The End of Finance? The monetisation of everything.

I know it's wrong, or at least deeply problematic, to adopt a teleological view of history: to say that History has an End, or Purpose, and is inexorably driven by deterministic Iron Laws towards that End, with perhaps an occasional hiccough along the way. But I can't stop myself.

What is the End of Finance? Where is it inevitably leading? I think it is leading towards the monetisation of everything.

The First Underlying Driving Force behind the monetisation of everything is that people want their assets to be monetary, other things equal. If two assets had the same expected return, and risk, but one could be used as money and the other couldn't, people would prefer to hold the asset that could be used as money. In equilibrium, assets that cannot be used as money need to yield a premium over assets that can be used as money.

Here's the Second Underlying Driving Force. Cows yield milk. Cows can also be used as money. But using cows as money does not mean they stop yielding milk. In principle, using an asset as money need not detract from its non-monetary yield. It's a bonus, that comes over and above the non-monetary yield. The supply price of this monetary bonus is zero. And it's a bonus that people want, and are prepared to pay for.

Here's the Third Underlying Driving Force. Money is an asset that is used as a medium of exchange; and one of the things that is peculiar about money is that a promise to pay a medium of exchange can itself sometimes serve as a medium of exchange. A coat keeps you warm and dry; but a promise to pay a coat does not keep you warm and dry. A promise to pay a coat is not a coat. A promise to pay money can, however, sometimes be money (Yeager?). That's how paper currency, as promises to pay gold, became money. That's how chequing accounts, as promies to pay currency, became money. And so on.

Cows can work as money, but they have their drawbacks. They can't be easily transported, for one. But a promise to pay a cow can easily be transported. Or a promise to pay something else, with the cow as colateral, can easily be transported. And if the promises to pay cows all cancel out across time and space, no cows need ever actually be transported.

There's a demand for the good (the First Underlying Driving Force). There's a free supply of the resource that can produce the good, since it does not prevent those same resources being used for other purposes simultaneously (the Second Underlying Driving Force). And there's a technology (promising) that can convert the free resource into the good that people want (the Third Underlying Driving Force).

So, it's inevitable, innit? The Iron Laws of Finance mean the eventual monetisation of everything.

The puzzle is not shadow banking. The puzzle is why this Inexorable Progress towards the End of Finance didn't happen instantly, centuries ago. Why is it taking so long?

The answer of course is that the technology of promising is imperfect. It doesn't always work. Will the promiser keep his promise? Will he be able to? What if his ability to keep his promise to you depends on others' keeping their promises to him?

Sometimes we find the technology of promising is not as reliable as we thought it was, and there's a crisis as everyone learns this, and the supply of money contracts. Milton Friedman was right. If we could only keep the money supply growing steadily at k% per year, and the monetisation of everything progressing smoothly, all would be well with the macroeconomy. But we can't.

It's not at all surprising that technologies sometimes turn out not to be as good as we thought they were. Bridges fall down. Rockets explode. But when most technologies fail, the crash usually affects only a small part of the economy. What's different about the monetary technology is that money affects every single market in a monetary exchange economy, because money is always one of the goods traded in every market. So when we learn that the monetary technology is not as good as we thought it was, this affects the whole economy, not just a small sector.

But we learn from crashes in the monetary technology, just as we learn from bridges falling down and rockets exploding. We revert to an older, more familiar technology temporarily. But then History Marches Forward again, and the monetisation of everything progresses further towards its inexorable End.

[I was going to write a post on Treasury Bills as money, and Monetarism, but I lead myself astray.]

Comments

[bob mcmanus]

Jan Toporowski published a Routledge book with this title. JT is largely a Minsky follower. I could link to the Table of Contents at Amazon:Pt I Theory of Capital Market Inflation;Pt II Ponzi Finance and Pension Fund Capitalism;Pt III Financial Derivatives and Liquidity Preference.

Haven't read it. $240, $192 Kindle. I have read his Theories of Financial Disturbance, which is a shorter history of financial macroeconomic thought, several times. I think, IIRC, that JT would call your "monetization" idea a version of "reflective finance", that capital markets are reflective of the commodity/output markets. He thinks that is wrong, capital markets are independent, at least on the ascent. I think.

I don't remember any cows.

[Greg Ransom]

The taxing authority promises to take endless future wealth from wealth producers and wealth holders.

The taxing authority can then, in the present, sell off part of its future claims to this steam of wealth -- it can consume now what it will collect later.

These claims can then be used in trade as money.

I thinkmyou left that one out.

The first money was claims to cows, which were needed to pay the cow tax, if I am not mistaken -- which is also linked to the development of the first notation / writing system.

[Greg Ransom]

You've rediscovered Menger. And Hayek. Again.

[Jim Rootham]

@Ransom
Taxes are the price we pay for civilization.
Thank you for informing me that you are uncivil.

[Victor]

I believe the Belgian economist Bernard A. Lietaer has a lot to say on this matter. His solution: the introduction (or rather the allowance) of complimentary cooperative currencies such as the Swiss WIR to act as buffer mechanisms for local economies during international financial crises.

As professional economists, what are your guys' thoughts? I'm just an anonymous Canadian grad student in the social sciences.

http://www.youtube.com/watch?v=OfMbYllbN6c

[Greg Ransom]

I made no normative argument, Jim.

You are unhinged.

[david]

Ransom, you need to learn to cite your sources. Where has Menger or Hayek predicted total monetization, or noted why it has not happened in the manner Rowe has described?

[david]

(and I don't mean individual sentences, which, when squinted at in the right light, can sorta be interpreted to read "everything can function as money". I mean an acknowledgment that it isn't currently the case, an assertion that it will be the case, and a hypothesis suggesting why the change might occur.

It might shock you to realize that Hayek did not include the theory to life, the universe, and everything in his books)

[david]

@Rowe - but we can tweak the money base to keep up with erratic changes in the technologically-based money multiplier, thus keeping M growing smoothly. Is that where this was going? :p

[K]

And the more promises can be enforced, the more we can releverage them, the more spectacularly the system blows up in the end. The "end of finance" is not a desirable or manageble economic state. It is a bizarre world of complete, infinitely leveragable markets which requires an absurd level of knowledge and understanding by individual agents in order to be stable.

The system might be far more stable and unleveragable without state enforced promises. Something more like the communal rating system used on eBay as well as collateralized non-recourse only lending (which might arise naturally without state enforced contracts).

[anon]

I thin you are confusing "monetary" with "liquid". Any liquid asset can be reliably used as a medium of exchange. A forward or option contract on a liquid asset (say, a barrel of oil in the spot market--pun intended) is effectively a promise to deliver the asset; this can be a liquid asset itself and become a medium of exchange. On the other hand, one could easily imagine a situaton where the market in "promises" is more liquid than the spot market in the underlying.

But usually, when one talks about "money", one implies a reliable standard of value, not just a medium of exchange. Also, I'm not sure what you're getting at with the shadow banking system. By definition, a "shadow bank" performs maturity transformation (borrowing short and lending long), which is _not_ an economically sound policy and has very little to do with "money" per se. We like to talk about a lack of "liquidity" when maturity transformation fails, but in fact, the market is perfectly liquid: it's just pushing the value of long-term loans down, since they can't be matched with short-term credit.

[bill woolsey]

You need more work on the "free supply" side. Funding an investment project that takes time with debt that is payable on demand (and so serves as money)is risky, and for the borrower to bear that risk isn't free.

I don't think this is an imperfection in lending technology. I see it as a reason for downward sloping supply curve (for yields) in intermediation. The lower the interest rates that "banks" must pay on deposits, the more they will choose to offer. The higher the gap between the yields on investment projects (or earning assets) and the yields savers will accept, the greater the supply of intermediation--perhaps in the form of money. And less money-like intermediation will be cheaper than more money like intermediation.

When you switch to mutual funds, then the saver bears the risk. Are you really sure that everyone is dying to hold all of their wealth in a checkable form, no matter what it's liquidity? Writing a check against my apple stock has some benefits, but doesn't that just mean I have an arrangement with my broker to sell the stock for me to cover checks rather than first oder a sale, and then write checks?

To put another gloss on it, do people really want to make sure they have a line of credit equal to their total wealth?

And these three things--having all one's wealth as a checkable demand deposit account or having all ones wealth in checkable form (like a mutual fund,) or having a very large line of credit, don't seem to be the same thing to me.

How they are different seems very much related to "finance."

[Nick Rowe]

Bob: I just skimmed through the Google books page on Jan Toporowski. It's really great that some finance people occasionally step back and try to write a Big Theory. The title "The End of Finance" was just too tempting not to have already been taken. Too bad. From what I can gather though, his approach looks a bit different. He's talking about the financialisation of everything, as opposed to the monetisation of everything. And I'm really not sure if that (Marxian?) distinction between finance capital and commercial capital etc. really holds water. If we want to invest in real assets, we either do the savings ourselves, or we borrow from others. If we want to save, we either invest in real capital ourselves, or lend it to others. Finance is just intertemporal trade, and allows individuals to separate their saving and investment decisions. Just like trade in beans allows me to separate my decision to consume beans from my decision to produce beans.

Greg: you can think of government bonds as promises to pay future tax revenues (they are also promises to pay future money, of course, but that money needs to come from tax revenues, at the margin, for a given rate of inflation). Yep, they get monetised. And they are prime candidates for monetisation, since they are simple, and there are so many of them, all alike. But government assets are not the only things that can get monetised. Chartalists, for example, seem to have an exclusive focus on government assets as money.

I can see my post as being Mengerian in the sense that I focus on the market forces leading to monetisation, as opposed to (say) Chartalists with their focus on government policy creating money. But I don't see it as more Austrian than that. I'm not sure how the Austrian economists view historicism (I know Popper didn't like it, of course).

Victor: Those local monies really interest me. Some thoughts:
1. They are money, not barter. It's multilateral exchange, because A buys from B who buys for C....who buys from X who buys from A.
2. Their existence contradicts the Chartalist claim that money is always a creature of the state.
3. Their existence contradicts the claim made by some libertarian private money proponents that the government has an effective legal monopoly on money.
4. The fact (if it is one) that they are countercyclical (they expand in recessions) is strong evidence to me that recessions are fundamentally monetary in nature, and are caused by a shortage of money.
5. They are probably more of a palliative than a cure.
6. I wish them well, except when they are just a way to evade taxes, but the idea of a *local* money is partially oxymoronic.

David: "I mean an acknowledgment that it isn't currently the case, an assertion that it will be the case, and a hypothesis suggesting why the change might occur." Nice clear statement of the logical structure of my post. Funnily enough, I hadn't seen that till you wrote it, at which point it became obvious!

"@Rowe - but we can tweak the money base to keep up with erratic changes in the technologically-based money multiplier, thus keeping M growing smoothly. Is that where this was going? :p"

That's a good and important question. I can't answer it. That's the question I should have addressed, and where my post should have gone next. My guess is that it helps, but can't fully compensate. But I can't explain why.

K: Agreed, the "End of Finance" is not necessarily a desirable state of affairs. But there is *something* desirable about it. We do want all our assets to be monetised, and in principle it seems do-able.

I don't think the monetisation of assets necessarily means leverage. Leverage means people hold debt, as opposed to equity (stocks, shares). Finance can do either debt or equity-finance. We could write cheques on stock market mutual funds? With current technology, it seems easier to monetise debt than equity, because debt is usually simpler, and so monetisation seems to promote a bias towards debt-finance. But I'm not sure this has to be the case, always.

[K]

My point, more clearly, is this: we need a system of promises that people can reasonably commit to. Not big promises that are only credible by virtue of threat of extreme consequences. People don't make thoses choices well when faced with an immediate benefit at the risk of an adverse consequence they have never experienced with a probability neither they nor anyone else have any ability to quantify. This is a less leveraged, less complete market place of real goods - not promises.

[Kien Choong]

Is "monetisation of everything" another way of saying "markets in everything"? If so, doesn't the existence of firms imply that not everything can be monetised? Activities within a firm cannot be monetised. While a substantial part of a firm's assets can be pledged (i.e., monetised), a residual amount cannot (e.g., because of moral hazard). So long as entrepreneurial effort cannot be observed completely, part of the value of a firm cannot be monetised.

[JKH]

I'd tend to put monetization and securitization in that order at the left end of a liquidity continuum.

The financial crisis was brought about by excessive securitization and the capital arbitrage and risk management dysfunction associated with it.

Maybe the post title could have been "The ization of everything".

:)

Remember this?:

http://en.wikipedia.org/wiki/Bowie_Bonds

[Ruth Harris]

I would say that you can't monetize debt. A person monetizes some asset by getting a bank (shadow or not) to let them issue debt against that asset, thereby creating money.

[Greg Ransom]

"I can see my post as being Mengerian in the sense that I focus on the market forces leading to monetisation, as opposed to (say) Chartalists with their focus on government policy creating money. But I don't see it as more Austrian than that."

Right. You are telling a Menger causal story -- which is one of the great paradigms of scientific explanation in economics. My point against "modern Austrians" is that the Chartalist story is equally sould as a causal story, involving both force and market forced (property rights are also enforced by force).

There are differences between historicist laws and ratchet mechanism that drive social coordination or discoordination.

Both Menger and Hayek wrote on the topic.

I've always believed Popper got his inspiration from Menger.

Hayek, of course, published Popper's original papers in the LSE economics journal.

There was a good recent article (citing Hayek) on fluctualtions in "shadow money" -- monetized assets -- during the recent boom and bust.

I'll post the URL.

[Greg Ransom]

Sorry, mKe that:

"My point against "modern Austrians" is that the Chartalist story is equally sound as a causal story, involving both force and market forces (property rights are also enforced by force)."

[Greg Ransom]

From Taking Hayek Seriously:

I recently came across a terrific Bloomberg On The Economy podcast with James Sweeney and Carl Lantz on “shadow money” — assets which are used as the equivalent of money during the snowball of the asset bubble / artificial boom.

The problem Sweeney and Lantz identify is that the stock of money expands and contracts across the boom and bust cycle in the domain of “shadow money” — leading to the differential distortions of the structure of relative prices and supplies across asset classes, and discoordination between planned levels of investment, savings, and consumption, as well as discoordination between economically sustainable streams of rival production processes.

Listen to the podcast or dowload here (mp3).  Listen for a discussion of Hayek toward the end of the conversation.  The podcast discusses ideas contained in their paper “Long Shadows:  Collateral Money, Asset Bubbles and Inflation” by Jonathan Wilmot, James Sweeney, Matthias Klein, and Carl Lantz (pdf).

Wilmot, Sweeney, Klein, and Lantz begin their paper with this quotation from Friedrich Hayek:

“There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.

Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.”

Friedrich Hayek, Prices and Production 1931 – 1935.

They continue their quotation from Hayek in the middle of their paper:

“It is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense would be required.  The criterion by which we may distinguish these circulating credits from other forms which do not act as substitutes for money is that they give to somebody the means of purchasing goods [or securities] without at the same time diminishing the money spending power of somebody else. …. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.”

Wilmot, Sweeney, Klein, and Lantz then comment:

Hayek’s point is that the economy can create its own media of exchange in order to economize on the use of inside and outside money when there is significant demand for some type of money for use in purchasing assets. Of course, when assets can themselves serve as collateral, allowing for leveraged purchases, then they take on money-like properties. And when financial assets serve as collateral for borrowing to purchase yet more financial assets (buying on margin) this form of shadow money can become particularly potent in driving asset price overshoots and bubbles.

I also recommend the transcript of an “On The Money” podcast with Sweeney and Lantz from Jan. 5, 2010 on the same topic.

UPDATE — Ellen Brown of Global Research presents a summary of Sweeney and Lantz:

Along with the disappearance of the “shadow lenders,” there has been a dramatic decline in something called “shadow money.” The concept of shadow money was presented by two economists from Credit Suisse, James Sweeney and Carl Lantz, in a Bloomberg interview in May. As explained on DemandSideBlog, shadow money is money the market itself creates in order to finance a boom — “money” in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral is used as near money or shadow money. Shadow money can include government bonds, private bonds, asset-backed securities, credit card debt (which can be incurred and paid off without drawing on the M1 money stock), and even real estate (when it is highly liquid and easily tradeable) . . .

Lantz and Sweeney calculate that at the peak of the boom there were six trillion dollars in the traditionally-defined money stock (or money supply). The private shadow stock accounted for $9.5 trillion, and government-based shadow money accounted for another $11 trillion. Thus the shadow money stock dwarfed the traditionally-defined money stock. This can be seen in the chart below provided by Tyler Durden. The blue strips at the bottom, called “outside money,” are dollars printed by the Federal Reserve. The red sections, called “inside money,” are money created as loans by the banks themselves. The green sections, called “public shadow money,” are money created by the government and the Fed as debt (or loans). The purple sections, called “private shadow money,” are the money created as private debt securities by the shadow lenders.

Lantz and Sweeney estimate the total drop in private shadow money (the purple blocks) during the current credit crisis at $3.6 trillion. This has been offset by an increase in public shadow money, both from the massive borrowing needed to finance the federal deficit and from the aggressive liquidity measures taken by the Fed in converting private securities into loans.  Those measures helped prevent an even worse drop in the commercial money supply than actually occurred, but they were not sufficient to eliminate the credit squeeze from lowered commercial lending, which continues to act as a tourniquet on the productive economy.

[Greg Ransom]

The URL -- where you'll find links for the above -- is:

http://hayekcenter.org/?p=2954

[David Pearson]

"Monetization" might represent four different dynamics:

-an evolution towards the liquidity transformation of all assets (your thesis)
-a transient, inordinately high appetite for liquidity transformation of long-duration, volatile collateral: an artifact of recent Central Bank "put" consensus that illiquidity in any broadly held asset=deflation risk=policy failure.
-a recently failed experiment in taking an innovation that facilitates liquidity/maturity transformation--pooling and tranching--to extremes (CDO's).
-some mix of the above

I'm not saying financial innovation doesn't occur; just that the steady march is not something that necessarily occurs. Capital markets changed little until the late 1980's, when we had a burst of over the counter derivative innovation--mostly interest rate and currency related. I would argue that was true progress, the absorption by financial markets of new, enabling information technology. Following that burst, we remained stable until the late 1990's, when tranching and pooling securtization began to be applied to more and more collateral types. This led to an explosion in ABS and CDO issuance, which in turn led to the growth in shadow banking system liquidity and maturity transformation. Post-crisis, those two innovations have failed to recover, and may not ever. So, is this a march to the "end of financial history", or a one-time failed experiment in the monetization of long-duration, volatile collateral? Its probably too early to tell.

[Mike Sproul]

Nick:

John Law beat you to it in 1715. He monetized land. It was a great idea, since it didn't take the land out of production. Unfortunately, his plan to develop the land in Mississippi didn't go well, and Law himself had some character flaws, so his notes lost backing, and we had history's first major hyperinflation.

I think I'll start my own land bank. Each "dollar" I issue will be a claim to 1 square foot of land. Now my question, which you probably saw coming, is what if the public keeps borrowing my dollars, while posting land of adequate value as collateral? What if the supply of my dollars increases thousands of times? Will each dollar now be worth something less than 1 square foot of land?

By the way: Schumpeter's History text (1950? I have it marked in my notes as p. 321.) has a passage that says you can't ride a claim to a horse, but you can trade with a claim to money.

[Greg Ransom]

Menger's account of the origin of money is here:

http://mises.org/resources/4984

Menger's examination of the difference between historicist laws and the causal explanations of the sort given in his origin of money story is here:

http://mises.org/literature.aspx?action=source&source=Online%20Books

Menger offered the first critique of historicism, as far as I am aware. He also offered a critique of crude "Millian" induction in ways similar to Popper's later work on this topic.

Menger's original critique of historicism (in German) is here:

http://oll.libertyfund.org/index.php?option=com_staticxt&staticfile=show.php%3Ftitle=1792&Itemid=27

"Die Irrthümer des Historismus in der deutschen Nationalökonomie"

[anon]

"-a recently failed experiment in taking an innovation that facilitates liquidity/maturity transformation--pooling and tranching--to extremes (CDO's)."

I'd argue that the true innovation here was the "shadow banking system", not asset securitization (which is only relevant as a proximate cause). Maturity transformation (what you call "liquidity transformation" above) is unstable in the absence of a lender of last resort[1], such as the the Fed or the U.S. Government. The shadow banking system thought they had Fed/USGov on their side via the "too big to fail" theory, so they engaged in lots of MT.

[1] In fact, a "lender of last resort" essentially bears the same risk as a "lender of first resort" would. Consider a bank which uses demand-deposits to make long-term mortgage loans. Let's split it into two banks: Bank A is a full-reserve bank: it stores deposits in its vault and redeems them on demand. Bank B borrows long-term from Fed/U.S.Gov and makes long-term mortgage loans. The catch is that Bank B is contractually obligated to borrow from Fed/U.S.Gov only in so far as Bank A has cash in the vault. In every respect, this is a financially stable system: instead of maturity transformation, we find monetary authorities which simply print money and loan it out, subject to some contractual constraints.

[Greg Ransom]

Here's a popular account of the origin of money, as archeology knows the story:

http://rhetoricaldevice.com/articles/BriefHistoryOfMoney1.html

Denise Schmandt-Besserat tells the story of the co-origin of money and writing in this book:

http://www.amazon.com/Writing-Came-About-Denise-Schmandt-Besserat/dp/0292777043

[Greg Ransom]

Silver became the first dominant standard of trade -- for two inter-related reasons. Those who taxed needed a commodity that did not degrade, and in demanding that commodity from everybody, they inspired a universal demand in the population for that commodity -- everyone needed the stuff to pay taxes.

Here's a popular account:

"The harmony between the nature of the goods in the market and the nature of the currency meant that — although incomes were far from equal — no one could get very rich because their money would lose its value within a couple of years. This storage problem was carefully studied by those with high incomes, particularly the Priest Kings who — though a small hereditary minority — received a tithe from every producer in the community. Their surplus income was so large that they were unable, even with the technologies of beer and cheese, to store all the commodities they received.

You probably won’t be surprised to learn that the idea of taking a smaller cut didn’t occur to the ruling class of ancient Mesopotamia. Instead, some time between 3,000BCE and 2,500BCE it was decided that temple taxes would only be accepted in the most expensive and durable commodity known at the time: silver. They chose silver for this purpose because, unlike barley, silver doesn’t spoil. These new silver weights, called shekels1414. Literally “barley weight” in Akkadian; it was both a unit of currency and a unit of weight, were the prototype for the other currencies of the Ancient Near East1515. "

[David Pearson]

Anon,

I agree that shadow banks were part of the "innovation". They took illiquid, long-duration, volatile assets and transformed them into liquid ones. True, there was some credit and maturity transformation involved, but shadow banks more often than not held AAA-rated assets (thought to have no credit risk); and they hedged rate risk using fixed/floating swaps (no maturity or duration risk). So, in the end, they mostly got paid to take illiquid assets and have them back liquid liabilities. It was precisely this liquidity risk that ultimately led to a broad panic in the shadow banking system. I am probably understating the amount of maturity transformation that went on, but just to underscore that it was not unexpected rate volatility that ultimately caused a financial panic.

I also agree that one can point to the Fed "put" for TBTF institutions as the source of the market's appetite for liquidity transformation. This fits with my second "Fed put" dynamic above.

[edeast]

Chartalism: Maybe local currencies are like dragon kill points, within the larger framework of the state. What does the crown control vs what individuals control: You know how we have a short position in housing; need to get the money to pay land taxes every year or rent, even if you grow your own food and don't participate in the economy other-wise. vs When you enter your home you don't usually pass money around to get family to do things, you have a different social accounting scheme. Second Kien Choong's comment on the firm.

[anon]

"So, in the end, they mostly got paid to take illiquid assets and have them back liquid liabilities."

Whether this is sound would seem to depend on what exactly the "liquid liabilities" are. If they are short-term redeemable debt then this is essentially MT by another name and thus problematic, but if it was equity then it wouldn't be an issue per se. Think of a REIT (real estate investment trust): it holds illiquid real estate as assets and issues liquid equity. If it weren't for information asymmetries and accounting distortions, CDOs and other securitized assets could well trade in a liquid market.

Essentially, what "liquidity" does is transfer the option of doing MT onto the retail/final investor: you could buy a liquid long-term bond with the intention of getting out after a while, because long-term bonds have higher yield than short-term ones. If everyone wants out at the same time (because their long-term demand for the bond was spurious, like yours) then the price of the bond will fall and the excess yield will disappear. The MT has failed. But AIUI the market may well remain liquid; the bid-ask spread need not widen.

[Scott Sumner]

Nick, It seems to me that it is becoming steadily more difficult to measure the value of all the assets that might, in principle, become monetized. You cite the example of currency that is backed by gold. But the share of our economy that is composed of easy to measure commodities has fallen dramatically over time, to only a small fraction of the level of the late 1800s. How can we monetize cows or computers or MBSs, when no one knows what a particular cow or computer or MBS is worth?

[Greg Ransom]

Scott, no one knows how to make a pencil, but pencils get made. No one knows how to monetize all this stuff, but it does get monetized.

What we want are institutions that make all this as transparent as possible, and without giant built-in moral hazard distortions, etc.

The argument for the de-nationalization of money in part is the argument that you can't centrally plan a stable money supply any more than you can centrally plan the making of a pencil.

The argument seems to be spreading. See Marc Faber's recent interview on money and the boom and bust.

Scott wrote,

"How can we monetize cows or computers or MBSs, when no one knows what a particular cow or computer or MBS is worth?"

[Greg Ransom]

De Soto and others argue that transparency begins with property transfer titles and documentation, etc.

We lack transparency here on Wall Street, I would argue. And we have pathological government institutions throwing a monkey wrench into the middle of it all.

All of this stuff should be public, on the internet, and written in standard form language.

Michael Lewis has guys explaining how no knew what many of the derivatives and insurance contracts said, or what they meant.

Even Madoff did all his business outside of public view.

More transparency and standardization, please.

[Greg Ransom]

er, make that "Michael Lewis has guys explaining how no one knew what many of the derivatives and insurance contracts said, or what they meant."

[Greg Ransom]

The 100% reserve folks want to eliminate these liquidity/solvency/transparency problems of monetization by law ...

[David Khoo]

Monetization involves transactional costs. You need to keep track of these promises and enforce them. You need to assess what these promises are worth via assessors or markets. These costs take the form of transfers to the financial and legal sectors from the "real" economy for market-making, custodial services, litigation, etc. Beyond the point where they generate value from more efficient allocation of resources, these costs become deadweight losses to the economy. This is the Underlying Driving Force that opposes monetization and with which the other forces will ultimately fall into equilibrium with. The lower the transaction costs, the greater the proportion of assets that will be monetized at equilibrium. Costs have been falling historically as technology improves, but it is nonsense to think that everything will eventually be monetized. Reality has more friction than economic theory gives it credit for.

[edeast]

Mark Carney interview: values the shadow banking system, and important for appropriate "light-touch" regulation. "We welcome-- growth in shadow banking."

[Simon van Norden]

Nick; come on, dude. You know better than this.

You know that money needs to be homogeneous. Last I looked, cows aren't (some have horns! and those horned ones get angry when you try to milk them!). People thought for a while that CDOs and MBSs were homogeneous and close substitutes for money. Many are sadder and wiser now.

You also know that money needs to be a reliable store of value. But the money prices of cow move around. People don't like that. You may recall that many major european economies didn't like that fact that the money prices of their monies moved around, so they took extreme measures to stop it. (And they still have a line-up of countries wanting to adopt the Euro.) Don't think they've tried to replace the cow, yet (but with european agricultural policies, who knows?)

I think these are just two reasons why there are important limits to monetarization.

Write about t-bills dude. You could teach me something.

[Nick Rowe]

anon: "I thin you are confusing "monetary" with "liquid". Any liquid asset can be reliably used as a medium of exchange."

I don't think I am confusing the two. There are degrees of liquidity, and money, as the medium of exchange, is the most liquid of all assets.

"But usually, when one talks about "money", one implies a reliable standard of value, not just a medium of exchange."

Usually, the medium of exchange is also the medium of account; but it isn't always that way. For examples, in hyperinflations, the two may become separate.

"Also, I'm not sure what you're getting at with the shadow banking system. By definition, a "shadow bank" performs maturity transformation (borrowing short and lending long), which is _not_ an economically sound policy and has very little to do with "money" per se."

All banks borrow short and lend long. That's what a bank is. And money is just very short.

Bill: "To put another gloss on it, do people really want to make sure they have a line of credit equal to their total wealth?"

I would answer "yes". I expect there are exceptions, where people freeze their credit cards to try to control their own spending.

The risk of real investment exists, and someone has to hold it. But I can't see why the variance of one's wealth should put a limit on the percentage of one's wealth at any point in time that can be used as a medium of exchange.

Kien: "Is "monetisation of everything" another way of saying "markets in everything"?"

No. We think of monetisation as a synonym for marketisation just because most markets are monetary. But I'm talking about all assets becoming money, not about marketisation.

JKH: "I'd tend to put monetization and securitization in that order at the left end of a liquidity continuum."

Yes, I think I would agree with that. Securitisation is close to monetisation, and can support monetisation. First securitise the real asset, to make it more easily tradeable, then use those securities as collateral (repos) for an essentially monetary asset.

To be continued..

[Peter T]

Nick

You just re-stated parts of the Communist Manifesto. Now read the bit where it goes on to note that, since endless universal fluctuation is deeply antagonistic to leading a human life, the masses will revolt. Then read the history of Europe 1870 to 1945.

[Nick Rowe]

David Khoo @11.35pm has it exactly. The limitations on the promising technology are the Underlying Force that limits the monetisation of everything. But he acknowledges that that technology has been improving over time, and the costs of monetisation have been falling. And what I am asserting is that those costs will continue to fall in future, and will approach zero in the limit, so that the monetisation of everything is the limiting case, at the End of Monetary and Financial History.

In order to argue against my thesis, I think you need to argue that there is some positive lower bound on those costs, some absolute upper limit on that technology, beyond which we cannot go.

Scott: "Nick, It seems to me that it is becoming steadily more difficult to measure the value of all the assets that might, in principle, become monetized."

Or, you can argue as Scott just did, that there's a second Underlying Force working against improving promising technology, which is that over time it's getting increasing difficult to measure the value of assets.

Hmmm. That's not obvious to me Scott. Why should it be inevitable that assets will become increasingly difficult to value over time? One can think of examples, and counterexamples. For example, the technology of measuring the physical properties of things is improving over time.

Simon: yep, cows are all different, which is a problem. But remember, the medium of exchange doesn't have to be the same as the medium of account. We can, e.g. measure prices in gold, but buy stuff with cows.

How to convert cows into money, while still keeping the cows on the farm:
Randomise the cows. I buy your car, and give you a lottery ticket to a 1% random draw of my cows' ear tags, so you know you are not getting a lemon cow.
Securitise the cows. You get 1% of the total milk and meat.
Collateralise the cows. Just get a line of credit with chequing privileges with the cows as collateral.

Greg: "The 100% reserve folks want to eliminate these liquidity/solvency/transparency problems of monetization by law ..."

The 100% reserve folks are standing full-square in front of the train of the Inexorable Forces of Historical Determinism, yelling "Stop!" to the Monetisation of Everything!

And yes, transparency and documentation are key parts to the technology of promising.

[Nick Rowe]

Ruth Harris: "I would say that you can't monetize debt. A person monetizes some asset by getting a bank (shadow or not) to let them issue debt against that asset, thereby creating money."

Banks monetise debt the whole time. The bank's assets are loans, which are debts, and its liabilities are chequable demand deposits, which are money.

David Pearson: "So, is this a march to the "end of financial history", or a one-time failed experiment in the monetization of long-duration, volatile collateral? Its probably too early to tell."

If I'm right about the Underlying Forces, and if technology doesn't go backwards, then it can only be the Long March to the End of Financial History!

Mike Sproul: good question. This gets to the heart of the Quantity Theory vs Real Bills debate. Let me re-phrase it: If the monetisation of everything means an increasing supply of money (relative to GDP), doesn't that mean inflation?

First, we need to distinguish medium of exchange from medium of account. Inflation is a falling value of the medium of account, which isn't necessarily the same as the medium of exchange.

Second, if the monetisation of everything means an increasing supply of money, but also an increasing own rate of return on money, the demand and supply could increase at the same rate, so there needn't be inflation.

[Nick Rowe]

Peter T.: I was trying to parody the Communist Manifesto in style. But I think my causal mechanism is a lot clearer than Marx/Engels!

Mike Sproul mentioned John Law. I read his biography. He was the original quant. Professional gambler. And he was way ahead of the curve, in money and finance. Too far ahead of the curve. David Laidler did a talk showing some lovely parallels between that financial crisis and the current one. Even down to people complaining about Law's using this damned new-fangled *Algebra* is what caused the crisis! But if you look back on some of the terribly risky and complicated innovations that Law introduced, many are things we take for granted now. Fiat money, shares in limited liability companies, etc.

There are always crashes when any new technology gets introduced. Cars, planes, finance. But the crashes aren't getting bigger over time (the Law crash sounded horrendous). And they seem less likely to lead to revolution now than in the past. This is yet one more Marx-Engels prediction that failed. (Plus, the Marxian mechanism, of rising constant to variable capital, surplus value falling rate of profit etc., makes no sense, because the whole Labour Theory of Value makes no sense.)

[Phil Koop]

I thought Scott Sumner's point was well-taken. There is a big difference between securitization and monetization; the one does not necessarily imply the other. Monetization seems to happen naturally with assets that meet some sort of volume requirement and are also so trusted that one needn't inquire too closely as to their value. "Information-insensitive" is Gorton's term. That is why it is common for financial derivatives to be more liquid than their underlyiers, but uncommon for them to be used as money. An oil future is more liquid than a barrel of oil, but you can't settle anything except a futures position with one. I think that securitization has a bright future, and we will continue to find new assets to securitize. But Sumner is right; the "easy" assets have already been taken, and on the frontier are assets that require ever-greater computing power to analyze. They don't lend themselves well to money creation.

[Kien Choong]

Hi, Nick. The point I was trying to make by comparing "monetization of everything" with "markets in everything" is to draw on the work of IO economists on why firms exist at all. If there are limits to markets, then those limits apply also to monetization, no? I realise monetisation and markets are not exactly the same; but the former must necessarily be a subset of the latter. Sorry if I am completely out of my depth and have misunderstood your post entirely.

On the desirability of monetizing everything, I do agree that it is desirable in some sense. Specifically, if the full value of a firm's assets could be monetized completely, it could also be pledged. This would allow all projects with positive NPV to be funded. However, if there is a wedge between the full value of a firm and the amount that can be pledged/monetized, this necessarily limits the set of positive NPV projects that can be funded. I learnt this insight from Tirole.

Monetization is not always desirable (as you have acknowledged). It may, for example, erode non-monetary motivation. (Suppose you paid your wife for sleeping with you each night.) Again, apologies if I have completely misunderstood your post.

[Scott Sumner]

I didn't follow all the comments as closely as I should have, so I may have missed something. But in response to Greg, I'd observe that I may have been drawing a distinction between "monetization" and "securitization" that Nick did not intend. Thus complex hard-to-measure assets can easily be securitized (as with common stock) but I assumed the sine non qua of money is its fixed nominal value.

I see Phil Koop had a similar interpretation. In any case, right or wrong that's what I was assuming Nick meant by 'monetization.'

[Nick Rowe]

Phil: Yes, Scott's counterargument was a strong one. But we need to distinguish the cross section from the time series. At any given time, with existing financial technology, we can only push the margin of monetisation so far, just as we can only push the margin of cultivation so far up the hill. But over time, as the technology improves, we can push the margin further up. Unless, as Scott argues, there is an offsetting change of the real assets getting more complex over time.

Securitisation is not the same as monetisation, though it is a step in that direction, and may promote monetisation. Gorton's term "information-insensitive" seems to me to be getting at the same thing that Alchian was talking about in the 1970's, in the microfoundations of monetary exchange. For a good to serve as money, the costs of ascertaining its quality must be low for everyone. Specialist traders buy and sell all the other goods, because they have the informational advantage. It's part of the Akerlovian Market for Lemons problem. Really goes right back to Menger's theory of money, just one aspect of his transactions costs, and the most important one.

Kien: we are all out of our depth here ;-)

Yes, there are limits to markets (Coase). And there are limits to the monetisation of assets. But you can have a market in something without it being used as money. But you may have a point, if you are arguing that the same sorts of things that create transactions costs and limits to markets also create limits to monetisation of assets. That seems right.

By the way, I'm sorry I have been a bit slow responding to comments. Sometimes I just need to clear my head, and go fix a couple of minor oil leaks in the MX6.

I also see I need to flesh out this post more. It's too abstract. So I'm halfway through a follow-up post on how to convert cows into money (while still milking them).

[Nick Rowe]

Scott: we were commenting at the same time. So I didn't see your latest comment when writing my previous.

" Thus complex hard-to-measure assets can easily be securitized (as with common stock) but I assumed the sine non qua of money is its fixed nominal value."

That's where we disagree. You are a medium of account man; I'm a medium of exchange man. I'm going to try to bring that out in my next post. The "standard cow" as a medium of account. Purely imaginary media of account, that don't actually exist.

[Phil Koop]

Nick: yes, it does sound like you'll need a lot of space to explain this claim, so I'm looking forward to the standard cow. I should have thought that certainty of nominal value is, if anything, more vital in a medium of exchange than in a unit of account. Without this, we would be back in a world of bimetallism (or multi-metallism.)

In a chain like gold -> paper money -> check on demand deposit of paper money, the value of each step in the chain depends on its ability to be expressed in the common underlying unit, and in a fair degree of certainty that this value will be stable. Note that AAA ABS tranches were designed to have exactly this property: on the one hand they are bonds, capping upside; on the other, they are deeply subordinated, in order to floor downside. What makes mortgages so troublesome as an underlying asset is that their special risks, default and prepayment, are inversely correlated, so that the terms required to produce a genuine AAA tranche may be uneconomic when the securitization is considered as a whole.

[Greg Ransom]

Help me to understand. The supply and demand of fiat currencies are worked out through the exchange of those monies with all other goods in the market -- and the exchange of those monies with other fiat currencies. What happens when there is a growth in the liquidity of "near monies" -- i.e. when there is a growth in the supply, tradability, and demand for"shadow money"?

Won't this change the supply and demand -- the value -- of the fiat money?

I'm just a philosopher of economics. Not an economist. Help me learn.

Maybe I'm misunderstanding what "fixed nominal value" means.

Scott wrote?

".. in response to Greg, I'd observe that I may have been drawing a distinction between "monetization" and "securitization" that Nick did not intend. Thus complex hard-to-measure assets can easily be securitized (as with common stock) but I assumed the sine non qua of money is its fixed nominal value."

[Greg Ransom]

Centralized governments stipulate a universal "medium of exchange" by demanding tax payment in a single "legal tender", by conducting all government spending using a single "legal tender", by mandating that all trade and debt payment be made using only a single "legal tender".

Doesn't this lower transaction costs for everyone, by assuring a universal market for the legal tender?

I mean, as long as you don't allow a hyperinflation to upend the apple cart?

Thought experiment. What happens if you eliminate legal tender laws and accept tax payment in all sorts of different securitized baskets of goods?

Is that even possible?

[Mike Sproul]

Nick:

"If the monetisation of everything means an increasing supply of money (relative to GDP), doesn't that mean inflation?"

If there are 100 paper dollars laying claim to 100 square feet of land, or if there are 5000 dollars laying claim to 5000 square feet of land, each dollar must be worth 1 square foot. Meanwhile, the supply of land relative to everything else is unchanged, so the value of land is the same, and the value of dollars, relative to land and everything else, must be the same.

"First, we need to distinguish medium of exchange from medium of account. Inflation is a falling value of the medium of account, which isn't necessarily the same as the medium of exchange."

If you start with $100 backed by 100 square feet, and then 50 of those square feet are swallowed by the ocean, each dollar will fall to .5 square feet (inflation) even though the value of the unit of account (a square foot of land) might be unaffected.

"Second, if the monetisation of everything means an increasing supply of money, but also an increasing own rate of return on money, the demand and supply could increase at the same rate, so there needn't be inflation."

The more interesting question is what happens if one more square foot is monetized (i.e., 1 more dollar is issued) while everything else (like return on money) is unaffected. The right answer is that one dollar must reflux to its issuer. For example, someone who had borrowed a dollar while offering land as collateral, pays back his dollar. He regains title to his land while the dollar is retired. Thus our hypothetical issue of one new dollar just leads to the retirement of another dollar, and the increase in the money supply that you (and I) spoke of never happens.

[Reverend Moon]

Pawn Shops already do this.

[Nick Rowe]

Reverend Moon: Yes, there's really little difference between a pawnshop and a repo. There's one trouble with pawnshops: if I pawn my watch, I can't use it to tell the time. It's like your cows stop giving milk if you lose physical possession. But pawning something shouldn't necessarily mean it changes location, or stops giving milk.

Mike: think negotiable cows. If half the cows fall off a cliff, half the money stock disappears along with half the assets backing them. But, the whole backing theory won't work, because the value of the cow is not independent of the fact that it is a monetary cow. Liquid assets have a higher value than non-liquid, even with the same milk yield. The money backs the backing, as much as vice versa.

Greg: if the supply of money increases, it falls in value. If the demand for money increases, it rises in value. When you monetise cows, that increases the supply of money (obviously), but it also increases the demand for money, because money now yields milk. So, the effect on general equilibrium value of money could go either way.

Money can exist even if the government does not demand payment of taxes in that money. If the government struck oil, and decided it could earn enough income from oil so it didn't need taxes. Would money disappear? Or fall to zero value? Of course not. Chartalism is wrong. The Hippy monies (local monies) cannot be used to pay taxes, and are unbacked, but still have value.

Gotta go to meeting.

[Scott Sumner]

Greg, When near monies develop, then the deamnd for fiat money falls. Unless the central bank reduces the supply, the price level rises. But not as much as you'd think, as near monies are actually not very close substitutues for cash.

[Greg Ransom]

The key is to see _where_ in the market economy near monies are close substitutes and where they are not.

When the demand and supply ofmonies and near money fluctuate in different directions, this changes relative prices and asset prices and the differential size of of non-identical production streams.

Scott wrote,

"Greg, When near monies develop, then the deamnd for fiat money falls. Unless the central bank reduces the supply, the price level rises. But not as much as you'd think, as near monies are actually not very close substitutues for cash."

[Mike Sproul]

Nick:

Whoa...Hold on there cowboy. First you said:

"How to convert cows into money, while still keeping the cows on the farm:
Randomise the cows. I buy your car, and give you a lottery ticket to a 1% random draw of my cows' ear tags, so you know you are not getting a lemon cow.
Securitise the cows. You get 1% of the total milk and meat.
Collateralise the cows. Just get a line of credit with chequing privileges with the cows as collateral."

But then you said:

"If half the cows fall off a cliff, half the money stock disappears along with half the assets backing them. But, the whole backing theory won't work, because the value of the cow is not independent of the fact that it is a monetary cow. Liquid assets have a higher value than non-liquid, even with the same milk yield. The money backs the backing, as much as vice versa."

Now, I take your first statement to mean each cow certificate gave its holder the right to claim 1% of the herd of 100 cows. So if 50 cows fall off a cliff, each certificate is now a claim to 1% of 50 cows, or half a cow. Now assuming that the loss of 50 cows had a negligible effect on the world cow population, a cow will still buy the same amount of apples and oranges as it used to, so each cow certificate will now buy half as many apples and oranges as it used to.

Of course the loss of 50 cows means we have still lost half the real value of the money stock, and the resulting tight money condition will be recessionary. No problem. People will simply issue 50 more cow certificates, backed by 50 additional cows.

(By the way, I'm personally more comfortable with land money than with cow money, since we don't have to worry about milk and such.)

[Reverend Moon]

Nick,

IMO, all you're really talking about when you talk about keeping the milk is about the price of the loan. You bring me a cow I monetize it then i rent the cow to you is the transaction you're talking about (mortagage, auto loan etc.). Or, I give you more money and you buy your milk from the store.

The cost of recovering the collateral pledged to the pawn shop is prohibitely high relative to the amount owed if you don't pay. Too much risk, which is why it doesn't happen like that. Its business, not economic theory. Not trying to be snyde. Just trying to simplify things as much as I can for myself. Like derivatives transactions being selling lottery tickets or buying insurance. Really enjoy your posts and the site in general and am learning a great deal.
Cheers

[David Khoo]

Nick, I do believe there is a nontrivial minimum positive value for transaction costs that will ultimately limit monetization, even with technological improvement. Transactional costs can be divided into two sources: natural obstacles and human obstacles.

For natural obstacles, we contend against the laws of nature, e.g. communication and data storage costs. As technology improves, these costs will fall to trivially low levels. For example, communication and data storage costs have fallen with modern IT. Gone are the filing rooms, courier boys and computers (people paid to do calculations) of yesteryear.

For human obstacles, we contend against other people, e.g. credit rating and litigation. In these cases, technological improvement cuts both ways. When a credit rating agency discovers a better heuristic to rate securities, securitization firms devise better ways to game it. In the long run, these costs do not fall but fluctuate as the point of technological equilibrium changes. In particular, I believe litigation costs actually rise over time as the volume and complexity of case law inexorably increases.

Over the past decades, the reduction in costs due to IT have swamped any other effects. However, we have reached a point of diminishing returns here. Even if all other costs due to natural obstacles fall to zero, there will still be costs from human obstacles. We will always need to catch cheats and settle differences, and that will never get easier as long as both sides can innovate.

Therefore, I believe transactional costs alone imply a maximum extent of monetization. There are also social and cultural factors that will limit monetization (Where do we stop? Can I monetize my kidneys? Can I monetize the kidneys of my unborn child?). My belief is that we are very close to this ultimate limit already but I am prepared to be wrong. Technological change is impossible to predict, by definition.

[Nick Rowe]

David Koo: You might be right. Which would make my thesis here wrong. I like the idea of a technological arms race, between the police and the cheaters, putting a limit on how far the *net* technology of monetisation can progress.

"In particular, I believe litigation costs actually rise over time as the volume and complexity of case law inexorably increases."

That's depressing, if you are right on that point. Technological regress. I hope you are wrong, because if you are right it won't just harm monetisation.

"Technological change is impossible to predict, by definition." Popper!?

Reverend Moon and Mike Sproul, on cows milk and land rent: for some assets (all financial assets?) they yield the same return regardless of who has physical possession and who "owns" them (in the sense of being residual claimant). For other assets it matters. My bank manager can't milk cows. The owner-occupier has less of a principal agent problem than a tenant farmer/landlord. The pawnbroker doesn't need my watch to tell the time, so the milk runs down the drain. This fact seems to be very important in Finance, and the monetisation of assets. I/we need to think through its implications.

Rev: thanks, and as you can see, I am learning a lot too.

Mike: Damn. You are right on cows and cliffs.

Scott and Greg: Yes, the monetisation of other assets does reduce the demand for central bank base money. And if that money remains the medium of account, the central bank will need to reduce the supply to prevent inflation.

[Phil Koop]

Getting back to the earlier question of demand for collateral money, I just noticed that the FRBNY reckons that treasury fails increased when interest rates fell below 3% - above that level, they think the (negative) cost of carry is sufficient to prevent cynical fails. They interpret the spike in fails to a perverse economic incentive due to a fall in interest rates rather than too much demand chasing too little supply, and they think they have fixed the problem by charging for fails. http://www.ny.frb.org/research/epr/forthcoming/1009garb.pdf.

[Greg Ransom]

Hayek pointed out the science could not predict its own advance independently of Popper.

I'm not sure who first stated the point. I think it was Hayek who said it first and most directly.

Hayek made similar points about technology and culture and social institutions more generally.

Processes which select over multitple variations tend to generate novelty and aspects of what can be called "progess" -- although there is no objective norm for progress.

The philosophical lit on Darwinian biology and "progress" rehearses the issues here.

[JP Koning]

Good post & comments.

Nick: "There are degrees of liquidity, and money, as the medium of exchange, is the most liquid of all assets."
and...
"But I'm talking about all assets becoming money, not about marketisation."

How can all assets become money if money is - according to your definition - the most liquid of all assets? Not all assets can be the most liquid at the same time.

[azmyth]

"using cows as money does not mean they stop yielding milk"
I'll turn this on its head - yielding milk means that cows cannot be money! Gresham's Law states that bad money drives out good. Given the opportunity to buy an asset with a low opportunity cost or an asset with high opportunity cost, people will choose the low opportunity cost money. Gold money drives out iron money, and paper drives out gold. People don't want to use an asset as money if they have better alternate uses of that asset.

Goverment bonds are closer to money than cows ever will be. Their major difference is the interest they pay and their default risk. Bonds are denominated in dollars and they represent no claim on capital. Defaulting on government debt is similar to destroying money in that it does not destroy real assets, only claims on those assets.

[Nick Rowe]

azmyth: Gresham's Law only works when all monies must have the same price. It did work for cows, funnily enough. If all you care about is the number of cows, because all cows are rated AAA, you forget about quality of cows (milk yield). So bad cows drove out good. That's if i remember the anthropology correctly. Where cows were money, cows were bad quality.

I think Gresham's Law was operating on AAA securities in exactly the same way. But it only works if all cows have the same nominal value.

JP: "most liquid" can mean "none is more liquid". So it's perfectly possible, in logic, for all assets to be equally very liquid and all used as money. If all goods are equally liquid, there are two ways to describe this economy: all goods are money; it's a barter economy. The two are observationally equivalent. So, that's a neat point. The monetisation of everything would be a reversion to barter, (but where barter is costless).

Greg: I had always wondered about the interconnections between Popper and Austrian economists. There are parallels. And none I can see for Wittgenstein and Freud, so it can't have been just the Vienna water.

Phil: you really lost me on that comment. What's a "treasury fail"?

[vjk]

What's a "treasury fail"?

Failure to deliver the Treasury for settlement.

[Reverend Moon]

Nick,

I think the confusion is in thinking that money is something different from credit. Credit is denominated in currency. Currency is the unit of measurement, that's all. It makes little sense to have a cow standard as the unit of measurement for pricing credit contracts. So if the question you were really asking is, "why do we not have a cow standard as the unit of account for credit contracts?", I think that question answers itself. As for my example, it doesn't have to be a pawn broker. It could be a credit card or line of credit, even a line of credit with another rancher. If I want to spend my cow but keep the milk until I actually settle the debt I've incurred, Visa or whoever will charge me for that privilege. The alternative is that you monetize the cow by selling it and forfeit the milk.
Its all just credit, currency included (it just has lower transaction costs because i will have little trouble finding someone who will take it). If you could settle your debt to me in cows I would not do business with you because then i would risk ending up a cow living in my apartment. I want you to bear the transaction cost and all other costs associated with disposing of the cow in return for credit or currency that doesn't have that liability.
So...I am not in favor of going to a cow standard for money or a gold standard for that matter. I guess I'm saying that all transactions are credit transactions unless you are satisfying a coincidence of wants. I hope that made sense and that i haven't misunderstood the point made in this thread.

[azmyth]

Thanks for the quick response.

"But it only works if all cows have the same nominal value."
If you were on a cow standard, they would need to have the same value to fulfill their role as a unit of account. Money needs to have three properties: Medium of Exchange, Unit of Account and Store of Value. If possible, it should be widely accepted, be easy to transport, uniform and have low opportunity cost (few alternate uses). I think you picked cows because of the ridiculousness of it. No one would sell loaves of bread and price it in terms of fractions of one particular cow. They couldn't possibly specify all the information needed to carry out such an exchange. Unlike cows, every dollar is the same. There is no informational cost to determining what kind of a dollar someone is trading you for. The problems of information and transaction costs are a big part of what makes one thing money and another thing not money.

I'd highly recommend this article by interfluidity: http://www.interfluidity.com/posts/1209978923.shtml

Here is a link to Menger's original article: http://socserv.mcmaster.ca/econ/ugcm/3ll3/menger/money.txt

[Mike Sproul]

Nick (and Scott and Greg):

"the monetisation of other assets does reduce the demand for central bank base money. And if that money remains the medium of account, the central bank will need to reduce the supply to prevent inflation."

In your article "Why do Central Banks Have Assets?" you argued that central bank assets are only necessary to handle normal ups and downs of money demand. For example, if money demand goes up and down 20% in a normal year, the central bank need only hold assets equal to 20% of the money it issued (or 30% for a comfortable margin). That way the central bank can use its assets to buy back its money when money demand is low, and re-issue the money when money demand is high. I argued the other side, that a bank whose assets are less than 100% of its money issue will suffer a run and collapse.

But if you believe that privately-issued money reduces the demand for base money in the way you describe, then a private bank can profit by starting a run on the central bank. For example, the central bank has issued $100, against which it holds only $30 worth of assets. A private bank then issues its own dollars, each of which is a promise to deliver 1 base dollar on demand. If the private bank issues $31, and 31 base dollars reflux to the central bank, then the central bank has no assets to buy back the 31st refluxing dollar, and as you say, the base dollars start to lose value. But every time the private bank issued a dollar, it was taking a short position in the base dollars. Just like if I issued and sold a slip of paper that said "IOU 1 share of GM", I am short in GM. The private bank has issued dollars that say "IOU 1 base dollar", so it is short in base dollars and gains as the base dollars fall. So the private bank keeps issuing more dollars until the central bank is dead.

You don't even need private dollars for the central bank to die. As soon as people realize that the first 30 people will get their money and everyone else gets nothing, they will rush to redeem at the central bank.

The alternative to this scenario is to allow that central banks must have enough assets to buy back all their base money at par. That central bank can always buy back its money at par, even if privately-issued money causes base money to reflux to the central bank.

[Nick Rowe]

Reverend Moon: "I think the confusion is in thinking that money is something different from credit. Credit is denominated in currency. Currency is the unit of measurement, that's all."

I disagree. I think the confusion is in *not* distinguishing money from credit. Money is the medium of exchange. Credit may of may not be a medium of exchange. Money usually also serves as a unit of account. Credit is usually denominated in the unit of account, but doesn't have to be.

Mike: neat argument. But what if the central bank simply refuses to redeem its money? Since the end of the gold standard, there is no promise by the central bank to redeem. It's the banks that issue redeemable money that face the danger of runs (unless they have 100% reserves).

axmyth: yes, cows don't seem to work very well as money, for all those reasons you cited. Bur then loans to small businesses don't work very well as money either, for much the same reason. But a bank that has loans to small businesses on the asset side and demand deposits on the liability side of its balance sheet has just converted loans to small businesses into money. There's no reason why Finance can't do the same to cows, and convert them into money.

vjk: thanks.

[Phil Koop]

Nick, re treasury fails.

A "fail" is shorthand for failed trade. Failed trades occur in most (all?) financial markets from time to time; they happen something goes wrong with the actual execution of the trade. This can occur when the terms specified by the buyer and seller do not agree, or when a third party does not receive or misunderstands the trading instructions, or when one party to the trade does not deliver the asset (cash or security) it promised.

As vjk says, the large spikes in failed treasury trades that have occurred over the last decade are mostly due to failures to deliver the promised treasury bond. Gorton implies that this might be due simply to an insufficient supply of bonds, and in fact one remedy that has been proposed is for the Treasury to increase supply by reopening bond issues when trouble arises. This interpretation accords with the monetarist view that you proposed.

The view of the NY FRB, though, is disappointingly prosaic and it takes the wind out of this monetarist idea. They think that failures to deliver bonds are deliberate; they monetize a "free option" created by the market convention for settlement that was in effect until May 2009. The paper I linked explains all this in detail.

[Mike Sproul]

Nick:

"neat argument. But what if the central bank simply refuses to redeem its money? Since the end of the gold standard, there is no promise by the central bank to redeem. It's the banks that issue redeemable money that face the danger of runs (unless they have 100% reserves)."

The central bank can redeem its money for its gold, for its bonds, for its buildings and furniture, etc. When you say "refuses to redeem", you probably mean for gold. But if people want to reflux $31 to the central bank, and the bank has nothing but $30 worth of bonds, the central bank just sells the bonds for $30 and retires the dollars. The central bank redeems its dollars for bonds, and a bank run can still happen even if the bank won't redeem in gold.

If the $30 worth of bonds was all the central bank had, then that 31st dollar (and the other $69 still out there) is truly not redeemable, and truly not backed. I say the base dollars will then be worth zero. If those 70 unbacked base dollars were worth anything, then private banks could issue their own dollars, each of which said "IOU 1 base dollar". As the private dollars were issued, the base dollars would lose value (since the central bank can't buy them back), and the private banks would profit from their short position in base dollars.

I was talking about 100% assets, not 100% reserves. A bank that has issued $100 might hold reserves of 30 oz. of silver, plus bonds worth $70. That bank is immune to a run, since it can use its $70 worth of bonds to buy back 70 base dollars, then redeem the last $30 with its 30 oz. You're probably thinking of some crisis where the $70 worth of bonds has to be liquidated for $60, but then the bank's assets are 30 oz. +$60 bonds, and the bank is insolvent, so of course there will be a run. Runs are caused by insolvency, not illiquidity (unless illiquidity leads to insolvency).

[K]

Mike Sproul:  I don't think Nick was talking about refusing to "redeem in gold".  He is saying that the bank doesn't have to redeem at all.  They adjust their balance sheet through open market operations at *their* discretion, not yours.  If they don't accommodate a loss of demand for money, you might get inflation or devaluation.  But you can't force them to take it back.

[Mike Sproul]

What else could Nick have been talking about? Modern paper moneys are always "irredeemable in gold" but still redeemable in bonds (and taxes, buildings, furniture..). If the issuing bank has bonds, they can use them to buy back their money and their money will have value. If the issuing bank has nothing, they can't buy back their money and the money will be worthless. Whether the buying back happens at the bank's option or at the public's option is irrelevant.

[K]

But it doesn't matter whether they (the bank) buy the money back with bonds or they (the treasury) take it back through taxation. Either way they reduce the quantity of the medium of account. If money gets too cheap, someone will buy it up for the purposes of paying taxes. No need for open market operations. To make it really clear you could imagine a proportional money tax which would have much the same effect as interest. So it just doesn't matter if the BOC has bonds on their balance sheet. They never have to spend them so they could just as well burn them. Like Nick said, it's just for the accountants. Nick would even claim that there isn't even a need for taxation. I would think that you would need at least the threat of it to secure the value of money.

[Nick Rowe]

Mike: I agree with K @1.49. The central bank can buy back the excess supply of money if it wants to, but is not obligated to do so. It's irredeemable in that sense, and is totally different from commercial bank money, which is a promise to redeem in central bank notes on demand. The central bank could just say "no", and let the excess supply of money eliminate itself through a rise in the price level.

[Mike Sproul]

K:

You are assuming that the government's assets are sufficient to buy back all the base money at par, should the central bank fail to do so. But if the government is barely solvent, and the central bank burns some bonds, then the money has less backing and it must lose value. Actually wait a minute. Change that. Those bonds would normally be the government's liability, so as the central bank burns them, it loses assets while the government loses liabilities, so there's no loss of backing and no effect on the value of the money. But if the central bank held some bonds that were issued by some foreign government, and burned them, then assuming the government was barely solvent, then you'd get inflation from the loss of backing.

Nick:

The central bank isn't obligated to buy back its money in the same sense that GM isn't obligated to pay dividends. Technically that's true, but failure to buy back money causes money to lose value, just like failure to pay dividends causes GM stock to lose value. The only difference between central bank money and commercial bank money is that the central bank has more leeway in refusing to redeem, but such a refusal will cause any money to lose value, whether issued by a government or by a firm.

You're still left with this problem: If the issue of private money causes base money to reflux to the central bank, and if we suppose that the central bank (or the government) has no assets with which to buy back that refluxing base money, the base money must lose value. (I think you might agree with this so far.) So the private bank, which takes a short position in base money every time it issues a unit of its money, profits from the inflation it caused, until the base money is worthless. That's a pretty crazy world. It would be as if writers of call options caused the value of the base stock to fall in proportion to their issue of calls.

This privately-caused inflation would not be a problem if the central bank had sufficient assets to buy back its money at par. Now, since neither you nor I seem to be able to think of a single historical example of a central bank that did not keep 100% assets (assets, not reserves) against the money it issued, the 100% asset proposition starts to look pretty reasonable.

[Nick Rowe]

Mike: " So the private bank, which takes a short position in base money every time it issues a unit of its money, profits from the inflation it caused, until the base money is worthless. That's a pretty crazy world. It would be as if writers of call options caused the value of the base stock to fall in proportion to their issue of calls."

Weird. Neat. (Only works if the private bank buys real assets, not nominal loans, but still).

[K]

Mike:

1) So we agree that banks like the Fed, the BOJ and the BOC whose balance sheets largely consist of domestic government bonds are effectively unbacked by real bills since "burning" their assets would make no difference.  If they actually needed to be backed by real bills, then holding domestic bonds causes a bootstrap problem.

2) You can't invoke foreign exchange reserves as backing.  The central banks of the world can't all hold each other up by the bootstraps.

3) You persist in ignoring the role of taxation.  Central bank refusal or inability to redeem currency (in domestic bonds) will cause rates to go down which may cause inflation.  But it's entirely curable through taxation.  Raising taxes takes money out of circulation, and increases the demand for money. If private banks tried to sink the currency by creating money (they did quite a bit of that recently), and the central bank was unable to buy it back, the treasury could just collect it all back as taxation and give it to the central bank. The ability of the treasury to collect revenues is vastly greater than the ability of a private bank to create money. It's taxation, not real bills, that insures the value of money.

[Mike Sproul]

Nick:

I think so too. Except I no longer think it's weird. It convinces me that any bank, including central banks, must have full backing for all the money it issues.

K:

1) I've never thought that the backing for money had to be real bills. I think that as long as the backing is of adequate value, that's all that matters. But dollars can be backed in part with bonds that are denominated in dollars. It just makes the dollar more volatile.

2)True, if the US backs its dollars with nothing but pesos, while Mexico backs its pesos with nothing but dollars, you get that problem. But a reasonable amount of real assets limits the problem. I cover this issue in my paper "There's No Such Thing as Fiat Money", which you can find by clicking my name above.

3) I often speak of money being backed by bonds, but of course bonds are backed by taxes, so taxes are the ultimate backing. Taxes can give money value in the same way that a stream of positive future profits can give stock value. But don't forget that governments can nose-dive into negative net worth, and when that happens they have less backing per unit of money.

[JP Koning]

I can't resist putting in this quote about the monetization of everything. Found it in James Steuart's 1767 Principles of Political Economy. Nick, your idea is a very old one:

"... by what we have said, it appears that there is no impossibility for a people to throw the whole intrinsic value of their country into circulation. All may be cut into paper, as it were, or stamped upon copper, tin, or iron, and made to pass current as an adequate equivalent for the produce of industry...

"That this is no chimerical supposition, appears plain by the activity of many modern geniuses, who, in an inconsiderable space of time, find means to get through the greatest fortunes; that is to say, in our language, they throw them into circulation by the means of the symbolical money of bonds, mortgages, and accounts....

"The use of symbolical money is no more than to enable those who have effects, which by their nature cannot circulate (and which by the bye, are the principal cause of inequality) to give an adequate circulating equivalent for the services they demand, to the full extent of all their worth. In other words, it is a method of melting down, as it were, the very causes of inequality, and of rendering fortunes equal."