the QT, the extra money being issued hits a "hot" sector first, and raises its price. Dependent sectors then experience price-inflation in turn. Retail prices are usually the last to be affected, but it is only then that there is belated recognition that money is trading below its NAV, as measured by the CPI.

  Under the discipline of a gold standard, this would provoke a rash of redemptions, and bank asset-sales to meet them. The firesale of bank-assets pushes up interest rates and thereby exposes the loan-component of existing monetary backing as inadeqate, since they were established at depressed interest-rates. Banks embark on capital raising, and many close down.

  Under the current monetary system, interest rates are raised in response to rising CPI, and the effects are similar, except that fewer banks need to close down because the Fed will bail many of them out. The Fed also degrades its own backing to ease the pain on the banks, by lending (via repos) at sub-market interest-rates, and recently by accepting illiquid assets at unrealistic valuations.

  Published: June 17, 2008 11:55 AM

• Mike Sproul

  Michael Clem:
  "A piece of paper has value because other people are willing to accept it in exchange for something of value,"

  You seem pretty well aware of the circularity and general absurdity of this view of money. I think you'd also agree that if money were backed by gold, then there would be nothing 'complicated' that required explanation. The only thing complicated about the RBD is the idea that money can be backed without being physically convertible. If the quantity theory were correct, and backing didn't matter, you should be able to find at least a few central banks that hold no assets against their money, but there are no such banks. Before 1933, the dollar was physically convertible, so nobody thought it was fiat money. Of course, the fed suspended physical convertibility every night and every weekend, but the dollar held its value because everyone knew that the fed's assets were still there in its vaults. So what happened in 1933? Physical convertibility was suspended for an indefinite time, but financial convertibility was maintained, and the fed's assets were still there, still backing the paper dollars issued by the fed. That's why I say that the dollar is backed by the fed's assets, and the idea of fiat money is an illusion.

  Alex: When money is issued for assets of inadequate value (like Mugabe's IOU) then the money will lose value. It might help to ask yourself what would happen if the fed issued money passively, rather than on its own initiative. Some citizen wants cash, and has a $100,000 T-bill. He takes the T-bill to the fed, which pays him $100,000 cash for it. (If the economy were already flush with cash, he would have gotten the cash on the open market, rather than going to the fed.) That way, money is only issued when the economy has a need for it. Since the fed does, in fact, try to issue the 'right' amount of money, this voluntary issue is a better way to understand money than those 'forced' scenarios you describe.
  The Law of the Reflux describes the process whereby a bank that issues more money than the economy can use will have the excess money returned (refluxed) to it by its own customers.

  Newson:
  "but the primary purpose of money is as a measuring stick of value. just as distance, to be measured accurately must be denominated in widely understood and accepted units, so to must money stock remain constant in order to accurately price different goods over different times."

  You are assuming the correctness of the quantity theory, which is the very point in dispute. To take a simple example, suppose that dollars are backed and physically convertible into 1 oz. of silver. In that case you would not have said that the money stock had to remain constant for the price level to stay the same. The price level MUST be the same no matter what the money supply is, since a dollar must be worth 1 oz. During busy times (christmas, harvest time) people would need a lot of dollars, so the bank would issue more than usual. After the boom was over, dollars would reflux to the bank as loans are repaid, bonds mature, etc. Through all that, the dollar is still worth 1 oz. If that seems reasonable enough, now take the next step, which is to recognize that physical convertibility can be replaced with financial convertibility. Then maybe it won't sound so strange when I talk about the supply of money rising and falling according to the needs of business.

  Joe S.
  "can you explain just what would be the consequences of having "too little money"?

  When the christmas season hits, people need more cash to conduct the extra business. If that cash is not issued, people will be forced to use some less efficient method of trading--think of people being reduced to barter because of the lack of cash.
  Money shortages were actually a major problem in the 1800's, which is why the fed's charter listed 'providing an elastic currency' as the fed's primary duty. Then, as now, quantity theorists did not know what to make of the claim of 'too little money'. They figured that if the money supply were doubled, the value of each dollar would be halved, so they resisted calls for more money. They did not see that if the money supply wer doubled, and the assets backing it were also doubled, there would be no change in the value of the dollar, but the extra cash would make it easier to do business.

  Fundamentalist: A bank that follows the RBD will accommodate booms and busts--not cause them. Think of a hot dog vendor. Should that vendor accommodate his customers by cooking hot dogs when they want them, and not when they don't? Or should he follow the Austrian 'countercyclical' policy of cooking hot dogs when nobody wants them, and then refusing to cook enough to accommodate the lunchtime rush? That's what a bank would be doing if it tightened its issue of money during booms, and eased during busts.

  Fusgerm:
  "Bonds are claims to future dollars, and dollars are backed by bonds, so they rise and fall in value together."
  True. This is what I've called 'inflationary feedback', in my paper "There's No Such Thing as Fiat Money"
  "It would be more reassuring if the Fed had conducted periodic gold trades to keep gold at $40/oz. That's the only kind of financial convertibility that's worth a crumpet."
  That's physical convertibility, not financial. Believe it or not, nobody has ever said "worth a crumpet" to me before.
  "According to you, the market-value of each share may be expected to trade at its net asset value (NAV). But what mechanism will ensure this? "
  Ordinary open-market operations are one way to ensure this. My "No Fiat Money" paper actually makes a concession to the quantity theory on this point. There's a graph in the paper that shows a falling demand curve for money, and in certain cases the overissue of money can cause it to fall below its backing value.
  

  Published: June 17, 2008 2:03 PM

• Person

  Mike_Sproul: If GM kept issuing new shares, and used the proceeds to buy frivolities, like gold statues of the executives, I would say, "Hey, GM is devaluing its shares." And I'd be right (though the effect could be blurred if somehow other forces propped up GM's profitability).

  Similarly, if the Fed kept issuing new dollars, and blowing the proceeds on giveaways (like it does), I would say, "Hey, the Fed is devaluing the US Dollar." And I'd be right (though the effect would get blurred).

  And the Austrians here would say the same thing. And they would be right. So again, why keep arguing about all the conditions under which the Fed "could" print money while not devaluing the dollar, conditions which don't actually apply today?

  Published: June 17, 2008 2:19 PM

• Joe Stoutenburg

  Mike, you either ignored or missed my post dated June 17, 2008 8:42 AM (understandable while you're engaging at least half a dozen people at once). I'm still interested in a return comment if you're willing - especially regarding my questions at its end.

  Published: June 17, 2008 2:54 PM

• Joe Stoutenburg

  Mike, I have to challenge your first statement:

  When the christmas season hits, people need more cash to conduct the extra business.

  I can conceive of situations when notes would become so scarce as to hinder transactions from a practical standpoint. To illustrate, suppose for example that we have an economy with a minimum denomination of one dollar. Suppose further that the economy has grown to the point at which the typical household only has a handful of dollars but makes scores of transactions a month. Clearly, there are not enough dollars in circulation.

  Fortunately, suitable candidates for money are divisible (even the farm IOU is divisible to a point though the division would be messy and highly subjective). You could break the dollars down to pennies or even smaller units. There would be practical limits to which the division could occur, and an adjustment to the monetary system would be required (such as changing the commodity backing, introducing another one or some other innovation). However, these limits would be entirely independent of any boom/bust seasonal factors.

  Even though your first statement kind of loses me on the rest, I will further challenge your closing statement:

  (Quantity theorists) did not see that if the money supply were doubled, and the assets backing it were also doubled, there would be no change in the value of the dollar, but the extra cash would make it easier to do business.

  I went along with you fine when you put a farm up as backing for money. It's a real, tangible asset. I can go along with financial assets as long as they are eventually backed by real assets. But you've lost me again there. How exactly do you double assets without making money appear out of thin air? And if money is a claim to real assets but is not backed by real assets, then won't the first receivers of this new money have just received a windfall at the expense of later receivers?

  Published: June 17, 2008 3:20 PM

• fundamentalist

  Mike: “Think of a hot dog vendor.”

  Ah, but the hot dog vendor must supply his customers out of his savings or borrow the savings of others. In order to have the hot dogs that customers will want when they want them, the vendor must save some of his sales revenue, or borrow the savings of someone else, and purchase the hot dogs to sell. If hot dog vendors could create weiners and bread out of thin air, I’m sure they would love it.

  If banks were limited to lending only the savings of depositors, that is, required to keep 100% reserves, then they would be like the hot dog vendor. Banks could make available for loan only the money that others had deposited, but could not create money out of thin air. In that case they would be free to make loans available when customers want them, but no more than what other customers had deposited from real savings.

  Banks differ from other types of businesses only in the fact that banks can create their product, money, ex nihilo. Everyone else on the planet has to save, or borrow other people’s savings, and buy the needed inputs. Banks don’t under RBD, which is a fancy name for fractional reserve banking.

  Mike: “Or should he follow the Austrian 'countercyclical' policy of cooking hot dogs when nobody wants them, and then refusing to cook enough to accommodate the lunchtime rush?”

  So you acknowledge that the money supply under RBD/mainstream econ makes booms and busts worse by being pro-cyclical, that is, giving a loan to everyone who wants one during the boom while making sure that no one who wants a loan during the bust can get one.

  Mike: “That's what a bank would be doing if it tightened its issue of money during booms, and eased during busts.”

  That’s not what Austrians advocate. They advocate letting the market determine interest rates. In the ABCT, a boom (as opposed to steady growth) would happen only if savings increased rapidly. If some event caused an increase in demand for loans, the interest rate would rise naturally. If savings increased relative to demand for loans, interest rates would naturally fall; banks wouldn’t manipulate the interest rate.

  The whole point of the ABCT is that capital goods are scarce and take time to make. If banks finance growth through loans from savings, then no mismatch between demand for and supply of capital goods will take place. But if you try to boost growth artificially by creating money out of thin air, as under the RBD, you destroy the balance between supply/demand of capital goods by creating excessive demand and the short-lived booms busts.
  

  Published: June 17, 2008 4:17 PM

• fundamentalist

  Joe: "I can conceive of situations when notes would become so scarce as to hinder transactions from a practical standpoint."

  Actually, that's not very likely. If money becomes scarce, prices don't stay the same. Scarce money means money is more valuable. More valuable money becomes evident through falling prices. Within a short time prices would fall to a level that matches the new, higher value of money so that the money available will be totally sufficient to allow all of the transactions that people want.

  Published: June 17, 2008 4:21 PM

• Alex

  Mike Sproul:

  Mike, you say: "Alex: When money is issued for assets of inadequate value (like Mugabe's IOU) then the money will lose value. It might help to ask yourself what would happen if the fed issued money passively, rather than on its own initiative. Some citizen wants cash, and has a $100,000 T-bill. He takes the T-bill to the fed, which pays him $100,000 cash for it. (If the economy were already flush with cash, he would have gotten the cash on the open market, rather than going to the fed.) That way, money is only issued when the economy has a need for it. Since the fed does, in fact, try to issue the 'right' amount of money, this voluntary issue is a better way to understand money than those 'forced' scenarios you describe."

  Mike, in the "passive" case that you mention. If the public's demand for money increases by $100 and the Fed increases the money supply by $100, there would be no spending increase resulting from the Fed's actions, nor would the Fed's actions cause an observed increase in the price level for goods and services. (Though spending and the price level will still be higher than they would have been had the Fed not increased the money supply to meet the $100 in increased money demand.)

  My "forced" examples simply make it easier to see that when the Fed causes the supply of money to increase faster than the demand for money, there will be increased spending on assets and goods and services, and a general increase in goods and services' prices.

  Again I ask you to explain what you think happens to prevent spending and price level increases when a central bank increases the supply of money at a faster rate than the demand for money is increasing. Surely you believe this happens all the time, in other words, that over and over again central banks expand the money supply in a (to use your terminology) non-passive manner.

  Published: June 17, 2008 5:46 PM

• Mike Sproul

  Person:
  "if the Fed kept issuing new dollars, and blowing the proceeds on giveaways (like it does), I would say, "Hey, the Fed is devaluing the US Dollar." And I'd be right (though the effect would get blurred).

  And the Austrians here would say the same thing. "

  Austrians are very explicit in denying the relevance of backing to physically inconvertible currencies like the dollar. Mises and Rothbard specifically say that the value of the dollar is determined by supply and demand, not by backing.

  Joe S.:
  Inflation happens when the fed's ratio of assets to money falls, as happens when the fed lends at below-market rates, overpays for bonds, (or if the bonds lose value), hands its interest earnings over to the treasury, wastes money on staff and buildings, etc. Certainly, borrowers gain from unexpected inflation and lenders lose, but if the inflation is anticipated there doesn't have to be a wealth trasfer.
  Yes; Austrians are gold bugs, especially mises and rothbard. It's not consistent with libertarianism, since they advocate some very unlibertarian restrictions on banking when they denounce fractional reserve banking.
  The RBD says you can back money with anything of value--from gold to wheat to land to bonds to lottery tickets. It's value that matters--and bonds can certainly have value just like precious metals can. Bonds might be less stable, but it should be up to the bank and its customers to decide how stable they want the backing to be.

  "How exactly do you double assets without making money appear out of thin air? And if money is a claim to real assets but is not backed by real assets, then won't the first receivers of this new money have just received a windfall at the expense of later receivers?"
  In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn't say those dollars were created out of thin air. The next 300 paper dollars were issued for the farmer's IOU, which was worth 300 oz. That is not a case of money coming out of thin air. That IOU has value, just like the 300 oz of silver. Further, the IOU is backed by a lien on the farm, and once that 300 oz. lien is placed on the farm, the farmer is unable to borrow any more money against that farm, unless the farm is worth more than 300 oz. That is not 'thin air'. Counterfeiters create money out of thin air. Banks only issue money to people who allow that bank to place liens on their assets.
  Since the new money is matched by new assets, there is no inflation, and no windfall to the first receivers.

  Fundamentalist:
  "If banks were limited to lending only the savings of depositors, that is, required to keep 100% reserves, then they would be like the hot dog vendor. Banks could make available for loan only the money that others had deposited, but could not create money out of thin air."

  See my 'thin air' comments above. The people with silver got their $300 because they deposited silver. The farmer got his $300 because he 'deposited' his farm. You say that deposits must be in the form of gold, silver, etc. I say they can be in any form that the banker and the customers agree to.

  "If money becomes scarce, prices don't stay the same. Scarce money means money is more valuable. More valuable money becomes evident through falling prices. Within a short time prices would fall to a level that matches the new, higher value of money so that the money available will be totally sufficient to allow all of the transactions that people want."
  Exactly the argument that quantity theorists made in the 1800's, while real bills'ers would have said that issuing new money for assets of adequate value would not cause inflation.

  Alex:
  "Again I ask you to explain what you think happens to prevent spending and price level increases when a central bank increases the supply of money at a faster rate than the demand for money is increasing. Surely you believe this happens all the time, in other words, that over and over again central banks expand the money supply in a (to use your terminology) non-passive manner."

  If the fed wants to force another $100 into circulation, and if the public is already well-stocked with cash, then the fed will start by bidding $100 for a bond worth $100. But by assumption, the public has no particular desire to trade the $100 bond for the $100 cash, so the fed has to offer $101 in paper for the $100 bond in order for the cash to be accepted by the public. Now the fed's assets have risen by $1 less than its liabilities, so there will be inflation. I say the inflation was caused by a loss of backing, while you say it was because there is now another $101 chasing the same amount of goods. If I added something about how the $101 of paper simply displaced $101 of checking account dollars (which would reflux to their issuers) then under reasonable conditions, your model would say there would be no inflation. Mine would say there is still inflation, because of the $1 loss of backing.

  I haven't really explained my more-or less complete dismissal of the concepts of supply and demand as regards money. For now I'll say that supply and demand works fine for commodities, but not for financial securities. Financial securities can be nothing but computer blips, which can be created and destroyed in an instant. Ordinary ideas of supply and demand simply don't apply.

  
  

  Published: June 17, 2008 8:08 PM

• newson

  fusgerm says:
  "I find the RBD helpful in explaining how money maintains its value. I don't think that the QT adequately explains why money supply growth is often associated with a RISING currency value - e.g. the Yuan or Aus Dollar in recent years."

  isn't it that the chinese currency is buoyed by tightening monetary conditions (raised banking reserves etc.), trade surplus vis-a-vis rest of world, and rising domestic interest rates? and that the aussie dollar is really only strong against the usd, and that the high interest rates and commodity story is the ostensible short-term reason?

  paper currencies can fail to reflect country fundamentals short/medium term, but not long term. i cannot see why this should negate the quantity theory. this seems to me to be the very beauty of the austrian approach - that increasing the amount of money will impact prices, but way various prices are impacted and time-frame are unknowable.

  the argentine peso remained overvalued for an incredibly long period before the peso/usd link was broken. money had flowed into the country for years, in spite of vast growth in money supply. why can't bubbles (mispricing) also affect currencies?

  Published: June 17, 2008 9:26 PM

• fundamentalist

  Mike: "In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn't say those dollars were created out of thin air."

  I can't see how you can describe it as anything else. Say the reserve requirement is 10% undeer the RBD. That means that a bank can loan out about 9 times its cash reserves. How does it create those loans? It simply writes the numbers in the accounting system under the account of the borrowers. The bank doesn't even have to print paper money, a simple accounting entry does the trick. If that's not creating money out of thin air, I don't know what you call it. In exchange for a simple accounting entry, the bank takes as collateral real wealth, such as a farm, so that if the borrower fails, the bank gets real wealth in exchange for its accounting entry.

  Published: June 17, 2008 10:28 PM

• fundamentalist

  PS: The bank uses the money it created out of thin air to pay workers, dividends, and buy the land it sits on and its building. In that way, the bank exchanges money from thin air for real wealth.

  Published: June 17, 2008 10:32 PM

• fundamentalist

  fusgerm: "I don't think that the QT adequately explains why money supply growth is often associated with a RISING currency value..."

  In addition to what newson wrote, keep in mind that money supply growth is relative. China may be inflating its money supply, but if the US inflates at a faster rate, Chinese currency will increase in value relative to the dollar, even though both are losing value against commodities such as gold.

  Published: June 17, 2008 10:35 PM

• fusgerm

  Newson says:
  the aussie dollar is really only strong against the usd, and the high interest rates and commodity story is the ostensible short-term reason? ...i cannot see why this should negate the quantity theory. this seems to me to be the very beauty of the austrian approach

  I was referring to the classic statement of the QT, e.g. by Fisher, which asserts an almost linear inverse relationship between the quantity of money and its value. That is certainly false, and Mises was one of its staunchest critics.

  The Austrian version of the QT indeed fits the facts of the recent boom very well. Looking at Australia, for example, the monetary base doubled in three years from $AU 52 B from Y/E Jun 30 2004 to $ 106 B in Y/E Jun 30 2007, yet no one claims that retail prices doubled in that time.

  In the same period, AUD rose by approx 10% against EUR, GBP and USD, by 20% against JPY, by 15% against CHF, remained stable against NZD, and fell against only one major currency - 10% against CAD. (visual estimates.) AUD has in fact risen against most currencies (except EUR, which also started from a low point in 2002), not just against USD.

  Clearly, the results are not what the classic QT would predict.

  Where has all the new AUD money gone? Into the local stock market, into the mining sector, and into the property prices of states most affected by the mining boom. This contradicts the RBD, which holds that the new money should be neutral in its effect on prices, so far as it is adequately backed.

  Why, then, do I say that the RBD is helpful in understanding AUD? Because the intrinsic value of the Australian dollar, as determined by the backing theory, holds AUD on a leash. When the commodity cycle turns, the bubble sectors will deflate to restore money closer to its intrinsic value. In Austrian terms, the boom can only end in a bust. Or else, of course, in the apocalyptic alternative of the crack-up boom and hyperinflation.
  

  Published: June 18, 2008 8:10 AM

• fusgerm

  Fundamentalist says:
  keep in mind that money supply growth is relative. China may be inflating its money supply, but if the US inflates at a faster rate, Chinese currency will increase in value relative to the dollar, even though both are losing value against commodities such as gold.

  I do not have the figures to hand for CNY, but this is contradicted by AUD, at least over the past 5 years. See my reply to Newson above.

  Moreover, it is impossible to define precisely the "purchasing power" of a currency, still less to predict it. And the reason is that monetary inflation never makes its presence felt in a uniform fashion. If by "purchasing power" you mean retail prices, then this is a lagging indicator and generally the last to be affected by money which is loaned into existence.

  Mises commented in TMC:
  we make use in our discussion of only one fundamental idea contained in the Quantity Theory, the idea that a connexion exists between variations in the value of money on the one hand and variations in the relations between the demand for money and the supply of it on the other hand...
  Beyond this proposition, the Quantity Theory can provide us with nothing.
  

  Published: June 18, 2008 8:16 AM

• Joe Stoutenburg

  Mike, you need to clarify something. In your examples to me, you've made it seem like you claim that RBD is backed by 100% reserves. What is different is that you say that assets other than precious metals can enter into the financial system as backing to the currency.

  This is at odds with what I understand to be the case for our fractual reserve system. To return to your farm-as-collateral example, it seems that posting the farm as collateral worth $300 would allow the bank to lend $3000. Do you claim that somehow the Fed holds assets of real value to back the extra lending?

  I see glaring contradictions between how you've characterized RBD and the fractional reserve system. The contradictions exist whether I rely upon my recent Austrian studies or if I rely upon my college macro-econ classes.

  Published: June 18, 2008 8:25 AM

• Mike Sproul

  Fundamentalist:
  " "In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn't say those dollars were created out of thin air."

  I can't see how you can describe it as anything else."

  A bank can issue a checking account dollar because someone (1) deposited one ounce of silver or (2) deposited a $1 IOU backed by a $1 lien on a farm. I've never heard anyone but you claim that case (1) creates money out of thin air. Austrians generally claim (wrongly) that case (2) creates money out of thin air, but the only case that I'd say qualifies for 'thin air' status is a counterfeiter who doesn't put his name on the dollar, and won't buy it back. I'm actually wondering if I heard you right. Did you really mean to apply the 'thin air' designation to case (1)?

  Joe S.:
  "This is at odds with what I understand to be the case for our fractual reserve system. To return to your farm-as-collateral example, it seems that posting the farm as collateral worth $300 would allow the bank to lend $3000."

  That's a plain old textbook error in your understanding of fractional reserves. If the bank has issued $300 to people who deposited 300 oz of silver, and another $300 to a farmer who 'deposited' a $300 lien on his farm, then the only way for the banker to issue another $2400 is for a borrower to 'deposit' something worth $2400--like an IOU backed by a lien on his house. Your concept of fractional reserves violates the first rule of banking: Never lend $1 to someone unless they give you collateral worth at least $1.

  ASSETS.............................LIABILITIES
  300 oz of silver deposited.....300 chk acct dollars
  IOU worth $300....................300 more chk acct $
  another IOU worth $2400......2400 more chk acct $

  If you can suffer through a T-account, you'll see that the left side of the balance sheet must equal the right side. The $3000 in checking account dollars are backed by $3000 worth of assets. Mind you, there is only 300 oz of RESERVES, and the bank has 'multiplied' that out to $3000, but only by getting an additional $2400 worth of assets.

  Published: June 18, 2008 9:22 AM

• Person

  Mike_Sproul -- college edition!

  "Mike, you can't just run up credit card and student loan debt to fund parties, pizza, and beer!!! Think about what this is going to do to your future!"
  "Whoa whoa whoa, timeout, Dad. Under the Human Capital Theory, going into debt *cannot* hurt your net wage, so long as you spend the funds on human capital enchancements that grow faster than the interest rate."
  "But you're ... NOT ... spending your money on that stuff, you're spending it on worthless frivolities, devaluing your own human capital."
  "Yeah, but some of you guys are all acting like going into debt MUST hurt your net wage, when that needn't be true."

  Published: June 18, 2008 9:47 AM

• fundamentalist

  Mike: "A bank can issue a checking account dollar because someone (1) deposited one ounce of silver or (2) deposited a $1 IOU backed by a $1 lien on a farm."

  In case (1) the customer either sells the silver to the bank, and receives dollars, or the customer used the silver as collateral for a loan. Either way, where does the bank get the checking account dollars to issue? In RBD it creates them ex nihilo because the bank keeps its cash as reserves and creates 9 more dollars for every dollar in reserve by making new bookkeeping entries. If the customer places the silver in a safe deposit box, he gets no dollars, just receipt. Case (2) is no different. The collateral doesn’t matter. What matters is where the bank gets the dollars to give to the customer.

  If you haven’t heard anyone call fractional reserve banking the act of “creating money out of thin air” you should read de Soto’s book. Opponents of RBD/fractional banking have been calling it that for at least four centuries.
  

  Published: June 18, 2008 10:51 AM

• Michael A. Clem

  You seem pretty well aware of the circularity and general absurdity of this view of money. I think you'd also agree that if money were backed by gold, then there would be nothing 'complicated' that required explanation.
  
  Here's the point you keep missing. Even a gold-backed dollar can have monetary inflation--the bank(s) simply issue more money by buying more gold--but the fact that it is gold, and that they have to buy gold, is the limiting factor on how much they can inflate. Commodity backing doesn't make inflation impossible, just harder. Currently, there's no firm limit on how much debt the Fed can buy in issuing currency.

  Published: June 18, 2008 11:02 AM

• Alex

  Mike Sproul:

  "If the fed wants to force another $100 into circulation, and if the public is already well-stocked with cash, then the fed will start by bidding $100 for a bond worth $100. But by assumption, the public has no particular desire to trade the $100 bond for the $100 cash, so the fed has to offer $101 in paper for the $100 bond in order for the cash to be accepted by the public. Now the fed's assets have risen by $1 less than its liabilities, so there will be inflation. I say the inflation was caused by a loss of backing, while you say it was because there is now another $101 chasing the same amount of goods. If I added something about how the $101 of paper simply displaced $101 of checking account dollars (which would reflux to their issuers) then under reasonable conditions, your model would say there would be no inflation. Mine would say there is still inflation, because of the $1 loss of backing.

  I haven't really explained my more-or less complete dismissal of the concepts of supply and demand as regards money. For now I'll say that supply and demand works fine for commodities, but not for financial securities. Financial securities can be nothing but computer blips, which can be created and destroyed in an instant. Ordinary ideas of supply and demand simply don't apply."

  Okay, so you do agree that when the supply of money is increased relative to its demand, that causes increases in spending and the relative price level. I thought you disputed that point. Semantics appear to be different, however. When the Fed buys a bond for $101, it has acquired an asset not worth $100, but $101, so in your terminology the "backing" for the $101 of new money is $101. In my terms when the Fed issues $101 of new money, there is never any "backing." The big pieces of meaningless paper (government bonds held on the Fed's balance sheet that don't pay the Fed any interest and will never be paid back) is no backing in my books. If the Fed simply burned those pieces of paper, what difference would it make, apart from the fact that it would hinder the occasional open market bond sale the Fed might want to make? (So, let's say the Fed burns almost all of their government bonds that they hold. Big meaningless deal!)

  I would love an example of how the laws of supply and demand are violated when credit transactions are carried out via securities created by computers.

  Published: June 18, 2008 11:42 AM

• PR

  IOU worth $300

  An asset is only worth what someone is willing and able to pay for it. If the farmer's IOU is truly worth $300, then he could exchange it for 300 of the existing paper dollars belonging to a real saver. If he can't do this, then his IOU isn't worth that much. Of course, the IOU might come to be worth $300 to someone after the RBD bank has printed up 300 more paper dollars and injected them into the economy, but doesn't that prove that the injection was inflationary?

  Published: June 18, 2008 11:56 AM

• Joe Stoutenburg

  So we should be able to look at the entire money supply and identify the reserves and collateral that backs it. I'm skeptical that you can do it, but I'd like to see actual data reconciling the Fed's balance sheet with the total money supply (realizing that much of it is now unpublished). I welcome anyone other than Mike as well who might have a handy data source.

  Supposing for the moment that there are assets backing every dollar in circulation, the backing must consist primarily of government bonds - IOUs by the federal government to pay in the future. Whatever your economic views, you must admit that an IOU by a government to pay out of future tax receipts differs markedly from an IOU voluntarily contracted on personal property.

  The federal government can issue bonds and sell them to the Federal Reserve in exchange for newly created cash. (Alternatively, it sells to the public or banks - ultimately some of them end up as reserves at the Fed.) By RBD, you may claim that the bonds have real value because they are claims on future tax receipts. (Am I right?) The government then spends the newly created money (enriching the connected contractors in the process). The new money enters the economy and begins circulating. Taxes are levied against this rising monetary base thus providing the income necessary to pay interest on the bonds.

  Have I followed the process through correctly? [Comments from others than Mike are welcome] Wouldn't this monetizing of government debt (really a promise to steal in the future) cause inflation? Is this really a system that you defend?

  Published: June 18, 2008 12:08 PM

• fundamentalist

  Mike or Alex (I'm not sure who wrote it): "I haven't really explained my more-or less complete dismissal of the concepts of supply and demand as regards money. For now I'll say that supply and demand works fine for commodities, but not for financial securities. Financial securities can be nothing but computer blips, which can be created and destroyed in an instant."

  So it wouldn't bother you at all if someone hacked into your bank's computer and deleted the "computer blips" stored in your account?

  Published: June 18, 2008 12:26 PM

• Alex

  Joe:

  You said:

  "Supposing for the moment that there are assets backing every dollar in circulation, the backing must consist primarily of government bonds - IOUs by the federal government to pay in the future. Whatever your economic views, you must admit that an IOU by a government to pay out of future tax receipts differs markedly from an IOU voluntarily contracted on personal property.

  The federal government can issue bonds and sell them to the Federal Reserve in exchange for newly created cash. (Alternatively, it sells to the public or banks - ultimately some of them end up as reserves at the Fed.) By RBD, you may claim that the bonds have real value because they are claims on future tax receipts. (Am I right?) The government then spends the newly created money (enriching the connected contractors in the process). The new money enters the economy and begins circulating. Taxes are levied against this rising monetary base thus providing the income necessary to pay interest on the bonds."

  You are exactly right, except for the last sentence. No taxes are levied against the rising monetary base. No taxes are needed to pay interest on Federal Reserve held government bonds, since almost all the interest on these bonds is remitted back to the government. And since the government bonds on the asset side of the Fed grow with the monetary base over time, effectively there are no taxes needed to pay off any of these bonds.

  Taxation occurs at the moment a government spends a given $1. The only question is the manner of the taxation. The government may decide to raise explicit taxes by $1 to finance the spending. The government may decide to borrow $1 to finance the spending, in which case the present value of the future taxes needed to repay the debt is exactly $1. When a central bank purchases government debt for $1, $1 of taxes are effected at that time through the monetary system.

  Published: June 18, 2008 2:52 PM

• Mike Sproul

  Fundamentalist:

  "In case (1) the customer either sells the silver to the bank, and receives dollars, or the customer used the silver as collateral for a loan. Either way, where does the bank get the checking account dollars to issue? In RBD it creates them ex nihilo because the bank keeps its cash as reserves and creates 9 more dollars for every dollar in reserve by making new bookkeeping entries. If the customer places the silver in a safe deposit box, he gets no dollars, just receipt. Case (2) is no different. The collateral doesn’t matter. What matters is where the bank gets the dollars to give to the customer."

  Case 1 is 100% reserve banking, not fractional reserve banking, and nobody but you puts the 'thin air' label on 100% reserve banking.
  The 9 more dollars are only issued if a customer gives the bank collateral worth at least nine dollars. No bank would issue the $9 otherwise. No thin air here either. That's why I want to hold on to my computer blips.

  Michael Clem:
  "Even a gold-backed dollar can have monetary inflation--the bank(s) simply issue more money by buying more gold--but the fact that it is gold, and that they have to buy gold, is the limiting factor on how much they can inflate. Commodity backing doesn't make inflation impossible, just harder. Currently, there's no firm limit on how much debt the Fed can buy in issuing currency."

  I suppose by 'monetary inflation' you mean an increase in the money supply, as opposed to price inflation. And of course the only limit on how much money can be created is how many goods the borrowers are able to present to the bank as collateral. But what we care about is PRICE inflation, and as long as every new dollar is adequately backed by the bank's assets, price inflation won't happen.

  Alex:
  "Okay, so you do agree that when the supply of money is increased relative to its demand, that causes increases in spending and the relative price level. I thought you disputed that point. Semantics appear to be different, however. When the Fed buys a bond for $101, it has acquired an asset not worth $100, but $101,"

  No; my assertion is that when money increases relative to the assets of the bank that issued it, there will be inflation. Supply and demand is not an appropriate model for financial securities--just for commodities. And when I said the fed paid $101 for a bond worth $100, I really meant the bond was worth $100--not $101.

  Joe S.
  "So we should be able to look at the entire money supply and identify the reserves and collateral that backs it. "
  You have to remember that paper dollars are issued only by the fed, so they are backed by the fed's assets, which are published every month. The fed's assets do not back wells fargo's checking account dollars. Those are backed by wells fargo's assets.

  " Wouldn't this monetizing of government debt (really a promise to steal in the future) cause inflation?"

  If the government loses the ability to steal, then the dollars have less backing and there will be inflation. If the government keeps the ability to steal, then the dollars are backed by that ability, and will hold their value..

  Published: June 18, 2008 7:21 PM

• Person

  Mike_Sproul: Didn't you think my post was kinda clever?

  Published: June 18, 2008 9:24 PM

• Mike Sproul

  Person:

  So clever that I didn't even understand it.

  Published: June 18, 2008 11:27 PM

• newson

  to mike sproul:
  leaving aside fiduciary media, would you acknowledge that if gold were used exclusively as money, and that its quantity were to increase markedly, then it's likely gold's purchasing power would be eroded to some extent?
  

  Published: June 19, 2008 1:03 AM

• fundamentalist

  Mike: "Case 1 is 100% reserve banking, not fractional reserve banking, and nobody but you puts the 'thin air' label on 100% reserve banking.
  The 9 more dollars are only issued if a customer gives the bank collateral worth at least nine dollars. No bank would issue the $9 otherwise. No thin air here either. That's why I want to hold on to my computer blips."

  Case 1 may or may not be 100% reserve banking. It all depends on where the bank gets the money to loan on the collateral, whether silver or land. If the money comes from reserves or from the savings of another customer, then it is 100% reserve banking. On the other hand, if the bank just enters the value in the borrower's account, it is fractional banking.

  No, everyone may not use the exact words "thin air" but every Austrian and most economists since John Law have used similar terminology for the same process of credit expansion.

  You're using "backing" for a loan as a red herring, attempting to distract the reader from the main event, the creation of money ex nihilo by the bank.

  Published: June 19, 2008 6:40 AM

• Person

  Mike_Sproul: What's not to understand? :-(

  -You claim that printing money won't cause inflation as long as certain standards are met, even though the Fed doesn't meet those standards.

  -I made fun of this by comparing it to your college-years rationalizations that going deep into debt wouldn't hurt your income as long as certain standards were met, even though you weren't meeting those standards.

  Published: June 19, 2008 8:26 AM

• Joe Stoutenburg

  Mike, I wrote:

  Wouldn't this monetizing of government debt (really a promise to steal in the future) cause inflation?

  Your response (paraphrased) was that the government's ability to steal ensures an absence of inflation. I disagree, though our disagreement may well be semantic and be due partially to the difficulty of defining inflation. So let's clarify what we mean when we say inflation. Let's consider an economy at an instant in time with a given amount of consumer goods, capital goods and money. A moment later, the money supply is doubled by entering some of the capital goods as collateral. The prices of the goods purchased by the new money will tend to rise to reflect the increased amount of money chasing the same amount of goods. This is inflation.

  So I'm left wondering what you mean when you claim that entering assets to back new money will not cause inflation. Even most gold-bugs admit that inflation would occur under a gold standard due to the on-going (and more predictable) discovery of gold that finds it way into coinage. The thing is, I could see inflation being benign that caused by an RBD banking system (one which is backed not only by assets held by the banks but also by assets pledged as collateral). If people voluntarily mortgage their assets in their desire for current consumption, it is right for them to bid up prices.

  Now here's an epiphany that I find very interesting. This price bidding (inflation) could be an alternative to rising interest rates that might be present with a gold standard. I'll explain. Suppose that in a gold standard economy that the demand for current consumption increased. In order to induce current money (gold) holders to increase loans, borrowers would need to offer higher rates of interest. On the other hand, if borrowers offered instead their property as collateral for newly issued credit, then the increased demand for current consumption would be felt in rising prices while interest rates remained steady.

  These are trade-offs that I think that we could all accept as long as they are made voluntarily. What is insidious about our current monetary system is that the government forces us to place collateral into the system through its issuance of bonds (promises to tax). The new money does cause prices of some goods to rise, and it does not get spread uniformly among the economy. In essence, the collateral represented by my future tax dollars gets distributed to someone else, and I have to pay higher prices to boot! This is theft just as the Austrians have been claiming. But it's not theft by virtue of the fact that we are not on the gold standard. It is theft by virtue that the government can create an asset out of my property and create money with its backing without my consent.

  So Mike, your claim that RBD does not cause inflation falls flat on its face as far as I'm concerned. This doesn't mean that RBD is without value. I have expanded my acceptance of money to include the possibility of a banking system with a variable amount of money whereby demand for current consumption is felt not by the interest rate but by inflation. The thing is though, inflation in this manner wouldn't need to be managed. And deflation might be just as likely (just as rising and falling interest rates would be normal with a gold standard) though general inflation trends would be expected as the economy grew and added new assets as backing to the currency.

  Published: June 19, 2008 9:30 AM

• fundamentalist

  Mike: "Supply and demand is not an appropriate model for financial securities--just for commodities."

  This is a key point of RDB. Money lives in an alternative universe not subject to the laws that every other commodity/service must respect. Austrian econ relies upon money acting like any other commodity with respect to supply and demand. RBD doesn't give a reason for money not being subject to the law of supply and demand; it assumes it. Austrian econ not only has the theory and logic to support its position, but history as well.

  Published: June 19, 2008 9:39 AM

• Joe Stoutenburg

  I agree with fundamentalist.

  Supply and demand for money in a banking system backed real assets would be driven by people's willingness to exchange unencumbered ownership of their property for new credit. The demand for money in this system would be manifest in inflation.

  In a more banking system with a more stable money supply (based upon gold or some other relatively rare asset), people would not write IOUs on their current assets. Rather, they would simply write IOUs on future earnings. Such a system would manifest demand in interest rates.

  Either way, there is demand for money. When its supply is fixed (commodity money), its price (interest rates) will fluctuate. When its supply may vary (real asset backed money), its price will remain relatively steady. The demand for goods would be seen directly in their prices.

  Published: June 19, 2008 9:58 AM

• Alex

  Mike Sproul:

  You said: "my assertion is that when money increases relative to the assets of the bank that issued it, there will be inflation. Supply and demand is not an appropriate model for financial securities--just for commodities. And when I said the fed paid $101 for a bond worth $100, I really meant the bond was worth $100--not $101."

  I'm not going to argue whether the bond is "worth" $100 or $101 when it finds its way onto the balance sheet of a central bank, though that distinction seems to be a central point for you. Instead, consider the following brief example.

  A central government prints up a $100 bond, carts it to the central bank and receives $100 deposit, which the government then spends on goods and services. How has this not created additional net purchasing power that will drive up prices?

  [Note: In your terms, note, there is 100% "backing" for the new money that the government created and spent. In fact, to the extent that some of this new money received by sellers of goods and services finds its way into the bond market, bond prices will rise and, again in your terms, there will be more than 100% backing for the newly created money, since the government bond held by the central bank will have a market value in excess of $100.]
  

  Published: June 19, 2008 10:29 AM

• Mike sproul

  Newson:
  "would you acknowledge that if gold were used exclusively as money, and that its quantity were to increase markedly, then it's likely gold's purchasing power would be eroded to some extent?"

  Yes. Gold is a commodity. Supply slopes up and demand slopes down, so there's a meaningful equilibrium of supply and demand. Paper or electronic dollars that are claims to something worth 1 oz of silver are not commodities. Both supply and demand would be horizontal lines with a height of 1 oz/$, with no meaningful equilibrium of supply and demand.

  Fundamentalist:

  "Case 1 may or may not be 100% reserve banking. It all depends on where the bank gets the money to loan on the collateral, whether silver or land. If the money comes from reserves or from the savings of another customer, then it is 100% reserve banking. On the other hand, if the bank just enters the value in the borrower's account, it is fractional banking."

  Case 1 was clearly 100% reserve banking. A customer deposits 1 oz of silver and gets a warehouse receipt for it. If the bank keeps the ounce on hand, that's 100% reserves. If the bank lends part of it out, that's fractional reserves.

  Person:
  "You claim that printing money won't cause inflation as long as certain standards are met, even though the Fed doesn't meet those standards."

  All I've ever claimed is that IF the fed adequately backs its dollars, those dollars will hold value, and IF the amount of backing per dollar falls, the dollars will lose value.

  Joe S.:
  "the money supply is doubled by entering some of the capital goods as collateral. The prices of the goods purchased by the new money will tend to rise to reflect the increased amount of money chasing the same amount of goods. This is inflation."

  One minute, a bank holds 100 oz of silver as backing for 100 paper receipts (dollars), each of which is redeemable at the bank for 1 oz. The next minute, customers deposit miscellaneous goods (gold, wheat, land, even bonds) that are worth 200 oz. of silver. The bank issues 200 more paper dollars to these customers.

  Before the issue of $200, one loaf of bread sold for 1 oz or $1. After the issue of $200, the real bills view is that 1 loaf will still sell for $1 or 1 oz. If you want to assert that the price of bread will rise because of this, either in terms of silver or paper or both, you'll have some pretty thorny arbitrage issues to work out. Think about them long enough and you'll see that the rbd is correct, and the quantity theory is wrong.

  Alex:
  "A central government prints up a $100 bond, carts it to the central bank and receives $100 deposit, which the government then spends on goods and services. How has this not created additional net purchasing power that will drive up prices?"

  One way to answer that is with the answer I just gave to Joe S. in the previous paragraph. Another is to note that the $100 bond has to be paid back, so every extra $100 the government spends is matched by a $100 fall in future government spending, or a $100 fall in private spending. Austrians should know all about the crowding out effect.
  

  Published: June 19, 2008 1:31 PM

• Joe Stoutenburg

  Mike, you said:

  Before the issue of $200, one loaf of bread sold for 1 oz or $1. After the issue of $200, the real bills view is that 1 loaf will still sell for $1 or 1 oz. If you want to assert that the price of bread will rise because of this, either in terms of silver or paper or both, you'll have some pretty thorny arbitrage issues to work out. Think about them long enough and you'll see that the rbd is correct, and the quantity theory is wrong.

  Let me summarize what you just wrote in my own words:

  My view is correct. There are mysterious problems with your view that I won't explain. If you think about them long enough, you'll see that I'm right and that you're wrong.

  Do you realize how poor of a job you're doing advocating your position? I can only guess at what you mean. Arbitrage pricing is squarely within my professional field, so I can think of plenty of ways to approach the matter. For all I know, you may have a point that I do not immediately see. But it is also possible that you're employing arbitrage principles incorrectly. So I don't know whether we need to discuss your valid points or your incorrect understanding of arbitrage.

  I'm not going to guess at what you mean. Please make an argument supporting your view, and we'll discuss.

  Published: June 19, 2008 3:32 PM

• Mike Sproul

  Joe S.

  Click on my name above and read about the real bills doctrine, and you won't have to guess at what I mean.

  Some arbitrage scenarios:

  1) A loaf of bread, which used to cost $1 or 1 oz., now costs $3 or 1 oz. because of the issue of 200 new dollars.

  Arbitrage problem: Each dollar is redeemable at the bank for 1 oz, so everyone runs on the bank. The bank pays 1 oz per dollar, as contracted. Customers sell the ounce for 1 loaf, which they sell for $3, which they return to the bank for 3 oz.

  2. A loaf of bread, which used to cost $1 or 1 oz., now costs $3 or 3 oz., because of the issue of 200 new dollars.

  Arbitrage problem: Bread from around the world floods in to this town to get 3 oz./loaf. Price of bread must fall to 1 oz, but if it still costs $3, same arbitrage probel as above.

  3. Bread stays at $1 or 1 oz.: No arbitrage problem.
  

  Published: June 19, 2008 4:00 PM

• Mike Sproul

  Fundamentalist:

  "RBD doesn't give a reason for money not being subject to the law of supply and demand; it assumes it. Austrian econ not only has the theory and logic to support its position, but history as well."

  On the first page of my paper "There's No Such Thing as Fiat Money", I referenced studies by Sargent, Wallace, Smith, Siklos, Bomberger and Makinen, and Cunningham. Each paper studied different historical episodes of inflation, and each found that the backing version of the real bills doctrine explained the episode better that the quantity theory. You haven't cited any historical episodes where the rbd did worse than the qt, and I don't expect you to, because there are no such episodes.

  Published: June 19, 2008 4:27 PM

• fundamentalist

  
  Mike: “Case 1 was clearly 100% reserve banking. A customer deposits 1 oz of silver and gets a warehouse receipt for it. If the bank keeps the ounce on hand, that's 100% reserves. If the bank lends part of it out, that's fractional reserves.”

  You may have forgotten your example. You wrote the following:

  “In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn't say those dollars were created out of thin air…The people with silver got their $300 because they deposited silver.”

  You’re right that if the customer deposits silver and the bank gives him a receipt for it, then that is not fractional banking. But that wasn’t you’re example. You said that the person depositing the silver got paper dollars in exchange for the deposit. If the dollars the customer received from the bank did not come from the bank’s reserves, then that is the very definition of fractional reserve banking. Again, the backing of the loan has nothing to do with the definition of fractional reserve banking. The loan can be backed by gold, or just a promise. It doesn’t matter. What defines fractional reserve banking is where the money comes from that the bank loans the customer. Is it from reserves or did the bank just make an entry into the customer’s account? If the money comes from reserves, then the bank practices honest 100% reserve banking; if not, it practices fractional reserve banking.

  Mike: "You haven't cited any historical episodes where the rbd did worse than the qt, and I don't expect you to, because there are no such episodes."

  I didn't write that RBD doesn't have any historical episodes to cite. I wrote "RBD doesn't give a reason for money not being subject to the law of supply and demand; it assumes it."

  Every theory, no matter how utterly stupid, can cite historical examples that appear to support it. That is why Austrians insist that you must approach history with sound theory. Otherwise, history doesn't make sense and it can support any idea.
  

  Published: June 19, 2008 5:05 PM

• Alex

  Mike Sproul: "One way to answer that is with the answer I just gave to Joe S. in the previous paragraph. Another is to note that the $100 bond has to be paid back, so every extra $100 the government spends is matched by a $100 fall in future government spending, or a $100 fall in private spending. Austrians should know all about the crowding out effect."

  Mike, I have explained at least twice before that the bonds on the balance sheets of central banks are never paid back and the interest on such bonds is simply bounced back to the central government. So, any way you slice it, there is a net increase in purchasing power.

  Published: June 19, 2008 7:14 PM

• newson

  mike sproul says:
  "Gold is a commodity. Supply slopes up and demand slopes down, so there's a meaningful equilibrium of supply and demand. Paper or electronic dollars that are claims to something worth 1 oz of silver are not commodities. Both supply and demand would be horizontal lines with a height of 1 oz/$, with no meaningful equilibrium of supply and demand."

  i cannot see why paper money, merely a convenient proxy for the silver or gold, should not be subject to supply/demand, just like the underlying (obviously this applies only if they're convertible).

  Published: June 19, 2008 7:23 PM

• P.M.Lawrence

  Newson, you forget that he is pulling a bait and switch. When he talks about money denominated as a certain weight of bullion, he is perfectly willing to issue any amount of these without actually moving bullion into the reserves in step. For him, the word "bullion" is only there to keep the punters happy while he goes about business as usual. In a certain sense he is correct - once you do that, there aren't any supply and demand constraints on the money from the bullion link, because he won't have a bullion link.

  Published: June 19, 2008 9:42 PM

• fundamentalist

  PM: "there aren't any supply and demand constraints on the money from the bullion link, because he won't have a bullion link."

  Exactly! The only limit to the supply of money in RBD is the desire for loans on the part of businesses with collateral.

  Today's money, mostly digits, has no supply limitations at all. So when banks supply more than people want, prices rise.

  Published: June 20, 2008 6:49 AM

• Joe Stoutenburg

  Mike, I will react to your specific scenarios. But first I have a few comments about arbitrage pricing in general.

  Arbitrage principles do not forbid the presence of arbitrage profit opportunities. Rather, they state that in efficient and complete markets, such opportunities will be fleeting because market participants will detect the opportunity and will take as large of positions as possible until prices are moved back to equilibrium. In practice, markets not entirely complete. So there is rarely, if ever, a single no-arbitrage price. Rather, there are ranges of prices at which arbitrage is unlikely.

  Arbitrage principles are employed to determine relative price levels. You're stretching them by implying absolute price levels. And you're ignoring more basic supply/demand principles (which are at the basis of arbitrage principles anyway).

  Here are my specific reactions to your scenarios:

  1) This is a statement of the relationship between the value of a dollar and an ounce of silver. When each dollar is backed exclusively by an ounce of silver as your scenario implies, then their exchange will not deviate much (if at all) from 1:1. On the other hand, when the backing is silver along with other real assets, then the silver to dollar ratio may vary based upon the public's perception of the value of the non-silver backing.

  2) You might as well use this scenario to justify why bread must always cost $1. It is within this scenario that I accuse you of ignoring basic supply/demand principles. Let's suppose that an increased demand for bread in a region manifests itself by people placing assets as collateral for new money. This will tend to drive up prices in the short term. As you note, foreign bread suppliers may start selling their bread to satisfy the increased demand. Not only that, but new domestic suppliers may open business to earn some of the profits represented by the increased price. In time, the supply and demand will settle down to new equilibrium prices (not necessarily the original ones - and not just the regional prices - foreign prices may adjust to reflect the new local demand). In reality of course, there is never equilibrium. Demand is continually changing. In an RBD banking system, demand may be manifest by new money. Both price and supply will change in order to adjust to the new demand.

  This is really just econ 101 mixed with money creation backed by real assets.

  3) As stated earlier, arbitrage provides no information about absolute price levels. You've taken the idea that arbitrage opportunities will tend to not persist and jumped to the conclusion that you can hold one price fixed and proclaim that other prices must remain constant to avoid arbitrage. Applying the mechanics of arbitrage pricing (no more complex than supply and demand, really) reveals only that prices must be relatively consistent.

  All of this being said, I'm still mulling over what would happen to general price levels (tricky since "general prices" don't exist) in response to newly created money. Differentiation must be made between money that funds productive activities and unproductive ones. And what happens to the money that goes to projects that prove to be unproductive. I'm open to the possibility that productive activities could leave general prices unaltered - that the new money will chase the new goods created. And it's possible that money funding unproductive activities could come back out of the system. The latter cases are more complex and require more thought.

  Published: June 20, 2008 7:47 AM

• Joe Stoutenburg

  I meant to stress at the end of my last post that it is silly, in my opinion, to conclude that new money will have no impact on individual price levels or the supply of individual goods. I only concede that I may become comfortable with no general price increases as long as the backing retains value and production is continued.

  To prime the system, allow me to highlight an unproductive activity that is allowed to continue in our economy. Suppose the government creates $1 trillion backed by bonds that promise to pay out of future tax receipts. It uses that money to build bombs. Incidentally, there has been inflation here for the price of bombs and everything that goes into them. Previously, they were zero. Now, the total price is $1 trillion.

  The people employed to build the bombs are diverted from productive activities. They also keep the money paid to them and use it to buy valuable goods. There is clearly a wealth transfer here. And the money spent by these people will clearly impact the prices of the goods that they choose to purchase. However, the basic mechanism for the transfer is simply the taxation. If $1 trillion of private property were instead offered as collateral for the bombs, I would have less issue since the loan would have to be made up from real production (and people who make bombs don't tend to be very productive).

  Published: June 20, 2008 8:26 AM

• fundamentalist

  Joe: “I'm open to the possibility that productive activities could leave general prices unaltered - that the new money will chase the new goods created. And it's possible that money funding unproductive activities could come back out of the system.”

  That’s fairly close to the Austrian position. If the money supply increases at exactly the rate of the increase in production, then prices won’t change. Under a gold standard, gold production would increase at about the rate of increase in total production, around 3%/yr. There is no business cycle, just steady progress. In such a system, businesses that fail, or businesses that pay off debt, don’t cause money to disappear from the system.

  Under the current system with no restrictions on the supply of money, lower interest rates on loans will incourage business to borrow and expand. Since most new money is created out of thin air, and not from savings of others, expanding businesses run up against a shortage of capital goods which eventually caused the failure of some. Businesses that fail, or businesses that pay off debt, cause money to disappear from the system, which has a dominoe effect and causes other businesses to fail.

  Mike has recognized in the past the fact that RBD encourages the expansion and contraction of the money supply, but sees it as a good thing. In reality, it is the business cycle that people hate.
  

  Published: June 20, 2008 8:39 AM

• PR

  Arbitrage problem: Each dollar is redeemable at the bank for 1 oz, so everyone runs on the bank. The bank pays 1 oz per dollar, as contracted.

  But the RBD bank isn't obligated to pay out 1oz. silver for each dollar. (It doesn't even have 1oz. of silver for every dollar out there, so it couldn't do this if it wanted to.) It can hand over any asset it claims is worth 1oz. The bank has many heterogeneous assets, and it is natural that their relative prices will fluctuate even though they are all nominally "worth" 1oz. on the bank's balance sheet. So, to punish people who try to start a bank run, it can hand over the weakest assets first.

  Published: June 20, 2008 8:45 AM

• Mike Sproul

  Alex:
  "the bonds on the balance sheets of central banks are never paid back and the interest on such bonds is simply bounced back to the central government. So, any way you slice it, there is a net increase in purchasing power."

  You might as well claim that my credit card balance is never really paid off. Sometime before I die, I will either pay it off, or else steal the money from the credit card company. Governments live longer than people, but the ultimate payoff is made in the same way as my credit card balance.
  Also, if the issue of money really gave the government the kind of free lunch you describe, then rival currencies would invade to get a piece of that free lunch, with the result that the value of the government's money would be bid down until there was no longer any free lunch to attract rival moneys

  Newson:
  "i cannot see why paper money, merely a convenient proxy for the silver or gold, should not be subject to supply/demand, just like the underlying (obviously this applies only if they're convertible)."

  If a piece of paper or a computer blip is nothing but a claim to one ounce of silver (or to goods worth 1 ounce of silver), then if those papers or blips sold for 1.01 oz, then quantity demanded would be zero, while quantity supplied would be infinite. If the papers or blips sold for 0.99 oz., then quantity supplied would be zero while quantity demanded would be infinite. Thus supply and demand are both horizontal at 1 oz. It's wrong to say, in this case, that the papers or blips are price at 1 oz. because of supply and demand. The correct view is that supply and demand are horizontal at 1 oz. because that's how much backing the papers or blips have. Supply and demand curves are useless in this case, and if you remember your basic economics, you'l remember that supply and demand curves are always applied to commodities, not claims to those commodities.

  PR:

  "But the RBD bank isn't obligated to pay out 1oz. silver for each dollar. (It doesn't even have 1oz. of silver for every dollar out there, so it couldn't do this if it wanted to.) It can hand over any asset it claims is worth 1oz."

  Nobody would have deposited silver in the first place unless they felt this problem was adequately handled, say by an neutral outside referee. Anyway, if the bank has issued 300 paper or checking account dollars, which it backs with 100 oz. plus IOU's worth $200, all the bank has to do in a run is sell the $200 IOU for 200 of its own dollars, which it retires. Then it has 100 oz. backing the remaining $100.
  

  Published: June 20, 2008 9:14 AM

• Alex

  Mike Sproul:

  "You might as well claim that my credit card balance is never really paid off. Sometime before I die, I will either pay it off, or else steal the money from the credit card company. Governments live longer than people, but the ultimate payoff is made in the same way as my credit card balance.
  Also, if the issue of money really gave the government the kind of free lunch you describe, then rival currencies would invade to get a piece of that free lunch, with the result that the value of the government's money would be bid down until there was no longer any free lunch to attract rival moneys."

  First, your second point. Wouldn't I love to create a central bank of Alex, print up some Alex bonds, put them on the Alex central bank's balance sheet and create an equal deposit account on the liability side, and then start spending this deposit. But who would take my cheques written on the central bank of Alex in exchange for goods and services? Plus, of course, rival currencies are illegal.

  With regard to the difference between your credit card balance and the government bonds on the balance sheets of central banks, the credit card company requires you to repay your balance (plus interest). There is no legal requirement for a central bank to reduce its monetary base, in fact, over time, the monetary base continues its upward climb and the government bonds held on its balance sheet clmb in step with the monetary base. As old bonds mature, they are replaced by new bonds.

  Say the central bank reduces the monetary base by $100, by selling government bonds from its own portfolio. At this point, since these bonds are now in the hands of the public, when the government pays interest on them, the interest will not bounce back to the government (hence taxes must be collected to pay this interest). And when this $100 of government bonds mature, the government must raise $100 in taxes to redeem them. But over time, of course, open market sales of government bonds by the central bank are swamped by central bank government bond purchases.

  Published: June 20, 2008 10:21 AM

• fusgerm

  Mike Sproul isn't really saying anything very radical.

  It's simple book-keeping, basically this:

  1. Money is the debt of a bank.

  2. Assets = liabilities.

  3. Therefore, each dollar is backed by a share in bank assets.

  But he's looking only at the balance sheet, not at the cash flow.

  I.e. at solvency, not liquidity.

  That's where he departs from the Austrian approach. We saw in March what happens to asset-values when the credit markets dry up.

  Published: June 20, 2008 10:25 AM

• jp

  Fusgerm, I think that's a pretty good macro view of the whole argument.

  To go further, Mike points out that modern currency is backed by financial assets, not physical assets. Therefore it is not fiat.

  While I don't think Mike has all the pieces in place it would seem hard for Austrians to ignore his points about the asset side of central and commercial banking, and how this determines the value of the money liabilities these banks have issued.

  Published: June 20, 2008 11:14 AM

• newson

  mike sproul says:
  "Supply and demand curves are useless in this case, and if you remember your basic economics, you'l remember that supply and demand curves are always applied to commodities, not claims to those commodities.

  but arbitrage means that the supply/demand curves fo the derivatives must be the same shape as the underlying, adjusted for the conversion/delivery costs. paper may trade at a premium to physical by way of convenience etc.

  futures and share markets operate along supply/demand lines, with technical trading preoccupied with this element, and less on the fundamentals (backing, if you like).

  Published: June 20, 2008 11:26 AM

• Alex

  jp:

  You said: "While I don't think Mike has all the pieces in place it would seem hard for Austrians to ignore his points about the asset side of central and commercial banking, and how this determines the value of the money liabilities these banks have issued."

  The monetary base (the liabilities of the central bank) control the money supply, regardless of the degree of fractional reserve commercial banking. So, it is most important to focus on this base to understand how the government, through, a central bank causes increases in purchasing power and hence increases in prices. Again, to repeat my example above:

  Wouldn't I love to create a central bank of Alex, print up some Alex bonds, put them on the Alex central bank's balance sheet and create an equal deposit account on the liability side, and then start spending this deposit. Of course no one would accept my cheques written on the central bank of Alex, but this is precisely what the government does with regard to central banking, and government cheques are accepted, because government money is legal tender.

  Published: June 20, 2008 11:43 AM

• Mike Sproul

  All:

  Sorry I'm going to fall even farther behind on blogging. Summer school is starting and I have young minds to corrupt with my real bills views.

  Also, I'll be busy setting up the central bank of Mike. I'm going to buy $100 worth of groceries from my local store and pay for them with 100 mike dollars, each of which has my signature, and my promise to deliver 100 green paper US dollars to the possessor on demand. The grocer will spend those mike dollars getting his car fixed at the local mechanic. The mechanic knows me, so he'll accept them. The mechanic will use them to pay his plumber, who also knows me. The plumber will pay them to a bricklayer, who will pay them to a carpenter, etc. The carpenter happens to need $100 worth of economics tutoring, so he'll pay me those mike dollars for the tutoring, at which point I'll burn them. But you'll notice I didn't have to maintain physical convertibility of those mike dollars--I never paid any green dollars, but I didn't defraud anyone either. In fact, I didn't do anything any different from what the federal reserve does. I think I'll print up another batch and use them to buy US government bonds!

  Published: June 20, 2008 12:25 PM

• jp

  Fusgerm,
  On second thought, it seems more to me that Austrians do consider a bank's balance sheet. But they focus on the liability side, specifically the growth in money issued. They assume that the asset side is empty - ie. that liabilities are unbacked. The only item Austrians will admit to the asset side of the balance sheet is gold, maybe silver.

  Mike Sproul talks about the asset side of the balance sheet a lot and he is willing to admit bonds and other financial assets, not just gold, onto the asset side. A favorite of his is houses. All these are collateral and show up on the bank's asset side.

  Austrian's don't like this since bonds are less real than gold and, being debt, can be created ad-infinitum. Therefore they maintain that bonds shouldn't be granted entry to the asset side of the balance sheet. With an empty asset column, everytime a bank creates more money liabilities it seems to be doing so out of nothing ie. with out assets to back it up.

  I think Mike does deal with the cashflow side of things. When there's a cashflow problem ie. a bank can't meet its convertability requirements, bank runs occur and that's it for the bank. Unless it puts a halt on convertability.

  Published: June 20, 2008 1:28 PM

• fundamentalist

  If a blip is a claim to 1 oz of silver, then why would it sell for 1.01 oz or .99 oz? Unless I miss something that could only happen under fractional banking in which the bank issued more blips (claims on silver) for ounces of silver than it had silver. In other words, the bank has just 100 oz of silver but issues 1,000 blips, each with a claim to one oz of silver. In that case, prices would rise to match the higher volume of blips and each blip would purchase fewer goods than before. So even though the bank claims it will redeem a blip for an ounce of silver, blips will buy less than an equivalent amount of silver. You mentioned that this would set up an arbitrage situation and you’re right. When people realize they have been defrauded, they rush to exchange blips for either silver or goods. If for silver, bank failures result; if for goods, hyperinflation results.

  Some confusion can be overcome by understanding that RBD doesn’t accept the subjective theory of value. RBD clings to the classical idea of intrinsic value: a blip or dollar has a fixed value determined by its backing. Most people debating the subject on this site follow the subjective theory of value.

  Another confusion arises because Mike conflates the demand for loans with the demand for money, as many people do. They’re not the same. The demand for money is the demand to hold cash. The demand for loans is that demand by entrepreneurs to borrow money to invest. New money often enters the system via demand for loans.

  With those definitions in mind, the supply of money depends upon the demand for loans, generally, which is tied to the interest rate, and the demand to hold cash. As the interest rate falls, demand for loans increase and the money supply increases. However, the demand for loans can fall flat when business confidence falls low enough. In that case, interest rates must fall dramatically in order to entice businessmen to borrow. In some extreme cases, banks can’t lower interest rates fast enough to catch the falling demand for loans. In those cases, the money supply falls.

  So using Austrian definitions of value, money and loans, the supply of money is not unlimited, but slopes upward with the interest rate. In other words, banks are willing to make more loans at higher interest rates. The demand for loans slopes downward with respect to interest rates, but shifts up and down depending on business confidence. The mathematical version of the quantity theory makes it seems as if the supply of money could be unlimited, but the Austrian understanding of it shows that the supply is limited by demand to hold cash. As in the case of Germany in the 1920’s, and Zimbabwe today, when the supply of money is sufficiently high above the demand to hold cash, the money system collapses and people fall back on barter.

  Published: June 20, 2008 1:32 PM

• fundamentalist

  fusgerm: "Mike Sproul isn't really saying anything very radical. It's simple book-keeping, basically this: 1. Money is the debt of a bank."

  Yes, that is how banks keep their books. If a bank loans out $10 is does simple double-entry book keeping. But it still doesn't explain where the bank gets its liabilities, that is the money it loans out. A bank can have reserves of $100 and loan out $900 if it keeps 10% reserves. Where does that money come from? The banks books balance, but they don't explain where the $900 came from. As de Soto explains in his book, it comes from thin air.

  Published: June 20, 2008 1:41 PM

• fusgerm

  fundamentalist:
  Rothbard called it "thin air"; Keynesians call gold a "barbarous relic". That's just name-calling on both sides. Anyone can create a promise out of thin air. Bills of exchange were created out of thin air, centuries ago. And then the market started to use those promises as money...

  jp:
  Yes, Sproul wants to admit financial assets on to his balance sheet, as backing for his demand-deposits. That works OK except in a liquidity crisis. But the problem is that a crisis is inevitable because the very act of granting loans out of promises instead of savings depresses interest rates and so gives rise to the Austrian business cycle.

  Mike's system would work OK if his money were redeemable. Then banking discipline - the need to prevent a run - would itself constrain credit expansion to very narrow bounds. That's Mises' "free banking" solution.
  

  Published: June 20, 2008 5:19 PM

• fundamentalist

  fusgerm: "Bills of exchange were created out of thin air..."

  Is that name calling, or are you trying to describe an actual fact? Fractional reserve banking allows banks to create money ex nihilo. How is that different from creating it out of thin air?

  fusgerm: "Mike's system would work OK if his money were redeemable. Then banking discipline - the need to prevent a run - would itself constrain credit expansion to very narrow bounds. That's Mises' "free banking" solution."

  Of course the free banking system described by Mises would work, but that's not what Mike is suggesting. And it would work not for the reasons given by RBD or Mike, but for the reasons given by Mises, which are the opposite of RBD.

  Published: June 20, 2008 8:09 PM

• fusgerm

  Fundamentalist:

  The expression "out of thin air" is far from neutral. It makes me think of a conjurer pulling a rabbit out of a hat. The connotation is that FRB is a cheap conjuring trick.

  The term "ex nihilo" is not much better. It makes me think of an immense deity proclaiming "Fiat lux!". The connotation is that man is trying to do what only God can do.

  Personally I prefer the more neutral expression "monetizing debt" or even Mises' term "fiduciary media". I do not recall Mises ever using the phrase "thin air" or "ex nihilo". Nor did Mises condemn it on any grounds other than economic.

  The term is also misleading. If a bank loans money into existence, it records the deposit as a liability and the loan as an asset. Only the balance sheet is affected. That is accurately described as debt-monetization. To say that a bank creates money out of thin air suggests rather that the liability is offset not by an asset but by an expense - e.g. that the bank prints money and uses it to pay wages. That's probably what "thin air" would suggest to an accountant.

  Yes, debt-monetization using discounted bills of exchange is a historical fact, developed by the market with no help or encouragement from central banks. I used the term "thin air" to show how inappropriate the term was.

  Mike Sproul is an old rogue who hijacks threads to peddle his heresies. But his papers are well worth reading to anyone who seeks a better understanding of money. And although he believes in free banking for what we agree are the wrong reasons, he is at least a fellow believer in liberty.

  Published: June 21, 2008 8:24 AM

• Alex

  Mike Sproul:

  I understand the demands of teaching, having been there, so don't worry about answering if you don't have time.

  Anyway, you said: "Also, I'll be busy setting up the central bank of Mike. I'm going to buy $100 worth of groceries from my local store and pay for them with 100 mike dollars, each of which has my signature, and my promise to deliver 100 green paper US dollars to the possessor on demand. The grocer will spend those mike dollars getting his car fixed at the local mechanic. The mechanic knows me, so he'll accept them. The mechanic will use them to pay his plumber, who also knows me. The plumber will pay them to a bricklayer, who will pay them to a carpenter, etc. The carpenter happens to need $100 worth of economics tutoring, so he'll pay me those mike dollars for the tutoring, at which point I'll burn them. But you'll notice I didn't have to maintain physical convertibility of those mike dollars--I never paid any green dollars, but I didn't defraud anyone either. In fact, I didn't do anything any different from what the federal reserve does."

  You just engaged in a multi-step barter transaction, which is a heck of a lot different from what the Federal Reserve does. Ultimately, you redeemed your I.O.U.s buy giving tutoring services. The Federal Reserve does not redeem its I.O.U.s and never intends to. As I explained earlier, when the Fed engages in a short run monetary contraction, by, say, an open market sale of $100 of government bonds from its portfolio, at that point the Fed is redeeming $100 of its I.O.U.s. The simplest way to think of it is to have the public pay for these $100 bonds by currency. In this case, the Fed's liability for currency outstanding falls by $100. The public now has a $100 bond which will pay interest and be redeemed. Note that this action also means that the government will have to raise taxes to finance the interest payments and bond redemption, whereas the government doesn't as long as the bond is on the balance sheet of the Fed. But, as I say, such Fed open market sales of government bonds are, over time, swamped by Fed purchases of government bonds, and thus the Fed's government bond portfolio grows, and grows. [In practice, of course, the $100 government bond sale by the Fed would see the Fed receive checks drawn on commercial banks and the Fed's liability that would be reduced would be commercial bank deposits rather than the Fed's currency liability.]

  
  

  Published: June 21, 2008 10:04 AM

• Mike Sproul

  Fusgerm:

  I would have preferred "pioneer" to "old rogue" and "corrects monetary fallacies wherever he finds them" to "hijacks threads to peddle his heresies", but at least you're doing your part to correct the misuse of the "thin air" description of money.

  Published: June 21, 2008 11:14 AM

• Alex

  Mike Sproul: The reason I focused solely on the Fed, rather than bringing in the commercial banks to money creation, is that everyone should agree that creating money out of "thin air" is certainly what the Fed engages in.

  Published: June 21, 2008 12:35 PM

• Alex

  Correction: The Fed creates money out of hot air.

  Published: June 21, 2008 12:36 PM

• fundamentalist

  fusgerm: "If a bank loans money into existence, it records the deposit as a liability and the loan as an asset. Only the balance sheet is affected. That is accurately described as debt-monetization."

  Your linguistic gymnastics are impressive! But with FRB the fact of the matter remains that at point A in time, only the cash reserves of the bank existed as money, while at the later point B, 9 times as much money exists. Yes, modern accounting practices make it look legit. But someone has to answer the question, where did the extra money come from?

  You write that the bank "loans" money into existence. Doesn't that require that the money not exist before the loan? And isn't "not existing" the same thing as "nothing"? Maybe you have a different definition for "exists" than I do. If banks didn't create money from nothing, ex nihilo, out of thin air, then banking would be nothing more than a transfer of money from one person to another, and it clearly isn't that.

  I'm afraid you get a rash from my terminology because it lays naked the reality of FRB.

  Published: June 22, 2008 10:22 AM

• TLWP Sam

  Egads fundamentalist! Is it turning into a circular argument? Apparently money comes from somewhere but where? Gold likewise is 'out of thin air' in that more gold simply inflates the existing supply. Did the gold miner ask people if they needed more gold? Who cares how much effort went in per ounce - more gold equals gold inflation. Perhaps the only difference is gold is an international currency whereas as most currency are national. Apparently the only around this is to say welll people are going to inflate the currency anyway (whatever it happens to be) so let's use gold coins as the fortunes of gold mining are rather random relative to anything else yet.

  Published: June 22, 2008 10:55 AM

• Mike Sproul

  Alex:

  Some elaborations on the central bank of Mike:

  I'll start by printing up 100 mike dollars, on blue paper, each of which says "IOU 1 green paper US dollar anytime, except nights and weekends, and subject to a 1-day delay when daily demands for redemption exceed $10."

  I'll spend tham at the grocer, who spends them at the mechanic, etc. I'll keep 10 green paper US dollars on hand at all times to redeem them, and if there is a run, I'll keep other assets (at least $90 worth) on hand that I can sell on one-day's notice, either for green dollars or for blue (mike) dollars.
  Then one day at the grocery store, I'll offer the grocer 200 mike dollars in exchange for a US government bond that he's been trying to sell for $200.
  Eventually, I'll stop paying out green dollars. I'll only pay out $1 worth of my bonds for each mike dollar, if anyone asks. This will work fine, until the day that 200 mike dollars get redeemed at once, which would use up my bonds. If that day ever comes, then I will have to resume paying out green dollars, or else my mike dollars will lose value.
  You might think I'll make a profit because I earn interest on the bonds, while I don't pay interest on the mike dollars. I doubt it. I think the cost of printing and handling will burn up my interest earnings. If they didn't, I'd quickly find rivals who want to issue ralph dollars, joe dollars, etc, and they'd offer interest on their dollars, do I'd have to do the same.

  Sometime before I die, I'll have to square up with everyone, unless I sell my bank to someone else, who continues the same practice indefinitely. No doubt my descendents will have to listen to fundamentalist's descendents, insisting that mike dollars are created out of thin air.

  Published: June 22, 2008 3:16 PM

• fundamentalist

  TLWP: "Gold likewise is 'out of thin air' in that more gold simply inflates the existing supply."

  Gold exists in the ground before the miners discover it. In fact, the production of gold is the result of someone's savings, because someone had to save the money at some time that sustains the miners digging for the gold. The gold the discover and refine is the result of savings mixed with labor.

  However, in FRB the new money literally comes out of nothing. Nothing was discovered. No labor or savings was required to produce it. You can have FRB with a gold standard. FRB under a gold standard started happening around 600 years ago in Italy. They didn't even use paper money. The gold dealers would just add an entry to the account of a client. Because people trusted the gold merchants and used his books to settle accounts, the accounts acted like gold and produced the same effects as an increase in the supply of gold--price inflation, bank failures and recessions.

  Published: June 23, 2008 7:57 AM

• TLWP Sam

  I don't care if gold is produced at a loss or suppose some rich nutter blows his fortune via extracting gold from seawater and floods world with new gold - gold is going to get hyperinflated, period. It's akin to a collectors paradox of sorts: 'the really valuable baseball cards were mass produced and boys of the era owned them yet only a few kept any let alone in mint condition hence these cards are valuable, but if the boys of times past had known about this and they all kept the cards, the cards wouldn't be valuable now'. It would said when the Spanish Conquisadors sent gold back from South America those who first received the gold could spend at low prices before others caught on and the last to hear about the new gold suffered and so on. Gold got inflated and people had to adjust - ooops tough luck for some! As I said before, and what people have also said, gold is unlikely to be mass recovered any time too soon. There could be more sudden mass discovery sites, economic seawater extraction might become economically feasible, true space travel might happen, economic gold transmutation might be discovered and monkeys might fly out of my butt. People here have pointed out, time and time again, that money from paper sources, base metals and electronic could be hyperinflated on whim therefore precious metals coins make for the obvious option. I'm sure people here have also stated that gold, silver and platinum/palladium isn't theoretically immune from the forces of hyperinflation but are very extremely unlikely without Star Trek-style technology. I just thought M. Sproul and fusgerm did make an interesting point about a type of open money being made via double-sided bookkeeping whereby the person get an asset and the issuer gets a liability therefore inflation might not occur as opposed to adhering to a precious metal standard and place faith there is neither finds nor losses (I wonder what happens when a ship carrying gold gets sunk on the way? Sudden losses? Deflation?).

  Published: June 23, 2008 8:41 AM

• jp

  "Gold exists in the ground before the miners discover it. In fact, the production of gold is the result of someone's savings, because someone had to save the money at some time that sustains the miners digging for the gold. The gold the discover and refine is the result of savings mixed with labor....However, in FRB the new money literally comes out of nothing."

  A bullion vault that stores gold on behalf of clients without lending it out prints the client a certificate. This certificate circulates as money. Didn't the vault owner create the certificate out of thin air too? It took him almost no time or effort, just a few strokes of his pen. Isn't this a case of new money coming from nothing, no savings and no labour required, just like FRB?

  Published: June 23, 2008 10:45 AM

• TLWP Sam

  Interesting point jp.

  Published: June 23, 2008 9:35 PM

• P.M.Lawrence

  In JP's scenario, gold is withdrawn from circulation as certificates are issued and released as those are withdrawn, all in step, so no money is created or destroyed using thin air.

  When Spanish bullion arrived there was indeed a range of inflationary effects (mostly from the silver as it was the main monetary medium in those days), but it wasn't hyperinflation. Money didn't lose its ability to transmit price signals, but people with resources tied to nominal values lost out and a few other things happened that mattered because of cumulative effects. Broadly, Spain lost infrastructure and countries like Poland and Turkey at the end of the transaction chain exported commodities for depreciating money, while middleman countries like England and Holland gained capital investments and infrastructure.

  Published: June 24, 2008 12:13 AM

• TLWP Sam

  But wasn't that M. Sproul and fusgerm were implying? That there should be a liability created along with the asset. Just as it would be to say for the gold coin & certificate - if the issuer treated the gold certificate as money and the coin as money then the issuer would have gained an asset and issued an asset therefore the system would break if the issuer collected the gold coins and turned around and spent them too. If the banker was being genuine in saying that the paper money is an asset and the gold coin is a liability to the issuer then things should be okay. But still money has to initially come from 'somewhere'. The issue is can new money be genuinely created in step as not to be inflationary as M. Sproul implies or does money have to be something like gold and hope the new gold will always be a trickle and cause virtually negligible effect?

  Published: June 24, 2008 1:11 AM

• Mike Sproul

  I think everyone agrees that coining bullion into gold coins does not affect the value of gold or of coins. If excess coins are minted, people will just melt them into bullion. The Law of the Reflux assures that excess coins will reflux to bullion. Of course it's better still if people trade with 100% reserve gold certificates, since they are handier than gold for exchange. Now, of course, people could use bushels of wheat as money too, and if a bushel were stamped into a (very large) wheat coin, then that wheat coin could, in principle, circulate side-by-side with gold, with excess wheat coins refuxing to the wheat market. In this case, 100% reserve wheat certificates would also be a great improvement over the wheat coins. Again, there should be no price effects from the issue of these wheat coins Now make just one change: Let the wheat certificates be denominated in gold. Now part of the certificates are backed by gold, and part are backed by wheat. We have changed to fractional reserves just by changing the denomination of some of the certificates. If you believe that this system is no more inflationary that the gold and wheat certificates circulating side-by-side, then call yourself a real bills'er. If you think that the mere change of denomination would cause inflation, call yourself a quantity theorist.

  Published: June 24, 2008 10:46 AM

• jp

  PM:
  I was trying to point out that Fundamentalist's critique of FRB as being based on "thin air" can be turned against good old fashioned gold warehouse banks that issued receipts to depositors. After all, these receipts come from "thin air", didn't require savings or sweat or labor on the part of the issuer, etc.

  That leaves Fundamentalist uncomfortably criticizing money certificates (ie 100% backed warehouse receipts), something Mises would have frowned on. Looking through the past comments Mike Sproul called him on that several times.

  I agree with Fusgerm on this. It would be interesting to hear a critique of FRB that avoids phrases like "out of thin air" and "money out of nothing".

  
  

  Published: June 24, 2008 10:57 AM

• Joe Stoutenburg

  You can call me a real bills'er to the extent that I accept that money may be backed by anything that people are willing to allow (including gold, real estate and financial assets representing claims to real assets). I have a number of remaining doubts and criticisms.

  1) I'm not completely convinced that our banking system is backed by real assets. I'm starting to drift toward being able to accept that government bonds are claims on real assets. If I accept that, I will still object to our monetary system on the grounds that the assets backing the money was posted coercively. It remains a wealth transfer as the quantity theorists claim but not for quite the reasons that they offer.

  1a) It is worth conceding that there is no wealth transfer if collateral is voluntarily posted.

  2) Because the market for bank collateral is hardly a free market (being composed primarily of claims on tax collections), I highly doubt that the value of the collateral is well reflected. If I'm not mistaken, you have conceded that inflation may occur if the monetary backing is proven to not be worth what it had been thought. (Am I correct?) It seems to me that there is not necessarily inflation as long as the collateral has value and that the money is used to purchase new products. You seem to come off as saying that inflation can not happen under RBD.

  2a) In any case, if you concede that inflation can and has occured in our monetary system, you'll make some headway. If you don't, then you and I remain apart in opinion.

  3) From your explanations, I fail to see the necessity for the Federal Reserve under a free market RBD monetary system. It seems that its primary purpose is to monetize government bonds. Because those bonds represent promises to steal, I can still find no reason to support the Fed's continued existence.

  Published: June 24, 2008 11:34 AM

• Joe Stoutenburg

  A few other comments came to mind (I've been writing this off and on during the morning).

  4) I still find fault with your insistence against inflation in RBD. Relatively speaking, given the same amount of goods, prices will be higher when there are more dollars offered against those goods. The problem I think, may be that some people tend to reverse causality. They say that the new money caused inflation. In a free market RBD money system, it is demand that brings the new money into existence.

  To illustrate, borrowing under a gold standard would require you to locate someone who already owned gold and offer to pay interest for the use of the money. In this arrangement, collateral may or may not be required depending upon the level of security desired by the lender. If the pool of goods increases faster than the supply of gold entering the money system, prices will tend to go down.

  Rather than borrowing existing money, you might instead offer property as collateral to back new money. In this arrangement, the posting of collateral is vital in order to keep the bank solvent. It's unclear to me whether inflation would result generally though it clearly could occur in the markets toward which the new money was directed.

  5) Though I may accept the legitimacy of free market RBD (as contrasted to the system currently imposed), I still would not advocate a system without a predictable money supply. It seems like RBD claims that what constitutes money may continually change. And while money may indeed need to change from time to time, I don't see the value of encouraging it to change continually. It seems that this kind of institution would only encourage fraud in the banking system as bankers attempted to introduce more and more questionable collateral to back their money.

  Published: June 24, 2008 12:10 PM

• P.M.Lawrence

  TLWP Sam wrote "But wasn't that M. Sproul and fusgerm were implying? That there should be a liability created along with the asset. Just as it would be to say for the gold coin & certificate - if the issuer treated the gold certificate as money and the coin as money then the issuer would have gained an asset and issued an asset therefore the system would break if the issuer collected the gold coins and turned around and spent them too. If the banker was being genuine in saying that the paper money is an asset and the gold coin is a liability to the issuer then things should be okay. But still money has to initially come from 'somewhere'. The issue is can new money be genuinely created in step as not to be inflationary as M. Sproul implies or does money have to be something like gold and hope the new gold will always be a trickle and cause virtually negligible effect?"

  The whole point of a bullion standard or similar is that it keeps the issuers honest. Of course an all wise and all good government could indeed arrange for "new money [to] be genuinely created in step as not to be inflationary" (although that still gives them a windfall "inflation tax" from eating up the deflation of a growing economy, one that a wise and good government would invest or use to pay off debt rather than simply spend). But to state that is to highlight the importance of keeping them honest; the issue is not as you supposed whether an honest lot can do the right thing but what keeps the real lot honest in the first place. In this sense, bullion is just a real bill backing that it is a lot easier to keep honest.

  Mike Sproul wrote "I think everyone agrees that coining bullion into gold coins does not affect the value of gold or of coins". Well, no. There is always seigneurage, corresponding to the real and actual growth that is released by having a monetary medium, that would be held back by the lack of it. In the very beginning days of a cash economy this can be quite large (think Midas or Croesus of Lydia), but in a mature economy it averages a small percentage. This is the "somewhere" that money comes from that TLWP Sam asked about in "But still money has to initially come from 'somewhere'" - it's a match to the accumulated seigneurage, and with any real medium like bullion a lot happened when it first got monetised. From our point of view, it's simply brought forward from some earlier stage.

  "Now, of course, people could use bushels of wheat as money too, and if a bushel were stamped into a (very large) wheat coin, then that wheat coin could, in principle, circulate side-by-side with gold, with excess wheat coins refuxing to the wheat market. In this case, 100% reserve wheat certificates would also be a great improvement over the wheat coins. Again, there should be no price effects from the issue of these wheat coins Now make just one change: Let the wheat certificates be denominated in gold. Now part of the certificates are backed by gold, and part are backed by wheat. We have changed to fractional reserves just by changing the denomination of some of the certificates. If you believe that this system is no more inflationary that the gold and wheat certificates circulating side-by-side, then call yourself a real bills'er. If you think that the mere change of denomination would cause inflation, call yourself a quantity theorist."

  This is leaving out a whole load of stuff, from carrying cost and risk. There is a contingent liability that's not being reckoned up. Everything is plain sailing until one day the cupboard is bare because some disaster has hit the granaries, e.g. a mouse plague. Then you find your loss realised in the form of inflation.

  JP wrote 'PM: I was trying to point out that Fundamentalist's critique of FRB as being based on "thin air" can be turned against good old fashioned gold warehouse banks that issued receipts to depositors. After all, these receipts come from "thin air", didn't require savings or sweat or labor on the part of the issuer, etc.'

  But, they did require the gold to be lodged. That's the point; it's not whether the issuer had to make a sound backing but whether someone had to.

  'I agree with Fusgerm on this. It would be interesting to hear a critique of FRB that avoids phrases like "out of thin air" and "money out of nothing".' Easy - it's whether the real bills are real that makes the problem. The difficulty is like a roulette system that says "bet red when it's about to come up red and black otherwise". It's not whether the trick works but whether you can do the trick. In the early days of an attempt at real bills it usually does work, partly because the underlying value hasn't yet hit serious problems, partly because you aren't yet loading it too hard, and partly because you can ride out minor problems by growing the overhang a bit more - all of which leaves more exposure later. In one sense all a bullion system is doing is insisting on a real backing of very high quality so as to minimise these risks, but it still can't abolish them (think what happened to the value of bullion money in cities under siege). But real bills are a standing temptation for getting in too far and having bills that are not real while kidding yourself that they are (subprime, anyone?). Someone in that position can ask quite seriously what is wrong with his real bills theory and still not get it that his problem is that they aren't real, and that he was always going to get into that bind sooner or later on some day of reckoning. The difficulty with the theory isn't in the reasoning but in the premises - which are often near enough true to begin with to get you into trouble later, like a motorcycle with enough power to get you up to dangerous speed but not enough to accelerate out of a dangerous situation once one comes up. This pretty much answers Joe Stoutenburg by confirming his early suspicions, too.

  Published: June 24, 2008 8:43 PM

• Joe Stoutenburg

  The more I follow this discussion, the more I am reminded of the subjective nature of exchange. As long as exchange is voluntary, lovers of liberty should have no objection (though they may criticize some actions as unwise). Thus, I can give qualified approval of a voluntary banking system of RBD and object to the very existence of government bonds (since they are ultimately backed by theft).

  Still, I believe that it is prudent to remember that not all people are forth-coming in exchanges. And the more wealth involved in transactions, the more fraud will be attracted. For this reason, we would be wise to keep our bankers on a tight leash. While there may be nothing intrinsically wrong with RBD, I wonder whether fraud may possibly be kept at bay. Heck, it might be a hard enough task to assure that banks have enough gold in the vault under a 100% gold standard. Are we to expect that the public (especially the current economic illiterate public) can really assure that the backing is real on uncountable numbers of IOUs?

  Published: June 24, 2008 9:57 PM