Home > Macro/Monetary Theory > The Value of a Dollar

The Value of a Dollar

Okay, yesterday I set out to explain how the value of a dollar  is determined and monetary policy functions under my collateral-backing theory.  I typed for two hours and felt like I didn’t get half way there (much of it is just rehashing what everyone else already believes).  So I am going to try to slice off a smaller piece again.  This time I won’t promise to fit everything else into the next post (reflecting on the fact that Sumner has been trying to explain that nominal rates are not a good indicator of the stance of monetary policy for five years…).  I will just take it one bite at a time and see what, if anything, people want to argue with and go from there.

So in this installment I basically want to deal with this criticism by J.P. Koning.

2) What anchors the price level? Why does $1 buy one apple and not $10 apples? Does a Canadian dollar by 0.98 US dollars because there are less debts to settle in Canada?

Frankly, I am a bit perplexed by this question because this is exactly the problem that I think his theory (and essentially every other theory I am aware of) has and which, in my mind, my theory solves quite nicely.  So in a sense, I feel like that’s what I’ve been explaining.  Somehow, I haven’t gotten my point across (maybe because I haven’t explained it well enough or maybe because there is a flaw that I don’t see), but I’m not exactly sure where the disconnect is so once I start trying to explain I tend to want to try to come at it from every possible direction and cover everything under the sun related to money.  I will try to resist that temptation here by avoiding a detailed discussion of how monetary policy functions.

So let me start by attempting to more clearly explain what I am trying (and not trying) to do here.  First of all, I don’t think I am overturning everything everyone ever thought about money and monetary policy and macroeconomics.  I think that monetary policy functions in essentially the same way that most economists do.  I just think that, on a basic level when you get to questions like “why is money valuable in the first place?” the explanations typically given are not the whole story.  In fact, I think they miss the most important piece of the story.

Once you fill in this piece of the puzzle, I do think that you can see some things that are a bit fuzzy without it more clearly and I do think that there are a few implications (or at least possible implications) that arise from this view which are missed by other simpler models of money creation though it takes a lot of analysis to get to them.  But this doesn’t mean, for instance, that I don’t think the CB can affect the value of the currency by buying and selling assets.

Now the answer to “what determines the price level at any given time,” on some level, has got to be the same for any theory.  It is determined by supply and demand.  At any given time, there is a certain number of dollars in circulation and a certain quantity of goods and services (or potential goods and services) and the dollars circulate at some velocity which is based on peoples’ willingness to hold them relative to other assets and this determines a “price level.”  This basically has got to be the case regardless of why you think the money has value.

The real question underlying this, which I have tried to answer is “why are people willing to hold money at all?”  Whatever the answer to this question, it will determine some willingness to hold money (which is to say a “demand form money” which depends on the cost of doing so) so people will hold money until the marginal benefit (from liquidity preference) is equal to the marginal cost (foregone return on other investments).  The higher the velocity, the higher the marginal liquidity preference will be (or vise-versa) and there will be some equilibrium price level.

Now, any theory about the demand for money also has to acknowledge that the willingness of people to hold money today depends on their beliefs about the value of that money in the future.  This is what makes everything complicated.  We know people must believe it will be valuable or else they wouldn’t hold it at all (and probably that it won’t be dramatically less valuable or nominal interest rates would be really high).  The question is: why do they believe this and, probably more importantly, is it reasonable to believe it?  Another (more rigorous) way of putting this is to ask whether the equilibrium is based on beliefs that are rational off the equilibrium path (is it a subgame perfect NE)?

For instance, if peoples’ willingness to hold dollars is based entirely on the belief that others will be willing to hold them in the future, and the value of them (either now or in the future) is not anchored to any real goods in any way, then if people started to question that belief, for whatever reason, you could see the willingness to hold them drop dramatically, possibly substituting other goods for use in exchange (essentially allowing P to decouple from M, V, and Y), and the price level could shoot off to infinity and the dollars become basically worthless in a Weimar/Zimbabwe-style hyperinflation.  This seems to be what most people who think the dollar is backed by nothing fear, and that fear would be reasonable if it were actually backed by nothing .

Similarly, if you think that the dollar is “backed” by the expectation that the CB would be willing to trade real goods for dollars to prevent the real value of the dollar from falling, then one must wonder whether they have enough such assets to do this if people “lost confidence” in a manner similar to that described above.  It is hard to see how this theory can explain a total value of the dollars which is much beyond the value of the real goods that the central bank has available to trade for them (accounting for a liquidity premium) without relying on the same type of logic, i.e. people know the CB couldn’t cash out all the dollars for gold at the current price of gold but they just hope that, for some reason, people will keep being willing to take the dollars at the current elevated value and so the CB will never have to do this.

The willingness of the CB to buy and sell a little on the margin does not seem to rectify this problem, if the promise to go all the way is not credible (due to insufficient real assets).  A classic Ponzi-scheme works for a while because the person perpetuating it stands ready to cash out people who demand their money but once it becomes clear that they do not have enough money to cash out everyone, it collapses.

I think what I have done is provide an explanation for why it makes sense for people to expect the dollar to continue to be in demand that does not rely on any kind of belief that could suddenly evaporate at any moment but instead is based on real exchange rates between dollars and real goods that are fixed in long-lasting, legally binding contracts.  In order to explain this further, let me start by defining what I mean by “money.”

Going forward, when I say “money” or “dollars” I mean anything that can be directly (without being converted to another form) used to repay debt from a bank.  I think the line may be a bit blurry in some cases but for the most part this includes, essentially cash and bank deposits (checking and savings).  I don’t count stocks or bonds because these must be sold at a market price for money before debt can be repaid.  Some things like money market funds or certificates of deposit are a bit tricky but I don’t want to get too distracted by this issue for now.

The important thing to notice is that I am coming at the “money supply” from the opposite direction of people who begin their reckoning from the money base.  This is only significant because they often talk about the willingness to hold money as the willingness to hold currency (cash) whereas I am talking about the willingness to hold dollars in any form.  Since currency and deposits can be converted into one another at any time at par, the composition of peoples’ “money holdings” between the two will be determined by the different liquidity of each.  While this willingness to hold cash has an important mechanical function in determining the amount of total “money” which will be created from a given quantity of base money at a given nominal interest rate, and is therefore important for modeling the effect of CB policy, this is not what I am after and so this distinction between cash and deposits is not of particular interest for my purpose.

So let us acknowledge that the CB has tools that can alter the quantity of money which is created at any given time and put the discussion of what those are and how they work aside for now.  It is true that people are willing to trade real goods for dollars and hold some quantity of those dollars.  This means that they must believe the dollars will be sufficiently valuable in the future (given their other options for holding wealth).  The question is why does this belief make sense?

The reason for the reliance on “network effects” to explain this, I think, stems from the Macro 101 view of the role of money in the economy.  This is essentially that money circulates through the economy like a perpetual, circular river and the CB simply determines how much water it wants and pours it into the system.  It can add water or take it out but it essentially has no purpose but to circulate and is not directly connected to the value of any real goods except by the seemingly arbitrary rate at which people choose to push it perpetually through the system.

I think this does serve as a reasonable approximation of how money functions but that the fundamental nature of this money is somewhat different.  I am saying that money does flow through the economy in this way and the quantity is determined by CB policy but that the meaning of those dollars is in fact anchored to specific real goods because of the way the dollars are created.

The CB does not just print dollars “out of thin air” and dump them into the economy.  Dollars are created when someone borrows.  CB policy does limit the extent to which this process can go on but that is what I’m trying not to get into here.  So I see the fundamental economic function of the banks as manufacturing liquidity.  Under a gold standard, if you don’t want to lug your gold around, weigh it for every transaction, slice it into pieces etc. you can take it to the bank and convert it into a more liquid form (bank notes) which are easier to use for transactions.

But this is not the only–or even the most significant–form of transaction cost that banks help people overcome.  For instance, if you are a shoemaker and you want to trade half the shoes you will make over the next twenty years for a house, you can offer this to the owner of the house but they will likely be reluctant to take it for several reasons.  For one, they don’t know you and don’t know if it is credible of you to promise this.  For another, they don’t want that many shoes and would have to be constantly re-trading them for the stuff they did want.

But you can overcome this by going to the bank.  The bank will verify your income, asses the value of the house and offer to lend you the money (or part of it) to purchase the house in return for a promise to repay some amount of money in the future or else lose the house.  You then trade this newly created money for the house.  The seller of the house now has an account representing the value of the house he just gave up which he can use to purchase other goods (including other investments) in whatever form or quantity and at whatever point in time he wishes.  You, on the other hand, are obligated to work (presumably producing shoes) for the next twenty years to get those dollars back to pay off your loan and keep your house.

So the question then is, why is the seller able to take those dollars and trade them to third parties for other goods?  The answer is that they know that somewhere out there is a guy who is obligated to produce shoes and trade them for those dollars in the future (as well as a bunch of other people producing other goods).  In this way, money is created by converting other real goods into a more liquid form.  This more liquid form of wealth then circulates in the economy in the way commonly understood and the willingness of people to hold it determines a velocity and a price level.  But that willingness to hold money, based on the belief that someone else will be willing to trade real goods for it in the future is “anchored” by all the people willing to trade “shoes” to get dollars and the rate at which they are willing to trade shoes is “anchored” to the rate at which they are contractually able/obligated to trade those dollars for their houses.  This rate, again, is nominally denominated and fixed (doesn’t fluctuate with market conditions or “confidence” in the dollar or anything like that).

So at any point in time there is some quantity of dollars circulating and there are people trying to get the dollars and “retire” them by paying off debt and there are people creating new dollars by securitizing new real assets and this determines the change in the quantity in circulation.  The CB can “steer” this quantity by altering the constraints on the creation of new credit (changing the money base for instance) or potentially by doing other things which I don’t want to get into.

Naturally, when someone enters into a long-term debt contract, they do so with some beliefs about market conditions in the future which will affect the price of the goods they intend to produce.  This depends largely on the rate of growth in the money supply relative to output and this depends on some belief about CB policy going forward.  Just how to model this becomes a complicated question which I will leave for another time but the central point remains that the real value of the dollar is inextricably “anchored” to real goods by these contracts.

This, I believe, is why we don’t see sudden losses of confidence leading to dramatic declines in the value of the dollar.  On the contrary, at times of financial panic (to put it dramatically) we tend to see the opposite.  People try to liquidate other assets and hold dollars, leverage dries up and we see defaults.  I suspect that if we drilled down, we would find that there are actually not enough dollars to pay off all the debt but doing so is not as easy as I first thought.

Finally, it should become clear how exchange rates are well defined here.  There are some quantity of US dollars circulating in the US which are “backed” by real goods in the US and represent claims on those goods and indirectly on the goods and services provided by the people holding the debt contracts on those goods.  This quantity along with the liquidity premium and associated velocity defines a price level in terms of US dollars in the US and the same process is going on in Canada with Canadian dollars.

When someone in Canada wants to buy shoes from the shoemaker in the US, they have to trade Canadian dollars for US dollars and vise-versa.  The flows of trade between the two countries, along with people speculating about future flows of trade and credit conditions in the two countries make a market for the currencies and the relative price is determined by supply and demand in that market in the way commonly believed.  But both currencies are “anchored” to real goods by debt contracts denominated nominally in their respective currencies and securitized by real goods.

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  1. J Thomas
    March 7, 2014 at 10:54 am

    First off, you have an important point when you pay attention to debt in connection to creation of money. People generally don’t pay enough attention to that part and it’s bound to lead to important conclusions.

    Let me see if I get your reasoning — you ask the question, why do people think fiat money is valuable? Why don’t they suddenly lose confidence in the money and stop using it?

    And your answer is that they have debts which must be repaid in dollars, so they scramble for dollars. Other people emphasize the other end of it, that they hope they can buy lots of stuff for their dollars. You point out that they have already bought stuff for dollars that they still have to pay for, so they have to get money to do it.

    I say that both of these are an issue of supply-and-demand. They need dollars, and dollars are hard to get. So they do the difficult things it takes to get them.

    And people are mostly trapped. If you go to your boss and say “I don’t trust dollars any more. I want you to pay me in swiss francs” he probably will not do it. His customers pay him in dollars. He takes the risk that his dollars will lose value. Why shouldn’t you take the same risk? If he agrees to pay you a set number of swiss francs per month, and the dollar falls in value, he’s essentially giving you automatic raises and he doesn’t wanna.

    If you get paid in dollars then you’d better hope that dollars are valuable. It’s out of your control.

    But if your pay gets adjusted for inflation, and the dollar inflates, you can be happy! Your fixed-rate mortgage is less of a burden every year.

    There have been one-company towns where employees were paid in company scrip, redeemable at the company store. Workers put up with it. They had no choice, if they wanted to work in that town they accepted the company money. And when the company store raised its prices? They put up with it. It was either take it, or walk out of town with a pocket full of company scrip and look for a new job somewhere else.

    And then when the unions came in and went on strike and one of their demands was to be paid in real money? When the company issues its own money it’s basicly a government, and the strike is basicly a revolution against that government.

    Asking why people accept the government scrip basicly boils down to asking why they don’t overthrow the government.

    Suppose people had a second currency available. Could they switch to it? Gresham’s law implies why they don’t. Government money slowly inflates. If the other currency inflates significantly less, people will prefer not to spend it. And if the other currency inflates significantly more, people will prefer not to accept it. Employees spend the currency they get paid in, and that will not be better than government scrip because employers have the advantage when bargaining with prospective employees.

    People tend to stop trusting the money around the time they think the government will fall.

    What else do we get from most of the money being debts? How about this — as a first approximation let’s say that every dollar in existence came from a loan. And let’s say the interest rate averages 5%. Then if all the loans get paid off, the banks increase their ownership of the economy by 5% per year. Why don’t the banks own everything by now?

    First reason — they pay out some of the profits as dividends to their owners who spend or invest the money. So it isn’t all compounded.

    Second reason — some of the loans do default.

    But it’s interesting that we pay something on the order of 5%/year to the banks for the privilege of using money.

    But then, credit card companies charge businesses around 2% per transaction to let their customers buy with credit cards. Not 2% per year, per transaction. If every sale was done by credit card, that would be 2% of GDP?

  2. Free Radical
    March 7, 2014 at 10:31 pm

    Thomas,

    Amazingly, you start out right there with me, then you go pretty far astray and then you manage to end with what I think is a very appropriate assessment of the implications of all of this.

    Some of the problems in the middle: Your boss may not be willing to pay you in Swiss Francs but you can take your dollars and immediately convert them to Francs if you want. You are not trapped in a particular currency by your boss’s insistence on paying you in it. If everyone tried to do this, the value of the dollar in francs would drop dramatically but if it go bad enough people would stop being willing to work for dollars. All of these explanations that amount to “you’re trapped in the currency because that’s what everyone else is doing” suffer from the same lack of credibility. It’s conceivable that you could believe them in the absence of a more compelling theory but I am offering a more compelling theory so I don’t think that we need to grit our teeth and swallow that kind of explanation.

    A company scrip (which I know nothing about the history of but I will accept your account) is different, it is not based on debt the same way that the dollar or the franc is, it is based on the expectation that the company store will continue to trade real goods for it at a given rate. In a sense, I think this is more like Koning’s money. But this is not a closed system. They get those real goods by trading the produce of the factory (or whatever it is) for some other currency and using that currency to purchase goods to sell at the store. Because the factory is profitable, this can be accomplished. If the prices at the store got too high (or if workers began to expect them to get too high in the future) then people would become less willing to work there.

    As I mentioned, banks are a productive enterprise. They produce liquidity. Liquidity is valuable and so they are able to make a profit at this. The amount of profit depends on the quantity of notes (money) they can float and the interest rate. The more they try to float, the less people will demand liquidity and the lower the interest rate will be. In a free market one might imagine equilibrium being one in which banks make the same profit as other enterprises (zero economic profit). It’s not a free market so what they actually make is determined by other things which are complicated. For more on this see this post (and the other posts in that series).008.

    https://realfreeradical.wordpress.com/wp-admin/post.php?post=1058&action=edit

    You are right though, (at least this is how I see it) that all the interest charged represents a large accumulation of real wealth in the banking system. The forms of “leakage” back into the rest of the economy are essentially what you say: banks spending those profits and defaults which wipe away debt without “retiring” the requisite quantity of money, so that some of the money created in the formation of that debt remains out there floating around.

    Regarding how much of the real goods of the economy banks “own” I suspect, if they all said tomorrow that they are going to stop lending and we’re gonna unwind the banking system and settle all debts, you would find out that they do own a very large amount of those goods. The distribution of this between the banks and the Fed and the government would be complicated to imagine but basically my point is that the value of the dollar is held DOWN by the expectation of future growth in the money supply through further expansion of credit. There is no danger (at least without a dramatic shift in the way we conduct monetary policy) of that value collapsing because expectations of the next guy’s willingness to accept it break down. On the contrary, there is some danger of it shooting UP if expectations of the continued expansion of credit break down and this is what we seem to observe in situations like 1929 and 2008.

  3. J Thomas
    March 8, 2014 at 12:36 am

    “Your boss may not be willing to pay you in Swiss Francs but you can take your dollars and immediately convert them to Francs if you want.”

    Yes, that’s true. And some people do that, with money they don’t want to spend. Notice that the more we do that, the easier it is for us to sell stuff to switzerland, and the harder it is for us to buy stuff from switzerland. A side effect of Americans holding swiss francs is to distort international trade. When we buy Swiss liquidity we must pay for it, and so we can pay for less other stuff.

    “You are not trapped in a particular currency by your boss’s insistence on paying you in it.”

    Kind of. Imagine that stores started listing prices in dollars and swiss francs both. And even without that you could trade swiss francs with your friends who also value them. But there would be that tendency to buy stuff with dollars as long as vendors accepted dollars, because it feels like it’s cheaper to buy with dollars. Savings in francs, spending in dollars.

    “If everyone tried to do this, the value of the dollar in francs would drop dramatically but if it go bad enough people would stop being willing to work for dollars.”

    Businesses would look for opportunities to sell to Switzerland. The more they could sell, the more francs they could get. But they’d prefer not to buy from Switzerland because things are too expensive there. Instead they trade francs at a premium for dollars and pay you with dollars. Then you trade your dollars for francs….

    If you can get a job with a Swiss company that finds cheap stuff to ship to Switzerland, they might very well pay you in francs. Great work if you can get it. And companies that sell mostly to the swiss might be willing to pay their employees in francs.

    This sounds a whole lot like what happened in the late USSR. The common people were paid in rubles, and they could buy common USSR-produced schlock in rubles. There were special stores that regular people were not allowed into, that sold imports and export-quality products for dollars. Only people who could get hard currency could buy there.

    If you visited the USSR you were required to trade dollars for rubles at the official rate. You could sneak in dollars and trade for rubles at a much higher illegal rate with practically anybody who didn’t think you were a snitch, and they thought they were getting a very good deal. Dollars could get them into the foreign-exchange stores.

    The late USSR might be a very good example. Most people were truly stuck with rubles even when they really didn’t want to be. They couldn’t trade rubles for swiss francs because first it was illegal and enforced, and second rubles were nearly worthless outside the USSR. All you could buy with them was citizen-class trash that nobody outside the USSR wanted. They were paid in rubles and they bought what they could with them. But party members and particularly valuable employees could get the good money and could buy in a different market entirely.

    “I am offering a more compelling theory”

    I keep missing something from it. Let’s review the bidding: Imagine you have a fixed-interest mortgage in dollars. But then all of a sudden the people around you stop believing in dollars. They switch to some other currency. Your employer is willing to pay you in the new currency. There is an exchange and you can get dollars. For the amount of new money that buys a loaf of bread you can get $500. Do you want to go back to dollars?

    I say no. Unless there are laws to protect lenders, every month you just peel off enough money to buy 2 or 10 loaves of bread, and get dollars to pay your mortgage. It feels just fine.

    So I say that if people were to decide that dollars weren’t worth much, the existence of a whole lot of dollar-denominated debt would not dissuade them at all. Except of course for the lenders who would be frantic that dollars should have high value. But if they could get laws that establish a good value in new money for their old loans, they wouldn’t mind either.

    Maybe this explanation will show you what I’m missing. I’m not saying you’re necessarily wrong, I’m saying that you haven’t explained it in a way I understand.

    • Free Radical
      March 8, 2014 at 7:10 pm

      “Maybe this explanation will show you what I’m missing.”

      Indeed, I think it does. You’re sort of thinking about it all wrong when you say “Do you want to go back to dollars?” It’s not about whether or not you want to go back to dollars. It’s not like we all get together every month and vote on whether to stay on the dollar or change to something else. The institution of the dollar is held in place by market forces. What you are saying is like saying “Imagine the price of apples went down, would you want it to go back up again?” Unless you are an apple farmer, everybody prefers lower prices and yet prices find some equilibrium level because there is someone on the other side (the apple farmer).

      The price of apples doesn’t fall below what it is because it doesn’t have to fall any lower to get people to buy what producers are willing to produce at that price. The point of the debt is that if the price of the dollar were to fall people would try to “peel off enough money to buy 2 or 10 loaves of bread, and get dollars to pay [their] mortgage.” And because there are a lot of people who are all trying to do that, the value of the dollar does not fall.

      • J Thomas
        March 9, 2014 at 2:10 am

        “It’s not about whether or not you want to go back to dollars. It’s not like we all get together every month and vote on whether to stay on the dollar or change to something else. The institution of the dollar is held in place by market forces. What you are saying is like saying “Imagine the price of apples went down, would you want it to go back up again?” Unless you are an apple farmer, everybody prefers lower prices and yet prices find some equilibrium level because there is someone on the other side (the apple farmer).”

        Yes. People put up with it because they have no better alternative and they don’t mind it so much. They are paid in dollars so dollars are what they can spend. If they were paid in something else they would convert to dollars as needed.

        “The point of the debt is that if the price of the dollar were to fall people would try to “peel off enough money to buy 2 or 10 loaves of bread, and get dollars to pay [their] mortgage.” And because there are a lot of people who are all trying to do that, the value of the dollar does not fall.”

        It depends. If people didn’t trust dollars but did trust something else, likely you could get your creditors to accept payments in the other currency because likely as not they wouldn’t trust dollars either. We’re talking hypotheticals here. We argue why is it that people don’t do something they don’t do, something that they have occasionally done with other currencies. If we were arguing about why the sky doesn’t suddenly turn green we could try out physics, but for the money we have to go with human nature and economic constraints which are somewhat less dependable.

        MMT guys claim that government creates demand for dollars by collecting taxes in dollars. I feel like that’s kind of bogus. Your claim that it’s because they can’t pay their debts without dollars looks somewhat better to me. It’s as good as the other side that says they can buy stuff with dollars, which I think is as true as yours — both go together. I think my claim that they are paid in dollars is part of it too. They could convert to something else at some rate and pay transaction fees, but when their creditors and their vendors accept dollars why bother?

        “And because there are a lot of people who are all trying to do that, the value of the dollar does not fall.”

        Usually the times people give up on a currency, there’s hyperinflation in that currency. The value does fall by supply-and-demand, so there aren’t enough people trying to get the currency to keep the value from falling.

  4. J Thomas
    March 8, 2014 at 1:23 am

    “…basically my point is that the value of the dollar is held DOWN by the expectation of future growth in the money supply through further expansion of credit.”

    Yes! This can happen with any commodity broker, and in most cases I consider it a moral hazard.

    If your broker holds your stocks, he has no obligation to return to you the stocks with the same serial numbers. He can buy and sell your stocks as often as he wants to, provided he can produce somebody’s stocks for you if you want them. He can let some other customer short your company, selling your own stocks. He can give them to a specialist to short. He can use your stock to drive down the price of your stock. Usually I would figure this is not in your best interest. You bought your stock hoping the price would go up, and he uses the commodity you trusted him with to drive the price down. Moral hazard.

    Your bank uses the money you trusted them with to inflate the money supply and make your money worth less. That might be good for the economy as a whole. If it turned out that it wasn’t good for the economy the bankers would want to do it anyway, because it’s how they make their profits.

    “There is no danger (at least without a dramatic shift in the way we conduct monetary policy) of that value collapsing because expectations of the next guy’s willingness to accept it break down.”

    I think they would have to mismanage things for that to happen. Or maybe our foreign creditors could do something. Like, imagine that the foreigners who hold dollars, probably led by China, started buying our commodities for export a whole lot. They bid up the price of oil to the point the USA became an oil-exporting nation. Bid up the price of wheat, corn, soybeans, coal, and took delivery. Do they have that many dollars? I don’t know.

    If they could, prices would rise because there would be less stuff to buy and more dollars to buy it with. It would be mostly export companies that had the dollars, and they could buy whatever they wanted while the rest of us would be in trouble. Say you have a job making wheat thins. If your company exports well then they will have the money to keep buying wheat and pay for shipping etc — they can keep paying you. Maybe they can pay you enough to keep gas in your car, or they can set up their own bus line to pick up their employees. But if they sell mostly to americans they’ll have trouble getting wheat or energy and they’ll likely shut down.

    I don’t know whether something like that could happen or not.

    “On the contrary, there is some danger of it shooting UP if expectations of the continued expansion of credit break down and this is what we seem to observe in situations like 1929 and 2008.”

    Yes. If we didn’t have banks we would have created some workaround that would let us get by without inflated money. When we do have banks, once every long generation they pull the rug out from under us. In the process some banks go broke while others get richer. It’s easy for me to imagine a conspiracy among the bankers who win, but I have no proof.

    • Free Radical
      March 8, 2014 at 7:42 pm

      I think you are abusing the term “moral hazard.” I’ve never heard of a stock broker being unable to produce the stocks owned by their clients. Assuming they have the assets to produce them when you demand them, whatever they do with the specific numbered stock certificates in the meantime, they bear the risk for (which is the crux of moral hazard). I suspect if you wanted to hold your certificates yourself you could demand them.

      “Your bank uses the money you trusted them with to inflate the money supply and make your money worth less.”

      I talk about “the bank” creating money because, as I said, I am using this bank to represent the banking sector. In reality, no individual bank determines the total quantity of money, this is determined by the Fed. The individual banks are just competing with each other over who will get to create that liquidity. If you are “trusting” the bank not to lend your money, you are terribly confused about what banks do. This is the whole point of banks. Everyone (who is paying attention) knows what is happening and aught to expect the effects of it when making financial decisions. (Obviously we have to try to guess what the Fed will do but the individual banks are just doing what banks do.)

      “If we didn’t have banks we would have created….” banks!

      • J Thomas
        March 9, 2014 at 2:49 am

        “I’ve never heard of a stock broker being unable to produce the stocks owned by their clients. Assuming they have the assets to produce them when you demand them, whatever they do with the specific numbered stock certificates in the meantime, they bear the risk for (which is the crux of moral hazard).”

        Since we’re talking about morality there’s always room for disagreement. But let’s look at what happens.

        Say I want to invest in gold. I go to the gold market and buy some. For convenience I leave it with my broker. I want the price to go up, if it goes up enough that I think it’s overvalued I’ll sell it and buy something else, and maybe buy more gold when the price comes down to something more reasonable.

        A bunch of other people are doing the same thing. They buy gold when they think the price is low, and sell when they think it’s high. The price will stay around where they think it ought to. If nobody’s buying or selling, it means the lowest one who has gold and thinks the price is too high has already sold to the highest one who wants gold and thinks the price is too low. All’s right with the world. If somebody wants gold they can bid the price higher.

        If everybody’s reasonable like that, then the market maker can’t do much. He can announce that the price is higher, and some people will sell gold to him. He’ll have more gold and less money. Then if he announces the price has gone down, somebody will buy gold from him. He’ll have more money and less gold, and less of both than he did before.

        But if there are people who are affected by the market, the market maker can manipulate them. He can sell gold he doesn’t own to drive the price down, and if people then get discouraged and sell then he drives the price back up. Enthusiastic investors come in and buy gold while the price rises. The market maker profits very well by introducing artificial instability. He does it by selling virtual gold. When nobody wants to sell, he can sell their gold anyway. He drives the price down. Officially one of the virtues of the market is liquidity — I can sell any time I need to. If I need to sell when he has artificially driven the price down I lose big because of his actions. Is that fair to me?

        The broker’s argument is that liquidity is increased. “There’s only so much gold in the world, and all of it that we know about belongs to somebody. If nobody wants to sell there’s no market. So by selling gold when nobody wants to sell, I make sure that anybody who want to buy gold actually can buy gold.” But when I own gold, I say that if somebody wants to buy it from me all they have to do is offer a price that I will sell at. My broker has no right to sell when none of the real owners want to, at a price lower than any of them want to sell at, hoping they will get so discouraged by his tricks they will sell out at a loss and let him win big.

        When it’s banks, everybody knows the bank lends their money. But most of them think it’s just lent once. I don’t think very many people understand that by the simple oldfashioned reasoning from reserves, that bank is lending your money 4 or 5 times so that by supply-and-demand your money is worth 20 cents on the dollar compared to what it would be without bank lending. And they don’t know that with the Fed it’s far worse than that.

        It could be argued that morally, a bank charter is literally a license to steal.

        “If we didn’t have banks we would have created….” banks!

        Maybe not. In engineering there’s usually more than one way to design a solution. Some are better than others, but often it isn’t at all obvious that one is best.

        There might easily be alternatives that would give us similar advantages without the glaring disadvantages of banks. But first we have to decide which advantages we want.

        Advantages of banks include:

        1. Inflate the money supply. I think we want this sometimes.
        2. Deepen the business cycle. Schumpeter argued that the business cycle is good for us, but we need to consider how intense we want it.
        3. Provide lots of money to bank stockholders. Society might be better off if we maintain a leisure class that spends a lot of money, we need to consider how large and how rich it should be.
        4. Provide loans to people who will go bankrupt. It isn’t clear whether banks do enough of this. We need speculative businesses that are likely to fail, but how many?
        5. Reduce corporate profits. Businesses need to borrow money at interest rather than retain profits to grow. If they retained profits and financed their own growth who knows what awful things would happen?

        Are there other advantages I have left out?

  5. J Thomas
    March 8, 2014 at 1:16 pm

    Partly inspired by your ideas, I tried to imagine something that is not exactly like money, but that has some of the same uses. I imagined a barter system where everybody can *sort of* coin their own money. No stock of money issued by anybody, nobody trying to manage inflation or deflation, no concept of persistence of money. I don’t know whether thinking about it would help clarify your ideas about real money, but I welcome you to try.

    http://pragcap.com/forums/topic/imagine-barter#post-62069

  6. March 9, 2014 at 12:51 pm

    “but the central point remains that the real value of the dollar is inextricably “anchored” to real goods by these contracts.”

    Yep, I agree with this. It sounds very similar to some of the ideas that Mike Sproul advocates, a frequent commenter on my blog.

    (I agree with it, but have reservations about the use of the word “dollar”. There are many types of dollar: Fed dollars, Bank of America dollars, MtGox dollars)

    But you’ve been sidestepping monetary policy — how the Fed increases/decreases the price level. That will probably reveal differences.

    • Free Radical
      March 9, 2014 at 7:25 pm

      By the way, I am (at least somewhat) familiar with Mike Sproul’s theory. I had a back-and-forth with him last year about it.

      http://realfreeradical.com/2013/04/03/why-is-fiat-money-valuable/

      It’s funny because I think his theory is basically the same as yours (the money is backed by the assets on the CB’s balance sheet). Here is what I said and his response.

      Me: it differs from Mike Sproul’s theory (at least as I understand it) in that he seems to assert that the assets backing the dollar are the assets of the Federal Reserve which are financial assets, meaning they are dollar denominated themselves. As I briefly mentioned in the intro, this does not get us out of the fiat money paradox because if the value of a dollar collapses in real terms (the quantity of real goods people are willing to trade for a dollar falls dramatically), then the value of these dollar denominated financial assets will fall equally dramatically.”

      Other Mike: The backing theory does require that at least some ‘real’ assets back the dollar, but it’s OK if some of the assets are dollar-denominated.

      Then there was a long series of “examples” and I don’t think either one of us changed our minds very much (although my thinking was a bit different then than it is now). The problem with all of these theories is that they want to explain the value of the money by looking at the balance sheet of the CB. The CB matters but it is part of a larger banking system. Once you look at the system as a whole, it is easy to see the connection to real assets. The economy is full of contracts linking dollars to real assets at specific “conversion” rates which are the “equal and opposite” reaction to the creation of money. But they are not on the CB’s balance sheet so they seem to get overlooked.

      • March 11, 2014 at 1:01 am
      • Free Radical
        March 11, 2014 at 2:44 am

        Yeah, he’s got the right idea about the nature of money. Thanks for sharing the link. I don’t think his model does much other than illustrate the idea (for instance, determine a price level, velocity, money supply, inflation, interest rates, or explain how monetary or fiscal policy work, or the business cycle). Why didn’t you demand that HE explain these things?

        [Note: that last question is a joke, don’t answer it. I really appreciate your input. Something on monetary policy tomorrow.]

      • March 11, 2014 at 7:22 pm

        I figured you’d like it.

        What do you think of my old post, the yellow certificate example?

        http://jpkoning.blogspot.ca/2013/01/how-do-legal-tender-laws-affect.html

  7. Free Radical
    March 9, 2014 at 6:56 pm

    Ok, I will get to that. I think it will reveal mainly differences in the way we look at it. For instance, I still think that (at least in normal times) when the CB expands the base, it is expansionary and so forth.

    As far as different kinds of dollars, I don’t disagree in principle, a deposit account with BofA is slightly different than a deposit at Capital One which is slightly (but more) different than cash. They will all have slightly different liquidity characteristics and risk associated with them and if you are trying to explain why the values (including interest rates) of these different “dollars” are different and why people choose to hold one over the other, then this stuff is important. But that’s not what I’m after, I’m trying to explain the price of apples, shoes, houses, etc. in terms of “dollars.” In most cases all of these dollars are convertible into one another at par and the prices of all of these goods in dollars are the same regardless of what kind of dollar you use. So I think lumping them together in the way I am is appropriate for talking about the price level.

    Incidentally, it is the power to create these “dollars” (slightly different though they may be) which are convertible into all other forms of “dollar” (by my definition) which is the primary difference between banks and nonbanks. I could print up some “Freimuth dollars” and lend them to you but if you tried to deposit them in your bank or buy anything with them I suspect you would have some difficulty. In order for me to give you a loan, I would have to get my hands on some existing “dollars.”

    • J Thomas
      March 11, 2014 at 3:52 pm

      I could print up some “Freimuth dollars” and lend them to you but if you tried to deposit them in your bank or buy anything with them I suspect you would have some difficulty. In order for me to give you a loan, I would have to get my hands on some existing “dollars.”

      The banks have a network. Traditionally if you tried to deposit a check from one bank into another bank, you had to wait 3 days or even longer for it to clear. You couldn’t get your money until your bank verified that the other bank had actually paid.

      “Freimuth dollars” would amount to checks signed by you. Once that legal relationship was established banks might accept them after the delay to establish that you had paid.

      Anything that’s convertible to dollars is as good as dollars, not counting exchange costs and changes in exchange rate.

      But the big difference between banks and nonbanks is that banks have the legal right to be banks. They have the legal right to create money out of nothing and lend it, provided they follow certain rules. By some ways of thinking they have the legal right to make counterfeit money.

      A bank charter is very very valuable. You can’t get one.

  8. Free Radical
    March 11, 2014 at 6:35 pm

    “They have the legal right to make counterfeit money.” That is a contradiction in terms. In order for the bank to take my check I have to have an account with “dollars” in it. I can’t just make them up and lend them to you and you deposit them in your bank. A bank can do this.

  9. J Thomas
    March 12, 2014 at 11:35 am

    Free Radical :
    “They have the legal right to make counterfeit money.” That is a contradiction in terms.

    They have the legal right to do it. The difference is, when you counterfeit cash you have to actually print it and pass it to somebody. Banks never have to show anybody the money they create.

    Also it’s legal for them to do it. If you tried to do what banks do, it would be a crime and you would be jailed for it. Because it’s a crime when you do it. You would be stealing. But banks have a license.

    • Free Radical
      March 12, 2014 at 8:52 pm

      I think we are saying pretty much the same thing here we are just arguing about how to say it. The word “counterfeit” implies illegality but your basic pint is correct, it is illegal for me to produce “dollars” and it is legal for the bank (my original point). For the record, it is legal to create some forms of private currency (ebay bucks for instace) it only becomes “counterfeiting” when you try to pass them off as “legal tender” (bank money).

    • Free Radical
      March 12, 2014 at 8:53 pm

      Reflecting on that last comment, ebay bucks may not be the best example of private money because they expire and as far as I know there is no market for them but there are other better examples.

  1. March 12, 2014 at 12:26 am

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