Home > Macro/Monetary Theory > Reply to Mike Sproul

Reply to Mike Sproul

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.

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  1. December 19, 2014 at 3:22 am

    1. “First of all, he calls a movement along the demand curve a decrease in demand. “
    No, you and I must be labeling our supply and demand axes differently. I was thinking of the quantity of base money (FRN’s+federal funds+coins) on the horizontal axis, and the value of a dollar (oz of silver per dollar) on the vertical. Let’s make it simpler and just put green paper FRN’s on the horizontal axis. I’m saying that as people borrow money, they create new bank money (checking account dollars, etc.) through the money multiplier process. This reduces their demand for FRN’s, and reduces the value of the dollar.
    2. “Second, there is nothing weird about borrowers “gain(ing) from the very inflation they caused.”
    It would definitely be weird if you could sell GM short, thereby cause GM shares to drop, and then profit from your short position in GM. So weird, in fact, that nobody thinks that it happens. That’s what’s so weird about the quantity theory: It implies that this crazy, impossible process actually happens with money.
    Think of a small country. If the value of that country’s money (pesos) was determined by money supply and money demand, then a single borrower could create money through the loan expansion process, cause inflation, and profit until he had driven the peso to zero. Of course this is crazy, and one problem with theories that have crazy implications is that you can’t trace through all those crazy implications without suspending the rules of logic.
    3. “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.)”
    The backing theory allows for liquidity demand for money. It’s just that I don’t think in supply/demand terms when it comes to money and other financial securities. Instead, I think of balance sheets, with money on the right and assets on the left. Supply and demand curves are for actual commodities, with production functions and utility functions. However, IF I were to think in terms of money supply and money demand, then I’d think of the money supply curve as horizontal, so changes in money demand would not affect its value.
    4. “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”
    As paper money displaces silver coins, silver will lose value against other goods (silver inflation), but a paper dollar will still buy 1 oz of silver (there’s no paper inflation.). But once people no longer use silver coins, any further issue of paper can’t reduce the demand for silver any further, so silver bottoms out at its “use value”. There’s no longer any monetary premium on silver, so further issues of paper money can’t cause any more silver inflation. The backing theory says that as banks issue new paper dollars in exchange for 1 oz worth of assets, then $1 will still buy 1 oz (no paper inflation) even as more paper is issued. People get confused over this because they don’t see the difference between the two kinds of inflation.
    5. “Declaring that these (money supply and money demand) don’t matter is not a productive first step.”
    If R=5%, and a bond promises to pay $105 in 1 year, that bond will sell for $100 today. No bond analyst tries to figure bond prices by drawing supply and demand curves. If he did, he’d just draw a pair of meaningless curves horizontal at $100. The bond price is determined by looking at the issuer’s assets and liabilities and applying interest formulas. Once price is found at $100, the supply and demand curves are drawn with heights of $100. It’s price that determines supply and demand, not the other way around. The same is true of stocks, bonds, and paper money. That’s not to say you can’t draw supply and demand curves for silver. It’s a commodity, so S and D curves are appropriate. But they are not appropriate for financial securities, including paper money.6.
    6. Your part II is a lot to chew, but let me start by saying that at least 2 old-time economists have said that every money that has ever been issued was at first made convertible into something else, and only later was convertibility suspended. So a country’s assets are worth 1000 oz, and the tax man collects 5 oz/year from everyone. If the government then printed and spent some paper dollars, which it declared it will accept in lieu of 1 oz. in taxes, then that establishes convertibility at $1=1 oz., as long as the government’s issue of money does not exceed its assets (initially 1000 oz.) No fair talking about the government chopping off your head if you don’t pay. The ability to chop off your head is worth 1 million oz, so you’d have to increase assets to 1,001,000 oz., and then the government could issue up to $1,001,000 before its money issue started to outrun its assets.
    So after dollars have been in use for awhile, people stop pricing things in ounces and start pricing them in dollars, even though it’s still true that $1=1 oz. Next, the government lends $200 to someone, and agrees to accept repayment of $210 (as opposed to 210 oz.) in 1 year. So what? As long as there is an anchor of real assets (1000 oz of silver) you can go ahead and get new assets that are denominated in dollars. The dollars are just as backed as before, and it’s still true that $1=1 oz. (Google “inflationary feedback” for a more detailed explanation.) It actually works to back a dollar with another dollar, as long as the silver anchor is there.
    7. “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? “
    That’s not how it works. The bank would first issue $100 to people who deposited 30 oz, and that sets $1=.3 oz. The bank ‘s assets consist of 30 ounces plus the $100 bond. Its liabilities are $200 it printed. Define E as the exchange value of the dollar (oz./$). Setting assets=liabilities yields
    30+100E=200E
    so E still equals .3 oz. Don’t believe me? Let the loan be repaid. The bank loses the $100 bond while it retires $100 of its liabilities, leaving 30 oz backing $100, and still, E=.3 oz.
    8. “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? “
    Nothing happens, because money is valued like bonds, not like stocks. Assets can rise and fall without affecting bond values, except that if assets fall below a critical level, then the bonds lose value. Same for money.
    9. “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. “
    I answered it. When the dollar was introduced it was made convertible into some weight of silver, and issuing new dollars in exchange for dollar-denominated assets does not change that value.
    10. “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. “
    We agree on that. It’s normally the governments assets (taxes, loans, land, etc) that back the money. But if the fed’s assets were all dumped in the ocean, and if the government didn’t provide other backing (like tax acceptance) then the dollar would lose all value.

    • Free Radical
      December 19, 2014 at 6:16 am

      “It’s just that I don’t think in supply/demand terms when it comes to money and other financial securities.”

      Yes, and that is the underlying problem behind all my points in part I. However, I don’t think you really get what I’m trying to say in that part because your responses don’t answer any of those points. For one thing what you are describing is certainly a movement along the demand curve, it is an increase in the quantity of money leading to a higher price level (lower price of money) but you are calling it a decrease in demand. Your number 2 completely misses my point and just says what you said in the first place again. There are plenty of reasons why an individual can’t actually benefit by causing inflation, including that an individual can’t actually cause inflation, but more importantly that market prices don’t work that way. The same problem in your reasoning is apparent in this line.

      “If R=5%, and a bond promises to pay $105 in 1 year, that bond will sell for $100 today. No bond analyst tries to figure bond prices by drawing supply and demand curves. If he did, he’d just draw a pair of meaningless curves horizontal at $100. The bond price is determined by looking at the issuer’s assets and liabilities and applying interest formulas.”

      All you are saying is that a bond analyst is a price taker. That doesn’t meant that there is no such thing as supply and demand. And this:

      “It’s price that determines supply and demand, not the other way around.”

      That’s a totally crazy statement. I don’t know, if you don’t get this stuff, there’s probably no point in arguing over it but I don’t think you are seeing this from an economic perspective at all, you are just insisting that “valuing” money as an economist must be the same as an analyst valuing a stock. There is no underlying asset to judge with money (except for collateral of course), and even if there were, a bunch of people trying to judge its value would still form supply and demand curves and they would still determine the price. Honestly, I think that if you insist on price determining supply and demand, there is no way we will ever make any progress here. I will go through the rest though just in case you realize how nuts that is.

      4. Again, you seem to miss my point, and this time it is very straightforward. You describe two kinds of inflation, I totally get what you are saying, but then you say “The creation of new paper dollars will not cause either kind of inflation” even though you just explained how the creation of new paper dollars causes “silver inflation.” But you’re not answering this point at all, you’re just repeating yourself.

      Now the more important stuff. First, you say this:

      “every money that has ever been issued was at first made convertible into something else, and only later was convertibility suspended.”

      I agree with that, but the fact that convertibility is suspended matters! Then you say imagine that there is convertibility at a fixed rate via the tax code but there isn’t! There’s no convertibility, so there’s no way to get your conversion rate between dollars and silver in the first place, so there is no way to even begin your analysis except by just assuming an arbitrary rate for no reason whatsoever. The only convertibility that exists is into the various collateral which secures the loans which create the money. That’s what you should be looking at, not some hypothetical silver in a hypothetical bank vault. Then there’s this,

      “That’s not how it works. The bank would first issue $100 to people who deposited 30 oz, and that sets $1=.3 oz.”

      No, that’s not how it works. When was the last time you deposited silver in the bank for dollars? Never. That’s not how it works. It used to work that way but now it doesn’t, that’s the whole problem with your backing theory. You are just pretending that money is still backed by gold and/or silver even though it isn’t.

      8. Now money is valued like a bond, before it was valued like a stock. But money does not carry any of the contractual obligations that stocks or bonds carry. It is not like either one. It carries different contractual obligations. If you are determined to just carry on insisting that the obligation is something that it clearly isn’t (and different things at different times no less), then I give up.

  2. December 19, 2014 at 3:40 pm

    I’ll start with just two points, since if we can’t come to an understanding on those, there’s no point in trying to settle the rest.

    1. “For one thing what you are describing is certainly a movement along the demand curve, it is an increase in the quantity of money leading to a higher price level (lower price of money) but you are calling it a decrease in demand.”

    Don’t just say “money”. There are federal reserve notes, checking account dollars, credit card dollars, eurodollars, dollars on gift cards, etc.

    I am talking about a leftward shift of the demand curve for federal reserve notes.

    If the price of apples falls, the demand for oranges will shift to the left. If US dollars start being widely used in Mexico, the demand for pesos (the ones issued by the Mexican central bank) will shift to the left. If credit cards are invented, the demand for federal reserve notes will shift to the left. If checking accounts become easier to use, the demand for federal reserve notes will shift to the left.

    On the other hand, if a frost damages the orange crop, the supply curve of oranges will shift left and the quantity demanded of oranges will fall. If half the federal reserve notes in circulation suddenly caught fire and disappeared, the supply of federal reserve notes would shift to the left and the quantity of federal reserve notes demanded would fall.

    2. ““It’s price that determines supply and demand, not the other way around.”

    That’s a totally crazy statement.”

    I’ve seen a fair number of microeconomics textbooks over the years, since publishers send me desk copies a few times per month. I was assistant author of one of those textbooks (with Jack Hirshleifer) in the 1980’s. Every one of those books talks about the supply and demand of commodities. They do not talk about the supply and demand for financial securities. The reason is that people consume commodities, but they do not consume financial securities. Commodities enter into the utility function, and we can use that utility function to derive a demand curve for those commodities. Not so with financial securities.

    Also, commodities are produced using scarce resources. There is a production function, and we can use that production function to derive the supply curve for the commodity. Not so with financial securities. These days, financial securities can exist only as computer blips, and they can be instantly and costlessly produced and retired in infinite amounts. Not so with commodities.

    So think of that bond, which promises $105 in 1 year in a world of 5% interest. If that bond were priced above $100, the quantity demanded would be zero. If it were priced below $100, quantity demanded would be infinite. The “demand curve”, if you insist on calling it that, is horizontal at $100.

    How about the so-called supply curve of that bond? If it’s price were less than $100, the quantity supplied would be zero. If its price were above $100, bond writers would eagerly issue infinite amounts. The so-called supply curve of that bond is horizontal at $100.

    What does it mean when both supply and demand are horizontal at $100? It means that supply and demand of bonds is an empty concept.

    Now, if the world’s interest rate fell to 4%, that same bond would sell for $101, meaning that if you tried to draw supply and demand curves, they would both be horizontal at the price of $101.

    So, the position of both the supply and demand curve for bonds is determined by the price of those bonds. More to the point, supply and demand curves are fine for commodities, but they are not applicable to financial securities.

  3. December 19, 2014 at 4:32 pm

    Interesting debate you two. I’ll jump in for a second. I work in financial markets and a can see the supply and demand curves for any stock and bonds by looking at the market depth; basically a list of willing buyers and sellers at various market prices.

    Here’s a good example of what this looks like:

    http://www.shareinvestor.com/help/prices-market_depth-station.html

    • December 19, 2014 at 11:32 pm

      Cool chart JP!

      Do we all agree that what we are seeing here is the effect of market uncertainty and transaction costs? Some people look at a stock and think it’s worth $3.80. others $3.90, and hardly anyone $4.00. The simpler the financial security, and the more certain its valuation, and the lower the transaction costs, the closer the bid/ask spread gets to zero.

  4. Free Radical
    December 20, 2014 at 10:53 pm

    Mike,

    If you are talking about two kinds of money, then what you say here about a decrease in demand for one when the quantity of the other one changes is fine although you didn’t seem to be talking about two different kinds of money in the first place. At any rate, if you are, then I’m not interested in the subject. I’m interested in the value of a dollar. Obviously, people can hold a dollar in different forms and they will have some demand for each at different relative prices but that is mostly beside the point when you are talking about the value of a dollar in general, which your remarks do nothing to explain.

    Second, you haven’t said anything here about supply and demand that makes me any less convinced that you don’t really understand the concept. The problem is illustrated quite clearly in this statement.

    “So think of that bond, which promises $105 in 1 year in a world of 5% interest. If that bond were priced above $100, the quantity demanded would be zero. If it were priced below $100, quantity demanded would be infinite. The “demand curve”, if you insist on calling it that, is horizontal at $100. ”

    When yous ay that the interest rate is 5%, you are assuming a price and then trying to derive a demand curve. That’s contrary to the whole point of supply and demand. You can’t go in with an arbitrary assumption about the price. It doesn’t matter if people “consume” it or what the cost of production is or any of that nonsense. People still have preferences over different combinations of securities and other goods and they are still willing to buy and sell different quantities at different prices and this means there are supply and demand curves and those determine the price (and the interest rate).

    And if you think there is no econ textbook that talks about the supply and demand of financial securities, you are also deeply mistaken about that. But I’d rather not get into a pissing match about how many textbooks we’ve read.

  5. Free Radical
    December 20, 2014 at 11:03 pm

    Mike,

    P.S. also, for the record, if you meant what you now say you meant about a change in one kind of money causing a decrease in demand for another kind, then you are not butchering the mainstream theory as bad as I thought but there is still nothing strange about that theory. If there were no demand for assets which are more liquid (in other words, if liquidity did not enter the utility function in some way) then there would be no money, or bank credit or anything of the like. People would hold all of their wealth in higher yielding assets. So the demand for money does depend on preferences.

  6. Free Radical
    December 20, 2014 at 11:05 pm

    J.P.

    I was going to say the same thing but you beat me to it.

  7. Mike Sproul
    December 21, 2014 at 2:18 am

    The reason I chose to talk about FRN’s is that they are the liability of the fed, and on backing theory principles, the value of the dollar is determined by the fed’s assets and the fed’s liabilities. If private banks issue a bunch of checking account dollars, then those are the private banks’ liabilities, not the fed’s. Checking account dollars are like call options on FRN’s, and you can’t just add up the amount of the base security (FRN’s) with the amount of call options. Keep in mind that when I spoke of the demand for FRN’s I was momentarily talking like a quantity theorist, just to address that theory. On backing theory principles money demand is irrelevant to money’s value.

    I said MICROeconomics textbooks. The number of micro texts that place financial securities in the utility function and thereby derive a demand for financial securities is zero. Of course there will be macro books that butcher the theory of supply and demand. The correct approach though, is to use supply and demand for valuing commodities, and balance sheets to value financial securities.

    Forget about interest rates if they bother you. Let’s say we’re talking about paper certificates that promise 1 oz of selver on demand. The supply and demand curves for those certificates will both be horizontal lines with heights of 1 oz/certificate. Once again, supply and demand is a meaningless concept when applied to financial securities.

    • Free Radical
      December 21, 2014 at 2:50 am

      No, supply and demand is a meaningless concept when you begin by assuming a price. It’s the same if you assume a silver price or an interest rate. And if you assume an asset for which the demand is likely to be horizontal, you haven’t proven that demand doesn’t exist or is meaningless, you’ve just assumed it is horizontal…?

      Just about any micro textbook that has a section about determining market interest rates will have a supply and demand for financial assets. If this is absent from any such texts, it is probably due mainly to the fact that this is commonly considered a macro topic. I would love to hear how J.P. feels about this. I’m pretty sure he believes that there is a demand for liquidity that comes from subjective preferences (in other words a utility function). Of course, even if there is no liquidity preference whatsoever, there will still be a demand curve for any particular asset and that, along with supply, will still determine the price. This business of denying that there is a demand curve or that it doesn’t matter is a misguided way of making your point at best. (Also your point is wrong and it is preventing you from seeing that.)

      • December 21, 2014 at 3:02 am

        The intertemporal choice section of micro textbooks discusses the supply and demand for current and future commodities, like “this year’s corn”, “next year’s corn”, etc. There is nothing about supply and demand for financial securities.

        Surely you must see the difference between commodities themselves, and bits of paper or computer blips that are claims to those commodities. Supply and demand curves are relevant to the former, not to the latter.

    • Free Radical
      December 21, 2014 at 3:08 am

      Also, this diversion into the distinction between commercial bank credit vs. central bank credit is not important. You can say that commercial bank credit is “convertible” into central bank credit and that explains why commercial bank money is valuable given that central bank money is valuable. But it still doesn’t explain the value of central bank money, which is the important question. Your explanation will probably go something like this: “start by assuming that the central bank issues notes that are convertible into (or “equal to” or “worth” or something like that) some amount of silver” but that is assuming a counterfactual. If central bank money were actually convertible into silver or something, then everything you say would be right and there would be nothing mysterious about it. But it isn’t. You should notice that the fact that you need to assume that to begin your analysis is a flaw in your analysis.

  8. Free Radical
    December 21, 2014 at 3:09 am

    Yes, I can see the difference and the difference does not negate the existence of supply and demand curves in the case of the latter. If people, instead of trading current corn for future corn trade current corn for bits of paper which entitle them to corn in the future, there is still a demand and supply for those bits of paper.

  9. December 21, 2014 at 4:38 am

    The reason that I start by assuming silver convertibility is that historically, that’s how moneys always start out. Then silver convertibility is suspended, but there’s always some other kind of convertibility that remains, like taxes, pegs to foreign currency, CPI targets, future liquidation of the bank, etc. The best historical example is American colonial currency, which was always pegged to English shillings to begin with.

    “there is still a demand and supply for those bits of paper.”

    And does it look any different from the demand for future corn itself?

  10. Free Radical
    December 21, 2014 at 7:05 am

    no there isn’t always some other kind of convertibility that remains–except, of course, for the one I am talking about, which is the collateral securing loans. You are just pretending that dollars are “convertible” into some kind of asset but that makes no sense. It’s obvious that they aren’t convertible into any real good like gold or silver (except, again, for collateral) and if you start trying to say that they are “convertible” through the tax system somehow, you will run into all kinds of problems because taxes are only levied in dollars (in other words, there is no alternative to pay in gold or silver or anything like that) and they are usually percentages of other dollar values (income, property value, etc.) which means that there is no way to pin down a price level through “tax conversion” and no way to pin down something any kind of notion like “backed by future tax revenue.” Those taxes are denominated in dollars, not silver or dollars. If all incomes and prices fall by half, then all taxes automatically fall by half as well. You can’t do it. This is just a thing you point to when you can’t find an actual hard assets to back your money.

    The thing that blows my mind about this is that I am giving you the assets you need to actually make this sort of make sense but you’re not seeing it because you are so convinced that what you are saying makes sense already. It doesn’t. The flaws are easy to point out but it’s a waste of time if you aren’t willing to look and that seems to be the case.

    And regarding this:

    “And does it look any different from the demand for future corn itself?”

    I think if you step back from that and look at it for a second, you will realize that you are making my point. Then again, I tend to be optimistic about things like that even in the face of overwhelming evidence to the contrary…..

    • December 21, 2014 at 6:49 pm

      A bank can hold 1 ounce of silver, plus bonds worth $99, as backing for $100, and the result is $1=1 oz. A small amount of “real” backing is enough to tie down money’s value, even if most of the backing is “nominal”. Taxes and possible future liquidation of the bank can be enough to provide that real backing. Loan collateral can too, provided the collateral is not denominated in the same money the bank issued.

      Stepped back, looked at it for a second, and no, I’m not making your point. My point, however, is that supply and demand curves are fine for valuing actual goods, but not for financial securities. Economists spend lots of time using supply and demand curves to value goods. Accountants spend lots of time using balance sheets to value financial securities. Accountants don’t use supply and demand curves. That’s why you don’t see supply and demand curves in accounting textbooks.

  11. December 21, 2014 at 7:52 pm

    “I would love to hear how J.P. feels about this. I’m pretty sure he believes that there is a demand for liquidity that comes from subjective preferences (in other words a utility function). Of course, even if there is no liquidity preference whatsoever, there will still be a demand curve for any particular asset and that, along with supply, will still determine the price.”

    Yes, I’d pretty much agree with that.

    • Free Radical
      December 21, 2014 at 9:58 pm

      Thanks J.P.

  12. Free Radical
    December 21, 2014 at 10:05 pm

    Mike,

    “you don’t see supply and demand curves in ACCOUNTING text books.” Now that I can agree with. But that doesn’t mean that they don’t exist, only that they are not part of accounting. They are, however, the foundation of economics.

    Take your bank with 1 oz. of silver and $99 worth of bonds. Then a thief steals half an oz. of silver. Does the value of the dollar fall by half? I’m not sure why I’m still asking questions like this. The theory doesn’t stand up to even a moderate degree of scrutiny as soon as you question the ASSUMPTION that any hard assets the bank has must be backing the money regardless of whether there is a contractual obligation to exchange those assets for money or not. But you don’t seem willing to question that assumption, so there doesn’t seem to be much chance of you seeing the problem.

  13. Mike Sproul
    December 21, 2014 at 10:55 pm

    We aren’t arguing about whether supply and demand curves exist. We are arguing about whether they determine the value of financial securities in the same way that they determine the value of goods. The correct answer is that the value of financial securities is determined by the issuer’s assets and liabilities, and that is the province of accountants using balance sheets, not economists using supply and demand curves.

    Yes, the dollar would lose half its value. It’s just like a highly leveraged firm. The loss of half its value doesn’t seem real to you because you think that there will be something or someone to bail out the bank. But if there is no prospect of a bailout, then the loss is real. Investors and bank customers will of course be on their guard against such over-leveraging, but when they fall for it, the losses are real.

    I

  14. John S
    January 12, 2015 at 11:03 pm

    Merry (belated) Christmas and New Year’s.

    Off-topic, but an interesting take on Austrian econ from George Selgin.
    http://www.freebanking.org/2015/01/11/something-nice-about-austrian-economics/

    • Free Radical
      January 20, 2015 at 1:09 am

      Thanks John, will look at it soon. Been kind of busy with other stuff and have been away from blogging lately. Wanna get back in the game though.

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