And the Law of Reflux is always and everywhere wrong. Unless the central bank decides to make it true. (The Law of Reflux says an excess supply of money will always revert to the issuing banks).
This post is too long. It was a bit off the top of my head, and I'm too busy and lazy to make it shorter. Sorry.
This post is for David Glasner. (Sorry for the delay, David; I was thinking about the best way to say it.)
This post is also for everyone who believes in the Law of Reflux, and that means almost every economist nowadays.
And especially for Mike Sproul (pdf), who makes a perfect foil because he is such a hardline waffle-free believer in the Law of Reflux! I'm going to go equally hardline in the exact opposite direction. How extreme a position can I stake out and defend? Just watch me!
(And also for those of you who say obviously true things like "the quantity of money is endogenous", or things that don't strictly make literal sense like "the supply of money is demand-determined"; because what you are really trying to say is that you believe in the Law of Reflux.)
I am going to tell you a (true) story about money, opals, and a used car. And lemons.
(OK, what about if we used cows as money? Sure, people want cows, because cows produce milk, and people want milk. But that's a demand for cows qua cows, and has nothing to do with the demand for cows qua money. So to keep things simple I'm going to ignore cows and talk about totally useless paper money, which nobody wants and nobody ever will want.)
I was leaving Australia and trying to sell my car. A guy offered me a bunch of opals in exchange. (This is slightly less strange than it would be elsewhere, because there were opal mines nearby). I didn't want opals, and believed I would never want opals. So I refused his offer.
You might say: "Hang on Nick. If he had offered you a really good deal, shouldn't you have accepted his offer? You could have sold the opals to someone else, even if you didn't want them. It wasn't rational for you to have refused to even consider his offer."
To make a simple explanation complicated: my reasoning was game-theoretic. If his opals really were worth as much as he said they were worth, why didn't he sell them to someone who did want opals? Or to a specialist opal dealer? Then bring the dollars to me, and buy my car? Rather than selling the opals to me in exchange for my car, and then me finding someone who wanted the opals? I simply couldn't think of any set of plausible assumptions that would create a game where rational behaviour by both of us would lead to an equilibrium in which he and I swapped opals for the car. I could think of plausible assumptions that would create a game where rational behaviour by both of us would lead to an equilibrium in which he and I swapped Australian dollars for the car. I was leaving the country, so I needed to sell my car, and he maybe wanted a car like mine to drive around in. (My needing to leave the country solved the Market for Lemons problem with my car; but I couldn't think up any plausible solution for the Market for Lemons problem with his opals.)
If we had been in the middle of the outback, and he had said he desperately needed my car all of a sudden, and didn't have time to sell the opals, and if his story seemed plausible, then maybe, just maybe, I might have accepted his offer.
If I had accepted his opals in exchange for my car, even though I didn't want those opals, I would have been using those opals as a medium of exchange. As money. As a temporary abode of purchasing power. As a hot potato I didn't want to hold but planned to get rid of, not immediately, but when a favourable opportunity arose, taking into account the costs of finding that opportunity or waiting for a better opportunity.
If I had sold my car for opals I didn't want, those opals would have been a hot potato in my hands that I planned to get rid of.
If I had sold my car for Australian dollars I didn't want, those Australian dollars would have been a hot potato in my hands that I planned to get rid of.
If I had sold my car for Canadian dollars I didn't want, those Canadian dollars would have been a hot potato in my hands that I planned to get rid of.
I don't want opals; I don't want Australian dollars; I don't want Canadian dollars. I would only ever accept any of those three goods because I planned to get rid of them. For me, all three goods are hot potatoes. The only difference is this: for some people (those who like wearing opals) opals are not hot potatoes. Dollars are a hot potato for everyone, and always will be.
If you offered opals for sale, with a condition attached that you could never ever sell them again, some people would still buy those opals, albeit at a reduced price. If you offered dollars for sale, with a condition attached that you could never ever sell them again, nobody would buy those dollars, at any price.
Opals are sometimes a hot potato for some people. Dollars are always a hot potato for everyone. We all only ever buy them because we plan get rid of them by selling them to someone else.
Who might that "someone else" be? Almost anyone. How long might we plan to wait before selling them? That depends.
Suppose I had accepted opals in exchange for my car. Who would I have sold them to? How long would I have held them before selling them?
I would probably have sold the opals to a jeweler, someone who is a specialised trader in opals and who holds an inventory of opals because he is always on the lookout for good deals to buy and sell opals, and those good deals aren't perfectly synchronised, so he needs to hold a stock of opals in inventory to handle days when he gets more good deals to sell than to buy, or vice versa. Now the opal dealer wouldn't really want the opals either. He only buys opals because he plans to sell them to someone else, someone who really does want opals to wear. If I had added a condition to the sale that the opal dealer cannot ever sell the opals again, he would refuse my offer at any price (unless he liked wearing opals himself).
Opals are a hot potato to opal dealers.
I expect there might have been a small chance that I happened to meet someone who wanted opals. If so, I might have sold the opals to that person. But it's very unlikely. Most people who want an opal would already have bought one from an opal dealer. Opal dealers and the people who want opals are much better at finding each other than they and I would be at finding each other.
How long would I have waited before selling the opals? I don't know. That depends. On a lot of things. I was busy. There wasn't an opal dealer right next door. Maybe I would not have accepted the first opal dealer's offer right away. Maybe I would have sold them quickly if I had needed the cash quickly because I wanted to buy something else quickly. Or maybe I would have waited till I got a really good deal.
It is very likely I would have sold the opals to an opal dealer. But it is very unlikely i would have done so the very instant after I had got the opals in my hand. I would have held the opals temporarily, as a temporary abode of eventual purchasing power. My guess is that I might have held the opals for about a month before selling them. My annual velocity of circulation for those opals would have been 12.
Did I desire to hold those opals for one month? Did I have a demand to hold that stock of opals for one month? Well, yes and no. I didn't really desire to hold them at all. I wanted to get rid of them. If I had accidentally lost them, I wouldn't have bought replacements. But I wasn't desperate enough to desire to get rid of them immediately at any price. Given the opportunities I figured were available to me, I did choose to hold them for one month, and in that sense only, I did have a demand to hold that stock of opals for one month, and I did have a desired annual velocity of 12.
And in exactly that same sense, the opal dealer, who doesn't really want opals at all, has a desired stock of opals to hold in inventory and a desired velocity of circulation of opals (a desired inventory turnover of (say) 12 times a year). If good deals to buy or sell opals came at exactly the right times, perfectly synchronised, the opal dealer would be very happy to buy an opal and sell it immediately, holding no inventory at all. But they don't. Just like there wasn't an opal dealer right next door when i sold my car.
Only opal dealers, and opal miners, and people who sell cars to desperate Australian opal miners in the outback, hold inventories of opals. We all hold inventories of dollars. That's because everyone is a dollar dealer. We buy and sell dollars whenever we sell and buy anything else. And if someone gives us a good deal we buy dollars and hold them in inventory waiting for another good deal so we can sell them again. Because the good deals to buy our dollars aren't perfectly synchronised with good deals to sell our dollars.
If I had sold my car for opals, which were a hot potato, I would very probably have sold my opals to a jeweler who deals in opals. Because, including transactions costs and search costs and everything else, I would probably have got the best deal from someone who specialises in trading opals and who holds an inventory of opals. Only jewelers do that.
I sold my car for Australian dollars, which were also a hot potato. I sold them at a place, called a "bank", which is a dealer in Australian dollars. Because, including transactions costs and search costs and everything else, I would probably have got the best deal from someone who specialises in trading Australian dollars and who holds an inventory of Australian dollars. Only banks do that.
If I had sold my car for Canadian dollars, which are also a hot potato, I would have looked for a buyer who specialises in trading Canadian dollars and who would give me the best deal. But everyone I deal with here in Canada specialises in dealing with Canadian dollars and holds inventories of Canadian dollars. Everyone does that. Not just banks, but jewelers too, and car dealers, and my local supermarket, and my broker, and everyone I know.
Right now I have $100 in my pocket. It's a hot potato. I don't want it. I plan to get rid of it. Only not right now, because I am typing this right now. I plan to get rid of it a little later. Where will I get rid of it? At my bank? Well, if I thought my bank would give me the best deal, and something I really wanted more than anything else right now, then yes I would get rid of it at the bank. But I don't think that. I think i will get a better deal at the supermarket and gas station. So that's where I'm planning to spend it, in a little while. (Unless the bank phones me with a great new offer that can't wait.)
The gas station trades gas for Canadian dollars. The supermarket trades food for Canadian dollars. Continue through a long list of other traders. And the bank trades IOUs for Canadian dollars. A bank is just 1 out of 999 other places I could trade Canadian dollars.
Start in equilibrium in a monetary exchange economy. But it's always a weird sort of equilibrium, if it is a monetary exchange economy. Because even in equilibrium, people will be holding stocks of money that they really don't want to hold, and do want to get rid of. It's just that they don't want to get rid of it right this very instant, given the opportunities for deals they think are available and will be available. Just like I would have been wanting to get rid of those opals, and was just waiting for the right deal.
Now suppose the banks suddenly start offering a better deal when buying IOUs. And they offer that better deal to me and everyone else. What happens next?
Some of us accept the banks' offer, just as we would if used car dealers suddenly offered us a better deal to buy our cars. But just because I sell my used car to the dealer for $3,000 doesn't mean I want those 3,000 extra dollars. And just because I sell my IOU to the bank for $3,000 doesn't mean I want those 3,000 extra dollars. I only want those dollars in exactly the same sense as I would have wanted those opals: so i could get something I did want when I got rid of them. They are a hot potato burning a hole in my pocket or chequing account.
Now, it is possible that if the banks make a better offer for my IOUs, and keep making that same better offer for my IOUs, my desired velocity of circulation of money might fall, now that the interest rate and opportunity cost of holding money has fallen. So it is logically conceivable that my desired average inventory of money might rise by exactly $3,000 on average and stay there. But that's very unlikely. Much more likely is that I borrowed that extra money because I wanted to get rid of it by spending it on something else I wanted more than my IOU. Just like I sold my car to the dealer because I wanted to get rid of that extra money by spending it on something else I wanted more than my car.
From my point of view there is no difference whatsoever between a bank and a car dealer. One buys and sells IOUs and the other buys and sells cars. But there's a massive difference for the economy as a whole. The bank creates money when it buys IOUs and the car dealer does not create money when it buys cars.
So when the banks offer better deals on IOUs to everyone, and people take them up on the offer, the stock of money expands. But individuals don't plan to keep on holding all that extra money in inventory. By assumption their desired turnover of inventory is the same. They plan to get rid of it. Each individual can get rid of money, by passing it on to another individual, but in aggregate they can't. The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs.
But why would they want to do that?
If I have opals i want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money i want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999? Moreover, wasn't the original shock that got the ball rolling a decision by the banks to offer better deals when buying IOUs? Why would they do that, and at the same time offer better deals when selling IOUs back to us? If the banks raise the prices at which they will both buy and sell IOUs (i.e. lower their lending and borrowing rates of interest) there is no way the excess supply of money will reflux to the banks. Instead we will sell more IOUs to the banks, buy fewer IOUs back from the banks, so more money is created and less is destroyed, so we are holding and trying to get rid of more hot potatoes than we did before.
It can't go on forever, of course. And an inflation targeting central bank will make sure it doesn't go on forever. Because if it does go on forever the inflation rate will rise above target. Yes, in the long run, banks cannot create hot potato money. Because if they did create hot potato money the central bank would tighten monetary policy to stop them creating hot potato money.
In the long run, which means when the central bank is doing its job right, commercial banks can only create money that people want to "hold" (in the same sense that I wanted to "hold" those opals for a month before selling them, and the car dealer wants to "hold" one month's inventory of cars on the lot). The central bank won't let them create more, if it wants to keep inflation (or whatever) on target. And in that same long run, commercial banks can only lend what they can borrow. Because central banks won't let them lend more.
But in the very short run, none of that is true. If a central bank ever does find inflation is heading below target, and wants to get it back up to target, it will take actions to ensure that commercial banks do create more money and do create a bigger monetary hot potato.
[Running through my mind as I wrote this: an old paper by Alchian(?) on specialised traders and costs of ascertaining values of goods and why we use money; a slightly less old related paper by Clower and Howitt; Laidler; Yeager; and Tobin of course too, on the inventory approach.]