Real Bills and Inflation
I am continuing my commentary on The Real Bills Doctrine at LewRockwell.com. The new essay focuses on the inflationary consequences of the system and identifies numerous errors in the arguments to the contrary.
Ludwig von Mises Institute - Tu Ne Cede Malis
Advancing the scholarship of liberty in the tradition of the Austrian School.
I am continuing my commentary on The Real Bills Doctrine at LewRockwell.com. The new essay focuses on the inflationary consequences of the system and identifies numerous errors in the arguments to the contrary.
Comments (54)
Robert Blumen writes in a clear style and is an open minded person, and he attempts to deal with the economic arguments in relation to money, and its two prices: the interest rate and the exchange rate. And so it is his analysis only that I would like to criticise.
His first claim is that welfare can never be increased by quantity of currency, and claims that the denial of this point is a fundamental error. This, taken strictly under a gold standard, would imply that the world's commerce could as easily be conducted with a a handful of sovereigns, as it could with millions of sovereigns. It seems more plausible the price of gold coin, in relation to other goods would be closely related to the cost of mining gold from the ground and minting it into coin, in terms of other goods and services, and the marginal benefit that can be had from using gold to make useful things such as equipment and ornaments, and that the efficient stock of gold coin would be such that each person could have the proportion of his wealth in the form of gold coin as he prefers, to execute his transactions and store his wealth.
Likewise he calls a 'fallacy' the claim that paper (i.e. debt-credit obligations) can create wealth. This claim, taken strictly, would imply that no transactions create wealth, because every transaction involves an exchange of claims over properties, which create debts that are discharged when the possession of the property is delivered to the claimant. Credit contracts in money create wealth as surely as credit contracts for the delivery of other goods. Really what Blumen means to say is that contracts to deliver money, and contracts to deliver money on demand in particular, cannot create wealth. However at this point in his article he has not made any arguments in favour of this point, but already he has denounced and called 'crank' and 'fallacy' and 'fundamental error,' so there is nothing to refute yet.
He then goes on to introduce the 'Real Bills Doctrine' (RBD), which, for the record, I do not support. He claims that RBD 'advocates the creation of more paper money substitutes.' However 'more' in relation to what? The answer is more in relation to what Blumen would condone, which happens to be zero. Such a description is therefore unfair, it would be better to say 'RBD advocates the issue of paper money substitutes', and then to describe the particular types of assets RBD holds as satisfactory investments for the proceeds from such issues, i.e. short term business loans.
He also claims that RBD is not exempt from the evil of 'paper multiplied without limit' which again is unfair, because RBD limits paper (i.e. debt payable in money on demand) to holdings of real bills (in addition to reserves of coin and a buffer of owner equity).
Blumen next claims that 'non-inflationary monetary expansion is a mythical beast. A counter-example to this claim can be modelled as follows. Suppose that a closed economy has a stock of 1 000 000 gold sovereigns 100 000 buildings, and the cost of an hypothetical basket of consumer goods was one sovereign. Suppose, at this level of purchasing power of gold coins the rate of gold production was 40 000 per year, and the rate at which gold coins were lost, worn or melted down to make jewellery was 20 000 per year. The gold coin stock is therefore increasing by 20 000 sovereigns per year. Suppose also the people really preferred to hold their wealth more in the form of gold coins and less in the form of buildings, and that people would forgo a high interest rate to hold coins, and that as a result of the high interest rate, capital investment in new buildings was uneconomic and the construction industry was liquidated, putting additional labour on the market, and this resulted in falling wages and prices. The result in this hypothetical economy is an increasing stock of money and an increasing purchasing power of the monetary unit.
I will not comment on the supposed difference between transfer credit and credit expansion, because I don't think it is a meaningful or valid distinction.
Blumen claims that 'fiduciary media' is always inflationary because he believes that an increase in the quantity of money is inflationary, and that 'fiduciary media' has the effect of increasing the quantity of money. This is valid but unsound reasoning. It is valid because the conclusion follows from the premises, but it is unsound because one of the premises is false, namely the supposed mechanical connection between the quantity of money and its price. The stock of any commodity does have a relationship to its price, but not in the way that Blumen proposes. Other things being equal, the higher the price of a commodity, the more of it will be produced and the less will be consumed, and so the higher the price of a commodity, other things being equal, the higher the *rate* of increase in its stock. Conversely lower prices lead to greater consumption and reduced production, which depletes the stock of the commodity over time. Clearly there is no direct relationship between the stock of a commodity and its price, because the relationship is with the first derivative of the stock instead.
Next Blumen attempts to explain how he thinks paper money can influence the prices of goods and services by increasing ‘purchasing power’. The theory is that a person holding a credit obligation payable in the future feels poorer and does not spend as much, while a person holding a credit obligation payable on demand feels richer and spends more. This may sound plausible, but why would the creditor have lent to the debtor who will pay in the future if it makes him feel poorer? If the credit transaction is profitable, it makes both feel richer. However, feeling richer does not really translate into spending more, how rich someone is is independent from the proportion of his income he will consume in the future.
Blumen’s claim rest on the idea that holders of demand debt are not savers. Such an idea does not stand up to scrutiny. Every holder of demand debt has the right to redeem his claim in coin, and therefore his act of not claiming the coin is an act of saving. The holder of demand debt considers it his asset and the issuer its liability. Obviously the demand creditor is providing finance to the demand debtor. If he took the gold coin and turned it into jewellery, he would have consumed it in that process, and so long as he holds the coin or the note he saves the value of the coin. Holding coin is to hold a non-financial capital investment, while holding a note is to hold a financial capital investment that allows someone else to borrow to hold a non-financial capital investment.
Blumen considers that ‘fiduciary media’ must lead to higher prices, or a lower value of the monetary unit. Under a commodity standard this is not the case. Assume that the commodity is gold. Suppose that the supply of gold was an increasing function of the purchasing power of gold coin. Note that the word ‘supply’ properly refers to a flow, not a stock. For clarity I re-phrase: Suppose that the production-supply rate was an increasing function of the purchasing power of gold coin. Suppose likewise that the consumption-demand rate is a decreasing function of the purchasing power of gold coin. It follows that there is a level of purchasing power of gold coin that results in a stable stock of gold coins, where the rate of production of new coins is equally offset by the loss, wear and scrapping of coins. Suppose that the production-supply and consumption-demand functions were static. Now we can consider two hypothetical monetary systems, one with fiduciary media and one without. Suppose that under the fiduciary media system, the stock of gold coins was 20 000 000 sovereigns and 90 000 000 sovereigns’ worth of demand debt, and that half of the coin stock was in demand debtor treasuries as reserves while the other half was held by non-demand debtor agents. Meanwhile, under the no fiduciary media system, the stock of gold coins was 50 000 000 sovereigns and there was no demand debt. The equilibrium purchasing power of gold coins is the same in both cases, even though the stock of coins and demand debt held by non-demand debtors is twice as high with fiduciary media than without. The difference between the two systems is that the capital stock consists of a smaller stock of coins and a larger stock of other forms of capital with fiduciary media, compared to the system without. In both cases, and fall in the purchasing power of gold below the equilibrium value results in a shrinking gold stock, which, under the Blumen theory would lead to a correcting increase in the value of gold coin.
Blumen is right to criticise the association of any demand debt with any particular goods financed with that demand debt. In fact it is the nature of money that it can buy myriad goods. All loans finance some goods by value, but generally no goods in particular, especially in the case of loans made to credit intermediaries, who by nature hold a portfolio of assets including reserves of legal tender and credit instruments. The provision of finance, therefore, does not rest on linking it to particular goods, but it does finance goods. In fact the RBD may in fact be unhelpful to those such as myself who advocate the free issuance of demand debt, inasmuch as it would skew demand debtor portfolios to some assets at the expense of others. The evils of regulation distorted bank portfolios are, for example, recounted in Vera Smith’s The Rationale of Central Banking.
He is also right to note that there is nothing special about the period of 91 days. Short term debt instruments are generally issued by high quality borrowers, and have less interest rate risk, however I get the feeling that RBD does not really have in mind high quality obligors but ordinary businesses as being the borrowers.
It is also correct to consider the business of banking as being the continual granting and repayments of credits, so that the bank’s intends to borrow and re-fund its obligations indefinitely. In fact banks live by continually re-financing their debts, because banks are credit intermediaries. However, the banking business should also be understood on a transactional basis.
Blumen attempts to argue that the demand for credit is heavily dependent on the quantity of credit, and of demand debt in particular. The idea is that if banks issue bank notes payable on demand, and demand deposits, and use the proceeds to lend to commercial borrowers, the result will be an increase in both the supply to and demand for credit from banks. However this argument is invalid, and assumes what it is trying to prove. If capital assets such as buildings and factories support commercial loans, which in turn support bank notes and demand deposits, why is this a bad thing? It allows for illiquid assets such as buildings and factories to support instruments that can be used for payments, and it provides finance for buildings and factories that produce goods and services. The limit on financing assets with debt is a function of the stability of the value of such assets, and the increasing cost and risk premium of debt finance. The banks have limits on the volume of commercial loans they can finance in terms of their capital strength, and the interest margin they can earn. The purchasing power of gold coin is limited by the production-supply and consumption-demand functions for gold, so the purchasing power of demand debt payable in gold coin will not deviate significantly from the equilibrium value. Conversely, demand debt that is in default but forced on people by legal tender statutes that make it lawful money by government fiat can become worthless.
When the proceeds of demand debt are lend out in the form of commercial bills and loans, and the demand debt is used as currency, but where only gold coin is legal tender the correct name for this is an ‘asset currency’ under a ‘gold standard’. Demand debt currency is therefore not backed by any asset in particular, but by a portfolio of assets held by the issuer, that will include specie and marketable securities for liquidity, as well as commercial loans.
I conclude that Blumen is little help in understanding what really determines the value of money or the interest rate. Without a serious attempts to answer to these questions the understanding of money and banking will remain poorly developed.
David Hillary
Published: July 18, 2005 6:09 AM
I have been following this discussion with great interest, but am still confused. This whole edifice is built on the problems created when the banks buy the real bills with unbacked funds, not the bills themselves. As such, this whole discussion is about the evils of fractional reserve banking.
Would someone please explain why there is this big focus on bills of exchange? (Something other than just saying that "the Real Bill Doctrine says that the banks monetize the bills". Because again, that is a problem with fractional reserve banking and not unique to bills.)
Please???
Published: July 18, 2005 8:13 AM
John the problem is -claims on future goods which
circulate as money today are inflationary.The fractional reserve banking system amplifies the problem, but is not the crux of the matter.
Published: July 18, 2005 11:32 AM
I thought the problem was in line with how John Bigelow laid it out. My guess as to why this has become such a big controversy is that some who do advocate the RBD, also do NOT advocate fractional reserve banking. So Blumen's point is (I think), the RBD IS fractional reserve banking and is therefore equally destructive to its any other forms. Therefore to advocate the RBD, while yet claiming to recognize the flaws of FRBing is to reveal an inconsistency and confusion on the topic. That’s how I understand this debate.
Published: July 18, 2005 1:28 PM
claims on future goods which
circulate as money today are inflationary
Yes, but the claims on future goods only circulate when they are bought by a bank. If I buy $1000 wood from you for my chairmaking operation and pay you with a bill due in 30 days, you are simply loaning me money. As far as I understand from reading all this, the inflationary aspect comes about when the bank buys the bill from you by crediting $1000 (or some discounted value) to your checking acount, rather than giving you $1000 in cash.
It still boils down to the actions of the bank.
Published: July 18, 2005 1:33 PM
Hi,
I posted a blog on "Real Bills and Real Anger" that may be of interest. Since the post somehow got jumbled up between the preview and the post, I have a link to the clean, readable version:
Click here.
Published: July 18, 2005 1:49 PM
Mr. Hillary:
You've accepted Blumen's piece as clearly written and his approach as "open-minded." In turn, I find these same characteristics reflected in your own critical piece.
However, I am astounded that, in case after case in which you take issue with some facet of the piece, your argument seems not directed toward some remark or interpretation attributable to Blumen himself but rather at the doctrine of Mises himself, of which Blumen can rightly claim to be a faithful expositor.
At least some of the differences are traceable simply to semantic difficulties--terminological differences and the like. But the divide is so wide on so many topics as to suggest to me that, contrary to all expectation of one who writes so well and clearly, you are completely unfamiliar with what has already been written in clarification of EVERY ONE of these subjects by Mises himself! Can I possibly be right in my assessment? I hope not--but cannot imagine another explanation.
Published: July 18, 2005 2:35 PM
Gene Berman,
I'll also grant to Robert Blumen he knows the authors he quotes, and better than I do.
My criticism is directed to those who oppose fractional reserve banking and claim that demand debt influences the equilibrium purchasing power of gold coin under a gold standard, whether he agrees with Mises, or anyone else for that matter, or not.
For the record I support a monometallic gold coin standard of money, free minting, and free-banking.
The criticism I have is not directed at Blumen, or Mises, but to economists in general, who have not produced a satisfactory theory of the two markets and two prices of gold: namely the production-supply consumption-demand market in gold and its exchnge rate to other goods and services, and the capital-stock asset-portfolio market in gold coin and its interest rate.
I just hope some readers will have a sufficiently open mind about this to consider theories of the markets for and prices of gold coin, rather than just assume their beloved quantity theory. I'd bet if anyone decided to start by putting aside what he thinks he knows about money, take a blank sheet of paper and try to draw up some curves, taking care to avoid confusion between stocks and flows, chances are he would come to some very different ideas about money. Anyone game for that?
David Hillary
Published: July 18, 2005 3:18 PM
David Hillary,
How can I take a blank sheet of paper and try to do anything with it if I am so limited in the endeavor so as to be reduced to drawing curves and not be subjected to someone’s quantity theory?
If money can be drawn out on a piece of paper precisely then is it not ideally suited to the purpose of gaining knowledge to first draw and document the actual concept of money rather than one persons perception of it?
Is not the purpose of science to separate objective knowledge from subjective interpretation?
What form then does a blank piece of paper become as it takes on an objective description of money?
If your example takes on the form of a series of curves then is it your subjective observation that such curves represent money objectively? Can you illustrate such an example that can stand the test of objective scrutiny?
Will your document require extensive subjective interpretation and therefore be liable to as many misinterpretations as there are readers trying to interpret it?
Can I offer my own subjective interpretation of money, drawn on my blank piece of paper, for any and all prospective interpretations with the serious challenge to find within it any room for subjective interpretation?
If no one can find disagreement in my document describing money, in its pure form, then has subjective interpretation been defeated, then has an objective observation been found, and then can money be further described in greater detail having found the basic principle of money?
Is this not the scientific approach, the application of the scientific method of gaining knowledge, and the only means by which human beings can gain knowledge?
Please consider posting your curves. I am anxious to know this thing you call money. Is it a coincidence that subjective interpretation is a problem when people try to communicate the concept of money and subjective interpretation is a problem when people try to exchange money?
Money is a means by which individuals inspire other individuals to act.
If the above is not a true description of money, in its pure objective form, then please correct the appraisal. What is your theory based upon? Is it possible to arrive at objectivity?
Published: July 18, 2005 5:26 PM
I'm glad to see this discussion continued with some effort to illuminate the differences between the Mises and Fekete camps, though I still see this article scattered with what I consider to be misnomers when describing RBD, such as referring to it as a theory advocating the creation more paper money substitutes.
Right there in that one definition (which I happen to think is over-simplistic due to the usage of 'paper money'), I believe I see the crux of this conundrum between the two camps, the word advocate. It appears that this isn't so much of an intellectual battle, as it is one amongst dueling social improvers.
Personally, given my knowledge of the political beast that is the Fed, I don't find it worthwhile/reasonable to advocate either reinstituting a 100% gold standard, or a RBD/gold standard, or even the dual fiat/silver standard as proposed in Mexico by Hugo Salinas Price.
To me, these dreams of rescuing sound money from the clutches of politicians and bankers are just that, dreams. Dreams which fail as soon as implementation mechanisms are raised, since they all require acceptance from those very same banking/political circles to be considered feasible. Anybody want to discuss the feasibility of those folks voluntarily reducing their power?
But here in ideology land, reality takes a back-seat to the advocates, advocating their own non-workable solutions all the while fearing that another advocate will spoil the soup first with their 'irrational' solutions, and in doing so, becoming a tool of the darkside. (Though Mr. Blumen, instead of Tastes great vs. less filling? how 'bout You inflators vs. you economy cripplers?) (at least that's the battle I think I see)
Well, the liberty lover in me would like to state that there are NO SOLUTIONS to be applied by ANY group, there is only the freedom for the individual to evolve or not. I would like to think that this should be obvious to anyone frequenting a site like this. The only 'solution' is whatever works best for you. If ya don't like fiat currency, then get ahead of the curve and stop using it!
As much as humanity has benefited from these past instances of sound money, today's fiat cat will not go back into the bag any more than we can regain our own lost innocence. Money cannot be made whole once again simply by attempting to undo the damage of past fiat, regardless of intent.
My experiences have shown that life has no back button. We move continuously forward, never quite sure of where we are, let alone where we're going. While I currently believe in the historical soundness of both RBD and of commodity money, I do not believe they can be imposed anymore today than they were ever imposed before. If we regain sound money, or RBD, it will be due to the same reason as it came about before, it spontaneously arose as free people found it benefited them. Which, in every instance other than the first, came about after the death of the previous round of unsound money.
Which is why, as painful as it is to watch, I have to applaud the bravery of Alan Greenspan, who lacking a magic rewind button, has glued down the fast-forward one in an effort to take us beyond this latest instance of fiat. Even though history is full of these examples, he seems to be the only one who understands that the death of fiat is the only escape from the trap. There is no 'fix' to recover the stolen wealth it consumes. Yet many of the smart people I read around here like to blame him for destroying the currency. I ask, what else is there to DO with fiat?
Meanwhile in frustration, we argue over resurrecting the past. And to me, it is this frustration that continues to wedge itself into the middle of the debate about the validity of RBD, keeping me ignorant of why it may not be so.
I do have one question though raised by Mr. Fekete; does the Mises camp consider 'Net 30' payment terms to be inflationary, and other than other than the discounting mechanism, how is that so different from 'Net 91?'
My apologies for the diversions contained in this post, but to me it seems that all this talk of how one side or the other of history fails to be a solution to today's problems have clouded our ability to understand the history itself. Just because something isn't true today, doesn't mean it once was not. Yet that is what I see driving this debate.
Maybe we're all just a bunch of tools?
(8?»
Published: July 18, 2005 5:48 PM
Mr. Hillary:
There's simply no way to have meaningful discussion of some subjects with those unfamiliar with basic concepts, terminology, etc. That's what's known to us elderly as a "fools errand." It seems (from your reply, though not stated in just so many words) that my previous surmise (as to your familiarity with Mises' work) was on target.
HUMAN ACTION is less than 900 pages if you don't count the Index. Not an "easy read," I grant--but a bright guy like yourself ought to be able to digest it in just a few years, then come back and pose some questions that actually meant something--that is, if the experience hadn't quite sufficed to answer whatever questions you might've started with. Who knows--some of us may even still be here when you get back.
Published: July 18, 2005 7:27 PM
Joe Kelley,
I am not sure why you feel so tangled up with the idea of attempting to conceptualise the market for gold coin, and how its exchange rate and interest rate may be determined. If you don't think it will help you understand the topic, well don't do it.
But for anyone who wants to 'have a crack at it' and wants some tips:
Try to draw a supply/demand diagram, as similar as possible from what you would find in an economics text book related to any produced product other than money. Be sure to mark the x axis as relating to the flows and not stocks of gold coin, and the y axis as the exchange rate (to avoid confusing yourself make sure your scale shows increasing exchange rate (lower goods prices) as you go up the axis).
Try to think of the stock of gold coin as a form of capital and to draw a diagram showing the relationship between the stock of gold coin and its marginal rate of return. So on the x asis put the stock of gold coin and on the y axis put the marginal rate of return (as a proportionate rate per period of time).
Next, review your work and try to think of what it means and test whether it is characterised correctly. You may want to use the following questions to help your evaluation:
Is there an equilibrium exchange rate? If there is, what are the consequences of the exchange rate at in any period being above or below its equilibrium value (including for the marginal rate of return in your second diagram)? Consider the second diagram and consider whether there is an efficient stock of gold coin. If you consider that there is such a stock, consider how capital could be converted from/to gold coin to/from substitute forms of capital (if so, does it take time?). Consider the opportunity cost of holding gold coin and consider if it is the same as the interest rate. Consider if the interest rate may be a function, therefore, of the gold coin stock.
If the answers you get from your diagrams and questions conflict with what you previously thought, don't let this stop your analysis. But if you are lost, well it is up to you if you want to continue the effort.
If you think your diagrams seem coherent and meaningful, try the following ones:
Try to draw a diagram showing the relationship between the interest rate and the capital price on fixed capital such as building capital. Consider the market for the construction of fixed capital assets in relation to the interest rate.
If you still seem to be making progress, try to draw a diagram showing the relationship between the interest rate, and the rate of change of the exchange rate. Consider any such diagram and try to assess its meaning and validity. Do you think the exchange rate requires time to change?
For those who have proceeded on this analysis to an advanced stage, consider how the interest rate and exchange rate change over time, and the methods that may be used to model such adjustments. hint: start with a non-equilibrium gold coin stock and model the interest rate and exchange rate response over time.
Conclusions:
Try to draw conclusions about the similarity and differences between the market for money, according to your analysis, and markets for other goods.
Published: July 18, 2005 8:27 PM
David Hilary,
Since your last post included a reference to me it may be appropriate to respond. Can I offer as question as a summary of difficulties in communication?
How do we communicate?
“There are three classes of people: those who see. Those who see when they are shown. Those who do not see.� (Leonardo da Vinci)
I do not see a need to determine exchange and interests rates for the gold coin market.
I do hope that some readers will have a sufficiently open mind about this topic to consider the possibility that their beloved theories may be subject to improvement with some diligent effort including communication requiring agreement.
I’d bet if anyone decided to start by putting aside what he things he knows about money, take a blank sheet of paper, and try to document, for the purpose of communication, a sound perspective on money, taking care to avoid confusion, chances are he would come to some very different ideas about money.
Anyone game for that?
Communication requires agreement. Have I not seen where we agree?
Published: July 19, 2005 10:18 AM
For Paul Edwards and John Bigelow- there is no disagreement between us except for what I think of
as fractional reserve banking.That is, the bank
loans out many times the value of its actual deposits.This is why I wrote that the problem is amplified by fractional reserve banking.But the effect would still exist, to a lesser extent, even if new fiduciary media were created only on
a one for one basis, as per John's example.
Of course, you could consider the bank's treatment of the bill as if it were actual cash,
to be fractional reserve banking. But this is not how fractional reserve banking is normally defined.
Thanks for your attention to my inarticulate mumblings.
Published: July 19, 2005 12:41 PM
Re: Real Bills Doctrine
Consider a bank that accepts 100 ounces of silver on deposit and issues 100 paper receipts called dollars in exchange. Then a farmer asks the bank for a loan of $200 of these paper dollars, giving his farm (worth at least $200) as collateral. The loan to the farmer triples the supply of dollars. If you believe the quantity theory of money (as most readers of Mises do) then you expect the loan to reduce the value of the dollar. If you believe the real bills doctrine (as I do) then you recognize that even though the bank tripled the supply of money, it also tripled the amount of backing for that money because the bank has the farmer's IOU, which is worth $200. This is all the real bills doctrine says: that an issue of new money, ADEQUATELY BACKED, has no effect on the price level. You can find further reading by doing a google search for "real bills doctrine" and clicking on my web page, which is usually near the top of the search results.
Published: July 19, 2005 12:43 PM
Thanks Mike: You have confirmed the discussion boils down as i suspected, although the RBD rationale was not as clear until presently. But would you mind giving me a typical example of what might constitute an issue of new money, INadequately Backed?
Published: July 19, 2005 1:03 PM
Joe Kelley,
It seems you have nothing to say about money. To me, and I think most of us here, that was the topic, along with RBD and banking.
David Hillary
Published: July 19, 2005 2:50 PM
Paul Edwards,
From the perspective of free banking, inadequately backed demand debt would be demand debt backed by insufficiently great quantity and liquidity of assets.
If the bank's assets do not exceed its liabilities to a sufficient extent, the bank's buffer of equity capital is inadequate and the chances of its consuming its equity with losses is too great. To get a credit rating of S & P AAA, the probability of default in the next year has to be less than 0.03%.
Also the bank has to maintain adequate liquidity, which means holding reserves of legal tender, demand deposits, and marketable securities, and diversifying its liabilities and managing its net funding requirements (i.e. re-borrowing requirements). If the bank has a probability of default of less than 0.03% over the next year then obviously it has to be able to reduce the probability of default due to running out of liquidity to the same (or better) standard.
So, from a banking perspective, the solvency standard is a probability of default. If the probability of default is less than the standard targeted by the bank, then the bank is, on its own policy, sound.
David Hillary
Published: July 19, 2005 3:22 PM
Hi David: The impression I got from Mike was that as long as a borrower gives something such as “his farm … as collateral� that “even though the bank tripled the supply of money, it also tripled the amount of backing for that money because the bank has the farmer's IOU� and so David concludes that “…an issue of new money, ADEQUATELY BACKED, has no effect on the price level�. If that is how the RBD advocates see it, then my question was what form of collateral or what form of loan would not constitute an adequately backed issue of new money?
My question was purely rhetorical, however, and the point to the question is that it is not the collateral that is relevant to the impact on prices, but the fact that after the loan there is more money pursuing the same amount of goods.
Your answer does explain how the banks attempt to maintain the facade that they are able to fulfill their contractual obligations to redeem their customer’s deposits on demand.
Published: July 19, 2005 5:17 PM
David Hillary,
I do not profess to speak for the majority who tend to be wrong as the voice of the majority is often a regurgitated fashionable falsehood and a source of great conflict.
My comment on money was presented to anyone with a capacity and desire to exchange viewpoints in an effort to better understand the concept. What seems obvious may in fact not be obvious and instead require thoughtful consideration if comprehension is desired.
If money is not a means by which individuals inspire other individuals to act then I am wrong. Simply ignoring the viewpoint does not invalidate it no matter how many viewpoints disagree with it.
I propose that the next time anyone on the planet desires another person to act, to exchange, to perform work, to murder, to steal, to hate, or to love, it will occur to them, right or wrong, that money may inspire the act. If I am wrong then my comments are as you seem to think them to be and if I am right then my comments are on topic, concerning money, and a good foundation to move toward a better understanding of specific forms of money including non-inflationary, self-liquidating, real bills.
From my foundation of perceived principle, knowledge concerning human action, the real bills doctrine could credit labor as well as merchandise. Of course that is another viewpoint often ignored by people who prefer to abdicate intelligence.
Published: July 19, 2005 5:22 PM
Mike Sproul,
That farmer gave those 200 dollars to me in exchange for some fertilizer I had on hand. Not having much faith in RBD, I promptly take these "paper receipts" back to your bank & demand 200 ounces of silver. This is where things get sketchy for me... can anyone elaborate on what happens next?
Published: July 19, 2005 5:38 PM
Mike Sproul,
Any holder of a bearer demand note can demand redemption with the issuer at any time. The result is that the issuer has less reserves and less liabilities. But it is not unexpected, because, after all, it is a demand debt and can be demanded at any time.
Paul Edwards,
Money does not go pursuing goods. Money is a stock, not a flow. Anyone can, therefore, hold his wealth in the form of money or non-money assets at will, via exchange on the asset markets. To exchange money for other goods is not the same as consumption, for example if I exchange funds on account with a bank for some shares, I am not increasing my consumption, I am increasing my holdings of shares and decreasing my holdings of money. I can run up my net worth by saving or run it down by dissaving independently of my holdings of money, because money can be exchanged for non-money assets and non-money assets can be exchanged for money. Money is an asset, not a flow, it is a form of wealth and a type of property, not a rate of consumption.
To give you a more technical answer to the question of what would constitute inadequate backing, as an asset:
"A asset is inadequate as backing for bank demand liabilities if and only if the acquisition of that asset would reduce the risk-adjusted capital ratio below the bank's target, or reduce the bank's liquidity ratios below the bank's targets"
In terms of assets that a bank can buy, provided it has excess capital (above target) it can use up the entire excess in exposure to any assets it likes, no matter how risky, because the highest risk weight amounts to 'deduction from capital.' For example, if the bank has a target risk-weighted capital ratio of 8% and an actual risk-weighted capital ratio of 9%, it has a 1% excess capital position, that it can pay as dividends or use up by getting exposure to assets as risky as it likes, such as stock options (provided, of course that the bank does not have exposure to losses beyond the value of the assets it buys).
Regards
David Hillary
Published: July 19, 2005 7:51 PM
“If you believe the real bills doctrine (as I do) then you recognize that even though the bank tripled the supply of money, it also tripled the amount of backing for that money because the bank has the farmer's IOU, which is worth $200. This is all the real bills doctrine says: that an issue of new money, ADEQUATELY BACKED, has no effect on the price level.�
This is the essence of the real bills doctrine: new money adequately backed by real bill secured by claims to real goods will have no effect on the price level. As long as money supply increases or decreases with legitimate needs of trade, there will be no inflation.
The problem with the real bill doctrine is that these “real goods� are measured in money prices, which is a nominal value. As prices rise, the nominal values of the needs of trade will rise.
In the example, an increase in the money supply of will be required to meet the needs of trade. But the money expansion, by raising prices, will further increase the nominal value of the needs of trade, which will require a further increase in the money supply causing an addition increase in nominal value of the needs of trade, leading to an ever-expanding increase in inflation.
The fallacy of the real bill doctrine is when one nominal value (the needs of trade) controls another nominal value (the money supply), this will lead to never ending inflation. The RBD falls to take into account the price-money-price feedback loop.1
1. I have borrowed heavily from “The Real Bills Doctrine� by Thomas M. Humphrey of the Federal Reserve Bank of Richmond. His article can be found at the Federal Reserve Bank of Richmond website.
Published: July 19, 2005 11:04 PM
Tom,
Aren't you assuming what you are trying to prove? If RBD is true then the increase in the stock of money will not effect nominal prices and so the needs of trade will not be affected by the bills.
David Hillary
Published: July 20, 2005 12:19 AM
David: Thanks for the insight that "Money does not go pursuing goods". I guess i gave the impression that i imagine dollar bills running around trying to catch up with elusive goods. What i actually meant to convey with my sloppy language, is that the receivers of the additional new money are able to, and actually do, bid up prices of goods which they otherwise would not have been able to bid up without this new money.
Furthermore, I think your "Money is a stock, not a flow" argument muddies the waters (figuratively speaking only). Money is a commodity, whose price, or purchasing power, is subject to supply and demand just as is the case for any other commodity. In this case, we're talking about its supply increasing, thereby reducing its price or purchasing power, at least (in the near-term) with respect to the particular goods that this new money is used to purchase.
While your technical answer to the question of what would constitute inadequate backing does indeed sound very technical, i think it strays drastically from answering the question; that being a request for a simple counter example to the land as collateral provided by Mike. And that was all i was asking for. However, i retract the question because i don't think it is going to prove helpful in this discussion.
Published: July 20, 2005 1:41 AM
Paul Edwards,
I don't mind sloppy language so much as the idea conveyed has merit.
Who are money receivers? Is this like when a firm goes bust and they liquidate the assets? Seriously now, the demand creditor does not 'receive' demand debt, he actually exchanges other property for it (whether over the bank counter or otherwise). Demand debt is not thrown out like a lolly scramble!
"Money is not a flow but a stock" is not really an argument it is an assertion. Is it true or false? If it is true it money is measured in units that have no relation to time, e.g. dollars or grams. If money is a flow, it is measured in units per unit of time, e.g. dollars per year or grams per year.
You wrote: "Money is a commodity, whose price, or purchasing power, is subject to supply and demand just as is the case for any other commodity."
This is true. Well said.
You then wrote: "In this case, we're talking about its supply increasing, thereby reducing its price or purchasing power, at least (in the near-term) with respect to the particular goods that this new money is used to purchase."
Inasmuch as 'supply increasing' refers to comparing a larger stock of demand debt with a smaller stock of demand debt, the difference is one of stock rather than flow, and so 'supply and demand' does not apply in the same way.
Supply and demand analysis properly refer to the production-supply flow rate as being an increasing function of the price of the product being produced, and the consumption-demand flow rate being a decreasing function of the price of the product being consumed. Applied to gold coin, production-supply and consumption-demand mean the mining of gold from the ground, and refining it and manufacturing it into coin, and the abrasion, loss and scrapping of gold coin respectively. The exchange rate price of money is unique in that the exchange rate of gold coin for any one good does not reflect the true price of gold coin, because it also reflects the price of the other good, and so there is a need to combine the prices of multiple goods in terms of gold coin to estimate its exchange rate. The contracting and discharge of demand debt does not qualify as supply and demand in this sense described here. The price of demand debt is the interest rate it bears (actually in relation to the rates of return on substitute assets), and not its exchange rate to gold coin, which is fixed at par.
So, the question is: how does the contracting of demand debt (or its discharge) affect the exchange rate of gold coin? Does it change the supply and demand functions for gold coin? No, it does not. So, neither can it affect its equlilibrium price. However it can lead to substitution in asset markets, as holdings of gold coin are relinquished for holdings of demand debt instead, and stocks of gold coin are allowed to run down freeing up capital for investment in buildings and capital. And changes in the gold coin stock can only be effected by periods of deficit in the gold market, implying a period of lower prices. However the equilibrium price of gold is the same.
To give you a non-technical answer to backing of demand debt, really demand debt is not backed by anything, generally demand debt is an unsecured claim on the issuer. So, to make it simple, demand debt is just a claim on a person, the debtor. The debtor holds a portfolio of assets. It is interesting to know that non-banks often have credit ratings equal to or in excess of banks, perhaps implying that even industrial plant and equipment can be a sound basis for debt. Also note that many companies have huge holdings of cash. So, the implication is that the scope of assets that can potentially support demand debt could be very wide, and that size seems to be the main indicator of credit risk (i.e. companies with large quantities of buildings, plant and equipment, and large stockpiles of cash and modest leverage are much better credit risks than small and medium sized firms with little debt).
Regards
David Hillary
Published: July 20, 2005 3:15 AM
“Aren't you assuming what you are trying to prove? If RBD is true then the increase in the stock of money will not effect nominal prices and so the needs of trade will not be affected by the bills.�
And if RBD is not true then an increase in money will affect nominal prices. So, basically, if you believe that inflation is caused by monetary growth, then the RBD is a prescription for an inflationary disaster. Or if you believe that inflation has a non-monetary cause and that the money supply expands passively to the needs of trade, then the RBD might be something to believe in.
The RBD was the basis of the German hyper-inflation of the early 1920s:
“the Reichsbank’s president, Rudolf Havenstein, considered it his duty to supply
the growing sums of money required to conduct real transactions at skyrocketing prices. Citing the real bills doctrine, he refused to believe that issuing money in favor of businessmen against genuine commercial bills could have an inflationary effect. He simply failed to understand that linking the money supply to a nominal variable that moves in step with prices is tantamount to creating an engine of inflation.�1
1. “The Real Bills Doctrine� by Thomas M. Humphrey http://www.richmondfed.org/publications/economic_research/economic_review/pdfs/er680501.pdf
Published: July 20, 2005 8:00 AM
The RBD is purported to avoid runaway inflation because after a season, all bills of exchange are, er, exchanged, essentially removing the excess money created.
In the example of the farmer above, the RBD goes awry at the beginning of the second season. After a successful season trading his first crop, he returns to the market with a second crop. He again goes to the banker to exchange an IOU for a bill of exchange.
"If you believe the real bills doctrine (as I do) then you recognize that even though the bank tripled the supply of money, it also tripled the amount of backing for that money because the bank has the farmer's IOU, which is worth $200."
Those last four words, "which is worth $200", is where the problem lies. Someone had to determine what it is worth. In the first season of RBD use, the amount was perhaps based on the previous year's prices. But now for the second season, surely the prices paid in the first season affect the estimate. Instead of merely scarce gold dollars being used to bid on the goods, the first season included bills of exchange as well and the prices rose. So for the second season, the estimated price of the goods will be higher, the IOU higher, the bill of exchange higher. This continues season after season, with previous prices the only guide to estimated value. Runaway inflation.
It is paper multipled without limit, not because there are no limits to the bills of exchange, but because the limiting factor (the estimated value of the backing goods) can increase without limit.
To support the RBD, it is not enough to suggest that the rise in prices is temporary or limited. You must support the idea that adding money to the economy would not raise the price of goods at all.
Published: July 20, 2005 9:44 AM
Tom,
The lessons of history can offer help to those able to understand them.
If inflation is caused by government intervention then it stands to reason that more of the same government intervention is not the cure unless one is to consider inflation to be like a virus and government is the vaccine. Is that not putting the cart before the horse?
From here:
http://www.appropriate-economics.org/materials/21stcent.html
“The 1930s in Germany
“In 1930, Herr Hebecker, owner of a small bankrupt coal mine in Schwanenkirchen, Bavaria, decided in a desperate effort to pay his workers in coal instead of Reichsmark. He issued a local scrip-- which he called "Wara"--redeemable in coal. On the back were small squares where stamps could be applied. A bill would remain valid only if the stamp for the current month had been applied. This negative interest charge was justified as a "storage cost." The workers paid for their food and local services with these Wara. For example, the baker had no real choice but to accept them, and convinced his wheat suppliers to accept them in turn. The process was so successful that by 1931 this Freiwirtschaff (free economy) movement had spread through all of Germany, involving more than 2,000 corporations and a variety of commodities as backing for the Wara. But in November 1931, the German Central Bank, on the basis of its monopoly on currency creation, prohibited the entire experiment.�
“The 1930s in Austria
�In 1932, Herr Unterguggenberger, mayor of the Austrian town of Worgl, decided to do something about the 35 percent unemployment of his constituency (typical for most of Europe at the time). He convinced the town hall to issue 14,000 Austrian shillings' worth of "stamp scrip," which were covered by exactly the same amount of ordinary shillings deposited in a local bank.
�After two years, Worgl became the first Austrian city to achieve full employment Water distribution was generalized throughout, all of the town was repaved, most houses were repaired and repainted, taxes were being paid early, and forests around the city were replanted.
�It is important to recognize that the major impact of this approach did not derive from the initial project launched by the city, but instead had its origin in the numerous individual initiatives taken in the process of recirculating the local currency instead of hoarding it. On the average, the velocity of circulation of the Worgl money was about fourteen times higher than the normal Austrian shillings. In other words, on the average, the same amount of money created fourteen times more jobs.
�More than 200 other Austrian communities decided to copy this example, but here again the Central Bank blocked the process. A legal appeal was made all the way to the Supreme Court, where it was lost.�
‘Private’ enterprise tries to work around the virus of government intervention to avoid whatever ‘hampers’ the market. The disease manages to return. The cures are relentlessly adaptive. The disease is a constant known as coercion.
RBD can be viewed as one of many possible ‘Private’ adaptations of money. The historical context, the present forms, and the future possibilities can be viewed as ‘free market’ money markets where those ‘private’ enterprises employing RBD choose not to stick their heads in the sand in the hope that government intervention will disappear.
From my admittedly prejudiced viewpoint, and therefore error prone viewpoint, this present argument looks like a one sided affair where the ostrich party is having a hard time separating fact from self-delusion.
If government monetary supply control is the cause of inflation, as RBD clearly states, then the Austrians should have this viewpoint in common with RBD. What possible purpose explains the continual false accusations being made that real bills cause inflation? Even if such inflation (by any definition whatsoever) did occur in the real bill ‘free market’ then of what concern is it to an Austrian “Free Market� advocate?
If an Austrian free market advocate wishes to use a real bill or a Worgl then who is advocating the force applied by the Central Bank to stop them?
Published: July 20, 2005 10:25 AM
Economic growth can come only out of savings. Existing land does not represent savings, and using land as the basis of creating new money will
be inflationary.RBD is inflationary as long as banks treat the bills as cash and enter their discounted value in their books in the same column
as actual cash reserves,and make loans on that basis.The heart of the problem is not FRB per se,
that is a separate problem.It is the fact that new wealth has not yet been created,yet the money supply has been expanded.
If the bills were treated as collateral, and loans made out of existing cash savings only, no Austrian would object.Nothing would be monetized,
the money supply would not be expanded.But that is not what Fekete is proposing.One one hand he gives an example of real bills being used to facilitate trade of existing goods between merchants.So far no problem. The bills are destroyed when everyone has finished exchanging.
But then he goes on to propose the use of Real Bills as a way of supplementing actual savings(production minus consumption).This is where his
doctrine falls to the ground.If he percieves savings as somehow being too small, there is only one fix-produce more and consume less.Expanding
the supply of money will not improve things, and Mises' explanation of why this is so is one of his great contributions.Mr Blumen applies Mises' ideas to refute the RBD. Feketes' ideas reflect a refusal to accept that money is a medium of exchange, nothing more or less.
Published: July 20, 2005 11:19 AM
Hi David: You are asking me "Who are money receivers?"
The money receivers are borrowers such as the farmer in question. He’s a borrower, so he gets the money in the form of an increased balance in his checkbook. What does he do with this money? He spends it (writes checks against his checking account) on capital for his farm presumably. Let’s say he spends it on whatever. He definitely spends it. In the process of spending this new money, which came about in a process of credit expansion, created in the books of the bank as an IOU on its assets page, and a demand deposit to the farmer on its liabilities page, he bids up prices in the commodities he buys. Without this new money, the farmer stays out of the bidding; with the new money, he’s bidding up prices.
This is how credit expansion affects prices and money purchasing power. Am I oversimplifying?
Published: July 20, 2005 12:07 PM
Joe, your Herr Hebecker history is hugely interesting to me! Assuming I’m interpreting it correctly, it is the first example I’ve heard of where a hyper-inflation led to the calamitous conditions of a truly barter market where an actual true blue commodity money was able to emerge. If I am correct then the one thing I’d like to know is if there is any Austrian analysis of this very short piece of economic history. To me it just sounds like a time of momentous economic significance.
BTW, there’s a little more detail at http://userpage.fu-berlin.de/~roehrigw/fisher/stamp4.html based on Irving Fisher’s work.
Published: July 20, 2005 2:38 PM
Tom,
German hyperinflation is to be expected because at the time the mark was not redeemable in in specie.
Mikey,
Economic growth can also come from more productive use of the existing stock of land and capital. For example the re-allocation from a less marginally productive form of capital to a more marginally productive form.
Paul Edwards,
The borrowers exchange property for property, generally a collateralised promissory note (payable in installments over time) for either specie or claims on specie payable on demand. The bank thus turns an illiquid form of wealth to a liquid form. The service being provided by the bank amounts to 'maturity transformation' and means that social wealth is held in a more liquid and shorter-dated form. However the equilibrium exchange rate of the money unit is not affected by this maturity transformation. In fact you could say it will increase its purchasing power because it reduces the costs of producing goods and services by reducing the cost of holding 'working capital' (i.e. liquid resources). For example, suppose that a bakery needed fixed capital worth 1 000 000 sovereigns, and non-cash current assets worth 100 000 sovereigns and cash of 100 000 sovereigns. If the cost of holding cash reduces by 3% p.a. (e.g. instead of paying 0.5% p.a. in storage costs the bakery earns 2.5% p.a. in interest), this reduces the operating costs by 3 000 sovereigns per year. In the bread market, this reduced cost is competed away and results in lower bread prices.
David Hillary
Published: July 20, 2005 2:40 PM
Paul,
Thanks for the communication. Your perspective appears to agree with my own excepting specific interpretations concerning certain observations.
The same source reporting the German and Austrian stamp script reports earlier examples of similar forms of money including the inscribed pottery used to record deposits of food into a common stockpile in Ancient Egypt. That reference reports: “This currency was used in Egypt for more than a thousand years, until the Romans forcibly replaced it with their own banking and currency system, more “modern� and having positive interest rates.�
If the principles involved can be identified then the relative merits of any ‘system’ can become more accurate. Is it not obvious that one common denominator separating many ‘systems’ from many other ‘systems’ is the element of coercion?
Romans coerced, the German Central Bank coerced, The Austrian Central Bank coerced, and is it not clear that the Federal Reserve is operating on the same principle and one what principle is the World Bank now operating?
Money, as a principle, can be used to control or it can be used to inspire cooperation much like words.
For example if an idea like RBD can be perceived as a commodity and words can be perceived as money then the progress of this topic runs like a communications market.
Some dealers use words (money) to control the exchange as they deem proper while others try to use words to inspire cooperation. The Central Bankers say: “It is my way or the highway.� The free traders say: “Can you agree with this exchange or not?�
Thanks for the link to more information on the Wara episode. The more information we have the greater the probability of gaining knowledge.
I wonder if the Central Bankers have managed to inspire other contributors on this RBD topic to choose exile. We all have a little Central Banker in us.
Published: July 20, 2005 5:34 PM
Hey Joe: I think i always find something in what you say to agree with, although i have to admit i don't always follow you. But what else is new as i am pretty slow.
I'm hoping that someone reading along will have had some exposure to this coal form of media of exchange and will be able to add something or point out other resources that have commented on it. It just dawned on me that i should copy it over to the other thread of RPM's on Hayek's ducat concept.
Published: July 20, 2005 6:40 PM
Paul,
Scarce commodities are valuable. Agreement and control are scarce and they too are valuable to some people. When someone agrees with me I find reason to smile. If I find the Central Banker in me erupting it makes me sad. Scarce bad things afford me the opportunity to smile. Have I stretched the limits of language?
Knowledge is scarce. There is an abundance of falsehood. I agree with you in the hope that someone reading along will have had some exposure to this coal form of media of exchange and will be able to shed some light. The RBD guys, it seems to me, could offer some perspective on the relevance between RBD and Stamp Script.
As ignorant as I am it occurs to me that both of us are at least conscious of our limitations.
Published: July 20, 2005 8:28 PM
Paul Edwards, David Mello, Tom, David Hillary,
and Brent Nelson
Regarding the farmer and the $200 loan:
If the bank lent $200 to a farmer and received an IOU worth less than $200 (say $190), then those dollars would be INadequately backed. In practice, this happens whenever a bank lends money on inadequate collateral, or at too low of an interest rate (like in Weimar Germany).
But back to the case of adequate backing. Define E as the exchange rate between dollars and silver, and initially assume E=1oz./$. The banker's assets consist of 100 oz. plus the farmer's $200 IOU, which is worth 200E ounces of silver. The bank's liabilities are $300 in paper, which is worth 300E ounces. Setting assets equal to liabilities yields 100+200E=300E, or E=1oz./$.
Now suppose the bank had gotten inadequate backing, by issuing $200 for an IOU worth $190. Then the same procedure yields 100+190E=300E, or E=.91oz./$. Thus, inadequate backing causes inflation.
As for David's question of what happens if he takes his $200 to the bank and demands silver, the answer is that he'd be just as happy getting something WORTH 200 ounces, and the bank's assets (silver plus IOU) are adequate. Even if all depositors descend on the bank wanting to redeem their dollars, the bank just has to sell the farmer's IOU for $200 in its own paper and burn the paper. Then there are only $100 in paper outstanding, which can be redeemed for the 100 oz. in the bank's vault. See my paper "There's No Such Thing as Fiat Money" on the UCLA economics working paper site.
As for Tom and Brent's objections about nominal and real values, they are answered by David's "assuming what you're trying to prove" post. Say the bank issues $200 in paper to the farmer. On the real bills view this $200 is adequately backed by the farmer's $200 IOU, so inflation never gets started, and Lloyd Mints' "self perpetuating cylcle of more money and more inflation" never gets off the ground.
See my "Three False Critiques of the Real Bills Doctrine" which is in several places on the web.
--Mike
Published: July 21, 2005 11:58 AM
To whom it may concern,
The relevance between RBD and Stamp Script can be viewed as both being commonly accepted voluntary freer market recipes inspiring cooperation between producers and consumers and everyone in between.
Both historical market practices managed to inspire cooperation in times of need. Both historical market practices competed with ‘systems’ propagated by people utilizing a different principle; i.e. might makes right. The principle of cooperation competed against the principle of force. Opposing the people promoting the freer market principle of RBD and Stamp Script were a group of people sharing a common desire to control, or in other words, a common desire to inspire obedience.
If the idea is to understand the historical significance of these events so as to better prepare ourselves for current and future situations then, it seems to me, the paper trail proves, beyond reasonable doubt, the necessary factual evidence required for objective discernment.
Who is paid in gold and who is in control?
RBD:
The producer of the merchandize asks for credit from distributors of merchandize to move merchandize to the consumer for a cut, or discount, of the final, mutually agreed upon, price of the merchandize. The consumer pays to the producer a previous agreed upon amount with the most accurate representation of a mutually agreed upon or standard of value (gold) at a specific time. In other words: the RBD voluntary ‘system’ of money inspires producers and distributors who are best able to supply the consumer with what the consumer wants to supply the consumer with what the consumer wants. The consumer decides who is paid in gold. The consumer is in control.
Stamp Script:
The producer of Stamp Script sells a self-liquidating monetary instrument at a predetermined cost based upon time. The producer of the Stamp Script is paid for the use of the currency by the consumers of currency. The consumers of the currency rent the currency from the producer. The producer best able to supply the consumer with what the consumer wants is paid in gold. The consumer decides who is paid in gold. The consumer is in control.
Austrian school: ________?
Fill in the blank please. E-gold?
Our current system of fractional banking:
The best producers of falsehood monopolize force and coerce everyone under their control into using a specific currency ‘for their own good’.
The producers (falsehood) best able to supply the consumer with what the consumer wants (falsehood) are paid in gold or whatever they prefer (falsehood is so profitable that gold pales in relative value). The producers of falsehood are in control. The consumers abdicate control by accepting falsehood.
When the producers of falsehood take control of commerce the market is lobotomized. Consumer knowledge in removed from the market brain. Money becomes stupid, inaccurate, ignorant, and ineffective. Producers don’t get the gold.
Production ceases when producers don’t get the gold for an extended period of time.
RBD and Stamp Script are two historical examples of what producers have done to get the gold and return to the business of producing what the consumers want.
Published: July 21, 2005 2:33 PM
Mike,
The liabilities of the bank you are describing appear to be denominated in, and payable in silver, and therefore they must have a fixed value in terms of the silver, so long as the bank is solvent.
The bank you describe, however, has no net worth, its assets and liabilities are the same, so that when it makes a loss on its lending it becomes insolvent, and its creditors recover only a proportion of their claims on liquidation.
Bank liabilities under a gold standard are payable in gold and have a fixed value in terms of gold, so long as the bank is solvent. The bank must have its own net worth, assets in excess of liabilities. This provides a buffer for the creditors, so that if the bank makes losses, they can still be paid in full, so long as the bank is still solvent (i.e. the buffer of net worth is not entirely exhausted). So, the measure of value of bank liabilities is their nominal value so long as they are solvent, and the purpose of owner equity and reserves in the banks is to provide an assurance of solvency.
Regards
David Hillary
Published: July 22, 2005 1:54 AM
David Hillary:
I assumed zero net worth as a simplification. So let's say the bank has net worth of 30 oz. before starting. Then its balance sheet looks like this:
ASSETS LIABILITIES
30 oz silver 30 oz. net worth
100 oz deposited $100 paper issued
IOU worth $200 $200 paper lent to farmer
As you said, the net worth gives a buffer, and reduces the probablilty of insolvency. But the value of the paper dollar is still 1 oz./$
Best regards,
Mike Sproul
Published: July 23, 2005 10:58 AM
Let's follow the changes as the farmer spends his money.
ASSETS LIABILITIES
30 oz silver 30 oz. net worth
100 oz deposited $100 paper issued
IOU worth $200 $200 paper lent to farmer
Farmer spends first $100, bank down to its 30oz of net worth.
ASSETS LIABILITIES
30 oz silver 30 oz. net worth
$100 paper issued
IOU worth $200 $100 paper lent to farmer
Farmer spends next $30, bank now insolvent.
ASSETS LIABILITIES
30 oz. net worth
$100 paper issued
IOU worth $200 $70 paper lent to farmer
Farmer or depositor spends another dime, bankruptcy. This is how banks collapse. Their short-term liabilities never match and are always much larger than their short-term assets. It’s a shell game.
Published: July 23, 2005 12:14 PM
Let's follow the changes as the farmer spends his money. (Let's see if i can overcome formatting issue)
ASSETS ........... LIABILITIES
30 oz silver ..... 30 oz. net worth
100 oz deposited . $100 paper issued
IOU worth $200 ... $200 paper lent to farmer
Farmer spends first $100, bank down to its 30oz of net worth.
ASSETS LIABILITIES
30 oz silver ....... 30 oz. net worth
.................... $100 paper issued
IOU worth $200 ..... $100 paper lent to farmer
Farmer spends next $30, bank now insolvent.
ASSETS LIABILITIES
..................... 30 oz. net worth
..................... $100 paper issued
IOU worth $200 ...... $70 paper lent to farmer
Farmer or depositor spends another dime, bankruptcy. This is how banks collapse. Their short-term liabilities never match and are always much larger than their short-term assets. It’s a shell game.
Published: July 23, 2005 12:19 PM
Mike Sproul,
The balance sheet you have drawn up is unclear. 'Deposits' shoud be the bank's liabilities, and funds 'lent' should be the bank's assets.
For the sake of completeness, the following items, if applicable should be listed as assets:
reserves of specie and legal tender
loans and advances
bonds and marketable debt securities
demand deposits held with other banks
notes issued by other banks
any fixed assets, freehold land and buildings, leasehold improvements, equity investments and other assets.
(Goodwill is generally not considered part of bank assets when assessing the capital adequacy of banks. However they do exist in the bank's general accounts, for example ANZ National Bank Limited (my employer) paid NZD 5 400 million for The National Bank of New Zealand last year, with net identifiable assets of NZD 2 022 million, leading to a goodwill value of NZD 3 378 million.)
The following items, if applicable, should be listed as liabilities:
Deposits and other borrowings
Notes issued
Provisions
Also the problem being solved should also be clearly stated. Is the problem to show how the bank can issue demand debt (payable in specie at a fixed rate) against the bankable assets, or to indicate the exchange rate at which a irredeemable 'freely floating' currency issued by a central bank, such a central bank having assets denominated in its own liabilities as well as outside assets, may be pegged or fixed?
In the case of a bank with liabilities and assets that are denominated in an outside unit (e.g. gold coins), the bank simply must ensure it has adequate net worth to bear the risk it has, and that its assets are sufficiently liquid and its re-financing ability is sufficiently great that it can remain solvent, and its demand liabilities will not deviate from their face value.
In the case of a central bank of issue, with both assets and liabilities denominated in its own currency (where its notes are legal tender for debts payable in that currency), its situation is different. Such a currency may have no fixed value in terms of outside assets such as gold coin. However, provided its assets are greater than its liabilities, and it holds a proportion of its assets denominated in outside assets, it may effectively peg its currency to such outside assets (e.g. gold bullion or a foreign currency).
For example, suppose the Reserve Bank of New Zealand has NZD assets of 20 billion, and gold denominated assets worth NZD 5 billion at today's NZD gold price of, say 0.05 NZD/g (i.e. it holds 250 million grams of gold denominated assets). Suppose it also has NZD 22 billion in liabilities. Its net worth is therefore NZD 3 billion.
The RBNZ could peg the NZD at 0.05 NZD/g, and it could redeem all its net NZD liabilities in gold at the pegged exchange rate, and have assets left over, and its capital ratio under this peg rate is 12%, that would probably amount to a risk-adjusted capital ratio of over 48% (central banks hold assets with risk weights of generally less than 25%), which is many times in excess of the 8% benchmark for banks.
However, the RBNZ could also double the exchange rate to 0.1 NZD/g. This would reduce its capital ratio to 2.2%, with a risk weighted capital ratio of perhaps 9%, which is still adequate. However, the result of this arbitrary 100% revaluation will be require great adjustments to wages and prices denominated in NZD. So, one has to ask, what is the point of arbitrarily doubling the value of a currency when restoring convertability?
Or if the RBNZ wanted to give itself a zero net worth, it only needs to peg the NZD to 0.125 grams of gold. But again, what is the point?
To me it seems that it is best to peg currencies to some value close to their current values in terms of gold, and to hold appropriate assets to sustain that peg, pending the manufacture of gold coin that would become the sole unlimited legal tender to replace the fiat currency.
Regards
David Hillary
Published: July 24, 2005 3:28 AM
Paul Edwards
When you say the farmer spends his money, I think you mean the farmer redeems his money for silver at the bank, since you are showing, for example, that when the farmer spends $30, the bank loses 30 oz silver. If the farmer just spent $30 on fertilizer, and if that $30 stayed in circulation, then the bank's balance sheet doesn't change--still $300 of paper backed by 100 oz. plus the $200 IOU. If the farmer really did redeem his dollars for silver at the bank, then the bank can simply sell the $200 IOU for 200 oz. of silver and redeem every dollar for silver. It's not a shell game. A shell game would be if the bank lent the $200 paper and got no assets at all. But the bank does get the $200 IOU, and that $200 IOU is not chopped liver!
Best regards,
Mike Sproul
Published: July 24, 2005 10:56 AM
David Hillary
"The balance sheet you have drawn up is unclear. 'Deposits' shoud be the bank's liabilities, and funds 'lent' should be the bank's assets."
I was referring to "silver deposited" as the bank's asset, and "paper dollars lent to farmer" as the bank's liability. There was no error here, though it was not crystal clear. Normally, if a depositor puts 100 oz of silver in a bank, then the bank issues a checking deposit for 100 oz, and the silver is the bank's asset and the deposit is the bank's liability. In this case the bank issued paper dollars and no checking deposit was issued, so "silver deposited" showed up as the bank's asset, and "paper dollars issued" showed up as the bank's liability. "Paper dollars lent" are also the bank's liability. It is the farmer's $200 IOU, held by the bank, that is the bank's asset.
No quarrel with including reserves, loans, demand deposits, etc. on the balance sheet. Just trying to boil things down to fundamentals.
Also no quarrel about the buffer created by positive net worth, and how this allows the bank to set its exchange rate within a certain range.
No agreement at all about fiat money, gold money, etc. I believe there's no such thing as fiat money, as suggested by the title of my paper "There's No Such Thing as Fiat Money", which is easy to find with a google search.
Best regards,
Mike Sproul
Published: July 24, 2005 11:16 AM
Hi Mike:
When i say spends his money, what I had in mind, was that the person he exchanged his money with for goods, (passed the notes onto) actually did the redeeming. But either way, yes the notes get redeemed for silver specie. This will happen, especially when the person receiving the notes realizes that there is a three to one issue of notes to specie backing those notes in the bank that issued the notes. Certainly if the notes are deposited in a competing bank, that bank would immediately redeem the notes for specie to increase its own reserves. The bank loosing specie would furthermore be hard pressed to convert this $200 IOU into specie because all banks are doing what this bank is; that is, they are all "loaned up" and unable to risk departing with more of their scarce reserves (silver specie). There will be not enough silver specie available to buy this IOU from this failing bank.
It turns out that when a long term asset such as an IOU is needed to function as a short term asset such as specie that IOU can indeed seem to be about as useful as chopped liver.
Published: July 24, 2005 10:14 PM
Paul Edwards
In times of tight money, of course it becomes hard to sell an IOU for silver. A wise banker would specify on his dollar notes that they are redeemable either into silver or something of equivalent value (e.g., gold, copper, land, foreign currency, etc). Historically, most note-issuing banks have handled this problem by reserving the right to suspend convertibility during crises. When the bank of england suspended in 1797, the banking crisis ended on the day of suspension, and the value of the pound was unaffected--until a few years later when the Bank started losing assets during the war.
In any case, I'll continue to insist that the $200 IOU is not chopped liver. In normal times it can be sold for 200 oz. of silver, and during a run it can be sold for $200 of the bank's own paper dollars. Either way the bank's dollars will always have a market value equal to 1 oz. of silver. Only when the bank doesn't have enough assets to back its liabilities (i.e., when it fails to follow the real bills rule of taking adequate backing for every dollar issued)--only then will the paper dollars lose value.
Best,
Mike Sproul
Published: July 25, 2005 10:56 AM
Hi Mike:
The bank could make such stipulations to redeem in other than specie; however the problem is, according to the balance sheet, the only asset available to the bank to redeem their dollar notes is in fact this IOU. They don’t have silver to redeem with, nor do they possess gold, copper, land or foreign currency. If this IOU is not good enough to buy its face value in specie, it will suffer the same fate against other hard assets.
The assertion that in normal times the $200 IOU can be sold for 200 oz. of silver is dubious. Why: because it was not bought and paid for with 200 oz. of silver in the first place. It was paid for with an expansion of credit in the form of $200 in bank note liability. I am sure the bank could sell the IOU for $200 in bank notes, but I don’t suppose that provides a solution to the customer asking for hard asset redemption.
Stipulating on the notes themselves that redemption might be suspended would go a step towards at least avoiding the issue of fraud. However, with the public now understanding the relationship between bank notes and specie, they would tend to recognize that depositing their silver in this sort of bank resembles greatly the buying of a lottery ticket to recovering their own property.
Published: July 25, 2005 5:48 PM
Paul Edwards:
The bank would never issue $200 in paper for a $200 IOU unless the IOU was worth at least 200 oz. of silver, because the bank knows that each dollar it has issued entitles the bearer to demand 1 oz from the bank. Therefore in normal times the IOU can be sold for 200 oz. of silver or something of equivalent value, and rational bank customers would always be willing to accept something other than silver, as long as it had value equal to silver. Given this, the expansion of bank credit does not affect the value of the bank's dollars.
If you're sure that the bank can sell the IOU for $200, then you should recognize that once the bank gets those dollars, there are only $100 in paper outstanding, and 100 oz. in the bank's vault. Thus there would be no customers being refused hard asset redemption.
Best regards,
Mike Sproul
Published: July 26, 2005 12:34 PM
Mike Sproul:
What does "the IOU was worth at least 200 oz of silver" mean? What is the IOU worth if the price today is 200 oz, but the price in three months will be 150 oz? Would bank notes based on the IOU be sound money if the bank issued notes corresponding to 200 oz when that was the price, but the price now is 150 oz?
Published: July 27, 2005 2:50 AM
hej:
When I say that the IOU is worth 200 oz, I mean that it can be sold in the market for 200 oz. If the farmer defaults, and the bank seizes the farm, and finds that the farm is only worth 150 oz, then setting assets (250 oz.) equal to liabilities ($300, worth E oz/$ each) yields 250=300E, or E=.833oz/$.
Published: July 27, 2005 8:36 PM
And would in that case the $200 be sound money? I guess your E is less than 1oz/$ answers the question, but how will the bank go about knowing that this is not the case any time it issues bank notes against anything but specie? Or more importantly, how would the customers know it?
What I'm getting at is that the mortgages allows people to get money for their houses while still owning them (as though the houses were means of production). This makes houses more valuable, so you can issue more money on the same houses, so the houses become more valueable...
The very high prices for houseing are the normal circumstances, until one day the bank must start redeeming the house-based money. Then, when bank-clerks start throwing people out of their homes and sell them to get specie, nobody wants to make that sort of investments. And then the prices of houses fall by half or more in short time. This is called a real estate bubble bursting, and is not all that uncommon. But with your calculations it would also be hyperinflation, which is rather uncommon even with pure fiat money.
Published: July 28, 2005 5:09 AM
hej:
The bank would know it is issuing sound money as long as it only issues paper dollars in exchange for assets worth $1 or more. The bank's customers, not knowing much about the bank, have only the bank's reputation to go by. In my paper "There's No Such Thing as Fiat Money" (easy to find with a google search) I explain that when a bank backs its dollars with assets denominated in dollars, it is in danger of creating what I call "inflationary feedback", where the bank's assets lose value, then its dollars lose value, then its dollar-denominated assets fall still more, etc. It is therefore desirable (though sometimes impractical) for a bank to issue its new dollars for assets that are not denominated in dollars.
As for the houses becoming more valuable, and more money being issued on them, and the house values rising again, you are commiting what I call Lloyd Mints' "Money's Worth Fallacy". You are assuming that the issue of new money (adequately backed by a house of adequate value) causes inflation. The real bills doctrine says it would not. Thus Lloyd Mint's "self-perpetuating cycle of more money and more inflation" never gets off the ground. See my "Three False Critiques of the Real Bills Doctrine" for further explanation.
Published: July 28, 2005 11:38 AM
I don't know if anybody is still reading this thread but...
If the RBD argument boils down to whether 'backing' checks inflation or the effects of inflation, its clearly hogwash and I don't think the length of this article was necessary to disprove it.
A bank that issues notes 'backed' by collateral of supposed equal 'value' is no different than a warehouse issuing receipts for goods it never had. The only difference is you have created a fixed rate at which such goods (some of which are purely imaginary) are convertable. Collateral is in use at the same time as notes and that is no different than gold being lent out at the same time notes for that gold is being spent.
A $200 loan backed by $200 or more in assets (like the farm mentioned above) begs the question what the heck is a dollar? Is it a piece of land or a piece of gold? Again, the only step beyond contemporary BS that RBD makes is merging two kinds of imaginary money quantities and calling them both 'dollars'. The only way this wouldn't be inflationary is if the land had been sold to the bank and exchanged for $200.
This isn't quantity of money theory versus asset backing theory. Thinking the Austrian position solely has to do with gold totals is ridiculous. Fractional reserve banking isn't inflationary because of the quantity of gold or the fraction of gold to notes issued! It is inflationary because assets, whether they be gold, land, or whatever you want to use as 'backing' or 'collateral' is being used in exchange more than once!
RBD is a new twist on an old tale.
Published: July 30, 2005 7:36 AM