Inflation Deflation Red-flation Blue-flation
A debate has been raging for some time among those in the finance industry about whether the United States is currently experiencing inflation, deflation, stagflation, reflation, hyperinflation, or maybe even some other sort of "-flation" that only Dr. Seuss could imagine. Given the confusion, this article will add some color to the debate by offering usable definitions of the terms inflation and deflation and then attempt to show what is occurring in today's economy.FULL ARTICLE
Comments (64)
Larry N. Martin
I am not sold on gold,
But gold is better than mold to hold
(so I'm told)
Or paper that folds
and can be rolled
To make an expensive cigarette.
Published: July 24, 2008 10:56 AM
fundamentalist
Very informative! Thanks!
Published: July 24, 2008 11:18 AM
Neal W.
Good article. Clears up much confusion.
Published: July 24, 2008 11:24 AM
billwald
Money is NOT a good (at this time), it is an accounting convenience, a unit of value (dollar) in the same way that gram is a unit of weight, a conversion factor between various assets and liabilities.
Inflation would be a more useful concept if it related work hours to the cost of consumer goods.
Published: July 24, 2008 11:49 AM
Michael A. Clem
So actually, a lot of the inflation is due to fractional reserve banking, and the Fed has only a minimal amount of control over the banks doing it?
Published: July 24, 2008 11:51 AM
Fephisto
Excellent article, but I have just one suggestion:
The title should be renamed to, "A Crash Course in Austrian Economics".
Published: July 24, 2008 12:18 PM
Matthew
Michael A. Clem: I wouldn't go so far as to say that the Fed only has "minimal" control of banks in inflating. The Fed has tremendous influence on banks. The point is that it's not absolute, direct control.
Published: July 24, 2008 12:34 PM
Walt D.
We define inflation ..... as an increase in the money supply.
Don't we also need to add "relative to goods and services?
If we mine gold and issue (commensurately) more money, is this inflationary?
Published: July 24, 2008 1:37 PM
Matthew
Walt D.: If you would like to adopt a definition of inflation "relative to goods and services" that's certainly you're prerogative, but I don't think it is the best definition of the term. The pace of production of goods and services can fluctuate just as the quantity of gold mined can too. I think it is easiest when trying to communicate to keep those things separate from one another.
I infer that you're focusing on how inflation causes a change in the price level (using that term loosely). Using the definition of inflation in the article, the price level could either go up or down, even if "inflation" is occurring.
Also, in case it's not clear, inflation (an increase in the money supply) that is faster than the increase in goods and services is not that which causes economic miscalculation and business cycles. Some people seem to have that idea, but it is not the case.
Regarding mining gold and "issuing" more money, I'm not sure exactly what you mean. Gold itself is/would be money and does not need to be issued. To answer your question, using the defintion of inflation in the article, yes, mining gold would be inflationary. This type of inflation would not, however, tend to cause business cycles.
Published: July 24, 2008 2:03 PM
Francisco Torres
Money is NOT a good (at this time), it is an accounting convenience, a unit of value (dollar) in the same way that gram is a unit of weight, a conversion factor between various assets and liabilities.
The problem is that this "accounting conversion factor" keeps changing with time, whereas the gram does not.
Inflation would be a more useful concept if it related work hours to the cost of consumer goods.
That does not make sense - what does the number of work hours have to do with the cost of consumer goods? The cost is determined by supply and demand, always.
Published: July 24, 2008 2:19 PM
KO
Matthew,
If you could clear up a few points for me I would appreciate it.
"Instead of printing, the Fed's second option is to try somehow to convince banks to extend more loans, businesses to borrow and expand, and consumers to continue to consume. This is quite a challenge indeed, given the general negative sentiment in the business world."
Does the Fed not convince banks to loan money by the interest rate in which they initially lend the banks money?
Trying to convince consumers and businesses to expand by offering them readily available credit seems like what got us where we are now. Shouldn't we encourage deflation and a contraction of the money supply?
"If it had allowed Bear to go bankrupt, the banks that had loaned Bear money would have had to take losses, thereby reducing their reserves and their ability to extend credit elsewhere. It is even possible that Bear's bankruptcy would have caused other large firms to become insolvent and declare bankruptcy as well."
Would allowing this to happen have been a bad thing? It seems it would have been a necessary correction by the market?
My final question is, doesn't the TMS have more of an impact on the value of the dollar then the AMB?
Published: July 24, 2008 2:26 PM
Francisco Torres
Thank you for this article. It is very informative - I did not realize the effect that knowledge (or rather, lack of it) had on inflation until you explained how deposits get lent off by the fractional reserve banks. If people think that their money is 100% available, then it makes sense that the money supply can increase to almost 1000%.
Published: July 24, 2008 2:27 PM
Matthew
KO:
Generally, banks do not borrow money directly from the Fed. They only do that through the discount window. The Fed, through its open market operations where it buys or enters swaps for securities, can increase the reserves of banks. Banks can then either sit on whatever reserves they have in excess of their requirements and earn nothing on them, or they can loan them out to businesses or other banks. Frank Shostak discussed some of these dynamics recently here.
I personally think that that's going to happen regardless of whatever encouragement there is (either that or hyperinflation, which would be the worse option). Murray Rothbard touched on this near the beginning of America's Great Depression. Basically, people need to start saving more and consuming less to eliminate the malinvestment. Deflation would probably encourage people to do that (because their money would be rising in value), so it would be good in that sense. More generally though, eliminating government interference and deeming fractional reserve banking to be fraud is the right way to go.
Allowing Bear to go bankrupt would not be a bad thing from the perspective of liberty and allowing markets to function, but it would be a bad thing for those parties interested in maintaining the current financial system.
Published: July 24, 2008 3:02 PM
KO
Matthew,
Thanks for the input. The Fed system still confuses me as someone new to economics. I will take a look at that article and try to understand how it all works. Recently I have been listening to a lecture Murray gave on banks and the banking system. I do have a question you may be able to help me with.
If the Fed were to increase the reserve rates the banks were required to have, would that have the same effect as a contraction in the money supply? I realize it would not change the current TMS but would forcing the banks to hold larger reserves, have the same short term effects as a contraction in the money supply?
I do hope you are correct that deflation is allowed to occur instead of hyperinflation. I do wonder if the Fed will allow deflation to happen. It seems contrary to their often followed course.
As far as the fractional reserve banking system, listening to Murray has convinced me of its fraudulence. He explains so simply why it is fraudulent.
Published: July 24, 2008 3:38 PM
Matthew
KO:
If the Fed raised reserve rates, yes, it would probably force the money supply to contract. The "multiplier," the theoretical limit of how much money can be created is the inverse of the reserve rate (if you're into math, you can sum the geometric series to get that formula). So with 10% reserve requirements, the money supply could grow to 1 divided by 10%, which is 10 times. If the Fed raised requirements to 20%, the theoretical limit would be 5 times. As banks sought to increase their reserves by discontinuing loans, it would have the effect of reducing the amount of circulation credit, which is a component of the money supply.
I hope that is helpful. Also, FYI, reserve requirements are not 10% across the board. There are some exceptions, which you can see here.
Published: July 24, 2008 3:59 PM
Chad
Regarding the fraudulent nature of fractional reserve banking, what if all banks were required to publicly post a notice that said something like the following with X being the current reserve rate:
"This banking institution is only required by law to keep X% of customers' deposited money available for withdrawal at any given time."
Would such a truthful disclosure help customers be more cautious as to where they deposit their money?
Also, could a bank choose to keep more reserves than what is required by the reserve rate (ex. reserve rate + 10%) and use that fact to market itself as being a more secure place to deposit money than at competing banks?
Published: July 24, 2008 5:18 PM
Matthew
Chad:
Such disclosure might help customers be more cautious, but I don't think it would be enough. As long as the bank allowed more than one person to have legal title to the same amount of money at the same time, problems would occur.
Yes, a bank could, but I don't know whether the benefit of such marketing would outweigh the revenue they could be earning by loaning out their excess reserves, especially given that the Fed is there to backstop them and their competitors.
Published: July 24, 2008 5:50 PM
Ireland
Re dangers of deflation I quite liked this article by George Reisman, he spells it out in nice details:
"Our Financial House of Cards" [ http://mises.org/daily/2926 ]
"In 1929, the quantity of money in the United States was approximately $26 billion and the gross national product (GNP/GDP) of the country, which provides an approximate measure of consumer spending, was $103 billion. By 1933, following wave after wave of bank failures, the quantity of money had fallen to approximately $19 billion and the GNP to less than $56 billion. The failure of wage rates and prices to fall to anywhere near the same extent resulted in mass unemployment." So a 27% monetary contraction resulted in 45% GDP drop.
And today "The potential deflation of the money supply as a whole, if nothing were done to stop it, is the difference between $3.3 trillion and $840 billion, i.e., approximately 75 percent."
Published: July 24, 2008 6:15 PM
Chad
"Yes, a bank could, but I don't know whether the benefit of such marketing would outweigh the revenue they could be earning by loaning out their excess reserves, especially given that the Fed is there to backstop them and their competitors."
So, it is theoretically possible (even under the current system) to have a bank to voluntarily choose to make itself relatively bank run-proof by keeping (for example) 80% of all deposits in reserve regardless of what the reserve rate may be.
You know, you really have to wonder how high the natural (vs. Fed-determined) interest rate would go in our current, no-savings climate if fractional reserve banking was not allowed. Also, I am sure there would be far fewer banks out there lending tens or hundreds of thousands of dollars to everyone buying a car or house due to a lack of matching deposits.
Published: July 24, 2008 6:23 PM
KO
Matthew,
Again thanks for your insight. I can not claim mathematics to be my strongest suit but it is amazing, simple how the money supply grows, somewhat unchecked.
Chad,
"Regarding the fraudulent nature of fractional reserve banking"
Just my opinion but you can't start with something fraudulent and make it work. If it is unsound eventually it will be exposed.
Published: July 24, 2008 7:03 PM
Chad
"Just my opinion but you can't start with something fraudulent and make it work. If it is unsound eventually it will be exposed."
I agree. However, if fractional reserve banking is going to occur (and it is ... for now), then the banking public should at least be made aware by the banks themselves of the risks they are taking when they deposit money in a bank. Too many (wrongfully) assume that the bank will always be able to return their deposits in full on any given day as they have never even heard of the reserve rate.
After all, even lotteries are required to spell out the risks involved (i.e., the odds of winning) up front to ticket purchasers.
Published: July 24, 2008 7:53 PM
Mike Sproul
A checking account dollar is just a call option on a green paper dollar, with a strike of zero and no expiration date. Just as the issue of calls does not reduce the value of the underlying stock, the issue of checking account dollars does not reduce the value of the underlying green paper dollars.
If I put $100 in a checking account, knowing that the banker will lend $90 and keep only $10 on hand, and knowing that this practice allows the banker to pay me interest instead of charging me fees, and also knowing that there will be times when my money is not instantly available, or that the banker might even be a crook, then that is between me and the banker. It's strange to see Austrians waving the libertarian flag while simultaneously trying to prohibit voluntary trade between a bank and its customers.
Published: July 25, 2008 8:29 AM
Richard
"In such a society, it would be expected that some amount of gold would be mined from the earth and added to the money supply each year. As long as the rate of this dilutive increase in the money supply was acceptable to the populace (if it were not, a different commodity would be selected to function as money), entrepreneurs would adjust their calculations and business plans based on this dilution. "
Wouldn't this be the case though if the Fed adopted the old Friedmanite plan of adopting 100% reserves but increasing the money supply by a fixed amount each year? If entrepreneurs knew what the fixed amount was wouldn't that make it easier for them to calculate?
Published: July 25, 2008 8:30 AM
Paul
Yes, in theory deflation would cleanse the system of all its malinvestments and misallocations over the past 70 years. Deflation would be the needle that pops the gigantic debt bubble that we're in. Obviously they aren't pretty and almost always are accompanied by severe recession or depression. The Fed, obviously, is under tremendous pressure to not let it happen.
Published: July 25, 2008 8:55 AM
fundamentalist
Mike: “A checking account dollar is just a call option on a green paper dollar…”
Not a good analogy. In derivatives trading, the difference between the option and the asset are clear cut. No one confuses the two. With money, none but economists can tell the difference between the two. Checking account dollars trade for goods just as well as green paper. So an increase in the number of options has the same effect as an increase in the volume of the underlying asset, which reduces its value relative to other goods.
Mike: “It's strange to see Austrians waving the libertarian flag while simultaneously trying to prohibit voluntary trade between a bank and its customers.”
I don’t think most Austrians would object to FRB if customers were fully informed of the potential loss of their principal. But then fewer customers would put their money in an FRB bank. Also, I think it’s short sighted to look at just the banking transaction as the only case for potential fraud. The real fraud takes place with the rise in prices that follows inflation of the money supply. The people who get the new money first can buy goods and assets before prices rise. The people who get the new money last are stuck with money that is worth less because prices have risen. So a transfer of wealth occurs, taking wealth from the late receivers without their consent and giving it to the early receivers. That is the fraud that no one understands but Austrians.
Published: July 25, 2008 9:09 AM
Jordan
Just curious--has a major deflation ever occurred with a completely-fiat monetary system (ie, one that doesn't even pretend to be convertible to some commodity)? It seems the history and fate of these systems is always inflationary over the long-term, but I admit to being somewhat a neophyte.
Published: July 25, 2008 10:54 AM
Oil Shock
I have no problem with Fractional reserve banking as long as government stays out of bailing out troubled bankers and their customers.
Published: July 25, 2008 1:35 PM
Matthew
Jordan:
I'm not much of a historian, but I don't think the world has had any pure fiat currencies before now, so the answer to your question would be no I suppose.
Oil Shock:
Such a position is equivalent to saying that you're okay with fraud as long as government doesn't step in and protect the fraudsters. While the second part of the statement is fine, not punishing people for committing fraud would not bode well for economic well-being and it would go against libertarian principles of justice. If those things are important to you, you should be opposed to fractional reserve banking itself.
Published: July 25, 2008 1:55 PM
Matthew
Richard:
You might want to confirm this with someone more knowledgeable about Austrian business cycle theory, but my understanding is that such a scenario would be superior to one that allowed fractional reserve banking because the natural interest rate would not be being systematically manipulated through the extension of loans using money that is not intended to be loans. However, misallocation of resources would still be occurring because government would be the one spending or distributing the newly-created money. With gold as money, miners who are doing something economically productive would be the ones with the right to spend the new money. In your scenario, those who are not necessarily doing anything economically productive (without the confirmation of a market test) are the ones with that right.
Published: July 25, 2008 3:04 PM
Ireland
Mike: "It's strange to see Austrians waving the libertarian flag while simultaneously trying to prohibit voluntary trade between a bank and its customers."
Economics is a science connecting cause and effect in the field of human action. Austrian economics is one particular branch, built in a certain way.
It shows what effects are brought about by the policy of liberty. It also shows what happens when the voluntary banking operations are allowed to include fractional-reserve practices. That's science at its best: do this, and the result is this.
Now the stance of endorsing liberty and despising FRB must be strange to all who for whatever reason refuse this theory and its results. In such worldview where there are no special effects of FRB, there's no good reason to repeal it, and anyone giving advice in that regard looks to be in logical conflict with the basic concept of liberty.
The strangeness doesn't work the other way round though. For one who pushes liberty but misses understanding of the austrian FRB theory it is natural to ask the FRB to be allowed.
There are many strange theories. Some people would make us believe that all the solid things around are mostly empty space, filled with gazillions of small, fast-moving, ever-interacting, half-waves half-particles. Totally crazy. Yet when it comes to the real-world test, it's the guys with these unbelievable theories who'll wield the Bomb, lasers, and other interesting stuff.
It's the same here. We wave liberty and condemn FRB at the same time, while others wave liberty and endorse FRB. Logic suggests that at least one of these groups is delusional. Then in the real world people will make different decissions to reach their respective goals, and they will fare with different success, depending of how close each worldview matches reality (a.k.a. "natural laws"). Those willing to honestly judge this can then decide between sound theories and junk.
Published: July 25, 2008 5:05 PM
Mike Sproul
Fundamentalist:
"In derivatives trading, the difference between the option and the asset are clear cut. No one confuses the two."
You could call a broker and order 1 share of GM today. He could say OK, record it in his books, take your money, and not actually buy the share for a few days. You would actually own a derivative share, even if you thought you owned a genuine share.
"With money, none but economists can tell the difference between the two."
Next time you get confused between a checking account dollar (the liability of a private bank) and a green paper dollar (the liability of the federal reserve), just let me know. I'll be glad to help out.
"Checking account dollars trade for goods just as well as green paper. So an increase in the number of options has the same effect as an increase in the volume of the underlying asset, which reduces its value relative to other goods."
1. If the company issues more of the underlying shares and sells the new shares for equal-valued assets, then assets rise in step with liabilities and there is no effect on the price of the underlying asset. When the fed issues more green paper dollars for equal-valued assets, there is no effect on the value of green paper dollars.
2. You ignore the law of the reflux, which says that as new checking account dollars are issued, existing moneys will reflux to their issuers, leaving the quantity of money unchanged.
3. Just as the issue of calls does not affect the assets and liabilities of the underlying company, the issue of checking account dollars does not affect the assets and liabilities of the fed, so the is no reason to expect an impact on the value of green paper dollars.
"I don’t think most Austrians would object to FRB if customers were fully informed of the potential loss of their principal. But then fewer customers would put their money in an FRB bank. "
Nobody is ever fully informed about anything. The most an Austrian should insist on is that the transaction is voluntary. FRB has been around long enough for people to be aware of its nature, and the banks seem to have enough customers--including you, unless I miss my guess.
"The real fraud takes place with the rise in prices that follows inflation of the money supply. "
Which brings us back to the heart of the matter: An increase in prices does NOT follow an issue of ADEQUATELY BACKED money.
Published: July 26, 2008 2:02 PM
Mike Sproul
Ireland:
If you want science, my "No Fiat Money" paper, which you can find by clicking my name above, cites empirical work from Sargent, Calomiris, Cunningham, Smith, Bomberger, Makinen, etc, all of which support the real bills view that the issue of adequately backed money does not cause inflation, as opposed to the quantity theory view supported by Austrians.
"There are many strange theories."
You mean like phlogiston, ether, and caloric? I don't see those guys shooting off lasers. And the economists who believe there is such a thing as 'fiat money', or that fractional reserve banking is inflationary, belong with the phlogiston crowd.
Published: July 26, 2008 2:23 PM
Alex
Fraud involves deception. If the public is fully informed that for every dollar on deposit there is not a dollar's worth of currency on hand, there is no deception and hence no fraud with the fractional reserve aspect of banking.
With fractional reserve banking, it is still the monetary base that limits the quantity of money supply in the economy. Since the Fed controls the monetary base, which all stems ultimately from currency issue, it controls the maximum amount of money supply in the economy.
Mike Sproul said: "When the fed issues more green paper dollars for equal-valued assets, there is no effect on the value of green paper dollars."
Here's the problem with this statement. To see it more directly, let's deal with the typically government-owned central bank rather than the Fed (though it works the same way with the Fed, it's a little indirect since the Fed is nominally privately owned). The typical central bank is part of the federal government.
Currency is a liabiltiy of the Federal government. Federal government bonds are liabilities of the federal government. So when a central bank uses $100 bill to purchase a government bond, effectively the government has placed in the hands of the public a small piece of paper that represents a $100 perpetual zero-interest I.O.U. The $100 government bond the public previously owned was worth $100 because that equalled the present value of the interest payments and principal repayment that was contractually guaranteed. The $100 value of the bond therefore also represented the PV of taxes that would be collected to service the bond. If the bond stayed in the hands of the public, the taxes collected to service the debt would occur bit by bit over the years.
When the government prints up a new $100 bill to buy back the $100 bond, the government is collecting the taxes all at once to cancel the bond liability to the public. The taxes are effected through the price increases for goods and services that occur due to the $100 increased currency outstanding. Note that if the government owns its own debt (through the central bank), effectively the debt has been cancelled. Imagine if you issued a bond in your name for $100 and then bought it back. What meaning would it be to hold your own I.O.U. You owe yourself $100? What does that mean?
Published: July 27, 2008 11:41 AM
Mike Sproul
Alex:
"What meaning would it be to hold your own I.O.U. You owe yourself $100? What does that mean?"
There is no hocus pocus involved in the issue of money.
In 1685, the payroll was late in arriving to a french fort in quebec. Soldiers were suffering, as were the shopkeepers who depended on their business.The payroll officer decided to issue paper IOU's, written on playing cards, that each said "1 livre", with the promise that when the payroll ship arrived, the possessor of the IOU could redeem it for 1 livre in coin. The IOU's circulated successfully as money, ending the bad economic times. Assuming the payroll ship contained 30,000 livres in coins, the payroll officer could safely issue up to 30,000 paper livres without causing inflation.
Now suppose that a soldier comes to the payroll officer and offers a french government bond with a market value of 100 livres, if the payroll officer will give him 100 paper livres. Another soldier requests a loan of 200 paper livres, and promises his farm (worth 300 livres) as collateral. Or suppose the payroll officer, in order to conduct business efficiently, needs a new desk, which he pays for by printing up 300 new paper livres.
In each case, the issue of new money was backed by assets of adequate value. In no case would the value of paper livres fall below a silver livre, even though it would be fair to say that the french government was holding its own IOU's (and those of the soldiers).
Published: July 27, 2008 5:54 PM
Ireland
Hello Mike,
the fact that all these people support a view tells little about the scientific value of the view. It may tell something about the people themselves, depending on if the view is good or flawed. Ok, if time allows I may read it and we can then discuss it.
What we _can_ talk about right now are the two paragraphs above and the possible confusion we see. First, there's something wrong with the statement "issue of adequately backed money does not cause inflation".
The context is fractional-reserve banking, and this practice (by its definition) increases the amount of the things people use in exchange for goods and services (i.e. money, by definition) and thus it does cause increase in money supply (i.e. inflation - again by definition).
Yes it's Austrian definitions used above, but being on Mises blog one could expect as much. These definitions are useful, because they allow manipulating matters efficiently and clearly. So if there's some error in *my* reasoning, I'm sure someone will be able to point it out.
Second paragraph references the part which was meant to remind us about how complicated the world around us is, and what is the scientific test of any theory that claims some connection with the reality.
Mike, the physics behind lasers and nuclear fission and frankly most of the modern science - because that's what I had in mind - these are indeed strange theories. Yet there's no escape, they work and such is the world, just as strange as the theories say. "God does play dice", no matter how much Einstein disliked it, and "FRB causes inflation", by definition, no matter how much you dislike us saying it.
Published: July 27, 2008 6:25 PM
Alex
Mike Sproul said: "The payroll officer decided to issue paper IOU's, written on playing cards, that each said "1 livre", with the promise that when the payroll ship arrived, the possessor of the IOU could redeem it for 1 livre in coin. The IOU's circulated successfully as money, ending the bad economic times. Assuming the payroll ship contained 30,000 livres in coins, the payroll officer could safely issue up to 30,000 paper livres without causing inflation."
When you use the term "inflation" I'm guessing you mean the mainstream one of rising prices of goods and services in terms of livres. The paper livres temporarily increased the money supply by the amount issued. When they were redeemed for silver livres, the 30,000 livres in coins increased the money supply by that amount. The increase in prices of goods and services in terms of livres that would have occurred by the increase in 30,000 livres of silver coins would not have been augmented by the temporary issuance of French government paper I.O.U.s. There is no dispute here.
To the extent, however, that some paper I.O.U.s of the French government permanently circulated as money, the French government taxed the purchasing public of Quebec by that amount, since the French government received the services of French soldiers and paid for some of these services by simply printing up some permanently circulating paper.
Mike, then you say: "Now suppose that a soldier comes to the payroll officer and offers a french government bond with a market value of 100 livres, if the payroll officer will give him 100 paper livres. Another soldier requests a loan of 200 paper livres, and promises his farm (worth 300 livres) as collateral. Or suppose the payroll officer, in order to conduct business efficiently, needs a new desk, which he pays for by printing up 300 new paper livres"
If these new paper livres are not redeemed for silver livres, the new paper evidences a tax the French government has imposed on the people of Quebec. Whenever some authority is able to have people accept a perpetual non-interest bearing I.O.U. in exchange for goods and services, the authority gets goods and services from the public and pays nothing back -ever, to anyone. That's a tax!
Published: July 27, 2008 6:56 PM
Ireland
re french fort in quebec: that's a perfect example, thank you.
So there were these ships that every now and then brought coins from abroad, thus increasing the money supply. And the people knew that and expected that, so issuing the same amount of paper had no effect, in fact it helped, as without it there would be effective decrease in money supply when the expected increase failed to materialize. Deflation can be quite nasty, so I'd say he saved the day, especially if all the cards were as soon as possible repaid in the promised silver.
One note about absolute statements: "In no case would the value of paper livres fall below a silver livre"
Just imagine what would happen if the officer refused to redeem the paper livres each for full silver livre once the ship docked. Or if the ship was late for a long time and someone had spread rumors about war/revolution/plague in France, hinting that no more coins are ever shipped to this fortress. Excellent example.
Published: July 27, 2008 7:17 PM
Mike Sproul
Ireland:
"The context is fractional-reserve banking, and this practice (by its definition) increases the amount of the things people use in exchange for goods and services (i.e. money, by definition) and thus it does cause increase in money supply (i.e. inflation - again by definition)."
You are ignoring the law of the reflux: a very sensible law that says that when a bank issues a new dollar, other things equal, some other dollar will reflux to its issuer. I could easily claim that minting gold coins increases the supply of gold coins 'by definition'. I'd be right as far as that goes, but I'd also be ignoring the fact as a new coin is minted, some existing coin will 'reflux' to bullion by being melted. The law of the reflux was discussed quite a bit during the bullionist and banking/currency debates of the 1800's, and it applies to all forms of money, not just gold coins.
Published: July 27, 2008 7:32 PM
Mike Sproul
Alex:
"The increase in prices of goods and services in terms of livres that would have occurred by the increase in 30,000 livres of silver coins would not have been augmented by the temporary issuance of French government paper I.O.U.s. There is no dispute here."
Oh yes there is. I say those paper livres had value because they were backed by the assets of the fort: 30,000 coins on a boat, plus the IOU's I mentioned. You say they had value because the total quantity of paper livres was equal to the value of the coins they replaced. By that logic, if the boat carrying the coins sank, the paper livres would hold their value just because their quantity was limited. I say if the boat sank, the paper would have lost value.
"Whenever some authority is able to have people accept a perpetual non-interest bearing I.O.U. in exchange for goods and services, the authority gets goods and services from the public and pays nothing back -ever, to anyone."
So if the notes bore interest, or if the cost of issue used up the interest, then the issuing authority pays for the goods like anyone else, and there is no need for the crazy monetary theory that says that pieces of paper can have value even though they have no backing.
Ireland:
"Just imagine what would happen if the officer refused to redeem the paper livres each for full silver livre once the ship docked. Or if the ship was late for a long time and someone had spread rumors about war/revolution/plague in France, hinting that no more coins are ever shipped to this fortress. Excellent example."
In each of those cases the paper livres would lose value, exactly in accordance with the real bills doctrine and exactly contradictory to the quantity theory. When I said "in no case" I meant "in none of the three cases I just mentioned."
Published: July 27, 2008 9:46 PM
Ireland
We may be getting to the flaw now, though not in the reasoning I laid out.
"as a new coin is minted, some existing coin will 'reflux' to bullion by being melted"
This for sure doesn't hold for coins minted from raw natural gold, unless all gold would appear in the form of "some existing coins", which it doesn't. And yes, by minting new coins one _does_ increase money supply - there are more of the things to be used in exchange for the goods and services, while at the same time the act of minting doesn't add to the stock of said goods and services.
"You are ignoring the law of the reflux: a very sensible law that says that when a bank issues a new dollar, other things equal, some other dollar will reflux to its issuer."
This is the place, namely I'd look into the details of how this "law" handles time lag. If it was true that each issued thing is immediately reflux back, what would be the point of issuing any of them? And how would any money get to the people in the first place? If the reflux is not immediate, the value of the livre needs to be discounted to cover the time lag, and it wouldn't be ok to talk about "the same livre issued and getting back" anymore. The fact that this was already discussed back in 1800s may be interesting, but for sure scientifically irrelevant.
If this theory speaks about banks, I wonder how it would fare in the situation where there are no banks. The original argumentation holds - if there is increase in the money supply, we get the effects tied to it, even if the money is not issued but appears miraculously or "falls from the sky" (think golden asteroid.)
Back to the french officer signing away those cards. Should the "law of reflux" hold, there'd be no need to have any silver shipped all the way from France - he'd just issue the cards and wait till they return back. Right? Well the people that try this find that it doesn't work, and that's why the underlying theories are considered false.
Re "no case": my non-native-speakerness must have left me down on that one - sorry for not getting the correct meaning. On the other hand it is good to keep the possibility of confusion in mind and phrase things so as to prevent it.
Published: July 28, 2008 4:03 AM
Ireland
This is interesting, and straight to the point too:
Mike: "those paper livres had value because they were backed by the assets of the fort"
No. The cards had value because people who accepted them valued them so.
It's that and it's all and yes it's that simple. Austrian theory of value in its purest form. The people believed they'll get their silver for the paper soon, and so they valued them about the same, and this allowed the economy to continue operating in the existing structure. No crisis/correction/adjustment.
I wonder if we could dig out some history about them cards either being discounted slightly, or pushing real silver out of circulation, or possibly both.
Ever wonder how comes all the expensive houses now sell for so much less? Well because there's no intrinsic ("per se", "an sich") value of any thing.
There are situations when even gold is useless. And paper things are only special in that they have very little other use besides the bond represented by the writing on it, and so they can be devalued both rapidly and completely.
Published: July 28, 2008 4:24 AM
TLWP Sam
Heh heh. That reminds, Ireland, when I posted something like "you know gold's only valuable because other people value it", I got a reply to the tune of "N.S. Sherlock that's Austrian Economics 101". Then again it's seems like a tautology - 'something is valuable because people value it'. Then again 'gold is money' is a bald, if not outright false, assertion. Who say gold is money per se? Sometimes gold has been used as money, sometimes not. Gold is only money when gold is the actual currency being exchanged at the shops or at least people are exchanging notes in lieu of physical gold because it's more convenient and/or safer. But at the current moment gold isn't money - people aren't exchanging gold coins nor papers promising payment in gold in time.
Perhaps M. Sproul helps to break the tautology by saying the fact paper and playing cards are valuable because they are contracts for the movement and transferrence of goods. Your signature may be no different in physical existence than a scribble but it's the difference between getting into a contract and not so. Maybe there's no answer to 'why is something valuable'. Why is the Australian 1930 penny valuable because there was only 5 made? You're paying a shipload of money for a piece of bronze. Why would someone pay $7.5 million dollars for a gold coin just because it was minted in 1933? There's one gold coin that shouldn't be stored in a bomb shelter. I don't know.
Published: July 28, 2008 6:26 AM
Alex
Mike Sproul said: "I say those paper livres had value because they were backed by the assets of the fort: 30,000 coins on a boat, plus the IOU's I mentioned. You say they had value because the total quantity of paper livres was equal to the value of the coins they replaced."
The paper livres had value because merchants were willing to accept them for goods and services. That the merchants were willing to do this was either because they believed that they could ultimately be redeemed for silver livres or because the French government dictated that the paper livres must be accepted by the merchants as legal tender. In this latter case, the merchants accept them because they believe that they can use them in turn to buy goods and services (in other words, that they will be generally accepted in commerce).
Mike, you said: "By that logic, if the boat carrying the coins sank, the paper livres would hold their value just because their quantity was limited." I say if the boat sank, the paper would have lost value.
I didn't say the paper livres would "hold" their value. I said if the silver coins arrived and all the paper livres were redeemed for silver coins, then the temporary circulation of paper livres would not cause the prices of goods and services to rise by any greater amount than that caused by the increase of 30,000 silver livres. I said that if some of the paper livres continued to circulate when the coins arrive, then the prices of goods and services would rise by a greater amount than that caused by the increase of 30,000 silver livres.
Mike, you said: "I say if the boat sank, the paper would have lost value."
Great! Now we're getting somewhere. So, Mike, do you mean that without the new silver coinage arriving the paper livres would be worthless, or just that their value would fall on news of the boat sinking?
But suppose the boat doesn't sink and the 30,000 livres of silver coinage arrive and the French government in Quebec spends all the 30,000 of silver coinage. And, also suppose that some of the paper livres continue to circulate, so that the money supply has increased by 30,000 silver livres plus say, 5000 (paper livres). In this case, do you contend that the prices of goods and services in terms of livres would be higher, just the same, or lower than if the 5000 paper livres didn't continue to circulate?
Published: July 28, 2008 10:22 AM
David Ch
TWLP Sam said: Then again 'gold is money' is a bald, if not outright false, assertion. Who say gold is money per se? Sometimes gold has been used as money, sometimes not. Gold is only money when gold is the actual currency being exchanged at the shops or at least people are exchanging notes in lieu of physical gold because it's more convenient and/or safer.
Response: I have yet to come across a completely satisfactory definition of money, because all invoke boundaries that owe more to arbitary classifications than to th eunderlying nature of the institutional relationships between people.
going back to first principles, human interaction at th eeconomic level arises from the division of labour and/or trade, co-operatively engaged in towards mutually-desirable ends. I see no fundamental difference between the arrangement within a household for one party to take out the garbage while the other cooks dinner, and an arrangement between one of those householders and a neighbour to, say mow each others lawns when the other is on holiday, and an arrangfement where any of those householders goes to the local butcher to buy some meat and tenders cash. They are all manifestations of trade arising out of the division of labour. the onjly difference between the first two and the third is that in the first two the reciprocal claim arising from the single act is tacit and implied, and tracked mentally by the participants ( cheaters and defaulters are dealt with socially, by refusal to give another tit if the last tat wasnt forthcoming, as it were), while the third entails a claim that is made explicit through the exchange of what both institutionally regard as 'money'. the substance in all these transactions remains the same though.
From an evolutionary economic perspective, Money only emerged in the first place to provide an institutional mechanism that permitted people to trade and divide labour with strangers to common benefit - extending the co-operative nature of small tribal groups to include a far wider group of participants than one person's brain can handle without losing track - which probably maxes out at about 120 individuals. IN effect, money does the accounting during the delay bwetween the tits and tats inherent in reciprocal altruism between people who don't know one another from a bar of soap.
At root, claims emerge among people trading reciprocally to mutual benefit, and however these claims are recorded, they all have some element of 'moneyness' to them - even the one between husband and wife about who takes out the trash and who feeds the baby. The only difference between, say, a specific contractual claim by A against B, and an amount of money in the hands of C, is that the latter represents a claim for some service or sale rendered to some individual in the past, , to be redeemed against some portion of the wealth in the hands of everybody else, settlement still to be negotiated with at least one of them by C at C's convenience. And the former the former is a claim by A only against the wealth of B. But the moment A finds an institutional structure in which he can sell his claim on B to D at whatever price agreed between A and D, that simple bilateral claim on B assumes a greater moneyness as it were, the more so if D has the option of selling it anyone else before being presented to D for settlement. As claims between participants in an economy expand in volume and value, wealth is being created, and so too is money being created, however opinion might differ on what portion of the total pool of claims between people are defined as 'money' at an econometric level. And however the Fed technically slices and dices M0, M1, M2, M3 etc.....,
And that is as it should be, . provided of course general claims of the 'C' variety above are not synthetically and unilaterally manufactured by, say, a government printing notes that they force others to accept in payment of debts. Thats where inflation comes in, because this entails the manufature of a claim against society at large without having rendered a concomitant service to some member of that society .........
$0.02
David Ch
Published: July 28, 2008 10:43 AM
Matthew
Alex said:
Not to disagree, but to expand on this, to truly eliminate the fraud in fractional reserve banking, what is necessary is to change the legal structure of deposits. Simply saying "oh, yea, we're loaning out your money" is not sufficient. As long as a FRB is structured so that a depositor has full legal title to his deposit at the same time as a borrower, the bank is committing fraud. It is telling two different people that they have title to the same sum of money. This is, ipso facto, fraud.
If the bank were to change the structure so that the funds were pooled, say as in a mutual fund, and there were clear delineation of title and/or control, the fraud would be eliminated. I maintain that fractional reserve banking by definition is fraud because we would probably refer to other, non-fraudulent structures by a different name.
Published: July 28, 2008 4:45 PM
Alex
Matthew said: "As long as a FRB is structured so that a depositor has full legal title to his deposit at the same time as a borrower, the bank is committing fraud. It is telling two different people that they have title to the same sum of money. This is, ipso facto, fraud."
The contractual arrangement between demand depositors and the bank is that the depositors are told that they can redeem their deposits on demand. Those who have the bank loans have physical possession of the depositors' funds (apart from the bank's reserves). As I say, assuming that this information is well known (as it is by anyone who actually wants to know it), there is no deception and no fraud. The demand depositors know that if the bank is badly managed, they may have to wait for their deposits (that is, the "on demand" part of the contract will be broken), or if the bank is really badly managed, the depositor (in the absence of deposit insurance) may lose his deposit entirely. This possibility is no different from the situation where anyone lends money contractually on the promise it will be repaid either on demand or at a specific time. If the borrower (comparable to the bank) doesn't manage properly, the contract will be broken.
In the case of deposit insurance, the demand depositor knows that, if the bank is mismanaged, then there will be an inconvenience in retrieving his deposit money on demand but the money will not be lost.
There is no contractual deception in fractional reserve banking any more than there is deception in normal direct lending? Of course, there is typically much less risk in demand deposits than in direct lending due to diversification that a bank can undertake. And, as I say, where there is deposit insurance there is no risk of deposit loss at all.
Published: July 28, 2008 5:43 PM
Matthew
Alex:
I believe the theory underlying what you're saying is correct, but to me it implies that you think in our present day, fractional reserve bankings are giving sufficient disclosure, they are not committing fraud, the general populace recognizes and comprehends what fractional reserve banks do, and it is intentionally assuming the risk that is involved. Is that indeed the case? If so, to what do you attribute business cycles? And do you disagree what the extant empirical evidence that unnatural credit expansion appears to lead to business cycles?
Published: July 28, 2008 6:02 PM
Alex
Matthew: I think those who wish to know about how fractional reserve banking works do know, though I think most people haven't got a clue and could care less anyway. If you told this majority how fractional reserve banking works, they would simply shrug. How many of those people (including yourself) who understand fractional reserve banking refuse to use the banking system? Why? Because it serves their purposes, is convenient, and of low risk.
I do think that money supply fluctuation can cause business cycles, but I'm not sure whether having lower required reserve ratios necessarily implies that the money supply will fluctuate more. After all, the central bank controls the monetary base and hence the money supply, whether demand deposits require 100% reserves or zero reserves. In Canada, for example, there are zero required reserves on bank deposits, yet Canada has seen its CPI rise by 35% since it instituted this policy, while the U.S. CPI has risen by 52% over the same period (1991-2007).
Published: July 29, 2008 9:17 AM
Matthew
Alex:
I agree that most people would shrug their shoulders if FRB were explained to them. I also use the services of FRBs because, as you say, they serve my purposes, are convenient, and low (acceptable anyway) risk. To be clear though, I also pay taxes and otherwise comply with unjust laws because, to me, not going to jail or having my property seized serves my purposes and is more convenient than going to jail. That does not make those practices okay.
Unlike you, I am convinced that ABCT is sound. While I agree that there is nothing precluding the general populace from understanding FRB and its implications, there must be some explanation for business cycles. If FRB is understandable and its negative effects are avoidable, why can't any other supposed explanation for the cluster of errors that occurs in a business cycle be explained away in the same manner. I perhaps don't take as hard a stance on ABCT as other Austrians, but it is still to me the best explanation available.
Published: July 29, 2008 9:51 AM
Alex
Matthew: I agreed that monetary manipulation by central banks can cause business cycles. My point is, that it doesn't matter for ABCT of business cycles whether there is fractional reserve banking or not. The cause of monetary inflation lies with the central bank.
You can call fractional reserve banking fraudulent if you wish. You can call any store that advertises "lowest prices at all times" fraudulent. You can call any business activity that you wish fraudulent. However, if people know about the operations of a business activity, or don't care, and voluntarily take part in such business activity because it makes them better off than they would be by not engaging in such activity, then it doesn't matter very much does it.
Published: July 29, 2008 8:23 PM
Mike Sproul
Alex:
"So, Mike, do you mean that without the new silver coinage arriving the paper livres would be worthless, or just that their value would fall on news of the boat sinking?"
The paper livres were just like any other financial security. If the boat sank, or if there was news of the boat sinking, then the livres would lose some or all of their value. Exactly the same thing would happen to shares of stock in the company that owned the boat.
"But suppose the boat doesn't sink and the 30,000 livres of silver coinage arrive and the French government in Quebec spends all the 30,000 of silver coinage. And, also suppose that some of the paper livres continue to circulate, so that the money supply has increased by 30,000 silver livres plus say, 5000 (paper livres). In this case, do you contend that the prices of goods and services in terms of livres would be higher, just the same, or lower than if the 5000 paper livres didn't continue to circulate?"
Prices would be just the same. Before the addition of the 5000 paper livres, you could have bought a loaf of bread with 1 silver livre or one paper livre. Afterwards, 1 loaf will still cost 1 silver livre, and since 1 paper livre can be redeemed at the payroll office for 1 silver livre, 1 loaf will still cost 1 paper livre as well. You have to keep in mind that this assumes the payroll office would only issue the extra 5000 paper livres if it got at least 5000 livres worth of assets to back them. You also have to ask why the 5000 extra livres would circulate? The answer must be that economic activity increased to the point where people needed the extra 5000 lvs to comfortably conduct their business--otherwise they wouldn't have been issued.
Published: July 29, 2008 10:16 PM
Alex
Mike Sproul: I'm sorry to keep asking you questions about your stance, but I would like to make sure exactly what you are saying.
You said: "Prices would be just the same. Before the addition of the 5000 paper livres, you could have bought a loaf of bread with 1 silver livre or one paper livre. Afterwards, 1 loaf will still cost 1 silver livre, and since 1 paper livre can be redeemed at the payroll office for 1 silver livre, 1 loaf will still cost 1 paper livre as well. You have to keep in mind that this assumes the payroll office would only issue the extra 5000 paper livres if it got at least 5000 livres worth of assets to back them. You also have to ask why the 5000 extra livres would circulate? The answer must be that economic activity increased to the point where people needed the extra 5000 lvs to comfortably conduct their business--otherwise they wouldn't have been issued."
Your original example, I understood, began with only silver livres circulating as money. Then, paper livres were issued in anticipation of the new boatload of silver livres arriving. So, I would like to keep those aspects of your example intact, so that we don't argue at cross purposes.
1. Initially, only silver livres circulate. And, as you assume above, when the boatload of 30,000 new silver livres arrives and that money is in circulation, 1 loaf of bread sells for 1 silver livre.
For simplicity, assume that production consists only of loaves of bread (or we could replace your loaves of bread with identical baskets of goods and services). Anyway, I'll stick the loaves of bread.
Assume the colony produces 200,000 loaves of bread each period (month, year, whatever). Assume the 30,000 new silver livres brings the money supply in the hands of the public up to 100,000 silver livres. So, as I said above, with this money supply, the price of bread is 1 liver per loaf.
Now, if the French government body in Quebec keeps 5,000 silver livres in storage to "back" 5,000 paper livres that are circulating as money (total circulating money=100,000 livres), I'm assuming we agree that the price per loaf of bread would be 1 livre per loaf (either in terms of silver or paper livres).
Now here's the question I was asking you in my prior post: If, instead, the French government in Quebec prints 5,000 non-redeemable, non-backed, paper livres and uses them to pay their military, so that now the circulating money supply is 105,000 livres, do you not agree that the price of each loaf of bread would rise above 1 livre per loaf? I'm assuming you will agree that it will, because you will argue that the paper livres are non-backed.
So, let's say that the price of each loaf rises to 1.05 livres in the above case. After this happens, suppose the French government in Quebec subsequently inks some French bonds and then announces, "There are 5,000 paper livres circulating as money in the colony, but they are all backed by French government bonds." Do you think that this will reduce the price of bread to 1 livre?
Published: July 30, 2008 9:50 AM
Matthew
Alex:
I suppose that I would distinguish between fraud as would be adjudicated by a legal system and fraud for practical purposes in making economic predictions. For instance, if a Ponzi scheme had a 100-page offering document and page 57 had one sentence in fine print that said "you will be receiving interest payments out of your principal account and your account balance will be overstated, as if these payments were not being so made," who knows...perhaps a judge would deem that to be adequate disclosure and not be fraud. However, I think it's likely that that investors wouldn't notice it and they would be angered when they realized that they had been swindled. Although not legally, it would be economically tantamount to fraud.
In the same way, whether you want to call fractional reserve banking fraud or not, or if you think that general consumers have sufficient information to make the determination on their own that it's a bad idea, I personally think it's all but certain that people are making poor decisions and don't truly understand what they're doing. To the extent that that sends a faulty signal on current vs. future consumption, it will tend to cause malinvestment and business cycles.
I also wonder how you explain the behavior of banks in making loans. Presumably, banks are competent and understand the implications of fractional reserve banking. So when they extend a loan to someone, why not place some covenant on it requiring the recipient to keep their deposits somewhere other than a fractional reserve bank. From the bank's perspective, there's nothing to be gained by allowing the borrower to take unnecessary risk with the funds they've been given. The bank wants to see those funds protected.
On a related point, I probably part company with other Austrians, but I feel similarly about MMMF holdings. They clearly aren't fraudulent in that legal title is transferred to the borrower and holders of MMMF shares presumably assume the risk that their holdings will decline in value, but I speculate that a lot of people view them as demand deposits for practical purposes, and I wonder if and to what extent this sends a faulty signal on current vs. future consumption.
Published: July 30, 2008 11:56 AM
fundamentalist
The late Scholastics discussed the morality of fractional banking back in the 16th century and could no more come to an agreement back then than people can today.
Published: July 30, 2008 12:22 PM
Alex
Yes, I think fundamentalist's point is well taken.
What I fail to understand, though, is whether or not we agree to call fractional reserve banking 'fraud,' why it is that some argue that fractional reserve banking is responsible for any malinvestment that would occur from a significant monetary expansion. The total responsibility for whatever degree of monetary expansion that takes place lies with the central bank. The central bank management can do arithmetic. For example, they would know if a $100 expansion in the montary base would lead to a $1,000 expansion in the money supply. Focusing on fractional reserve banking for any malinvestment that monetary expansions may cause, therefore, seems to me to be inappropriate.
Published: July 30, 2008 1:05 PM
Matthew
Alex:
I think your understanding may be incomplete in distinguishing between inflation (money creation) that gets funneled directly into the supply of loanable funds vs. money that just gets added to the money supply and spent by government. It is only the former that tends to cause business cycles. By its nature, fractional reserve banking is the former in that money which is not intended to be loaned out (we'll assume that much, let's ignore our other conversations for the moment) is added to the supply of loanable funds.
That is distinct from the Fed "printing" bills, handing them to the Treasury, and Treasury buying up and consuming commodities. Although it would be expanding the overall monetary supply, that would not tend to cause economic miscalculation. It would just be the appropriation of wealth from one party to another. It is only the type(s) inflation that systematically manipulate the natural rate of interest which cause business cycles.
Published: July 30, 2008 1:23 PM
fundamentalist
Alex: "Focusing on fractional reserve banking for any malinvestment that monetary expansions may cause, therefore, seems to me to be inappropriate."
There's plenty of blame to go around. The Feds can influence the money supply two ways. 1) Buying bonds from banks will raise bank reserves and give them more money to lend. 2) Lowering the rate at which banks can borrow from the Fed or from other banks can increase reserves.
At the same time, if the Fed commits neither of the above two crimes, banks can expand credit, and therefore the money supply, on their own through the ponzi scheme of fractional banking. (Hayek has a great analysis of this in "Monetary Theory and the Trade Cycle") Hayek shows a number of things that can cause an increase in the demand for loans. One is new technology. If the new demand comes when a state of equilibrium has been reached, the bank will need to raise interest rates in order to attract the new savings that it will loan to the entrepreneur with the new technology. But that will put him at a competitive disadvantage with other banks, so he lowers his reserves and makes the loan anyway which sets in motion the money creating aspects of FRB.
Also, reserves tend to increase during recessions as companies build cash balances and don't take out loans. When business confidence returns and demand for loans increase, banks will on their own (without Fed prompting) lower their reserve ratio to make new loans.
Published: July 30, 2008 2:39 PM
Alex
Fundamentalist, you said: "banks can expand credit, and therefore the money supply, on their own through the ponzi scheme of fractional banking."
Hold it. Let's assume the banking system has $10 of reserves consisting of $2 of paper currency and $8 of deposits at the Fed. Explain to me how the banks' (in totality) can acquire $1 more in new reserves that the Fed cannot sop up (for example, by engaging in open market bond sales.) Therefore, explain to me how the banks can expand the money supply without the Fed letting them do so.
Published: July 30, 2008 3:17 PM
Alex
Matthew: Each time the monetary base increases through an issuance of currency or a central bank purchase of government bonds, there is a tax involved, that is a transfer of wealth from the private sector to the government. Here is a numerical example of each of your two cases.
Case 1. The Fed purchases $100 government bond on the open market. This causes the banks' reserves to increase by $100 (suppose the desired amount of currency in the hands of the public is unchanged). The bank's expand their loans by, say, $900 and the money supply expands in total by $1000.
Case 2. The Fed prints up $100 of currency and gives it to the Treasury Dept. The Treasury would normally give $100 government bond for these funds (though that bit of nonsense is irrelevant). The Fed's balance sheet has $100 more government bonds on the asset side and $100 more liability for the currency on the liability side. The Treasury, as you say, spends the money on goods and services. At this point, the private sector has been taxed by $100, as in case 1. Also, as in case 1., assuming unchanged desire for currency in circulation, the $100 in additional currency will be deposited in the banks. The banks' reserves thus increase by $100 as in case 1., and the banks expand their loans by $900. The money supply thus expands by $1000, as in case 1.
In each of cases 1 and 2 there is an expansion in bank loans of $900, an expansion of the money supply by $1000, and a tax of $100 imposed on the public.
Published: July 30, 2008 3:34 PM
Matthew
Alex:
Both of your cases involve the expansion of money through fractional reserve banking, so don't juxtapose the distinction I was trying to draw. Let me try again:
Case 1: The Fed buys $100 on the open market. Banks expand credit with the additional reserves, resulting in a $1000 increase in the money supply.
Case 2: The Fed buys $1000 of debt directly from the Treasury. Treasury spends the money.
In both cases, the money supply increases by $1000, but only in the first one is it sending a false signal about current vs. future consumption preferences.
Note: whether or not the $1000 that Treasury spends in Case 2 ends up in bank deposits and is expanded to $10,000 is a completely different matter and does not enter into the above analysis.
Published: July 30, 2008 4:00 PM
Alex
Matthew: Thank you for your latest reply and the clarity of your example. I didn't realize from the wording of your prior post that you wanted a ten-fold increase in the amount of government bonds purchased directly by the Fed in Case 2 relative to Case 1 (though qualitatively it doesn't change comparisons of the two cases).
You said: "Note: whether or not the $1000 that Treasury spends in Case 2 ends up in bank deposits and is expanded to $10,000 is a completely different matter and does not enter into the above analysis."
Of course the $1000 that the Treasury spends in Case 2 will end up in bank deposits since there is no reason that the public's demand for currency would be different in the two cases. So in your case 2 (using your figures) the banks' loan portfolio will end up expanding by $9000 and the money supply by $10,000. You can't say that in case 2, you want to stop the analysis in the middle of the process (that is without considering the final effect on bank's balance sheets, while considering the final effect in case 1). Of course, if you do that you will end up with different scenarios. Matthew, both cases 1 and 2 have the same effect on loan portfolios of the banks and the money supply if you use the same quantitative amounts in both cases (either a $100 open market purchase of government bonds by the Fed and a $100 purchase of government bonds from the Treasury. OR $1000 figures in both cases.)
In both instances, then, the interest rate will be artificially lowered by the same amounts and whatever malinvestment will occur, it will be the same in both cases 1 and 2.
Published: July 30, 2008 5:08 PM
Mike Sproul
Alex:
"So, let's say that the price of each loaf rises to 1.05 livres in the above case. After this happens, suppose the French government in Quebec subsequently inks some French bonds and then announces, "There are 5,000 paper livres circulating as money in the colony, but they are all backed by French government bonds." Do you think that this will reduce the price of bread to 1 livre?"
You can't just blithely assume that new money is issued without any existing money refluxing to its issuer, any more than you can assume that you can stamp bullion into coin without somebody, somewhere, melting coin back to bullion.
But if, as you say, the government issued 5000 new paper livres while getting no new assets, then yes, the value of paper livres would fall by 5%. If the government then dedicated 5000 livres worth of assets (newly inked bonds, as you say) to back those livres, then yes, the value of the paper livres would rise by 5%. But I have a feeling you have not asked yourself the important question of whether the french government has sufficient net worth to back those new bonds. If it does, the bonds, and the money, will hold their value. If not, the bonds and the money will lose value.
If you're still unclear on my position, click on my name above to read about the real bills doctrine.
Published: July 30, 2008 9:13 PM
fundamentalist
Alex: "Therefore, explain to me how the banks can expand the money supply without the Fed letting them do so."
You're right. Banks can only expand money if the Feds do nothing. If the Feds decide to stop banks from expanding credit, they can.
Published: July 31, 2008 8:28 AM
Alex
Mike Sproul said: 1. "You can't just blithely assume that new money is issued without any existing money refluxing to its issuer."
2. "But if, as you say, the government issued 5000 new paper livres while getting no new assets, then yes, the value of paper livres would fall by 5%. If the government then dedicated 5000 livres worth of assets (newly inked bonds, as you say) to back those livres, then yes, the value of the paper livres would rise by 5%. But I have a feeling you have not asked yourself the important question of whether the french government has sufficient net worth to back those new bonds. If it does, the bonds, and the money, will hold their value. If not, the bonds and the money will lose value."
1. One of your favorite terms is "refluxing" and it somehow seems to be critical to your thinking about the money supply. The word means "flowing back," so you are saying that when new money is issued existing money somehow flows back to the issuer (the French government in Quebec, or in modern day terms the central bank). So, to answer your point 1.: Of course, I can assume the normal thing that money does not flow back to the issuer. Explain why when the French government in Quebec issued the 5000 paper livres, these paper livres would naturally flow back to the French government.
When the Fed issues $5,000 dollars more currency, how does this automatically flow back to the Fed? In fact, it doesn't; the liability for currency grows and grows over time.
2. I'm glad you answered my question with regard to the effect of "inking" some government bonds by the French government in Quebec and the fact that you believe this announcement would raise the value of the previously issued currency. Can you explain why the announcement by the French government in Quebec that they have printed up some big pieces of paper (government bonds), which they intend to hold in a cupboard indefinitely somewhere in the fort, is going to reduce the price of a loaf? After all, nothing has happened to the quantity of money and it is never naturally going to flow back to the cupboard in the fort. Instead, more boatloads of silver money will come or the French government in Quebec will issue more paper livres as time goes on.
Suppose the French government finds 5000 of silver livres in a cupboard in the fort that they had forgotten about, and redeems the 5000 paper livres for 5000 silver livres. In other words, suppose the 5000 paper livres do flow back into the fort (to be ripped up), there is no change in the money supply by this flow back and issuance of new silver livres. How then will there be any change in prices? The only way a flowing back of the paper livres into the fort could change prices is if the French government in Quebec taxed the people 5000 livres and then permanently kept the 5000 livres out of circulation (buried them in that hard to find cupboard or something). Such action would lower the money supply.
By the way, I shall read your real bills stuff at my earliest convenience. I'm sure the topic will come up again.
Published: July 31, 2008 9:47 AM