Archive for June, 2014

A Model of All You Can Eat

June 20, 2014 3 comments

Frances Wooley has a post about all-you-can-eat sushi.  It was meant to illustrate a broad, overarching truth about economics.  That point is valid, but the discussion got a little sidetracked by the al-you-can-eat-sushi issue.  Since this is the kind of thing I am actually trained in (as opposed to monetary economics which I am basically absorbing/making up as I go along), I figure I will interject myself.  I tried to explain it in the comments but I need a bit more space to really knock it out of the park.  Here it goes. Read more…

Categories: Uncategorized

(More on) Endogenous and Exogenous

I might have gotten a little too cute in the last post and failed to make some of my simple points as simply as possible.  So let me take a different approach.

The status of something as either endogenous or exogenous is not a state of nature, it is a characteristic of a particular model.

There’s your thesis statement right up front in bold print.  Now I will try to explain with the simplest possible example.

Usually the first model we teach econ students is a simple model of consumer choice.  In this model, the price is taken for granted and we determine how many units a consumer would buy given the price and their MV schedule.  In other words, price is exogenous and quantity is endogenous.  We do the same thing with sellers, determining how many they would be willing to sell (or produce) for a given price.  Then we derive demand and supply schedules by determining how many people would buy/sell for any given price.  At this point, we have two models: a model of buyer behavior in which the price is exogenous and quantity demanded is endogenous and a model of seller behavior in which the price is also exogenous and quantity is also endogenous.

But then we put those two models together to determine a market price and quantity.  Now it is a different model!  We added the condition that Qs=Qd and this is only possible at a particular price.  The (equilibrium) price is now endogenous!  But we got there by assuming that all market participants treat the price as exogenous.

Now, if you ask: “well which is it, is price endogenous or exogenous,” you are asking a nonsensical question.  In the model which is designed to explain the determination of the price, it is (necessarily) endogenous.  In the model which is designed to explain the behavior of an individual, it is exogenous.  Neither model is “right” or “wrong” they are just useful or no useful, and in my humble opinion, both of these are quite useful.  It so happens that the latter is useful in constructing the former.

This is how economics generally works.  We start with the simplest questions we can and then we put them together to answer more complicated questions.  As you get more complicated (add endogenous variables to explain) you need more layers of reasoning and exogenous information.  In order to say how much someone would buy, you need a price and a MV schedule (or function).  Ditto for how much someone would sell.  If you want to make price endogenous, you need both the MVs of buyers and the MCs of sellers and you need the condition Qd=Qs.

So there is nothing inherently incorrect about constructing a model of the macroeconomy in which the quantity of money is exogenous.  We just have to understand that such a model does not explain the quantity of money.  Similarly, we can make a model that takes the price of money (the interest rate) to be exogenous and this allows us to say, to some extent, that we are “explaining” the quantity of money but then we aren’t explaining the interest rate.  And if our “explanation” of one or the other comes down to a downward sloping demand for money and a monetary authority who choses one or the other, it doesn’t matter much which one we say that they choose.

The real question is “is this model useful?”  When it comes to the standard model of money and banking, I say “yes, but it could be better.”  I agree that the mechanism which determines the quantity of money matters and a careful treatment of it is missing from mainstream models.  But it is not a question of being endogenous or exogenous, or even worse: “supply determined” or “demand determined.”  If you just say that the CB sets the price of money and not the quantity, and you are ignoring the fact that the quantity “demanded” depends on the price, then you are not saying anything helpful.  If you are saying that the CB controls the price of money but not the quantity, and you are recognizing that the quantity demanded depends on the price but only via the same downward sloping demand curve as in the model you are criticizing, you aren’t saying anything helpful either, you are just saying the same thing you are criticizing in a slightly different way.  If you are saying that money is “demand determined not supply determined” you don’t understand supply and demand.

If you want to say something useful, you need to add a dimension to the model that better explains how the price and quantity are determined and takes into account some additional information that is overlooked by both assuming that the CB sets M and the interest rate is determined by Md and assuming that they set the interest rate and M is determined by Md.  In short, if you want to make something endogenous, without just making something else exogenous, you have to add something else that is exogenous and plug it into the system with some kind of meaningful equation.

So you can make money endogenous simply by making the interest rate exogenous but this demonstrates nothing interesting.  Alternatively, you could make both M and i endogenous by adding something else like a (less trivial) money supply curve but then you would have to say where that comes from and why it makes sense to do it that way and why it matters.  Just declaring that in the “real world” money is endogenous gets us nowhere.




Categories: Macro/Monetary Theory

Endogenous or Exogenous Money

June 15, 2014 27 comments

There are quite a few arguments in economics which are entirely superfluous.  One of them is over whether central banks determine the money supply or whether it is determined by the banking sector.  I have dealt with this previously (following along on the coat tails of Rowe and Sumner) but as I work through Keen’s lectures on “endogenous money” (see primarily 06 part 2 and 07 part 1) I can’t help but notice that this issue seems to be central to much of his criticisms of mainstream economics.  So in pursuit of my ultimate goal of rescuing the theory of money and debt from the Marxists–er, I mean “post Keynesians”–and folding it somehow neatly into regular old-fashioned economics, let me first address this whole endogenous/exogenous ball of wax.

The first problem with this debate is that it usually begins with a misunderstanding of the significance of those terms.  Endogenous and exogenous only have meaning in the context of a model.  A model can be designed in such a way that it treats something as exogenous, meaning that the determination of it is not explained in the model but taken for granted, or it can be designed in such a way that that thing is endogenous or determined in the model.  Neither one of these is right or wrong.  In the real world, everything is endogenous (except the laws of nature and some set of initial conditions).  Of course, if we are trying to demonstrate how or why a thing is what it is, we have to make a model in which it is endogenous or we are just saying what it is without adding any additional layers of logic to justify it.

Now keen characterizes the debate as over money being exogenous to “the economy.”  However, I think most staunch “exogenous money” types would still agree that the behavior of the central bank depends to some extent on conditions in the economy.  So, in some sense, as I said, everything is endogenous.  But let’s be honest, that is dancing around the issue.  The real question is what is the best way to model monetary policy.  It is hard to make a model where everything is endogenous.  And monetary policy, at least in theory, could be conducted independently of other conditions in the economy.  And furthermore, a large part of what we are usually trying to determine/demonstrate is the effect of monetary policy.  So it makes sense to treat this, somehow defined, as exogenous.  The question then becomes how to define it.

At this point, we arrive at the real crux of the matter.  The exogies claim that the central bank determines the quantity of base money and then the market determines the rate of interest.  The endogeroos insist that it is the other way around and the central bank merely determines the rate of interest and then the economy determines how much base money is needed and the central bank supplies it.  Now we have a report from the bank of England which tells us that what banks really do is the latter.  But the problem with Keen’s exposition on the subject is that he seems to act as though the rate of interest set by the central bank has no effect on the quantity of money which is thusly “endogenously” determined.

Essentially, this boils down to a common “paradox” in principles classes.  Does the monopolist take price for granted and choose a quantity or take quantity for granted and choose a price?  Answer: No.  The monopolist takes the demand curve for granted and chooses a price/quantity pair along that demand curve.  And so it is with the monetary authority, at least in the short run.  In the long run, there is a sort of supply and demand for money, though it is difficult to characterize them precisely.  The supply takes the form of some kind of reaction function by the central bank specifying either the quantity of money they will provide (if you are an exogie) or the short-term interest rate they will charge (if you are an endogeroo) under all possible economic scenarios.  The demand can be thought of as the quantity of money “the economy” will “demand” at any given interest rate (if you are an endogeroo) or the short-term interest rate that they will bid up to for any given quantity of money (if you are an exogie) under any given set of economic circumstances.  These two then interact in a very complicated way to determine the interest rate and the quantity at any given moment and market expectations of them at all points in the future which are represented by prices (including various interest rates).

Now, is the quantity or the price (interest rate) endogenous?  Answer: yes.  Better answer: they both are, of course, that’s supply and demand 101, can we get some harder questions in here?

So for most practical purposes, this distinction doesn’t matter.  It becomes the horizontal/vertical supply curve debate which Keen alluded to but I didn’t see him address (maybe he did it earlier).  That might make a difference for some minor reasons like the effect of misestimating demand or of changes in demand in the ultra-short run (faster than the CB can adjust policy) but as far as the big picture is concerned, this is a smokescreen.

But Keen seems to take it a step further than just arguing about what I would consider a bit of meaningless minutia.  He seems to be implying that monetary policy in general is not exogenous.  Which, in this context, since we know that the CB has the ability to determine monetary policy independently of what is happening in the economy, amounts to the statement: monetary policy is meaningless.  Here is the argument “in a nutshell.”  For the record, Keen is quoting Basil Moore.  By the end, the astute observer, thoroughly trained in sound “neoclassical” economics should see the flaw in this reasoning leaping off the page (or screen, as the case may be).

“Changes in wage and employment largely determine the demand for bank loans which, in turn determine the rate of growth of the money stock.

Central banks have no alternative but to accept this course of events, their only option being to vary the short-term rate of interest at which they supply liquidity to the banking system on demand.

Commercial banks are now in a position to supply whatever volume of credit to the economy that their borrowers demand.” (Moore 1:3-4)

In a nutshell

-The supply of money and credit is determined by the demand for money and credit.  There is no independent supply curve as in standard micro theory.

-All the state can do is affect the price of credit (the interest rate).

Did you spot it?  Here’s a hint: a monopolist doesn’t have a supply curve.  Does that mean the monopolist’s quantity is determined only by the demand curve?  No, because the monopolist can control the price.  But wait! says the smart kid in the front of the class.  If he doesn’t have a supply curve, and he is facing a given demand, and he controls the price, then isn’t he effectively choosing a quantity?  Like, couldn’t we just as easily say that he controls the quantity and the price is determined by the demand curve given that quantity?

Yes! Bonus points for the smart kid who doesn’t need them anyway!  Now all of the other people in the class hate your guts even more, congratulations!  A demand curve can’t determine a quantity all by itself.  There has to be something else determining which point along the demand curve we are at.  You can say that the central bank sets the price and then the demand curve, along with that price determine the quantity.  If you say that the CB sets the quantity and the demand curve, along with that quantity, determines the price, it’s not really different (assuming the demand curve is fixed and the CB knows what it is.  No doubt, Keen would say “well those assumptions aren’t true so your whole theory is garbage” but those are at best second order concerns).

Keen’s (and I guess Moore’s) mistake is to ignore the effect of controlling the price of money (interest rate) on the quantity demanded.  He acts as if this is a meaningless novelty.  But if the demand curve is downward sloping, this is everything.

Furthermore, the Keen/Moore theory has a gaping hole in the middle of it.  He claims that the money supply doesn’t “cause” price increases but that price increases cause an increase in the money supply.  But that leaves us with no way of determining a price level (or a change therein).  By the way, this is why it’s hard to make a model where everything is endogenous.  What determines all of them in that case?  Each exogenous variable you want to make endogenous requires another equation to identify it.  This presents problems if you are trying to have all of your equations make sense for some reason.  On the other hand, if you are just assigning arbitrary relationships between variables and calibrating them to fit the data, then no problem.

Finally, Keen begins with an empirical analysis by Kydland and Prescott which apparently finds evidence that changes in the money base lag the business cycle while changes in credit money (M1-M0) lead the cycle.  This is not surprising to me and fits with my view of the role of credit and monetary policy in the business cycle (which, for the record, I think has a lot of overlap with Keen’s view) but this does not prove that one causes the other.  The flaw is in Keen’s notion that if X follows Y, X couldn’t have caused Y (and therefore by implication, Y must have caused X).  Though he does make some equivocations for this, I think it shows what happens when you try to strip the “agent” out of economics, which seems to be Keen’s overarching mission.  You treat relationships between variables like the sterile cause/effect relationships that underlie most of the hard sciences.  The rate of acceleration due to gravity (near the earth’s surface) just is what it is and it is just a matter of measuring it.

In economics, things are seldom that straightforward.  Because you are modeling the behavior of thinking people, they have the ability to anticipate things that will happen in the future and this affects their actions today and in turn affects what happens in the future, just like those movies in the eighties with Michael J. Fox, it becomes a whole confusing mess with paradox on top of paradox that is difficult to sort out.  Or, to put it in the words of Scott Sumner quoting Paul Krugman: “it’s a simultaneous system.”

Holy Marxism Batman!

June 10, 2014 2 comments

Well my intellectual odyssey regarding the nature of fiat money has taken a dramatic and hilarious turn.  Thanks to Nick Edmonds, after months (years?) of shouting crazy theories about money and debt into the internet, I have finally come across the right words to type into Google that lead to other people who have been saying this type of thing for  a while now.  Those words are “monetary circuit theory.”  Go ahead give it a try.  Doesn’t sound hilarious so far?  Well I haven’t gotten to the punch-line.  It turns out these people are pretty much all Marxists.

Man, didn’t see that one coming.  So the bad news is, I have to admit that Marxists (some Marxists) got something right.  But the good news is that, being Marxists and all, they seem to have a lot of issues to work out that I can probably help them with.  Of course, they may not want my help but that’s beside the point.

For instance take Steve Keen who appears to be the main circuit theory guy out there right now.  I still don’t know a whole lot about him but I’ve been working through his lectures on endogenous money on youtube and I don’t know if he would call himself a Marxist but it’s pretty clear that he has a lot of gripes with “neoclassical economics” (which is what I would call “economics”).  He also has a lot of nice things to say about Marx, including that we should all read Marx and he has a lot of not-so-nice things to say about Adam Smith and David Ricardo.  Also, by the end of the second lecture he clearly establishes that he is on the wrong side of the fundamental divide between Marxists and “mainstream” (or “neoclassical”) economists.  I will get to that in a bit.  Also, he is being paid by George Soros.

Here are the lectures I have watched so far.

Lecture 07 part 1

Lecture 07 part 2

Lecture 08 part 1

Lecture 08 part 2

I tried to start with lecture 01 but about fifteen minutes in he started telling me how the normal consumer choice model is nonsense by pointing out how many bundles a consumer would have to keep track of in order for the completeness assumption to hold.  At that point I decided to skip to the part about endogenous money which kicks in at number 7 in order to keep so much blood from shooting out of my eyes that I could no longer maintain consciousness. (I am resisting the urge to go off on a tangent about how that is a silly argument) In these lectures there is some really great stuff and some not-so-great stuff and I will delve into these issues in the near future.

Steve’s main point seems to be that the problem with economists is that they aren’t equipped with the analytical tools that engineers use.  I would say this is partly a valid point although there are a lot of truly dynamic mainstream models so I think he is exaggerating the ignorance of the profession to some degree.  But in trying to make economics more like engineering, he basically strips all the economics out.  What I mean by economics is any sentient being making a choice between different alternatives.  This is not totally surprising considering the reckless abandon with which he began tearing down the established principles for modeling such choice at the very beginning.  It’s a lot easier to make superficial criticisms of the assumptions other people have to make to get a model to work.  It is a lot more difficult to come up with an alternate way of modeling it without making those assumptions (or others that would be vulnerable to similar criticisms).  So just take that out and make a model of flows where you just say how the flows depend on variables and it’s totally arbitrary.

And yet, like I said, there is some great stuff in there.  We just have to take the great stuff and try to work it into mainstream economics.  I think it can be done.  Probably not by Marxists but luckily I’m on the job now.  So we’ll see how that goes.  For right now let me tackle an issue from the last lecture linked above (08 part 2, about 15 minutes in) which is just too egregious to let stand.

The issue is a quip about climate change.  But let me say up front that if you read the following and find yourself arguing with me about climate change you are missing the point.  This is about models, economics, and intellectual integrity.

Physicists learned as a fundamental law of reality, what’s known as the second law of thermodynamics.  And that’s a true law.  Economists have all these crazy laws like the law of one price saying that a good costs the same all over the planet–garbage.  It is violated all the damn time.  You cannot violate the second law of thermodynamics.  And that basically says that the amount of disorder in the world increases over time.  Entropy being a measure of disorder.  And production involves going in the opposite direction, you take raw materials and you transform them into something as elaborate as a computer which is obviously getting more order over time.  Now for that to occur and still live within the second law of thermodynamics, there MUST be a greater offsetting increase in disorder.  And that’s where pollution comes from, pollution, waste energy and so on.  So necessarily, to get that local increase in complexity and a decrease in disorder, an increase in order, there has to be overall increase in entropy.  And that’s our link between what we do in production economics and what’s happening in the biosphere.  It’s necessarily, unavoidably true, which is one of the reasons I find the climate skeptics a bit on the silly side.

Now I don’t know much about thermodynamics but I happen to know quite a bit about the law of one price and the law of one price does not say that the price of a good should be the same all over the world.  It says that it should be the same in a given market.  Exactly what a given market means is somewhat open to interpretation.  This is a law derived within a particular model.  And the assumptions of that model are that there are no transaction costs, imperfect information or other frictions involved in trading.  These are not assumptions because they are true, they are assumptions because assuming them allows for the creation of a model which yields some results that are helpful when thinking about how things work.

Even a clumsy interpretation of the law of one price would hold that the same good in different places can have different prices (which I am assuming is what he mans by “cost”).  A careful interpretation would hold that if we observe the same good selling for different prices, we must be observing one or more of the assumptions of the model being violated.  So Keen is two degrees removed from a proper characterization of the law.  But surely this is just because economic laws are all garbage, not like the “true laws” of the hard sciences.  It must be that Keen is so used to dealing with “true laws” that he can’t wrap his mind around the significance of these crazy economic laws that are always violated because they only hold under a set of assumptions that are almost never strictly in effect.

Now I’m no physicist but it seems to me like we have observed things getting more complex here on the blue marble.  Even if you take humans, with all of our productive activity, out of the mix, what about all this life I’m looking at?  Isn’t a duckbilled platypus a higher level of order than rocks and water and primordial ooze?  So I kind of felt like this second law of thermodynamics was being violated all over the damn place.  And (rather than just declaring the law garbage) I figured he might be mischaracterizing it.  After all, he had just demonstrated a propensity to do this.  So I did a (very) little research on the topic.  Turns out Wikipedia can sort this out in about two minutes.

Naturally, I started at the “second law of thermodynamics” page.  You only need to read the first sentence.

The second law of thermodynamics states that the entropy of an isolated system never decreases, because isolated systems always evolve toward thermodynamic equilibrium, a state with maximum entropy.

When I saw that, I was pretty sure I could see the problem already.  I wasted a couple minutes trying to figure out exactly what entropy means (I still don’t know) and then I clicked on “isolated system.”  Again, read the first sentence.

In physical science, an isolated system is a thermodynamic system which is completely enclosed by walls through which can pass neither matter nor energy, though they can move around inside it. Or it is a physical system so far removed from others that it does not interact with them, though it is subject to its own gravity.

Does that sound like the Earth to you?  If it does, you probably haven’t noticed that big orange ball in the sky which is constantly blasting in energy (not to mention having a gravitational influence).  So wait, doesn’t that mean that the second law of thermodynamics is dependent on a set of assumptions that don’t apply to the case under consideration?  Yes, but at least he is being consistent.  And in fact, if you read down a couple of paragraphs, you find this little gem.

Because of the requirement of enclosure, and the near ubiquity of gravity, strictly isolated systems do not occur in nature. They are thus hypothetical concepts only. Sometimes people speculate about “isolation” for the universe as a whole, but the meaning of such speculation is doubtful.

. . .

The concept of an isolated system can serve as a useful model approximating many real-world situations. It is an acceptable idealization used in constructing mathematical models of certain natural phenomena; e.g., the planets in our solar system, and the proton and electron in a hydrogen atom are often treated as isolated systems. But from time to time, a hydrogen atom will interact with electromagnetic radiation and go to an excited state.

So really this law is a conclusion reached under a set of assumptions that never actually hold, in order to illustrate some interesting point that helps us understand how actual systems work and therefore, in practice, if you try to just go around applying the conclusion to everything without paying attention to the assumptions and what the model (and therefore the law) actually means, you can’t help but find that it is violated all over the damn place.  Or in Keen’s words, the law is “garbage.”

So he is being consistent in the sense that he is mischaracterizing the meaning of these laws as they relate to the real world.  But he is being inconsistent in the sense that with the law of one price, he fails to observe what he incorrectly says the law implies and concludes that the law is garbage.  In the case of the second law of thermodynamics we fail to observe what he incorrectly says the law implies and he chooses to not believe the observation but rather to simply assume that there must be some other unobserved consequence which is more significant (somehow measured) than the observed increase in order.  It is not necessary to actually observe this because, after all, it’s a law!  And of course, I mean a real law, not like one of those garbage economics laws with all their false assumptions…

And this, is the fundamental divide between Marxists and “neoclassical” economists.  We assume that production and exchange are (or at least have the potential to be) constructive in the sense that everyone can benefit.  Or you might say, it increases order (though these are not really the same issue, they are somewhat analogous).  This comes from the concept of subjective value which implies that people can value goods in one form more than another (production) or one person can value certain goods more than another (exchange).  There is a lot of reasoning behind that framework but ultimately, every model has to start with some set of assumptions and in this case they are related to this notion of subjective value.

On the other hand Marxists assume that this trade and production is redistributive at best and often that it is actually destructive.  This is an assumption (just like the opposite view which I hold) and there are different ways of characterizing it.  Originally, it was based on the labor theory of value which holds that there is an objective value of everything that is based on the amount of labor it takes to produce it and this is attached to the item, not to individuals who want the item.  This means that it is the same for everyone which means that there are no possible benefits from trade.  And that single fact changes everything about the way Marxists see the world. 

In this case, we have an example of an entirely different approach where Keen is literally just assuming that everything is inherently destructive citing (erroneously) the second law of thermodynamics and taking any notion of value (economics) entirely out of the equation.  But the effect is the same, you reach the “conclusion” that improvement is impossible, only degradation and this paradigm undermines the entire foundation of mainstream economics.

So what needs to be done here is becoming pretty clear to me.  We need to rescue the good parts of monetary circuit theory from this Marxist quagmire and try to include some actual economics where there are some people making rational decisions and there is the potential for real gains from trade.  Stay tuned for that.

The Money Contract

June 7, 2014 2 comments

I seem to look at money differently from most monetary economists.  I think it is because I took an unusual path to the issue.  I always thought that the treatment of money and macro in school didn’t make sense.  I thought the things that they assumed seemed wrong but I didn’t have any better ideas so basically I figured they probably know what they are doing and I just didn’t get it and it and I distanced myself from it by taking a micro path through grad school, studying things like industrial organization, property rights, game theory and contract theory.  Then, being a staunch libertarian, I sort of got drawn into the whole Austrian thing that happened after 2008 but (luckily) I had enough training by that point to realize there are a lot of problems there.  But that got me thinking about things like money and inflation and interest rates and then one day I had a sort of epiphany.

I thought that might allow me to make sense of a lot of the macro that didn’t quite seem right before, and frankly, I figured that I would discover that everyone else knew what I just figured out all along.  The first part of that did work out but after spending quite a bit of effort trying to confirm the second part, I am becoming more and more confident that the profession as at large is suffering under a particular misconception–a sort of mythology–that is highly problematic.

This mythology can be summed up in the words of Narayana Kocherlakota.  “But of course, money itself is intrinsically worthless.”  This is a deeply ingrained belief that everyone from top economists to conservative talking heads seems to take for granted.  But it is complete nonsense.  The misconception has two dimensions.

1.  “Hard” money

[This is a bit of a rehashing of my last post.]

Here is Scott Sumner on gold as money.

We all agree that gold need not be “backed” to have value.  The QTM implicitly thinks of cash as a sort of paper gold.  It’s a real asset that has value because it provides liquidity services.

The implication being (at least it seems to me, maybe I am misinterpreting him) that gold would have no value if it were not used in exchange (providing liquidity services).  This I think is clearly not the case.  Rather than reinvent the wheel here is what I said about it in the last post.

Here is one possible scenario:

Imagine we are in a primitive society with some knowledge of metal working.  Some guy discovers a shiny gold metal that is pretty rare.  He thinks it looks cool.  He digs some of it out of the ground and takes it to the blacksmith and says “can you make a cool looking design in the shape a dragon on my shield with this?”  The blacksmith says “beats me, let’s find out.”  He tries it and discovers that he can and it looks pretty cool.  Then this guy goes around with his cool looking gold dragon shield and everybody is like “whoa that guy has the coolest looking shield I’ve ever seen how did he do that?”  They all want shields and swords and plates and cups and what-have-you with the shiny gold metal because it looks cooler than these things look without it.  So they start looking for the metal.  They discover it is fairly hard to find.

Also, these people have quite a bit of other goods like grain and goats and stuff like that and some of them have so much that they are willing to trade some for seemingly frivolous items like a gold-plated shield or candelabra.  So the price of gold becomes fairly high.  Now, in light of this, people eventually realize that gold is very durable, uniform, easily divisible and has a high value to weight/volume.  So these people figure it is more convenient to accumulate some of their wealth in the form of gold than additional grain, goats, etc.  And then, having some of their wealth in that form, they discover that it is easier to carry out transactions using the gold than using the goats.

In this scenario, gold becomes valuable because people think it looks cool and then it becomes a medium of exchange.  It’s ability to provide liquidity services no doubt adds a liquidity premium above what it’s price would be otherwise, but it does not account for the entire value.

Alternative scenario:

On the other hand, imagine a primitive society where somebody discovers a shiny yellow metal and nobody cares, nobody has any particular use for it and it has no value.  But then that guy figures out “hey, this stuff is durable, uniform, easily divisible, and has a high….er, zero value to weight/volume–but if I could convince everyone to use it to trade because it would be easier than using other goods, it could be a high value because of its ability to provide liquidity services, so I just have to do that.”  And then this guy set about convincing everyone to trade stuff for the otherwise worthless metal that nobody cared about and somehow managed to do that and it became valuable purely because of its utility in exchange.

I think it is fairly obvious which one of these is more likely.  But if you are still not convinced that the first scenario is totally plausible just look around at how much of our wealth we currently devote to stuff that looks cool.  Is a Gucci or Prada handbag really that much more functional than a $20 bag from Sears?  Or just imagine that there was a particular kind of cool looking pebble that could only be gathered in small quantities at the tops of very tall mountains.  Do you suppose that people would go to a lot of trouble to climb those mountains and get them and make little necklaces and bracelets and paperweights out of them to impress their friends?  And do you think people who had never climbed a mountain might go on ebay and pay significant sums of money for them….to impress their friends?

Maybe you think that these pebbles would only be valuable because they would be rare.  Well there are pebbles on the tops of mountains.  There are only so many pebbles on Mt. Everest.  Why aren’t they valuable?  Answer: because they don’t look cool!  People value things that look cool.  When something looks cool and is rare, the value tends to be high.  Is it “rational” for people to value things just because they look cool?  Sorry, that’s a fundamentally non-economic question, you’ll have to ask someone else.

For a more detailed treatment of this concept check out this post.

Bottom line: gold, silver, sea shells etc. became money because they had some other intrinsic value.  The liquidity services they then provided surely increased the value but I think it is silly to imagine that they just materialized for the sole purpose of providing liquidity when nobody cared about them for any other reason.

2. Paper money

With paper money, we have the issue that the actual paper it is printed on is (at least practically) worthless.  That is undeniable.  But here the issue is different.  The deed to your house is printed on paper as well.  Is that intrinsically worthless?  Or the contract between you and your employer or your clients, is that worthless?  Of course not, because we have a system of laws and those papers entitle you to some other items of “intrinsic” value.  Paper money is the same.  It is a piece of a contract and it is the contract that makes it valuable.  The fact that it is highly liquid is a consequence of the type of contracts that it relates to and this liquidity does affect its value relative to other forms of wealth but this value does not spring forth inexplicably from nothing or rest on some strained “network effect.”  It is written clearly in black and white on otherwise intrinsically worthless pieces of paper.

When it comes to convertible notes, this is obvious.  When a bank issues a note that contractually obligates the bank to redeem it for a fixed amount of a real good like gold or silver, it is easy to see that this contract anchors the value of the note to the value of the gold or silver for which it can be redeemed.  This is not difficult to understand.  And, unless you believe that the gold or silver is also intrinsically worthless and has value for some mysterious network-effect reason, then it is easy to see how this contract instills an otherwise worthless piece of paper with “intrinsic value” equal to that of the real goods for which the contract allows it to be exchanged.

But modern “fiat” money is not convertible into anything like that, I can almost hear you exclaim.  So how can that be valuable if not for pure liquidity services and mysterious network effects?  Well there is still a contract there.  It’s just that the contract is not as straightforward.

With fiat money, there is no contract obligating someone to redeem it for gold or silver at a fixed rate.  But there are still contracts requiring people to redeem it for real goods.  To see this, you only need to look at how money is created (“multiplied”) by banks.  Banks–at least collectively, if not individually–create money by lending.  When they do this, they create a contract.  They give the borrower some quantity of dollars (or pesos or yen or euros or whatever) and the contract clearly states that you have to pay back a specific number of dollars (usually more than you go) at some point in the future or else they are going to take your house or your car or something like that.

So there you have it, the dollars are convertible into your house at a fixed rate and this rate is fixed by a contract that is enforceable by law.  It’s just that simple.  The only difference is that not just anybody can take in a dollar and redeem it for your house at that rate.  Only you can.  But you are probably going to want to do that and, since you probably spent the dollars you got in the first place, this means that you will be willing to do stuff and trade stuff to get dollars back in the future.  And a lot of people are making these contracts all the time so there are always a lot of people that are able to redeem dollars for real goods at fixed rates and are willing to trade stuff to get those dollars because the dollars a piece of everyone’s debt contracts.

These dollars are not just floating around, unconnected to any real assets in any contractual way.  The contracts are right there.  They are easy to see.  You just have to look for them.  These dollars still serve as a medium of exchange and a store of value and the monetary authorities can still pump more of them into circulation in various ways which result in more dollars chasing the same number of goods and driving prices up (at least for a while but that is a bigger can of worms) but the reason they function this way is because they do have intrinsic value, or at least they are contractually connected to things with intrinsic value.  We don’t need to look for magical network effects.

I think that sums it up.  Every time I try to explain it, it seems simpler.  Hopefully that means I am getting better at explaining.  So if you are thinking that this is obvious then I am making progress.  If not, please tell me whatever you think is wrong with it and I will work on it.

Categories: Uncategorized

Sproul and Sumner on Backing and Quantity Theory of Money

June 6, 2014 34 comments

Mike Sproul recently did a post on J.P. Koning’s blog contrasting his version of the real bills doctrine with Scott Sumner’s (perceived) view of the quantity theory of money.  Sumner’s reply his here.  I think both are partly correct and partly off base.  In short, I think that money is “backed” by real assets, though I think Sproul is missing the true nature of this backing.  But I also think that the price level depends on the quantity of money in circulation.

The big, glaring problem on Sproul’s side is this:

The quantity of convertible FRN’s can be increased by any amount without affecting their value, as long as they are fully backed.

The obvious question this raises, which Sumner points out, is “then how have we had all this inflation?”  Sproul offers this explanation:

Two explanations:
1) The quantity of FRN’s outruns the Fed’s assets by 2%/year on average. This might happen because the Fed issued $100 while getting a bond that is only worth $98 (after transaction costs), or maybe the Fed’s printing and handling costs exceed its interest earnings by 2%/year.
2) The Fed has enough assets to fully cover all its FRN’s with zero inflation, but through habit, ignorance, or painful experience of deflation, the Fed chooses to maintain inflation at 2%, in effect, defaulting on 2% of its obligations per year.

As far as I can tell this is only one explanation.  Regardless of the mental process involved, according to the theory, in order to create secular inflation, the CB has to somehow cause it’s liabilities outrun it’s assets.  The trouble is that this explanation appears to be purely hypothetical with no evidence that this has been the case.  And in fact, this does not seem to be the case.  If this were the case, it seems like it should be relatively easy to show the Fed’s balance sheet leaking assets (relative to liabilities) at a rate roughly equal to the inflation rate at any point in time.  I don’t think that is possible because I suspect that all of the money issued by the Fed has in fact been “fully backed” by Sproul’s definition.  Assuming this is the case, the claim fails the empirical test in a very simple way that is not subject to any kind of difficult identification problem.

On the other hand, I take issue with this statement by Sumner.

We all agree that gold need not be “backed” to have value.  The QTM implicitly thinks of cash as a sort of paper gold.  It’s a real asset that has value because it provides liquidity services.

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Categories: Macro/Monetary Theory