The actual explanation for the value of fiat currency, which I have been trying to argue, (also here) I think is actually fairly simple but seems to be absent from all discussion of the topic. One dollar is precisely what is required to extinguish one dollar worth of debt. When money is created, there is always a corresponding debt created. The central bank creates base money by buying government debt or MBS or lending to banks. Banks then “multiply” this money (create additional money) by making loans to businesses and consumers. But these loans eventually need to be paid back....
In this way a dollar can be said to represent an IOU but I see it as exactly the opposite. Rather than an IOU from the bank, it is a means of extinguishing an IOU to the bank. It can be seen either way because the two look the same on the bank’s balance sheet. If the bank takes in gold and hands you an IOU redeemable in gold the gold goes on its balance sheet as an asset and the IOU as a liability. If you take out a loan, you are essentially writing an IOU to the bank for a quantity of dollars and the bank hands you the dollars. In this case, the loan goes on as an asset (account receivable) and the dollars go on as a liability to balance out the new asset. The gold IOU in the first case is a liability because it can be brought back and redeemed for the asset (gold). In the second case, the dollar is a liability because it can be brought back and redeemed for the asset (debt). In both cases the rate at which this redemption occurs is fixed and not subject to market fluctuations. The accounting is the same but the meaning is somewhat different and this seems to me to be why people have difficulty seeing dollars as an IOU.Free Radical
Is Fiat Money an IOU?
Mike Freimuth
(h/t JP Koning)
See also the follow up, On the Convertibility of Fiat Money
Also, an excellent critique of Austrian economists by a self-professed Libertarian who admits it is a normative (moral) stance rather than a positive (scientific) one. Why Austrian Economics is Devastating to Libertarians
Also, an excellent critique of Austrian economists by a self-professed Libertarian who admits it is a normative (moral) stance rather than a positive (scientific) one. Why Austrian Economics is Devastating to Libertarians
22 comments:
"In the second case, the dollar is a liability because it can be brought back and redeemed for the asset (debt)."
For some reason he forgets to mention that a bank deposit is a liability because you can withdraw your deposit from the bank, causing the bank to lose funds.
As someone who has never predicted imminent hyper inflation, I hope you guys just keep on keepin' on quoting and citing "Why Austrian Economics is Devastating to Libertarians".
That writer doesn't understand the first thing about Austrian Economics. Or the second or the third thing. Daniel Kuehn and Lord Keynes understand much more of it than that guy.
Bank money - the kind that exists as a bank deposit balance - is a negotiable liability issued by the bank, i.e. a transferable debt of the bank, and is clearly a type of IOU. But government money - the kind that exists in the form of government issued notes, or reserve account deposit balances - is an IOU in name only. Its nominally official status as an obligation of the United States government, entered as a liability on the central bank's balance sheet, is nothing but a managed public relations fiction, useful for communicating to the public about central bank operations in a language people are somewhat familiar with - the language of business balance sheets - but talk which distorts financial reality more than it accurately represents it.
The fact that government-issued money can be used to discharge tax obligations does not provide adequate reason for treating that money as a government IOU. This is easy to see. Suppose a company issues some IOUs for $20,000 that are now in the possession of Smith, and Smith has a debt of $10,000 to the company. Smith can use $10,000 worth of the company's IOUs to discharge his own debt to the company. The result? The company still owes him $10,000.
Now compare the situation with government. If Smith possesses $20,000 in government-issued currency notes, and has a $10,000 tax obligation to the government, he can use half of the notes to discharge the obligation. So, suppose he does that and has no more obligations to the government. Does the government still owe him something? No of course not. Those notes entitle him to nothing other than more notes of the same kind. The government clearly has no meaningful liability here, no debt to Smith.
I have heard it said that the government's "obligation" is to preserve the market value of the notes themselves. But this is more pious sentimentality than economic realism. Government's have unconstrained discretion over their monetary policy. If the government follows an inflationary policy that devalues the market value of its notes, nobody has a legal case against the government for failing to meet its so-called obligations.
The language of "obligations", "full faith and credit", etc. are a vestigial remnant from an older time, when government notes were genuine debt instruments representing the government's obligation to surrender gold, silver or something else. These expressions are no longer economically meaningful. They are solemn-sounding slogans used to impart a feeling of gravity to the government's money, similar to the decision to put occult symbols or pictures of dead dignitaries on the notes.
It is important to be clear about this because a liability, in accounting theory, is something of negative value to the person or entity that owns it, and in the case of financial liabilities the negative value of an IOU consists in the fact that the issuer is legally bound to surrender something of positive value in the future. Yet the central bank notes in circulation do not bind the government to surrender anything of positive value, and the idea that the central bank must maintain a positive net nominal financial worth on its so-called balance sheet to remain solvent, or as a sign that it is being well-run, is quite erroneous. Thinking of the central bank as a financially constrained business is just as misleading as thinking of it like a household.
Innis was right about the status of bank money as a credit instrument. But in elevating this observation into a comprehensive theory of the nature of all money, he erred. The language of credit money survives in central bank communicative practices, but that language is not a good representation of reality.
"So, suppose he does that and has no more obligations to the government. Does the government still owe him something? No of course not."
The state still promises to accept the notes in payment. It "owes" that to the bearer of the notes, whoever they may be. Even though Smith may no longer owe anything, others do or will do in the future.
"Yet the central bank notes in circulation do not bind the government to surrender anything of positive value"
Technically Smith's tax liability is an asset of the government. When Smith pays the tax, this government asset is extinguished, as is the government's liability (the money used to pay the tax).
Personally I think you can look at it in different ways. I think Knapp actually argued that state money is not a debt, as he seems to say this in places in the State theory of Money. The American Monetary Institute people argue that it isn't a debt. As do Michael Kumhof and Jaromir Benes, authors of 'The Chicago Plan Revisited'. However seeing it as a form of debt is not illogical in my opinion.
y, yes, but I think that the notion that the tax obligation is an asset of the government is just as much a fiction as the idea that the issued currency is a liability of the government. If someone owes you or me $1000, the IOU which we hold is an asset because it commits that person to surrendering something to us which is of positive value to us. It's of positive value because when we get that $1000 we are $1000 richer in purchasing power. But the government's ability to make purchases in neither raised nor lowered in any appreciable way by payments or disbursements of dollars.
"If someone owes you or me $1000, the IOU which we hold is an asset because it commits that person to surrendering something to us which is of positive value to us."
The government receives something of value when it issues/spends the money. It is the 'borrower' in that case - it gets a real good, for example, in exchange for its debt (money) - and the seller of the good is the 'creditor'.
"But the government's ability to make purchases in neither raised nor lowered in any appreciable way by payments or disbursements of dollars."
If it never taxed at all (or otherwise demanded payment), then according to MMT its debt tokens (money) wouldn't have any purchasing power at all.
From the article:
The central bank creates base money by buying government debt or MBS or lending to banks. Banks then “multiply” this money (create additional money) by making loans to businesses and consumers.
You really can't throw a rock without hitting five people still clinging to the money multiplier. Good thing I brought plenty rocks.
Otherwise, the piece was a good read.
Technically, he's right about that. As Randy Wray says, banks leverage off the monetary base. Has nothing to do with the money multiplier but rather the hierarchy of money. Banks can leverage off the monetary base because they can get currency either in the interbank market and money market, or by borrowing from the cb to meet promises that require it on demand. So I don't have any issue with this statement.
but Wray includes government bonds in his definition of the 'monetary base'.
re the money multiplier, the standard view (expressed in that statement) is that banks get base money from the central bank and then multiply it by making loans. In this view the CB starts the process by increasing the amount of base money, which then leads to an increase in broad money via bank lending. The MMT view is banks are not constrained in their ability to make loans by the quantity of reserves they currently hold. Rather the CB sets the price of reserves and banks can buy them at that price, before or after making loans, if need be. In this view the process normally starts with a loan, increasing broad money, possibly leading to an increase in base money (or not, as the case may be).
Has nothing to do with the money multiplier but rather the hierarchy of money. Banks can leverage off the monetary base because they can get currency either in the interbank market and money market, or by borrowing from the cb to meet promises that require it on demand.
Seems to me the way "leverage" is used there is wrong for the same reason that the money multiplier is wrong.
Like the money multiplier, leverage is just a ratio. It's not a causal explanation or prior constraint, just two numbers juxtaposed that may or may not convey useful information.
Leverages happens to be useful (moreso with NFA:total assets, not base money:other money) because it's a good barometer of risk levels and financial stability. What it's not is a restatement of the discredited money multiplier constraint.
Banks generally don't borrow from the cb through the discount window at the penalty rate but by using tsys as collateral.
Seems to me the way "leverage" is used there is wrong for the same reason that the money multiplier is wrong.
Take it up with Randy. Some others don't like his using "leverage" in this way either, e.g., MR.
Like the money multiplier, leverage is just a ratio
The ratio as I understand it is broad money to base money (HPM). The difference between the two is the portion of the money stock that the banks create denominated in the currency and which they promise to exchange for the currency.
Say there were a bank run, treating the banking system as a single bank, and all the holders of bank deposits wanted to withdraw cash. The cb would provide the difference between vault cash and excess demand in exchange for rb and make rb available if needed to do so by lending. After conversion, the ratio would 1/1. It's never that, and the difference is the amount of leveraging of bank credit off the currency.
The key point here is that bank credit is a promise (legal obligation) to convert deposits to currency and banks cannot issue currency. So their obligation involves leverage that gives them risk exposure. This is an issue with lending long and borrowing short.
A purpose of the cb is to provide cash flow to prevent bank runs and liquidity crises. The GFC started in the US due to a liquidity crisis in the banking system.
Before getting into the other points, I'm still a little puzzled at how the quote in my first comment can be read as anything other than a plain statement of the money multiplier. To say it's "technically direct" is in direct contradiction to "loans create deposits".
Take it up with Randy. Some others don't like his using "leverage" in this way either, e.g., MR.
Conceptually, leverage is usually constructed as some form of debt:equity or total assets to net assets and "leveraging" is not obtaining a dollar of equity and multiplying it up to X dollars of debt. Leveraging is the stacking debt on a foundation of equity, increasing the ratio, instability and risk.
The distinction matters because in the former, the smaller number in the leverage ratio is a prior constraint (just as with the money multiplier) and in the latter, it is not. From what I've seen (with the caveat that I could be getting it all wrong) taking the MMT position as making the prior constraint claim is a mis-reading of MMT.
The ratio as I understand it is broad money to base money (HPM).
Does that construction really fit with any conventional notion of leverage? Whether you're talking about a firm (debt:equity) or a bank (assets:capital ...not the same thing as base money or HPM) or the private sector in aggregate (total debt:nfa ...also not the same thing as base money) I can't think of a balance sheet entity for whom broad:base is a meaningful description of leverage.
The problem is that leverage is about solvency and reserves are about liquidity. Including reserves by constructing leverage with "base money" which includes reserves muddles liquidity and solvency together in a way that loses sight of what leverage would normally highlight.
I can't answer for Randy, but I would say that the leverage issue is about bank solvency in the case of a bank run when the bank is unable to convert its deposits to currency. CBs and government guarantees shift this to a liquidity issue.
I am not defending Randy's choice of words, here, which I agree is confusing to some at least. Why use "leverage" when it is associated with the discredited money multiplier.
I am just saying that I understand his use of the term, I think, and it makes sense to me. But I would not put it that way.
Banking is a fractional reserve system, however, with currency taking the place of PMs (gold, silver, copper) as the backing. The bank is crediting accounts using entries denominated in the unit of account (currency) that it does not not issue and has to get from the issuer as demanded iaw its legal obligation. That's a solvency constraint that the government converts to a liquidity issue through its being the franchisor with unlimited liquidity at its disposal and being ready to use it.
This was the point of Randy's pointing out that the Fed extended some 30T in liquidity to support the solvency of the banking system. His claim is that the big banks were technically insolvent (couldn't meet cash flow) and the government floated them with leverage.
On the point from my original comment, I'm still at a loss how this: "The central bank creates base money by buying government debt or MBS or lending to banks. Banks then “multiply” this money (create additional money) by making loans to businesses and consumers." can be read as anything other than a simple statement of the conventional money multiplier idea and in direct contradiction with "loans create deposits".
On the leverage tangent, the question "Why use "leverage" when it is associated with the discredited money multiplier." convinces me that I'm just failing to properly express what I'm trying to say and/or missing something important so I'll just mull on it for a while and maybe pick it up again in some future thread.
We'd probably have to ask him what he means by that to clear it up.
"If it never taxed at all (or otherwise demanded payment), then according to MMT its debt tokens (money) wouldn't have any purchasing power at all."
Im not sure thats a fair way to read what MMT says about taxation and purchasing power. This relationship is discussed when the question of why one money may be used over another. Its obvious that anyone can issue money, its getting it generally accepted that is the trick, so how does the states money become more generally acceptable than any competing private monies? Demand a tax payment in it and only it. None of the competing monies will extinguish the liability, so the trick is completed.
Where we may have gone astray is in letting all the private bankers in on it so their deposits are just as good at extinguishing the tax liabilities.
I'm pretty certain the MMT view is that taxation gives fiat money a basic value.
"deposits are just as good at extinguishing the tax liabilities."
I don't think that's accurate. Ultimately the Treasury requires payment in reserves or cash. Depositors can make a payment to the govt from their bank account, but the bank then has to pay the govt with base money, at some point.
Taxation creates demand for the currency, which allows government to use its currency to move private resources to public purpose. The prices the government is willing to pay in markets establishes the value of the currency. For example, if the government is willing to hire anyone willing and able to work at a certain wage, that that wage level sets the value of a units of account (nominal) in terms of units of labor (real), say an hour of unskilled labor, setting the floor.
Post a Comment