Archive for December, 2014

Reply to Mike Sproul

December 18, 2014 22 comments

Mike Sproul has a post on J.P. Koning’s site explaining the “backing theory” of the value of money.  I think that there is a certain insight about the nature of money in this, but it goes horribly wrong when it starts talking about backing.  I will divide my critique into two sections.  The second one is more important. I. Criticism of the existing theory I happen to be a fellow critic of the standard monetary model, so I’m not saying it is perfect but there is some carelessness apparent in the way Mike characterizes it.  Take this paragraph.

It’s reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

First of all, he calls a movement along the demand curve a decrease in demand.  (He does it a second time later on as well.)  That may seem nitpicky but it is kind of a serious error in this context.  Changes in demand for money play an important role in all mainstream theories and none of them would say that such a thing is caused by an increase in the money supply.  Second, there is nothing weird about borrowers “gain(ing) from the very inflation they caused.”  Things like the price level, and interest rates are market prices.  They are determined by the individual actions of many people interacting with each other.  The idea that “borrowers” can somehow act collectively to borrow, cause inflation and then benefit from that inflation is deeply confused.  No theory claims that individuals try to create inflation by borrowing.  If the central bank does something that causes people to expect higher inflation, then the cost of borrowing and lending will adjust to take that into account.  To quote Scott Sumner, quoting Paul Krugman: “it’s a simultaneous system.” Then there is this.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued.

But that is not an either/or proposition.  Every market price is determined by supply and demand in some sense.  The question is what determines the supply and demand for money.  And this brings us to the biggest problem (except for part II).  Unlike a stock, the whole point of money is that it provides liquidity.  (There is a sense in which a stock exists because it is more liquid than other ownership arrangements but it is not created from nothing for the sole purpose of making it easier to buy other things.) Mike Sproul seems to understand this in his characterization of money in the beginning.

Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank’s IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money

And he recognizes that there is a liquidity premium in the comments.

But once silver has lost all its monetary premium, additional creation of paper dollars (through short selling) can’t cause silver to fall any further. At that point the backing theory would be fully correct. The creation of new paper dollars will not cause either kind of inflation.

So there must be some supply and demand for liquidity and these must determine the “monetary premium” on silver in his example and an increase in the quantity of silver credit decreases the level of the monetary premium by moving along the demand curve for liquidity.  (His last sentence doesn’t seem to make sense since it is the creation of new paper dollars which he is talking about causing “silver inflation” in the first place, but that’s probably not worth dwelling on.)  So I think it is misguided to argue that the price of money is not determined by the supply and demand for money.  Any attempt at explaining the value of money is really an attempt to explain the supply and demand for the same.  Declaring that these don’t matter is not a productive first step. II.  What is backing the money? The issues above aside, the real problem here is that Sproul is mischaracterizing the contract involved in the creation of money through credit.  When a company issues stock, the stock represents ownership of a portion of the company.  We can call this an IOU for the real assets and future earnings of the company.  So money goes from the buyer to the issuer and the IOU goes the other way.  Simple. When a bank issues money, the IOU goes from the borrower to the bank.  The bank creates the money “out of thin air” and lends it and the borrower promises to pay back the same thing–namely money.  So the money goes from the bank to the borrower and the IOU goes the other way.  The money is not an IOU from the bank for any kind of real good.  Mike Sproul is going astray by calling both things IOUs.

But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU.

But the role of money is the opposite of an IOU.  It is the means with which the borrower’s IOU must be paid.  There is no silver in this contract.  There is no promise to deliver a stock, there is no ownership in the bank.  The bank does not promise to redeem the money for anything except for wiping out the debt of the borrower(s).  So there is no underlying asset forming the basis for the value of the dollar (there is actually, but it’s not what Mike Sproul says.  I will come to that in a bit).  In a short sale of a stock, the stock is the underlying asset.  In the issuance of stock, the company is the underlying asset.  If we had a gold or silver standard, in which dollars were redeemable for gold or silver, then those things would be the underlying asset and everything Mike Sproul says would be right (except for the part about decreasing demand in part I).  However we don’t have that! So take this claim.

For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$.

And ask yourself what exactly he means by “assets.”  No matter what you answer, the above makes no sense.  For instance consider the following scenario. A bank is formed which has 30 oz. of silver.  It then invents a unit of measurement called a dollar and prints 100 of them.  Then it trades those 100 dollars for a promise to repay 100 dollars in one year (in other words, it lends them).  Now what are the bank’s assets?  Mike Sproul might say that their assets are 30 oz. of silver and therefore, you simply divide those assets by the number of dollars in circulation to arrive at the value of a dollar.  But this can’t be right because didn’t he say that they are like a short seller and if they create more money, it doesn’t diminish the value of the money? Of course, if you are an accountant, you might say that their assets are 30 oz. of silver and an account receivable for 100 dollars, and of course this would be correct.  But now how do you determine the value of a dollar?  You divide 100 dollars and 30 oz. of silver by 100 dollars?  Obviously that’s not mathematically possible.  Maybe you need to find the net assets by subtracting the liabilities of the bank.  In this case you get $100-$100+30 oz. of silver.  So their net assets are 30 oz. of silver because, as Mike says, they have a neutral dollar position.  They didn’t get any richer or poorer by this transaction.  But then what do we divide these 30 oz. of silver by, now that we cancelled out the liability?  If you answer that you divide them by the number of dollars outstanding, then you are back doing the same thing we established was wrong in the first place. Furthermore, what happens if the bank is laying some pipe in the back and they discover another 30 oz. of silver?  Does the value of a dollar double?  Does the bank now owe you twice as much silver for your dollar?  After all, that would be the case if GM found some silver and you owned the stock.  But money is not a stock!  It does not represent ownership in the bank.  The bank doesn’t owe you anything more than before, because they didn’t owe you anything in the first place except to extinguish your debt.  Whatever other assets the bank happens to have, have no bearing on the contract between themselves and borrowers because they are not part of the contract. The bank does not need to have any other assets to create money like this.  The bank can have no silver, make up the unit dollar, create 100 of them and lend them in return for a promise to pay them back in the future.  Then what is the value of those dollars?  How many of those dollars will it take to buy a TV?  Or an oz. of silver for that matter? That’s a serious question and mainstream monetary theory has a crappy answer.  But Mike Sproul is not answering it either, although, in a way he is getting close.  If you are selling TVs and somebody comes to you with those newly created dollars, assuming you know that their contract with the bank is binding and therefore, they will want to get them back in the future by trading you some real assets in order to repay the bank, how would you go about trying to determine how many of them you should demand for a TV? Seriously think about it for a minute before I tell you.  If I know anything about teaching (a big if) it’s that you gotta get them to consider the question before you answer it.  I’ll wait. . . . OK, ready?  You would want to know what will happen to the guy if he doesn’t repay!  Does he get his head chopped off?  If so, those dollars are worth a lot of TVs cause he will do almost anything to get them back.  You will be able to demand everything he owns.  If nothing happens to him, then you probably shouldn’t take them for any quantity of TVs.  But what if the contract says that if he doesn’t repay the $100 in one year that he loses his car?  Well then, in one year, you would able to demand anything up to the value of his car so you would probably be willing to sell him several TVs (depending on the car of course).  If it is his house, then you would probably sell him a great many TVs. Now imagine millions of people with debts like this all competing to  sell real goods and services for dollars which they can all use to retire their debts to the banks and keep their stuff and you have a modern fiat-money economy.  The quantity of gold and silver in the central bank’s vault has nothing to do with it.  If the Fed opened Fort Knox and there were no gold there, everyone would act outraged for a week and nothing would change. It is the value of the collateral securing all of those debts which is the underlying asset in the contract that creates money and it is the thread connecting nominal money values to real good values.  And this is the reason that this value can change over time, because the value of that collateral changes (both in the sense that the original collateral for a particular loan changes in value and that the value of collateral required for new loans changes).  So in some sense, of course, it is a relationship between the bank’s assets and liabilities that determines the value of the money, but I think that Mike Sproul is missing the relevant assets.  Money is not an IOU it is a YOM (“you owe me”).  If you have a loan, you owe money.  If you don’t pay, then you owe some goods which you pledge as collateral.  That is the asset that matters.