Home > Uncategorized > Et Tu, Nick Rowe?

Et Tu, Nick Rowe?

Nick Rowe has another post about “red money.” I love these posts because they are very close to the concept that I am trying to advance regarding the relationship between money (which Nick sometimes calls “green money”) and debt (which he sometimes calls “red money.”) But I have two gripes with this one. One is his abuse of the concept of utility, which some people who have read me before may roll their eyes at, but since I have assumed the role of internet utility policeman, I can’t let it slide. However, I will save it for last. The other is his insistence that his red money is not a debt.

Now, what is this a theory of? It’s not simply debt, because debt is an asset of someone. Red money is an asset of no one.

This is purely semantic of course, but I kind of take it as a shot at folks like me who like to talk about debt, so I feel compelled to point out the fact that it is purely semantic and based entirely on an entirely unrealistic assumption of his.

This conclusion is based on the notion that the red money is not an asset of anyone. But red money is an obligation to pay real goods in the future to someone. It’s just that the obligation is to a group of people (future young people) rather than to a specific individual. Therefore, it is difficult to say that any particular individual holds an asset.

However, in order to make this work, he has to make the (unrealistic) assumption that people have to dispose of all of their red money before they die. In reality, if you had red money, in the sense it is described, people would just accumulate vast amounts of red money and then never pay it back (sell it back?). The reason for this is precisely the reason that Nick claims it is not a debt, namely that no particular person holds an “asset” on the other end of that debt which could require them to pay.

Nick, of course, is aware of this and he deals with it by assuming that there is some punishment in the afterlife for dying with red money. But this assumption only serves to take the asset out of this mortal coil and place it instead in another realm. So, if you want, you can imagine that God holds the asset on the other end of your liability and it will be him that extracts payment if you fail to transfer it to someone else before death, but that is not changing the fundamental nature of the debt.

Of course, in real life, this wouldn’t work because many people would not believe that God would punish them if they didn’t sell all of their red money. So if you wanted to actually make red money work in a way similar to what Nick describes, you would need to come up with some way to punish people on earth for accumulating too much red money.

One way of doing this would be to create some kind of entity, on earth, that would hold the asset on the other end of the liability which is red money. This entity could then take the goods from the old and transfer them to the young, along with the requisite amount of red money. Then you would have a specific contract with that entity which would require you to pay real goods in a given timeframe and if you didn’t, that entity could come after you for the goods. At this point, someone would hold an “asset” for each unit of red money, and I think it would be difficult to argue that it was not a debt.

Of course, if that entity didn’t want to deal with collecting and distributing real goods, they could also issue another kind of notes, let’s call them “green money” to the young, along with their red money, and they could allow the old to use this green money to cancel out their red money. Then the young would trade the green money for goods from the old and the old would use the green money to repay their debt to the entity which issues red and green money and keeps track of who owes what (which is another way of saying that they hold the assets backing the red-money debts). Then they wouldn’t have to bother with real goods except in the event that some old person failed to come up with the requisite quantity of green money in the allotted time period.

Now I have no problem with making unrealistic assumptions in order to make a point, but if the point you make is driven entirely by an unrealistic assumption and when you replace it with a more realistic assumption that point is no longer valid, then you have a bad assumption (or a bad point depending on how you want to look at it).

So whose model seems more realistic, Nicks, in which red money is “not a debt” but people always resell it out of fear of punishment in the afterlife, or mine, in which red money is a debt and people resell it out of fear of having their stuff taken by the issuer of that debt? If it’s mine, then maybe we should think about the role that debt plays in all of this and not dismiss it as an unimportant detail.

Now, regarding utility, it is becoming apparent to me that it is macro people who are driving this particular regression in economic understanding. And the reason is somewhat understandable. Put simply, it’s easier to just assume diminishing marginal utility in each period than to assume the correct thing which is that people have diminishing marginal rates of substitution between consumption in each period. If Nick had proposed the same model, with the same equations and said that, I would have no beef.

Notice that his utility function, also exhibits the latter property, and it is that property which drives the results, not diminishing marginal utility. To see this, you can simply plug in a utility function which has increasing marginal utility and also diminishing MRS (for instance (cy^2)(co^2)). So Nick probably thinks it doesn’t matter whether you say it his way or my way, and I would have rolled my eyes and held my tongue if he hadn’t gone on to say this [emphasis added]:

“Diminishing Marginal Utility. If U=log(C), then dU/dC=1/C, which is a decreasing function of C. Every extra apple you eat per day gives you less and less extra utility. So you would rather eat 10 apples every day, than 9 apples on even days and 11 apples on odd days. And 0 apples on even days and 20 apples on odd days, would be even worse. We want to smooth our consumption across time periods (and across states of the world, because insurance is motivated by the same thing).”

So it’s not just a convenient mathematical assumption he is making, he is justifying that assumption with a defunct philosophy, with no theoretical or empirical justification, which the profession discarded a century ago. (Please note that I am talking about DMU not consumption smoothing, which I have no problem with, but which can be generated by diminishing MRS without resulting to making conjectures about purely hypothetical things like “satisfaction” or “happiness.”)

This corrupts peoples’ understanding of a concept that is at the heart of much of economics and it is frustrating to those of us who have to try to teach people intermediate micro in the proper way (at least those of us who care about getting this right which, much to my consternation,  seems to be a dying breed, …..). I wish smart, reputable, economists, whom I know are capable of comprehending the distinction, could refrain from falling back on this type of logic.

So I’m writing Nick a citation from the internet utility police department. If he fails to correct the violation, there will be no consequences, since it’s a department I made up and I have no real power or sway with anyone. Except, of course, that a bunch of people may read your stuff and become confused about what utility means, or heaven forbid, become utilitarians. May their intellectual blood be on your hands. (Maybe there will be some penalty in the afterlife…)

 

P.S. Just for the record, I’m being smug here, I love Nick Rowe and I hope his afterlife is filled with nothing but happiness and satisfaction. But if it is, I hope he doesn’t describe it as a high level of utility.

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Categories: Uncategorized
  1. January 22, 2015 at 4:01 pm

    Mike: I did a post which contains both red and green money:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/02/colateral-and-the-money-supply.html

    The standard New Keynesian model, in its Woodfordian version, implicitly assumes that both red and green money exist, and that the central bank issues exactly equal amounts of red and green money. Some individuals hold red, and some individuals hold green, but it all exactly balances out, because the central bank will only issue red and green in a fixed 1:1 ratio. But we can relax that assumption if we like. Samuelson 58 is a model with only green money, which is an asset to the owner and a liability of noone. No individual would want to hold red money in his model. Money is positive net wealth. I have a model with only red money, which is a liability of the owner and an asset of noone. No individual would want to hold green money in my model. Money is negative net wealth.

    (Why do people insure?)

    • Free Radical
      January 23, 2015 at 1:00 am

      Nick, thanks for the reply. I read that post, it was good (I think I might have actually written about it but might have been a different one). My only gripe is that you say that this isn’t a theory of debt. I think it’s a stretch to come to that conclusion. This is useful feedback though, I probably need to look at Woodford again more carefully. My understanding of what most people seem to have in their minds is that they contain only green money. I basically have a model of green and red money where they are not constrained to be equal.

      Also, regarding your parenthetical comment, I think you have identified for me the exact point where the profession went (back) off the rails with utility. I vividly remember learning that insurance as an undergrad and that causing utility to (seem to) make sense. The only problem was that what clicked in my mind was an incorrect understanding of utility that didn’t get corrected until several rounds of arguing with my graduate micro prof. Considering the parentheses, I’m guessing you aren’t very interested in the subject but the short version is that people have preferences over different risk profiles and they choose the risk profile with the highest level of utility. You could create a utility function over what they are choosing between (different risk profiles somehow defined) and you would get an interior solution if there was a diminishing marginal rate of substitution (convex indifference curves) but you can get this with any number of different but equivalent utility functions, some of which have diminishing marginal utility and some of which have increasing marginal utility). The fact the people buy insurance doesn’t imply anything about their relative happiness in different states. The DMU explanation is super handy for teaching an undergrad finance class though and I’m guessing that is the main reason so many smart economists still use it the way you do. It would be better if you didn’t….

      And just for the record, I mentioned that I have no problem with consumption smoothing (or insurance), just that explanation for it.

      • May 15, 2017 at 3:18 pm

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    • Free Radical
      January 23, 2015 at 1:05 am

      Oh, and P.S., if we live in a world with red and green money like the one I describe here, then the explanation for the value of money should not start and end with liquidity preference, it should start with the relationship between “red” and “green” money (in other words, it should start with debt) and then liquidity preference should explain relatively small deviations from a base value which is determined by the consequence for holding too much red money.

  2. January 23, 2015 at 3:26 am

    Just as an aside (you may, or may not, already understand this) we need to keep money and debt conceptually distinct. If I write “IOU 1 apple, signed Nick Rowe” on a bit of paper, and sell it to you, that bit of paper is debt (my liability, and your asset). It may or may not be used as a medium of exchange. Some debt is money, but not all debt is money. Some money is debt, but not all money is debt. Two overlapping but distinct sets.

    Yep, most simple models of money assume only green money. But if I have a negative balance in my chequing account (I have an overdraft, I can still buy something with it, by increasing my overdraft) that is red money, and it is my liability and my bank’s asset.

    DMU is very parsimonious. But then people buy lottery tickets too.

  3. January 23, 2015 at 3:29 am

    Yes, assume you and I both have overdrafts, then I buy something from you. Your overdraft goes down, and mine goes up. You give me some of your red money, along with the apple you sold me..

    • Free Radical
      January 24, 2015 at 5:05 am

      “Some debt is money but not all debt is money.”

      I think I’m actually separating them even more. I’m not saying money is debt, I’m saying it is something like “anti-debt.” I think you get this because your red and green money thing is right along these lines. I think we see it similarly. And I agree that it’s possible to create debt without creating money but usually money isn’t created without debt (it can be done but usually not in western countries). Yet most models assume that it always is. It’s a meaningful difference. And then, yes, some slips of paper will have more value for their liquidity than others and that is what I mean by liquidity preference explaining some variation in the value of money but not why “intrinsically worthless” pieces of paper magically become valuable. They are valuable because they are attached to debt contracts. The fact that they are liquid makes them slightly more valuable than they would be if they weren’t liquid. (And of course, it is that fact which leads to them existing, but that doesn’t mean that it single-handedly explains their value. This is also a meaningful distinction I think.)

    • Free Radical
      January 24, 2015 at 5:10 am

      By the way, I think this overdraft version of red money works fine except that if some people have positive balances you need green money. And if there is cash, it has to be green money (practically if not necessarily theoretically), and there has to be an enforcement mechanism for punishing people whose balances get too low for too long. And this is a theory of debt.

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