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Is Fiat Money an IOU?

February 27, 2014 34 comments

J.P. Koning has a post (make that two posts) about the IOU nature of bank notes.  While I agree that bank notes (fiat money) are not a Samuelsonian bubble asset, I think he still comes up short of the full explanation of why these are valuable.  Of course I think that I have that explanation but first let me explain why I think his is not fully satisfactory.

The meat of his argument is this.

So in the case of the two central banks that I’m most familiar with, banknotes are ultimately claims on whatever stuff the central bank happens to have in its vaults. This means that on the occasion of the winding down of the Fed or the BoC, note holders are entitled to receive real assets, in the same way that a bond holder or stock holder would have a claim on a company’s property, plant, & other assets upon the dissolution of that company. Banknote holders have an added bonus of being senior to other claimants, since notes provide a “first claim” in the case of the BoC, and a “first and paramount lien” in the case of the Fed.

But this does not fully address the problem.  This is because the process of unwinding a central bank, along with a currency, is fundamentally different from unwinding another type of entity.  Consider an individual bank that issues dollar-denominated bonds and uses the money to buy assets including some “real assets” (land, buildings, gold bars etc.) and some financial assets (loans) and imagine that the default rate on the loans is unexpectedly high and this causes the bank to become insolvent and need to be unwound.

The bonds, in this case represent a senior claim on the remaining assets of the bank.  The question is how much of those assets are the bondholders entitled to?  The answer in this case is straightforward because the bonds are denominated in dollars and the value of a dollar is determined independently from the state of this individual bank.  In other words, you can just liquidate all of the assets (convert them into dollar terms) and then assign that value to the various claimants in the order of seniority relative to the size of their claims in dollars.

If you are unwinding the central bank, you are unwinding the dollar itself.  So let’s imagine that the CB has some amount of gold in its vaults and it has some amount of notes outstanding which are denominated in dollars.  Those dollars are said to be a senior claim on the assets of the bank (the gold) and let us assume that there are some other claims (these may be dollar denominated debt or undenominated equity).  But the notes do not entitle the bearers to a specific quantity of gold.  So how much of those assets are they entitled to?

In this case the assets cannot be converted into dollar terms and divvied up in the same way as with an individual bank because the value of a dollar is not clear.  The whole market for dollars which forms the basis for the valuation of the assets relative to the various claims in the former case is the very thing being unwound in the latter case.  So how much of the gold goes to note holders versus other claimants?  The answer is not at all clear.  So it is hard to see how this claim serves as any kind of foundation for determining the value of a dollar.

The actual explanation for the value of fiat currency, which I have been trying to argue, (also here) I think is actually fairly simple but seems to be absent from all discussion of the topic.  One dollar is precisely what is required to extinguish one dollar worth of debt.  When money is created, there is always a corresponding debt created.  The central bank creates base money by buying government debt or MBS or lending to banks.  Banks then “multiply” this money (create additional money) by making loans to businesses and consumers.  But these loans eventually need to be paid back.

When a person takes out a mortgage the money supply (some measure of the money supply at least) increases.  But this also sets in motion a 30-year process by which that person must grab money back out of the economy and pay back the loan.  If they don’t do this, they will lose their house.  In this way the increase in money is accompanied by a built-in increase in demand for money in the future.  And in this sense money is “backed” by real assets.  In this case the borrower is able to “convert” dollars into his house at a specific rate.  It is just that this rate, and the convertible asset, varies from person to person rather than applying uniformly to everyone.

This demand for money to repay loans is fundamentally different and separate from the demand for liquidity (though demand for liquidity also factors into the value of a dollar).  It is also not based on any kind of “greater fool” or “bubble” mentality.  It is (at least to some degree) stable in the sense that it does not depend on mysterious, arbitrary feelings about the value of a dollar.  The amount of debt owed is a real number that is denominated in dollars.  It is the product of actions that have taken place over a long period of time and it doesn’t suddenly change drastically or disappear because people “lost confidence” in the dollar.

This in fact explains why people don’t lose confidence in the dollar.  If the value of the dollar were based only on the expectation that someone in the future would accept the dollar at a given rate in exchange for goods and services and that belief were suddenly called into question for some reason, the “bubble theory” leads us to believe that everyone would start trying to get rid of the dollars and the value would plummet.  But if this happened, we would find that many (most) people would actually try to take advantage of the newly weak dollar by exchanging newly valuable (in dollar terms) goods and services to get the dollars to pay off their debt.  In this sense, that demand is backstopping the real value of the dollar and because of this, that scenario never occurs (at least in major “developed” economies).

This also solves the unwinding issue.  Imagine that we wanted to abandon the entire system of central banking we currently have and replace it with nothing, no new fiat currency, just whatever the market wanted to use.  We stop creating new dollars and set a date by which all current debt obligations have to be settled using the current supply of dollars.  These dollars would not become worthless, people would be trying to get them before that date to pay off their debts and keep their homes, cars, boats, businesses, etc.  This would mean that there would still be a market for them in terms of other (real) goods.  You might have to refinance your mortgage in some other terms (gold, silver, Yen, whatever) but this would be better than defaulting and losing it all together.  The quantity of dollars would not exactly match the quantity of debt (I suspect it would actually be much less but haven’t been able to quite figure out the right way to observe this) so there would probably need to be some method of settling the excess dollars/repossessed property, and the whole thing would admittedly be pretty messy, especially the issue of how to treat government debt which is not collateralized and makes up the bulk of CB balance sheets, but when you look at it this way, I think you can see that dollar denominated debt (and the collateral backing it) is the main factor guaranteeing the value of the dollar.

In this way a dollar can be said to represent an IOU but I see it as exactly the opposite.  Rather than an IOU from the bank, it is a means of extinguishing an IOU to the bank.  It can be seen either way because the two look the same on the bank’s balance sheet.  If the bank takes in gold and hands you an IOU redeemable in gold the gold goes on its balance sheet as an asset and the IOU as a liability.  If you take out a loan, you are essentially writing an IOU to the bank for a quantity of dollars and the bank hands you the dollars.  In this case, the loan goes on as an asset (account receivable) and the dollars go on as a liability to balance out the new asset.  The gold IOU in the first case is a liability because it can be brought back and redeemed for the asset (gold).  In the second case, the dollar is a liability because it can be brought back and redeemed for the asset (debt).  In both cases the rate at which this redemption occurs is fixed and not subject to market fluctuations.  The accounting is the same but the meaning is somewhat different and this seems to me to be why people have difficulty seeing dollars as an IOU.

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Technology and Outsourcing

February 24, 2014 12 comments

This post is inspired by the following question on Twitter.

Does anything need to be done to deal with the loss of jobs due to technology or outsourcing?

To which I replied:

 short answer: no (long answer more than 140 characters)

The poster then pointed out that the long answer would fit in a blog post, which was a good point, so here we are.  Let’s start with the long version of the short answer.

In a free market it would not be necessary to do anything about this.  This assertion is standard fare in introductory econ classes and is based on the notion of comparative advantage.  Essentially, the disconnect between economists and others on this issue comes down to a difference in thinking about the labor market.  Many people think about the market being made up of a fixed supply of jobs that have to be distributed among some number of workers.  They then conclude that these things reduce the number of jobs.  This is not a very good way to think about a market.

Economists see an exchange between two parties with a supply and demand for labor.  In a free market we expect “jobs” to exist if the cost of labor is lower than the value of the produce.  Jobs that are worth more will pay more and people will find their most productive occupations by seeking the highest wage/compensation.

Essentially, if there were a totally free market, it would make no sense to say jobs were created or lost.  If someone invented a robot that could build widgets really cheap and all the widget makers got laid off, they would simply find other jobs.  Their comparative advantage would go from making widgets to making something else.  This may make those individuals worse off (though it may not) but the total output of society and the total benefits would increase because it would get cheaper to make widgets which would make them cheaper and everyone would be able to have more of them.  (The same argument applies to outsourcing.)

By the way, these concerns have been around for hundreds of years and so far technology has not destroyed the working class.

Now for the actual long answer.

As I said, the above analysis assumes a free market.  In reality, what we have is far from a free market.  There are a ton of laws and regulations which gum up the works of this process.  Here are some examples

Minimum wage: If the value of your labor in your most efficient production is less than the minimum wage, you’re out of luck.  You might be willing to work making widgets for $6/hour and somebody might be willing to hire you and it might cost people in China $6.50/hour worth of other goods, but if the minimum wage is $7.25 then the widgets get made in China anyway and you end up unemployed.  This makes you worse off as well as the consumers of widgets who must pay more for them.

Unions: Similar situation.  You might be willing to work at a certain wage but the union won’t let you because they have “negotiated” a higher wage for themselves by creating barriers to entry to keep you out.

Licensing: Let’s say after losing your job at the widget factory your new comparative advantage is as a hair stylist.  But you can’t just go out and do that.  You have to go to beauty school for two years, pay a bunch of fees and pass some tests.  Don’t have the time/money for that?  Too bad for you.

Labor Laws: So you could make a widget cheaper than the Chinese but in order for someone to hire you to do so, they would have pay a bunch of taxes, get insurance incase you stub your toe on the way to work and try to sue them, comply with a million OSHA regulations, provide you with healthcare etc.  If the benefit of your labor is not great enough to make it worth it to them to do all of this, again, you are out of luck.

Here are some cases from an older Stossel show.  The moving company who had to get permission from their competition to enter the market is my personal favorite.

So the real answer to the question “should anything be done” is yes, we should liberalize the labor market by getting rid of all these ridiculous regulations which are designed to protect some special interest group.  If we did that, then no further meddling would be necessary.  Of course the other side will argue that we have to do a bunch of other interventions in the economy to try to mitigate the damage that they blame on things like outsourcing and technology but that damage is really the result of those things combined with all the interventions we already have.

Categories: Micro

Loans and Savings

February 19, 2014 1 comment

The next installment of my organic credit model, following on from these previous posts.

I.  Commodity Money

II.  Banks and Credit

III. Credit Expansion

Remember, this is intended to describe a decentralized free-market economy with free-market (commodity) money.  The connections between this and our current economy are not entirely straightforward.

Loans and Savings

When most people think about banks, they think of an entity whose function is to allocate capital by borrowing from people who wish to put off consumption until some point in the future and lending to people who would prefer to consume or invest today and pay for it with future goods.  And of course banks do perform this function.  However the function described above serves a different purpose.  In our model so far the purpose of the bank is purely to provide liquidity by allowing people to use bank credit as a medium of exchange in place of hard currency.  It is my assertion that this is the primary function of banks as it is the function which distinguishes them from other institutions which also serve to allocate capital such as stock markets, corporate bonds, mutual funds, venture capital firms, etc.  But since these two functions are bound up together, we must take a moment to distinguish between them and see how they interact. Read more…