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what is money?

there is no technocratic solution to capitalism. At least, there is no solution that policymakers and capitalists will consistently institute without overwhelming pressure from a highly organized general public. searching for an alternative is like waiting for Godot or the messiah.the only way that prosperity will be restored permanently to the united states or the world is through massive, intense and consistent democratic participation (and i don't mean just voting) by people.

Well, I believe the root of the problem lies in the following developments:

1) High and increasing marginal tax rates after 1945. Whatever else may be said, people work to earn money for themselves. Taxes made them feel like they weren't earning enough money for themselves. Therefore any political party that managed to say "you're overtaxed and we will cut your taxes" consistently and for long enough would get into power. A simple political ploy based on a simple appeal to greed.

2)The Keynesian Consensus replied in good part on large government and large government spending, which drove up taxes. This made it a perfect target for the strategy in (1).

3) Stagflation in the 1970's. Replace the Hard Money Lobby with the Scary Inflation Lobby. We have a large class of people who rely on retirement savings who feel very vulnerable to inflation. They benefited from the Keynesian Consensus but inflation scared them away from it once their generation got into power. Now whenever a Keynesian tactic is suggested, they scream "Inflation!!!". It really appeals to the middle class.

4) Ignorance. The generation in charge was taught that the Great Depression was over. It ended in WWII and was followed by a post-war boom. In their heart of hearts, they think the Depression is history and we will never, ever go back there. They were promised that we would never again need to settle economic problems with guns and that governments would do their absolute best to prevent that.

Secure in this belief, they then proceeded to forget or disregard all the practical lessons and sacrifices that had to be made to make that belief tenable. They imbibed that faith so much they felt confident in being able to ignore its practicalities. They were taught that the progress of humanity is always forward and we would never, ever manage to conjure up a time warp where we brought back the 1930's in the 2000's.

The end result is that we are in the Great Recession, er, Junior Depression of the late 2000's.

Interest rates at zero, Americans losing their homes left and right to repossession, a weak banking sector and double digit unemployment. The figures are skewed so the real number including "discouraged workers" is higher than reported.

The difference is that 70 years of social policy have allowed us to develop the tools to take the sharp edge off a depressed economy, particularly through unemployment insurance. However that still leaves the problem of a weak economy, lax demand and pathetic job creation at the core. If we have sanded the rough edges, the block is still there and won't move.

The problem is that we won't even acknowledge that the block is in the room and taking up space.

Don't see the problem, we approximately did what they said and we approximately made the things smoother. I give them at least a c+.

Perhaps its scary when smart people like DeLong come off as very narrow minded.

For instance: the tea-party focuses on the budget. Delong equates this with the hardest of hard money policies? Canada seems like a dream on this front. Cannot we not the least be rational that the tax system should be efficient (not just poach the rich) and monetary policy should smooth AD not fiscal policy where the expectation of future taxation negates most of the benefit?

Then Delong makes this whopper: "That is entirely standard. The only slight difference is that the Fed is buying seven-year Treasury notes rather than three-month Treasury bills. " Of course this isn't the difference at all. The Fed always bought (on the net) mostly Treasury notes and bought very few treasury bills. Delong has trouble getting his head around this simple point, I think because he has an obsession about the monetary transmission mechanism being through t-bills. Let me be clear: the Fed always bought notes.

What's different now is the volume of purchases. That's much higher, but its also a large volume being sterilized by IOR. I want a looser Fed policy, but I think more bond purchases isn't the right first step. The right first step is eliminating IOR whose stated purpose way back when WAS sterilization.

Delong acts as if the world is black and white where policy fits into just two bins. I'm disturbed we cannot have a rational policy discourse in this country.

Maybe the Canadians can come over and offer to run our monetary policy and give some advice to our congress. Delong and Krugman are in a time-warp.

Good question.

How about we create the medium of exchange exclusively as electronic M0 which can be carefully and directly controlled exactly as the monetarists imagined it. And then let the banks do as they wish, unencumbered by regulation. Let them raise capital to lend. And let them take "deposits" if they want to. But make it clear that those deposits are absolutely neither guaranteed nor redeemable at the BOC for the medium of exchange. That anyone who deposits with a private institution does so entirely at their own risk. Given the ability to keep unlimited unconditionally guaranteed money with a system of instant payments at the BOC I doubt that very much money would kept be in risky deposits at private banks.

The first benefit of this is that the financial system would be vastly more stable with the banks no longer able to inflate their profits through expansion of the money supply. They would have to raise their capital in the markets just like every other legitimate business. And to do so they would likely have to use a lot less leverage, take less exotic risks, and provide a lot more transparency. And we wouldn't have to care that much if they did collapse since the medium of exchange would be secure.

The second benefit is that the BOC could create inflation/prevent deflation as needed by depositing funds directly into accounts. These are basically helicopter drops (and as I'm writing this I'm realizing that the Fed is already doing this kind of helicopter drop by paying interest on reserves, but in that case I think the effect is perverse). How to control inflation? With a fixed money supply I think its questionable whether inflation could ever become a real problem. But if it did, you could delete money either through negative rates on deposits or by hiking rates on e.g. a sales or land tax. Could you have negative rates on deposits? Only if the supply of paper money was fixed in which case it would go out of circulation and trade at a premium to electronic money.

The third benefit is that the money supply would be a perpetual loan to the government rather than to the banks. That would reduce the Canadian public debt by about half a trillion dollars.

The fourth benefit is that without massive regulation and a half trillion dollar public subsidy, the credit market and the whole economy would be vastly more efficient and competitive.

I'm sure some will claim that banks perform some kind of Great Maturity Transformation Social Benefit and that without the ability to create money we will be vastly poorer. There are at least three objections that I can raise to this:

1) You like maturity transformation??? Haven't we blown up enough already?

2) Diamond-Dybvig points out that banks optimize utility by providing the economy with investment *and* providing depositors with liquidity, but that this optimum can't be achieved because of a market failure (the bank run). And therefore governments need to step in. But it is implicit in all this that depositors can only have their desires fulfilled by a private bank. If government simply holds the deposits, then the optimum only has to be achieved between investors in the bank and the bank lending to the economy. No bank run possible and the market can find equilibrium *all by itself*.

3) Banks barely perform maturity transformation any more anyways. Maturity transformation is a big part of what went wrong in the S&L crisis. These days a banks ALM desk carefully matches asset and liability maturities. They do perform liquidity transformation though - until they suddenly, disastrously don't. This is exactly the kind of "glass" we need less of.

Advocates of narrow banking typically want to regulate the banks a lot more. But when even Paul Krugman is starting to question our abilities to regulate a profoundly unstable financial system, maybe it's time to reexamine our core assumptions. Maybe we can create a system that is less regulated, more stable *and* more efficient.

Jon: "Let me be clear: the Fed always bought notes."

You mean "repoed"?

I think this article is making a fundamentally monetarist assumption: that you can find the 'Holy Grail' macro model that controls the flow of money and which is robust against various forms of excesses, stresses and shocks.

IMO that is a too narrow viewpoint. To adequately explain the hard data we have today you have to take other forces into account, beyond money and a central authority that controls the flow of money - and at that point you stop being a monetarist really.

Whether you call that model 'new monetarist' or 'reformed monetarist' or just simply new keynesian (because, well, in science, those who think of new concepts first get to name them, right?) is besides the point. The main essence of monetarism is gone, which essence gave monetarism its name: the ability to control economies via the monetary machinery and a 'free market'.

(Whatever this 'free market' really means. Why is there not a 'free market' of central banks? Why is there no 'free market' of the judiciary? Why is there no 'free market' of the military? How come that the 'free market' can only work if certain entities are kept monopolies artificially - i.e. if certain central entities are as anti-free-market as it gets? It's an ironic and grotesque flaw of free market fundamentalism.)

Once you accept that step, once you realize that central banks can get stuck in ZIRP traps where the monetary machine stops working, once you realize that central banks can generate bubbles and can be devoid of basic 'wisdom' just as much as policy makers can be dumb, once you start introducing other forces into your model to help it explain reality, a natural first step is to consider other huge economic actors, not just central banks.

And the biggest economic actor happens to be the government and fiscal policy. That's a simple fact of life - not some political preference.

As a sidenote, it would be reasonable to consider other big actors as well: huge multinational companies, monopolies. Even if they decided to cooperate, they are generally frowned upon from colluding on policies: any competent action by them against deflation could be (fairly ...) seen as price fixing, cartel building, etc.

Which pretty much leaves the government and fiscal policy as the only player big enough who can break the economy out of game theory situations like the stag hunt.

At that point your question is indeed on point: how fool-proof can fiscal policy be, and can incompetence and fraud be eliminated by use of 'clever design' and 'wisdom'?

In democracies that looks rather unlikely for a fundamental genetic reason: humans over-weigh short-term interests over long-term interests, and fiscal policy is directly coupled to the short-term wishes of the electorate (no matter how stupid those wishes may be in the long run) in most developed countries.

So I think boom and bust is genetically hard-coded in our economies. It's a price of democracy and we need to learn to live with that - just like we need to learn to live with the idea that the electorate may prefer an intellectual heavyweight (Sarah Palin) as the next President of the United States :-)

White rabbit: "(Whatever this 'free market' really means. Why is there not a 'free market' of central banks? Why is there no 'free market' of the judiciary? Why is there no 'free market' of the military? How come that the 'free market' can only work if certain entities are kept monopolies artificially - i.e. if certain central entities are as anti-free-market as it gets? It's an ironic and grotesque flaw of free market fundamentalism.)"

Some searchers for the Holy Grail believe it is a free market in money. They want to abolish state control of money. I am yet to be convinced of that.

"So I think boom and bust is genetically hard-coded in our economies."

You right-wing defeatist you! ;-)

K: sounds like narrow banking, with the BoC as the only true bank. A purely electronic money would make it easy for the BoC to directly control the demand for the medium of exchange by varying the rate of interest it pays on money. And it could be set at negative levels, if it desired. It might be closer to the Holy Grail, but it still requires the BoC's judgment in setting the right rate of interest on money. But yes, that's the sort of "Blue Sky" thinking I had in mind.

Jon and Matt: yes, Canada has done OK this time around. It could have been worse. C+. But will we always be this smart/lucky?

Determinant: you just have a different theory of where the magneto is, and why we failed to fix it.

Nathan: "the only way that prosperity will be restored permanently to the united states or the world is through massive, intense and consistent democratic participation (and i don't mean just voting) by people." Sounds a bit like the Tea Party?

Nick: "It might be closer to the Holy Grail, but it still requires the BoC's judgment in setting the right rate of interest on money."

I think that's an open question.  I suspect part of the failure of Friedman's k% vision is the lack of stability of M1-M3, and their varying degrees of "moneyness".  Demand deposits are insured but don't earn interest.  Term deposits are insured but do earn interest.  Large deposits are not officially insured, but probably are anyways.  Money market funds earn interest, but are not insured - but maybe they are:  In the US they got bailed out; in Canada only partly so.  As interest rates and credit risk change, so does the relative demand for different kinds of money.  The actual money supply is very nebulous, so even defining k% is pretty hopeless.

If all money was transactional real money, used not as investment, but rather exclusively for its medium of exchange properties for real economy stuff, then, maybe, just maybe, the value of such money would be much more closely linked to its quantity.  Don't forget, velocity couldn't vary that much since it would be intricately linked to economic output. And then perhaps k% is all we would ever need.

K asks: You mean "repoed"?

No. Repo agreements are used to manage day-to-day imbalances in the FF market. Bills are held to keep a large pool of highly liquid securities with which to Sterilize discount window borrowing. Notes, are, and have long been, the vehicle through which broader policy is implemented. Now that the board has IOR, I don't think they will ever purchase another bill (they have none now, they sold them all during the crisis to sterilize the Term Auction Facility and the Swap Lines.

The overall size of the Federal Reserve’s portfolio of domestic securities is dictated by the FOMC’s monetary policy objectives. The liquidity and matu- rity of that portfolio depend on the FOMC’s prefer- ences, which have evolved over time. In the early 1980s, the average maturity of the portfolio was slightly more than four years, similar to the average maturity of the public’s holdings of marketable U.S. Treasury debt (table 2). In 1984, when Continental Illinois National Bank faced a severe liquidity crisis, emphasis on the liquidity of the portfolio increased because the Desk had to offset the massive volume of balances provided to Continental through the dis- count window. The Federal Reserve was able to maintain the desired level of reserve balances by allowing Treasury bills to mature without replace- ment and by selling them in a market that was recep- tive to liquid short-term issues of the highest quality. The crisis underscored the importance of having a liquid portfolio, one that could accommodate devel- opments requiring large cuts in holdings over a short period. Over the next seven years, the average matu- rity trended down as the Desk purchased more Trea- sury bills than Treasury coupon issues on balance.7 By the end of 1991, the average maturity of the portfolio was just under three years. In the spring of 1992, the FOMC reviewed the maturity structure of the Federal Reserve’s portfolio holdings. It concluded that the portfolio was suffi- ciently liquid and directed the Desk to take steps to keep the average maturity from falling further.

Nick:

You wrote a political OP and I wrote a political reply. ;)

You say you're a quani-Monetarist New Keynsian, so surely you must recognize that the Central Bank and the Government both have a role to play in economic management.

But Keynes had a real political problem. You say he had a very humane philosophy, but the flip side of it was that he was a world-class snob. He was a Mandarin, a Public Service heavyweight who was the go-to man for policy. His ideas were predicated on a "a few good men" going into a room and coming up with a good solution. It may be good academic work but its horrible politics. Keynes always thought of himself as the best man in the world in that regard.

Keynes' method of operation is very, very susceptible to a populist political attack. Mandarins like him are anathema to politicians who want to be in control and a populace who feel that letting the mandarins run things leaves them without control.

Thus your OP is an intensely political question, whether you wanted it to be or not.

I want to modify what I said.  Money would still serve as a store of value and the unit of account as well as the medium of exchange.  But it would *not* serve as government subsidized investment (M1-M3) in real stuff.  The critical thing is that the supply of the medium of exchange could never be directly impacted by bubbles, lending and financial crises.  There would be no ability/incentive by private institutions to inflate it, and no ability to destroy it in a financial crisis.  Only the BOC would determine the supply.

Jon:  OK, I get your point.  They've always held notes, even if only in small amounts by today's standards.  The difference between then and now is quantitative (no pun intended) only, rather than qualitative.

I find myself partially in agreement with White Rabbit. Maybe Canada had magneto trouble. The rest of the world poured sand in the oil pan and is now wondering why the engine is smoking.

I don't think the monetary system can do much about crazy, stupid or criminal actors. And everything I've read about the mess in the US and Europe suggests that that these are the root causes of their (and our) woes.


Determinant: "But Keynes had a real political problem. You say he had a very humane philosophy, but the flip side of it was that he was a world-class snob. He was a Mandarin, a Public Service heavyweight who was the go-to man for policy. His ideas were predicated on a "a few good men" going into a room and coming up with a good solution. It may be good academic work but its horrible politics. Keynes always thought of himself as the best man in the world in that regard.

Keynes' method of operation is very, very susceptible to a populist political attack. Mandarins like him are anathema to politicians who want to be in control and a populace who feel that letting the mandarins run things leaves them without control."

Spot on! And in that regard, both Brad and Paul (OK, minus the "snob" in the English sense) are very very Keynesian. That's part of what I wanted/should have said in my post. It's at the root of it.

"You say you're a quani-Monetarist New Keynsian, so surely you must recognize that the Central Bank and the Government both have a role to play in economic management."

Yep. I do. But I realise the dangers. And I want an alternative.

Patrick: "I don't think the monetary system can do much about crazy, stupid or criminal actors. And everything I've read about the mess in the US and Europe suggests that that these are the root causes of their (and our) woes."

I disagree. Sure, even with perfect monetary policy, the economy will do worse if people do stupid things. But it shouldn't cause a recession and financial crisis that magnifies the effects of the stupid things. Brad DeLong is very good on this.

Nick Rowe wrote:

Some searchers for the Holy Grail believe it is a free market in money. They want to abolish state control of money. I am yet to be convinced of that.

If that Holy Grail is based on the gold standard then it has all the same problems really. The thing is, 'free market' is a self-contradictory term, even in a super-deregulated, gold standard backed economy. The contradiction arises from the following paradox:

If a big enough economic actor starts 'securitizing' 'promises' in a legally binding manner, then currencies are reintroduced in essence, and debt can be leveraged. If that actor gets big enough, and if debt is distributed in some stupid way, and if the effects of a deleveraging bust are systemic, then this big entity will be bailed out by a democratic society and the whole cycle of boom and bust plays out - just in another economic dimension. It will all be done parallel to a gold based currency.

Unless the Holy Grail includes some mechanism to avoid big players / monopolies, it's hard to see how that could be avoided. But here is the paradox: who watches the monopolies? It can only be something that is bigger than a monopoly that poses a systemic risk - but that, by definition, will be some sort of big entity in itself ... posing a systemic risk.

If it's legislative bodies or the judiciary that has the final say in what is too big, then all the same issues will play out as in today's government regulated economies - just on a different level.

Not to mention the fact that economy of scale is a very powerful positive force, and is the major force driving monopolization in today's economies. So whatever 'final authority' there is to avoid boom-and-bust it will be facing very strong parties who want to influence, corrupt and abuse that authority.

I don't think that it is possible to get a Holy Grail of monetary policy under such circumstances.

On a related note, Canada can be applauded for not letting banks grow too big and too risky - and I think much of Canada's strong fiscal position today can be attributed to that detail. That I think is as close to the Holy Grail as it gets. (It still does not isolate Canada from the effects of almost everyone else being stupid.)

Ok Nick, then the problem is that Politicians are the ones in charge of answering the question "Where do we want to go?" Economics is about answering the question of "How do we get there?" in particular what tools we use to do that. But the answer of where we want to go constantly changes. Therefore the tools we need to get there also need to change. But we can't change the tools (economics) until we get a sense of political direction.

By politics, I mean both legislators, the government and the public opinion consensus on which they operate.

Ultimately since we live in a society of laws it's politicians who have the ultimate freedom of action since they control and change the law. Economics, particularly as implemented through central banking has to live within the law.

That's why when I argue for government-paid pharmacare, I'm making both a political and economic argument. It's political because it requires a change in public policy. It's economic because I feel that the purpose of private enterprise is to make money. If there is nannying to do, that is the role of the government. If we want a free and mobile labour market that goal is best served by having a universal standard applicable to all workers as citizens. It is the job of business simply to pay their taxes and get on with profitable work.

You'll never escape the capriciousness of politicians because macro policy requires legal support and control of revenue and spending. In order to do that you need popular assent as given by the legislature. Otherwise you're arguing for a dictatorship of economists.

[I posted this comment but Typepad is not showing it so I'm resubmitting it. Sorry if it appears twice.]

If we really want to make sure that demand shocks don't cause in/deflation in a system of pure electronic M0 money, it might be worth considering how we could remove the use of money as a store of value.  I think it was Silvio Gesell who proposed using a negative interest rate on money (a stamp tax) as a way to encourage real investment rather than speculative saving.  So, what if the BOC, along with their policy money supply interventions, also confiscated say 5% of M0 per year (continuously of course) and then redistributed all that money to all citizens equally.  The redistribution would insure that the confiscation would not be deflationary.  In the end people would only hold a minimal amount of money - whatever they needed for their short term transactional requirements.  The rest would be invested in real stuff - physical assets, stocks and corporate (including bank) bonds.  I don't think this confiscation would involve very much redistribution as I don't think there would be very much money.  To the extent that recessions are caused by excess demand for the medium of exchange, it might even make the economy recession proof.

What problem was the Euro supposed to fix anyway? Aren't the mandarins the ones who created the problems in Europe by shoehorning so many very different countries into a single currency?

Nick: FWIW, I don't think the mess was caused by a failure of monetary policy, so perhaps that's the source of disagreement. I agree that more could be done in the US, though practically I think the Fed is doing about as much as it legally can.

Patrick:

It was a subset of the European Union project, which was supposed to integrate Europe so much there would never be another World War over European politics.

The Euro was supposed to put the European Union in the pockets of every European. Give the whole project a retail face.

The economics were secondary.

K: a -5% negative interest rate would be equivalent to a capital gains tax of 105% on liquid assets, so it's not particularly difficult to implement even in current policy frameworks and does not necessarily need electronic money either.

The 'political will' is very much not there though. Think of the moral message: punishing austere savers and rewarding gamblers? It's a non-starter really.

The best way to achieve something very similar is a higher inflation target of 5%. That has enough cushion space to ZIRP and does the same economically as a negative interest rate on deposits, but without the ugly "yikes, the numbers printed on my monthly bank statements are getting smaller!" psychology of voters.

Also, the BOC should not be worried about deflation too much. The CAD is not a global reserve currency (like the USD or, lately, the CHF) so on financial shocks there's no "risk on" deflationary force when a couple of trillions in liquid assets stream into the country from all over the world, weakening the export output of the local economy.

The advantages of being a relatively small fish.

White Rabbit: "Think of the moral message: punishing austere savers and rewarding gamblers?"

Don't imagine the system we have now, except with a tax on money.  Imagine instead that money is no longer a place to keep savings.  Savers invest e.g. in stocks and bonds and there's no capital gains tax. So it doesn't punish savers.  It punishes only those who hoard the medium of exchange.  If you want to save, you need to invest in productive activities. As always, in the real world, this will involve varying degrees of risk.  

Money would just be something you obtain, very temporarily, in the brief periods between sales and purchases of goods, labour or investments. At equilibrium, I think there would be so little money (just enough to transact) that the actual quantity of money tax would be small.  You should think of it more as a barter economy, but with the transactional efficiency of a monetary one.

And raising the inflation target is nothing but a one time transfer from savers to borrowers.  It does nothing to address the instabilities of the financial system which, in my opinion, can only be resolved by ending the use of M1-M3 as government subsidized investment in private banks.  As long as the money supply is a free endowment to the banks they will *obviously* be incentivized to inflate it to the maximum extent possible.  This is *the* central point that has to be addressed.

K wrote:

Savers invest e.g. in stocks and bonds [...]

Short-term bonds are money equivalents.

So to force people out of money equivalents into 'real' investments you'd have to force long term bonds or stocks.

Then there's the added problem that investing in stocks is regarded by many as gambling.

'Enormously infeasible' wouldn't even begin to describe the political viability of a system that eliminates money as we know it, eliminates 'safe methods of saving money' and 'forces people to gamble' would be enormous.

Thirdly, the core of my argument remains as well: how about too big entities that pose a systemic risk? If say 40% of 'savers' decided to 'invest' in a 'safe' stock such as IBM, if IBM faced bankruptcy there would be huge political pressure to bail it out.

Just like there was huge political pressure to bail GM out. (Not the stockholders - but the workers who work there - but it's a very similar political process really.)

IBM stock (or whatever other large-cap stock that almost everyone holds) would in essence serve as a virtual currency - with all the moral hazard attached.

It does not matter what the legal situation is - that the fine print said that investments are risky. If enough voters are affected by a particular large entity's troubles then there will be a bail-out - or the decision makers will be voted out.

And raising the inflation target is nothing but a one time transfer from savers to borrowers.

Well, combined with low interest rates on deposits, it implements a negative effective interest rate on deposits, doesn't it?

( There would indeed be a one-time transient when the policy is implemented, but it can be done gradually, and it's not like electronic money with an explicit negative interest rate wouldn't have rather drastic transients ... )

Money is really mostly just numbers in computers, so it does not matter to the real economy whether the numbers inflate or not - what matters is what people think about those numbers.

And the overwhelming majority of people does not like to see numbers that decrease: be that bank balances or pay check amounts. They are more willing to accept constantly up-creeping prices in the shops (and grumble about OPEC at the gas pump) than to accept visible 'numeric cuts' in their income stream.

Especially as retailers are very good at hiding price hikes - while employers have no way to hide a pay cut, nor can a bank hide a decreasing account balance.

Somewhat weird and counter-intuitive, but true.

So instead of trusting future mechanics to fix our magnetos, we should concentrate on developing the self-repairing, zero-maintenance magneto? And it's Krugman who's supposed to be the technocrat!

It's not that I would want to discourage you from blue sky speculation. On the contrary, that's why I read the blog. But let's suppose your quest bears fruit, and you discover the ideal self-regulating monetary regime: crystalline, perfect, beyond the scope of human intervention, still running good as new when the sun finally goes nova. No doubt you will richly deserve your Nobel prize. But what makes you think the one-time effort needed to impose this regime will be politically more palatable than a steady, boring diet of good government?

Before obtaining this utopian state, you would first need to purge the inherent utopia from the economic models.

As it currently stands, the standard econ models have everything backwards.

They assume that money neutrality is the same as monetary non-existance.

That's just a lazy excuse to present models that have internal accounting inconsistencies, including the insertion of fake transactions (in which production equals income) as well as the omitting of necessary transactions (e.g. the purchase of a good for money).

No monetary transactions are included in the model. That's a whole different ball game from long run neutrality. Or even short run neutrality.

The only slight hints of actual monetary transactions occurring in which a purchaser buys something using money from a seller, are in the OLG models, but and these are ones with "strange" effects -- e.g. dynamic inefficiency, path dependency, sunspots, bubbles, etc.

As a result of that, all the conclusions are wrong, from start to finish, at the most basic level.

Taxes are not paid by delivering consumption goods to the government. Government purchase of consumption goods delivers these goods to the government. It's a conflation of revenues with expenditures. And there are similar conflations of balance sheets with income statements, liabilities with assets, and savings with lending.

Basically everything is completely backwards, including the monetary policy/fiscal policy divide. All because no actual financial transactions are included in the models, and so the arrows of transactions all point in the opposite direction of where they should point.

That's the cost of assuming monetary non-existence.

Let's first re-write all of the micro and macro on a solid footing, in which someone with money buys a good from someone else, rather than assuming that production equals real income. Then we can talk about the a flexible price situation, in which taxes have zero real effect, and not be confused into saying that government expenditures have zero effect.

Then we can talk about even a basic competent model. After that, we can worry about the utopian blue sky situation.

Hmm, the Globe and Mail's recent article on a budget leak from a committee and its tangent on Budget Secrecy made me think about this thread. In days gone by Budget Secrecy was a big thing. In a world of mandarins where the government attempts to cajole, corral and otherwise command the economy, budget secrecy makes sense.

However in a "populist" or politically-directed world where a consensus is desired, budget secrecy makes far less sense. If you want to achieve a broad base of support and consensus for your budget, then lots of consultation makes sense. When you broadcast your intentions so far in advance, arbitrage falls away as the market slowly digests the government's intentions.

Actually I think Budget transparency is both better for the markets, better for policy implementation and better for politics than the alternative. It's better to slowly bring everyone to a consensus than have the government attempt to shock the markets every budget day. Such things should be saved for emergencies.

nick rowe said..."Sounds a bit like the Tea Party?" well except that the tea party is organized, funded and run by corporate interests. it also doesn't involve a critical look at the facts and opinions involved in each issue. I guess i didn't detail this in my first post ( but it was in my head when i typed it) that democratic participation also involves a critical review of issues and the arguments and evidence involved. In my mind effective policies will only be formed and implemented when the general population critically review the issues, forms an opinion on the issue, proposes their solutions to the issue and force their representatives to pass a version of their solutions or face the consequences in the next elections. Marx (and other so called "radicals") imagined a world where people would spend a few hours working and then move on to various other intellectual (now called "academic") pursuits.In my mind this wouldn't be just ideal, it would be necessary for a society (any society whether "capitalist", "socialist" or communist)to prevent rotting from the inside out.(as an avid Minskyan, in my mind i derived this line of argument directly from minsky and his insights into the inner-workings of capitalism...but that's a story for another day.)

White Rabbit: "Short-term bonds are money equivalents."

No, they are not. You are still stuck arguing by analogy to the economy you are familiar with. Nobody is going to create a bond backed by money. It'll just decay like money, which is 5% faster than a basket of non-perishable goods. Bonds and stocks represent investments in real assets. They will or will not pay off depending on the real returns of those assets. There is no straight forward way to maintain nominal wealth in a barter economy. But so what. People need to stop fixating on nominal wealth.

"Then there's the added problem that investing in stocks is regarded by many as gambling."

Buying a house is gambling. Investing in money, today, is gambling. Anything but a representative portfolio of all available assets is gambling.

"how about too big entities that pose a systemic risk? If say 40% of 'savers' decided to 'invest' in a 'safe' stock such as IBM, if IBM faced bankruptcy there would be huge political pressure to bail it out."

Nortel made up some 25% of the TSE. Probably more than 40% of savers decided to invest in it... I don't have to tell the rest of the story. The point is Nortel, IBM, whatever is not "systemic". And without private bank money to help people buy stocks on margin, they are less, not more, likely to bubble their way up to astronomical valuation.

"IBM stock ... would in essence serve as a virtual currency"

No, it wouldn't since we have *real* currency.

"Well, combined with low interest rates on deposits, [inflation] implements a negative effective interest rate on deposits, doesn't it?"

Only if inflation exceeds rates, i.e. only for demand deposits. And if we do run higher inflation/higher rates then presumably there would be a shift from demand to savings deposits. It's better since at least we are providing less free funding to the banking system. But it's still enormously subsidized by virtue of the government guarantee and therefore it still leaves far too much incentive for the banks to inflate the money supply and distort the supply of credit.

"'the numbers printed on my monthly bank statements are getting smaller!' psychology of voters."

Actually since negative rates would be applied on all money but the proceeds distributed equally to all citizens, and since most voters' bank accounts are smaller than the mean, their balances would be going up. I think that's pretty palatable, politically.


RSJ: It's the system itself rather than the models that are broken. Proving that the system is broken and finding ways to fix it, may be far easier than to correctly model the abomination we call our financial system.

Phil Koop: You can't go in the right direction if you haven't even spent a minimal effort trying to figure out where you might like to end up.

Nathan Tankus: Well said! Long live using your brain.

K,

"It's the system itself rather than the models that are broken"

Of course, but here I will recall Keynes' quote about defunct economists ruling minds.

If your models assume that production = income, then there is an embedded market clearing assumption from the beginning. From that point, it is easy to "prove" that the market clears. And if the models assume that production = income, then it will be difficult to detect an aggregate demand failure. You will get a supply side bias.

Really I believe the big breakthrough with macro was that at least they used national income identities. At the very least, that properly counts transactions -- it is a legitimate form of accounting -- so the macro was much better than the micro. The crude multipliers were at least an attempt to count transactions, in which people realized than when I invest, the recipient of the funds also does something, and that recipient does something. It may have been extremely simplistic, but at least was an honest effort to capture all the transactions. Capital goods are not spit out, but people are hired to produce them, and therefore the more you invest, the more income you receive, and in fact you receive back all the income that you spent, so that investment is always self-funding in the aggregate economy.

I guess the problems started when people began to insist that macro have "micro roots". That's when macro made the big reversal and started seeing everything backwards.

And I don't think that modeling the current economy should be hard. I'm not talking about a realistic model that predicts everything, but just getting some stylized facts right would be nice. I think Samuelson did some cool models in which there were different people actually transacting with each other, rather than just spitting out capital goods and eating money. He did the OLG model, in which people transact, and he also did a cool model of endogenous capital based on Ricardo's corn model, and he even generalized to production of silk and wine, etc. I don't remember the reference off-hand, so I am probably screwing this up. But I don't understand the deep aversion to having a model with consistent accounting at the micro level, in which no one is eating money, and in which investment actually employs people and therefore supplies income to others.

In any case, I'm sorry for ranting about this. Now I feel a bit guilty about ranting too much. I am going through some exercises, and I was just forced to argue that if the government levies a tax on coffee drinkers, and spends the proceeds on doctors, that there will be a dead-weight loss in terms of coffee consumption (something dear to me). As if the doctors didn't drink coffee, and as if taxes are actually paid by supplying coffee to the government. I think unless those who don't drink coffee increase their savings by the amount of the extra income they receive as a result of the government expenditure, then you are not going to get less coffee purchased. You may even get more coffee purchased. But that wasn't in the answer key.

K wrote:

"IBM stock ... would in essence serve as a virtual currency"
No, it wouldn't since we have *real* currency.


So you think that once there's "real" currency, other forms of money wont be utilized?


I'm not convinced about that: there's multiple dimensions to "money" as we speak, beyond the official form of money: there's cash funds (which are really a complex, dynamic composite of various short term instruments), there's the balances of margin accounts which are often just internal account representations of brokers (not real money yet - only cleared into a real account overnight), there's virtual currencies in online communities, there's food stamps used as money, there's gold used as money, etc. etc.


Heck, a favor owed to me by my best friend can be a form of "money" to me, I might even be able to 'transact' it to another friend. There's a non-trivial amount of interpersonal, ad-hoc 'promises in flight' that buffer the future distribution of resources. (It even matters for some aspects of the economy.)


"Money" is really a shortcut for "widely accepted note of promise in a given economic domain, backed by a big enough player".


Money is not a binary concept, it's a spectrum of often conflicting parameters of risk, transaction cost and other circumstances.


A short-term bond by a big enough, stable company is as good as money today - and it will be as good as money tomorrow as well. You claim that it will be replaced by 'real' currency - but how and why would people disregard its qualities as a "generalized promise"?


Automatic stabilizers help a lot. That is one reason (although not the biggest - the biggest was high savings rates and low population growth => trade surplus and no housing boom) that Germany has recovered better from the financial crisis than other countries.

Phil: "So instead of trusting future mechanics to fix our magnetos, we should concentrate on developing the self-repairing, zero-maintenance magneto? And it's Krugman who's supposed to be the technocrat!"

Good point.

In the case of Germany the housing bubble was also dampened by there being very limited securitization of titles to houses: title is almost always personalized, and this reduces fraud and other mis-pricings.

There's also limited leveraged debt in Germany - partly for cultural reasons (earn before you spend), partly for institutional reasons (most german banks active in residential development projects are relatively small, boring, fat and content - which makes them risk averse - a good bubble antidote).

Plus, to be fair, Germany has high population density (229 per km^2) combined with a cultural bias against living in high-rise buildings, which dampens housing excesses in a natural way. Dubai could freely grow into the desert (or upwards), Ireland has a population density of only 63 per km^2 - the US has 32.

It's much harder to rationalize away excesses of a housing bubble and remain in a bubble for too long if there's limited unused quality free space to build on.

As a side note, China's population density is 139. It's an interesting question whether they have a housing bubble currently. (Probably yes, as most of the population is concentrated into big urban areas with lots of relatively free space around them.)

RSJ: "If your models assume that production = income, then there is an embedded market clearing assumption from the beginning."

Nope. There can indeed be a "fudge" in in assuming production = income (depending on how you handle inventories) but it certainly does not amount to embedding market clearing at the beginning. Many simple Keynesian models make this assumption, but do not have market clearing.

"But I don't understand the deep aversion to having a model with consistent accounting at the micro level, in which no one is eating money, and in which investment actually employs people and therefore supplies income to others."

There is no deep aversion. There is no aversion at all.

"As if the doctors didn't drink coffee, and as if taxes are actually paid by supplying coffee to the government."

You are thinking about income effects. The question is about substitution effects. Your (implicit) assumptions about the difference in different people's income elasticities would result in an unstable equilibrium.

White Rabbit: By "real" currency I didn't mean "more real than today". I meant if we have money we won't use IBM stock or commercial paper to buy carrots or houses or any other good. Just like today. Most people can't take delivery of those things so they are not a good medium of exchange in the real economy at all. The point is to make currency less subject to uncertainty, both inflation and credit risk.  I don't see why we would be less likely to use it than now.

Nick: "Good Point"

No it isn't.  By that logic future mechanics aren't supposed to think about making a better magneto either.  So we can never have a better one.

I feel defeated.

Our monetary system is founded on a massive arbitrage: a half a trillion dollar endowment to private banks in the case of Canada in the form of the money monopoly and deposit insurance. Because the size of the arbitrage profits depends on the size of the money supply and because banks control the money supply through lending, they have an incentive to lend and inflate the money supply to the maximum extent possible (until it all collapses).   This is *the* source of instability in our financial system.  

Narrow banking is clearly part of the answer.  It was obvious to 235 leading economists back in 1939.  But the way people typically propose narrow banking involves more rules and constraints on banks. And we know that we aren't good at juggling rules and constraints.  Which is why the solution is to create a straightforward BOC money system for all economic participants - kind of like the one they run for the banks right now, but for everyone.  Then give everyone a chance to transfer their deposits to the BOC.  And then cut the banks loose.  Let them be free of rules and regulations.  And let us be free of deposit insurance.

Nick, you asked for "blue sky" proposals.  I've given you lots (none necessarily original). And nobody has raised any objection to any of the underlying causes as I've laid them out.  But, now, after a glimmer of initial enthusiasm, I feel like we are left with a chorus of indifference.  Apparently nobody wanted a better magneto after all.  So what say you?  What do you think is wrong with our magneto?  You are truly a magneto expert and I really am not.  If you had to design a magneto from scratch, what would it look like?  Really different from the one we've got, or just like that one but with another 10 feet of duct tape?  It would be great to hear your opinion.

K: Good point ;-)

I'm working on another post. Will try to respond later.

K:

"The first benefit of this is that the financial system would be vastly more stable with the banks no longer able to inflate their profits through expansion of the money supply. They would have to raise their capital in the markets just like every other legitimate business.
"

I've talked about a somewhat similar approach at bilbo, but without causing much interest. Apparently, people are more fascinated by various idiosyncrasies of the existing shoelaces-and-chewing gum fin monster than trying to find a solution(s) that might really work. Perhaps, they've surrendered to Hayek's dictum:

“So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them.”


For what it worth I feel sympathetic towards some your ideas. That's very well put:

Proving that the system is broken and finding ways to fix it, may be far easier than to correctly model the abomination we call our financial system.

Abominations, indeed.

Thanks, vjk.  And very funny Hayek quote.  But I don't think it's even true, though people probably do believe it.  Personally, I don't have any reason to believe that output would be lower if our savings weren't extorted from us.  I just reread the Diamond-Dybvig paper.  Just for laughs here's a summary of the actual conclusion:  Assuming bank managers optimize the utility of the depositors, then an efficient equilibrium can be reached if the banks are charged a fair market rate for deposit insurance.  Also, there exists an equilibrium in which fair market rate is zero because runs never happen.  This is the apparently the basis upon which people conclude that fractional reserve banking is good for us.   God, it's depressing.

Scott Sumner says he's found the Holy Grail and it is called NGDP futures targeting.

Thoughts on narrow banking:

1, People want to make all of their assets as liquid as possible. They want to convert their cows into money. Broad banking promises to do that for them, by issuing deposits on the liability side, and holding cows on the asset side. And, if we can, we ought to give people what they want. Converting cows into money fulfills Milton Friedman's optimal quantity of money, not through deflation pushing the nominal rate of interest on cows down to the 0% nominal interest rate on money, but by paying interest on money equal to the rate of interest on cows.

2. It will be very very hard to stop people getting what they want, and banks giving it to them. They will find ways around narrow banking legislation. Then, when there's a financial crisis, the Samaritan's dilemma will kick in. It will be impossible politically not to pull them out of the ditch, even if they did get drunk. And because they know they will be pulled out of the ditch, they will get drunk.

Gregor: Yes, Scott thinks he's found it. I'm not so sure.

Nick: I agree with both of your final points. That aspect of Gorton's analysis is very good. Whether his specific proposal would work, I don't know.

Thanks, Nick. It's quite a bit clearer for me now. Money, being a claim on all the assets of the economy, should earn the rate of return of the economy. And in your simple model, banks just issue deposits. Which we might as well call 100% equity. So you are saying that 100% bank equity (funding all assets) should be our currency. That makes perfect sense and also solves the money illusion: holding money is now a perfectly diversified portfolio so it's the right nominal asset.

Now back to the real world. Lets take July 2007, roughly the last "normal" period in the Canadian economy. At that point the target rate was at 4.5%. Prime was at 6.25%, one year mortgage rate was at 7.05%, and five year at 7.24%. Meanwhile on the liability side, overnight savings at 0.1%, overnight savings over $100K at 0.5%, one year deposits at 3.287, and five year at 3.73%. Demand deposits, as always, at zero. So, weighted average spread, at least 5%. Profit margin: 60-70%. I would deduct some credit spread, but those mortgages are either CMHC guaranteed or 20% down. So 4-5% on $950Bn of deposits. That's more than double the banks' profits but the bankers take quite a bit of it. Any way you look at it, your theory doesn't seem to get close to the real world. We could look for the reasons why competition doesn't somehow bring closer the rates on deposits and loans. But whatever the market failure doesn't matter very much. The persistence of this arbitrage alone (for whatever reason) is all that is needed to produce distortion of credit markets and the resultant instabilities.

I think I have a proposal that addresses your concerns (which are also mine) about giving people what they want, but also removing the source of arbitrage and instability. Start with an economy with a certain amount of base currency. Create a bank. Lets say a farmer wants to monetize his cows. The bank issues some bonds to an investor, takes the money from the bond issue and lends it to the farmer against the cows. The investor now takes the bank bonds and repos them to the central bank for new money, at which point the cows are fully monetized. Through this mechanism we get to have our cake and eat it too. Money is created to the full extent possible and investment in banks is made willingly, at free market rates. The money is bomb proof, being issued by the central bank and backed by excellent collateral. Whatever the real cause, the source of bank funding arbitrage will be gone, and along with it, a great source of economic inefficiency and instability. I think this gets as close as possible to your model of having a single bank's 100% equity used as money while incorporating the necessity of having multiple competing banks issuing securities as they see fit. Does this make any sense?

K: it sounded lovely, as a way to convert cows into money!

But isn't the debt glass? What happens if the cows get mastitis, and lose value? Doesn't the farmer go bust, and the bank go bust too?

I have two answers to that:

1) The system, as proposed, is unequivocally better than the one we have in which money is also glass.  So you are not raising an objection to the proposal.

2) I've changed my mind about plastic and glass.  I don't think the distinction is that important after all.  When a corporation goes bankrupt the bonds rarely suddenly jump from par to the recovery value.  The price process of corporate bonds is about as continuous as the price process for stocks.  The illusion of glass is helped by accrual accounting, which obviously needs to be fixed.  But nothing suddenly breaks.  Different parts of the capital structure represent different claims on the assets of the company.  All of them are continuously affected as the asset value rises or declines.  So I would recommend the central banks take all liquid, transparently traded assets as collateral, with a reasonable haircut for each.

Your question made me think about another big problem with money which is that it is denominated in some random numeraire unrelated to real assets.  So here's a proposal, and you can only pull it off with purely electronic money.  Lets redefine the dollar as one trillionth of the money supply.  We now have a trillion dollars representing the total claim on all liquid assets.  And what's cool is that we don't pay interest anymore.  The growth of the economy is embedded in the currency.  This obviously has some features of hard money (it's in fixed supply), but without the obvious drawbacks of gold or other unnatural currencies.

So what happens when Cow Bank goes bad?  The bank's investors will gradually lose their wealth as their assets decline with the value of cows; and they will experience it very directly as their money account at the central bank declines.  But others will gain from the loss in the only sense that matters:  they will have a proportionately bigger claim on the economy and they will experience this as a rise in their nominal wealth.  A cool way to think of this is that by denominating assets in this currency, the systemic risk factor disappears:  no more beta.

Could this "hard money" cause a debt/deflation spiral? I don't think so, since the economy as a whole can't dump real assets in favour of money, since (unlike gold and the economy) they exist in a fixed ratio.  So, there, your holy grail: no banking inefficiency, no credit cycles, no interest, no beta and no inflation or deflation.

This is what I wanted to say at the start of the second paragraph above:  "Your question made me think about another big problem with money which is that it is denominated in some random numeraire unrelated to real assets. ***This is what makes money like glass to the real economy.  When the economy is worth less than the money there is trouble.***"

The "hard money" dollar definition is not actually required in order to have default free money. All that is needed is that the amount of money is at all times less than or equal to the value of all liquid collateral that backs it. But if the number of dollars is not fixed, it is possible, to have a run on collateral assets which will cause a drop in the nominal money supply resulting in deflation of consumer goods. The only way to avoid this is to fix the total number of dollars and allocate them in proportion to the market value of the owners of the collateral. I think this does make a run on assets (deflation spiral) impossible.

Having a fixed amount of currency would, of course, cause a stable deflation at the rate of economic growth. If this is inefficient due to some prices wanting to stick it might be necessary to increase the money supply either by paying interest or distributing money by any other means. The cost of doing this is that it reintroduces the money illusion as a possible irrational bias.

[I think I may be talking to myself here - it helps me think. But if so I apologize for taking up the bandwidth.]

K: You are not talking to yourself. I'm reading. Others almost certainly are too. As I've learned from blogging, number of comments (or replies in this case) doesn't always correlate with number of readers. My guess is that dozens, maybe even hundreds of people, have read your comments above.

"2) I've changed my mind about plastic and glass. I don't think the distinction is that important after all. When a corporation goes bankrupt the bonds rarely suddenly jump from par to the recovery value. The price process of corporate bonds is about as continuous as the price process for stocks."

I can see why that should be true. Debt should immediately get converted into equity when there's a default, and everything should continue seamlessly. But it doesn't seem to happen. Instead, the lawyers arrive, and everything freezes up, and the firm breaks.

Thanks for reading!  I've noticed that to really get attention you need to either 1) Stick your neck out and say something that might be wrong, giving somebody the opportunity to raise their status by calling you an idiot; or 2) call somebody an idiot thereby provoking an intense desire to rehabilitate their public persona and even seek revenge by proving that they are not, in fact, the idiot.

Anyways, you are an idiot.  If you knew anything about anything, it would be patently... sigh, can't do it...

Nick: "I can see why that should be true."

But it *is* true.  Check almost any time series of debt and equity of a deteriorating company.  They tend to be very continuous.  The bankruptcy costs are very large but that is fully anticipated by the investors and not a source of discontinuity.  Only *new* information causes jumps.  And in practice information tends to be very incremental.  This is just an empirical fact that you can verify from time series.  But there should definitely be no difference between debt and equity.  New information about asset value will effect them both in proportion to their sensitivity to asset value.  But it doesn't cause jumps in one and not in the other.

An important exception I can think of is the bankruptcy of Lehman Brothers.  In this case debt was trading around $75 dollars on the close of Friday, Sept 12, 2008.  On the open Monday morning, they were bankrupt and the bonds were trading around $35.  The stock, on the other hand, traded quite continuously down from $60 over the previous 6 months, losing only the last $4 over the weekend.  What happened was that over the weekend the bond holders discovered that, unlike in the case of Bear Stearns, they weren't going to get bailed out.  But, the value of Lehman's assets and the intrinsic values of its liabilities barely changed at all over the weekend.  After the bankruptcy the debt traded continuously as low as $4 and are currently around $20.  So if there hadn't been the possibility of government intervention there would never have been any discontinuities, debt or equity.

But in my prosed monetary system the central bank does have to take some margin to protect itself against jumps.  It could be 2% or it could be 20% depending on the properties of the asset.  You cannot risklessly monetize 100% of capital assets.

This morning I removed a spam comment from an Irish lawyer advertising for Irish farmers who had been hurt in a farm accident. That lawyer obviously thinks there's a non-zero probability that someone from that very small subset of the world's population is reading comments here!

K: I see your point: even if the returns to debt have a step function at default, the price of bonds will move smoothly provided the location of that step is uncertain, and news comes in smoothly. But there's still a real step there. Lawyers and bankruptcy are costly. The glass really does break. (OK, it's not worthless when it breaks, but a small extra force causes a discrete step in the value of the firm.)

" You cannot risklessly monetize 100% of capital assets."

I think you (almost) can.

Suppose there is only equity, and we all hold it in mutual funds. And we write cheques on our mutual fund balance.

The only risk of default is during the few hours or days it takes the cheques to clear. If I write a cheque for 40% of my balance, and my mutual funds drop by 41% overnight before the cheque clears, then the cheque will bounce.

"a small extra force causes a discrete step in the value of the firm."

It's not quite how I would put it. I would rather say that the value of the assets reflects a probability that bankruptcy will occur resulting in significant costs. As the probability of bankruptcy tends continuously towards one the asset price fully incorporates the cost of bankruptcy. So no jump in firm value. Anyways it's a nit pick. The point is that there are indeed significant costs associated with the breaking of a firm, but that equity and debt price processes tend in practice to be fairly continuous (and neither is more continuous than the other). I think the main sense in which debt is "glass" is that companies don't go broke immediately when the asset value drops below the liabilities and additionally bankruptcy costs are large. Therefore bonds break on bankruptcy, i.e. don't recover 100%. Equities don't "break" because they were never supposed to recover more than zero if the firm value dropped below the nominal amount of debt. But none of this needs to pose any challenge for monetization.

I assume you meant if you write a 60% cheque it will bounce if asset value drops by 41%. Prime brokers will let you buy bonds with 2-30% margin depending on the liquidity and credit risk of the bond, which means that they will lend you 70% to 98% of the value of the bond. That's about the extent to which you can monetize them today. But much of the jump risk they are protecting themselves against is systemic. If the bonds were denominated in a beta=1 currency, I think they could lend you significantly more as the jumps would be smaller and, being idiosyncratic, would pose a much smaller risk to the prime broker. Think of it as them lending you a basket of bonds against your bond. I think keeping the number of dollars in the economy fixed achieves that goal and would therefore make the monetization stable and far less prone to incurring losses to the central bank.

I just thought of another big efficiency of a beta=1 currency. It obviates the whole investment industry. You just hold money for a perfectly diversified portfolio. Only hedge funds would be trading securities.

I really think my proposal is sane, elegant, and enormously beneficial (and I sure hope those Irish farmers are reading it - they could use a decent banking system). But the more I think it's right, the less I think it's likely to be original. Or maybe it's obvious, but somehow irrelevant. Or maybe it's just wrong. I actually have no idea.

K: It's related to an idea I once toyed with: instead of targeting inflation, the Bank of Canada should target the total return index of the TSX (or some broad index of share prices).

Suppose the BoC makes the nominal value of the TSX grow at (say) 7% per year, in nominal terms. Then holding an index mutual fund would be exactly as safe, in nominal terms, as having money in a savings account.

"You are thinking about income effects. The question is about substitution effects. "

No, I'm not ignoring substitution effects. In general, voluntary exchange will be inefficient, in terms of allocative efficiency, and there is no a priori reason to believe that taxing one good and subsidizing another will cause an overall output or utility loss. It depends on whether the economy can produce the subsidized good more efficiently than it can produce the taxed good. Perhaps it will be a loss, perhaps it will be a gain. At least, I worked out some examples (*fingers crossed*) and I don't see stability problems.

On the other hand, if all goods are taxed equally, then there will be no effect on output or consumption. If the proceeds of the tax are "thrown away", then this must come out of a decrease in nominal financial wealth, but there will be no decrease in real wealth. If the government taxed and threw money away every period, then this would not be stable -- e.g. prices would converge to zero.

Re: accounting, OK, I disagree, but let me try to explain why:

It's hard to look at financial transactions, and easy to look at real transactions.

The notion of equilibrium is one in which you are trading your endowments, so this is naturally viewed as a process of adjusting stocks. When you do this over many periods, it's easy to forget that you need to talk about flows, not stocks. So it boils down to fudging, but in the course of fudging, you can miss things.

In a pure barter context, you start out with some fixed endowments, and everyone trades these endowments until they all reach indifference. At best, if you have production, an endowment of labor can be converted into real consumption output in the course of the barter.

But in a monetary economy, you can have the following situation. A firm, X, sells a bond to Y. X uses the proceeds of the bond sale to hire Z to produce capital goods. Z uses his wages to buy the bond from Y. So Y starts out with money and ends up with money. We can view Y as a financial intermediary that neither saves nor invests. Y is a broker. Z saves, but he obtains the funds to save from X's dissaving. Z does not fund X, but X funds Z.

How would you describe this in terms of endowments?

X's endowment is "expansion plan". Y's only endowment is money. Z has labor that can be supplied to produce 1 capital good. In the barter model, this transaction collapses to Z using his own labor to produce 1 capital good, which he keeps. It's autarky. X and Y disappear from the picture.

Therefore Z can never be unemployed. He can always make some capital goods whenever he wants, and it's non-sensical to take about an excess savings demand by Z, since Z saves in the real capital that he creates.

In the monetary model, Z does not want to buy capital, since pieces of machinery are no good for him.

Z wants to sell his labor so that he can get the IOU. And Z cannot bid down the interest rate in order to entice the firm to dissave because he only gets income to lend to the firm *after* the firm borrows. So if, for some reason, the interest rate is too high, then it will not fall as a result of Z's unmet saving demand, because Z has no resources with which to bid down the interest rate.

So this is a variation on Clower's constraint, but with investing (a flow) as the constraining factor, and the excess demand is not for the medium of exchange but for bonds more generally. The rigidities are not price rigidities but real rigidities, in the sense that pieces of naval shipyards cannot be bartered for consumption goods in the same way that bonds issued by a naval shipyard can.

RSJ: "In general, voluntary exchange will be inefficient, in terms of allocative efficiency, and there is no a priori reason to believe that taxing one good and subsidizing another will cause an overall output or utility loss. It depends on whether the economy can produce the subsidized good more efficiently than it can produce the taxed good."

The First Theorem of Welfare economics says otherwise. True, that theorem depends on some assumptions, like the existence of competitive equilibrium, and no externalities, but the assumption that the economy can produce all goods with the same "efficiency" (Productivity?) is not one of them.

No, the first welfare theorem only gives you *pareto* efficiency.

Maximizing individual utility only maximizes total utility when you (effectively) have only a single consumer. I think separable preferences is enough -- you probably know the criteria better.

In general, in order to maximize total utility, you need to impose some form of tax and subsidy -- you will not get to the allocatively efficient equilibrium by voluntary exchange, as there will be inefficiencies due to voluntary exchange.

For example, suppose that half the economy consists of those who prefer coffee over tea, and half of the economy consists of those who prefer tea over coffee.

Assume there is no labor discrimination, in the sense that coffee drinkers can be employed making tea and vice versa. Assume that both groups have the same labor endowment.

Their utility functions would be something like u_1 = ln(2C + T) and u_2 = ln(C + 2T).

Now you are not going to get MRS = MRT.

But if the economy can produce coffee more efficiently than tea, given the same unit of labor input, then taxing coffee and subsidizing tea will result in more total production and more total utility, as the utility loss of the coffee drinker is less than the utility gain of the tea drinker. Such a solution does not dominate in the pareto sense, but it is more allocatively efficient.

This is why it makes sense, for example, to tax gasoline and subsidize public transit, provided that the economy can deliver transportation more efficiently via public transit than via cars. In that case, the utility loss of the person who prefers driving may be less than the utility gain of the public transit user, and both total utility as well as aggregate output goes up as a result of the tax and subsidy. And this is more allocatively efficient that an endowment transfer from one demographic group to another, because an income transfer will not result in all the new income being spent on the more efficiently produced good.

Oops, in the above, I meant to say "if the economy can produce tea more efficiently than coffee" :)

The point is the individual operates in a way to maximize their own utility, given their endowment. But a macro policy is about the economy wide allocation of scarce resources -- there are winners and losers, so you want to exploit the macro gains by subtracting some utility from one person and giving more utility to another person while keeping the *total* resources fixed. These are efficiency gains that voluntary exchange cannot give you, and it less efficient to obtain these gains by means of income adjustments rather than price adjustments.

RSJ: OK. I understand you now. You see, when you say "In general, voluntary exchange will be inefficient, in terms of allocative efficiency,...", economists read "allocative efficiency" as "Pareto Optimality". That's how we normally use those words.

RSJ: "These are efficiency gains that voluntary exchange cannot give you, and it less efficient to obtain these gains by means of income adjustments rather than price adjustments."

But now you are contradicting the Second Theorem of Welfare economics.

There are many notions of efficiency. Pareto efficiency, allocative efficiency, production efficiency. I think economists use all these terms, right?

Pareto efficiency is that no one is hurt and at least one person gains. I.e. there is no cost, and there is only a benefit.

Production efficiency is that the most stuff is produced.

Allocative efficiency is that the most utility is obtained.

Macro should be about cost-benefit trade offs, right? Here I am measuring costs and benefits in terms of loss or gain of utility.

You should judge the effects of a tax in terms of this cost-benefit trade off.

Generally speaking -- e.g ignoring specific examples of market failure -- All the macro policies are about these trade-offs, because you assume that due to voluntary exchange, these are the only trade-offs left.

But saying that these are the only trade-offs left on the table does not mean that any price adjustment must be a net loss or gain.

That assumes that the allocative gains are zero, which is implausible.

The second welfare theorem only tells you that every Pareto-efficient allocation can be obtained via an income transfer. It does not tell you that every allocatively efficient equilibrium can be so obtained.

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