Money is always and everywhere a hot potato

And the Law of Reflux is always and everywhere wrong. Unless the central bank decides to make it true. (The Law of Reflux says an excess supply of money will always revert to the issuing banks).

This post is too long. It was a bit off the top of my head, and I'm too busy and lazy to make it shorter. Sorry.

This post is for David Glasner. (Sorry for the delay, David; I was thinking about the best way to say it.)

This post is also for everyone who believes in the Law of Reflux, and that means almost every economist nowadays.

And especially for Mike Sproul (pdf), who makes a perfect foil because he is such a hardline waffle-free believer in the Law of Reflux! I'm going to go equally hardline in the exact opposite direction. How extreme a position can I stake out and defend? Just watch me!

(And also for those of you who say obviously true things like "the quantity of money is endogenous", or things that don't strictly make literal sense like "the supply of money is demand-determined"; because what you are really trying to say is that you believe in the Law of Reflux.)

I am going to tell you a (true) story about money, opals, and a used car. And lemons.

The best way to understand the demand for money is to start out from the proposition that there is no demand for money. Nobody ever wants the stuff, because it is totally useless. For every other good, there's somebody out there who wants it, or who might want it sometime, even if you don't. But money is different, money is weird, because nobody wants it, and nobody ever will want it. Unless you understand that, and start from there, you will never understand the demand for money, and why the demand for money is so very different from the demand for all other goods.

(OK, what about if we used cows as money? Sure, people want cows, because cows produce milk, and people want milk. But that's a demand for cows qua cows, and has nothing to do with the demand for cows qua money. So to keep things simple I'm going to ignore cows and talk about totally useless paper money, which nobody wants and nobody ever will want.)

I was leaving Australia and trying to sell my car. A guy offered me a bunch of opals in exchange. (This is slightly less strange than it would be elsewhere, because there were opal mines nearby). I didn't want opals, and believed I would never want opals. So I refused his offer.

You might say: "Hang on Nick. If he had offered you a really good deal, shouldn't you have accepted his offer? You could have sold the opals to someone else, even if you didn't want them. It wasn't rational for you to have refused to even consider his offer."

To make a simple explanation complicated: my reasoning was game-theoretic. If his opals really were worth as much as he said they were worth, why didn't he sell them to someone who did want opals? Or to a specialist opal dealer? Then bring the dollars to me, and buy my car? Rather than selling the opals to me in exchange for my car, and then me finding someone who wanted the opals? I simply couldn't think of any set of plausible assumptions that would create a game where rational behaviour by both of us would lead to an equilibrium in which he and I swapped opals for the car. I could think of plausible assumptions that would create a game where rational behaviour by both of us would lead to an equilibrium in which he and I swapped Australian dollars for the car. I was leaving the country, so I needed to sell my car, and he maybe wanted a car like mine to drive around in. (My needing to leave the country solved the Market for Lemons problem with my car; but I couldn't think up any plausible solution for the Market for Lemons problem with his opals.)

If we had been in the middle of the outback, and he had said he desperately needed my car all of a sudden, and didn't have time to sell the opals, and if his story seemed plausible, then maybe, just maybe, I might have accepted his offer.

If I had accepted his opals in exchange for my car, even though I didn't want those opals, I would have been using those opals as a medium of exchange. As money. As a temporary abode of purchasing power. As a hot potato I didn't want to hold but planned to get rid of, not immediately, but when a favourable opportunity arose, taking into account the costs of finding that opportunity or waiting for a better opportunity.

If I had sold my car for opals I didn't want, those opals would have been a hot potato in my hands that I planned to get rid of.

If I had sold my car for Australian dollars I didn't want, those Australian dollars would have been a hot potato in my hands that I planned to get rid of.

If I had sold my car for Canadian dollars I didn't want, those Canadian dollars would have been a hot potato in my hands that I planned to get rid of.

I don't want opals; I don't want Australian dollars; I don't want Canadian dollars. I would only ever accept any of those three goods because I planned to get rid of them. For me, all three goods are hot potatoes. The only difference is this: for some people (those who like wearing opals) opals are not hot potatoes. Dollars are a hot potato for everyone, and always will be.

If you offered opals for sale, with a condition attached that you could never ever sell them again, some people would still buy those opals, albeit at a reduced price. If you offered dollars for sale, with a condition attached that you could never ever sell them again, nobody would buy those dollars, at any price.

Opals are sometimes a hot potato for some people. Dollars are always a hot potato for everyone. We all only ever buy them because we plan get rid of them by selling them to someone else.

Who might that "someone else" be? Almost anyone. How long might we plan to wait before selling them? That depends.

Suppose I had accepted opals in exchange for my car. Who would I have sold them to? How long would I have held them before selling them?

I would probably have sold the opals to a jeweler, someone who is a specialised trader in opals and who holds an inventory of opals because he is always on the lookout for good deals to buy and sell opals, and those good deals aren't perfectly synchronised, so he needs to hold a stock of opals in inventory to handle days when he gets more good deals to sell than to buy, or vice versa. Now the opal dealer wouldn't really want the opals either. He only buys opals because he plans to sell them to someone else, someone who really does want opals to wear. If I had added a condition to the sale that the opal dealer cannot ever sell the opals again, he would refuse my offer at any price (unless he liked wearing opals himself).

Opals are a hot potato to opal dealers.

I expect there might have been a small chance that I happened to meet someone who wanted opals. If so, I might have sold the opals to that person. But it's very unlikely. Most people who want an opal would already have bought one from an opal dealer. Opal dealers and the people who want opals are much better at finding each other than they and I would be at finding each other.

How long would I have waited before selling the opals? I don't know. That depends. On a lot of things. I was busy. There wasn't an opal dealer right next door. Maybe I would not have accepted the first opal dealer's offer right away. Maybe I would have sold them quickly if I had needed the cash quickly because I wanted to buy something else quickly. Or maybe I would have waited till I got a really good deal.

It is very likely I would have sold the opals to an opal dealer. But it is very unlikely i would have done so the very instant after I had got the opals in my hand. I would have held the opals temporarily, as a temporary abode of eventual purchasing power. My guess is that I might have held the opals for about a month before selling them. My annual velocity of circulation for those opals would have been 12.

Did I desire to hold those opals for one month? Did I have a demand to hold that stock of opals for one month? Well, yes and no. I didn't really desire to hold them at all. I wanted to get rid of them. If I had accidentally lost them, I wouldn't have bought replacements. But I wasn't desperate enough to desire to get rid of them immediately at any price. Given the opportunities I figured were available to me, I did choose to hold them for one month, and in that sense only, I did have a demand to hold that stock of opals for one month, and I did have a desired annual velocity of 12.

And in exactly that same sense, the opal dealer, who doesn't really want opals at all, has a desired stock of opals to hold in inventory and a desired velocity of circulation of opals (a desired inventory turnover of (say) 12 times a year). If good deals to buy or sell opals came at exactly the right times, perfectly synchronised, the opal dealer would be very happy to buy an opal and sell it immediately, holding no inventory at all. But they don't. Just like there wasn't an opal dealer right next door when i sold my car.

Only opal dealers, and opal miners, and people who sell cars to desperate Australian opal miners in the outback, hold inventories of opals. We all hold inventories of dollars. That's because everyone is a dollar dealer. We buy and sell dollars whenever we sell and buy anything else. And if someone gives us a good deal we buy dollars and hold them in inventory waiting for another good deal so we can sell them again. Because the good deals to buy our dollars aren't perfectly synchronised with good deals to sell our dollars.

If I had sold my car for opals, which were a hot potato, I would very probably have sold my opals to a jeweler who deals in opals. Because, including transactions costs and search costs and everything else, I would probably have got the best deal from someone who specialises in trading opals and who holds an inventory of opals. Only jewelers do that.

I sold my car for Australian dollars, which were also a hot potato. I sold them at a place, called a "bank", which is a dealer in Australian dollars. Because, including transactions costs and search costs and everything else, I would probably have got the best deal from someone who specialises in trading Australian dollars and who holds an inventory of Australian dollars. Only banks do that.

If I had sold my car for Canadian dollars, which are also a hot potato, I would have looked for a buyer who specialises in trading Canadian dollars and who would give me the best deal. But everyone I deal with here in Canada specialises in dealing with Canadian dollars and holds inventories of Canadian dollars. Everyone does that. Not just banks, but jewelers too, and car dealers, and my local supermarket, and my broker, and everyone I know.

Right now I have $100 in my pocket. It's a hot potato. I don't want it. I plan to get rid of it. Only not right now, because I am typing this right now. I plan to get rid of it a little later. Where will I get rid of it? At my bank? Well, if I thought my bank would give me the best deal, and something I really wanted more than anything else right now, then yes I would get rid of it at the bank. But I don't think that. I think i will get a better deal at the supermarket and gas station. So that's where I'm planning to spend it, in a little while. (Unless the bank phones me with a great new offer that can't wait.)

The gas station trades gas for Canadian dollars. The supermarket trades food for Canadian dollars. Continue through a long list of other traders. And the bank trades IOUs for Canadian dollars. A bank is just 1 out of 999 other places I could trade Canadian dollars.

Start in equilibrium in a monetary exchange economy. But it's always a weird sort of equilibrium, if it is a monetary exchange economy. Because even in equilibrium, people will be holding stocks of money that they really don't want to hold, and do want to get rid of. It's just that they don't want to get rid of it right this very instant, given the opportunities for deals they think are available and will be available. Just like I would have been wanting to get rid of those opals, and was just waiting for the right deal.

Now suppose the banks suddenly start offering a better deal when buying IOUs. And they offer that better deal to me and everyone else. What happens next?

Some of us accept the banks' offer, just as we would if used car dealers suddenly offered us a better deal to buy our cars. But just because I sell my used car to the dealer for $3,000 doesn't mean I want those 3,000 extra dollars. And just because I sell my IOU to the bank for $3,000 doesn't mean I want those 3,000 extra dollars. I only want those dollars in exactly the same sense as I would have wanted those opals: so i could get something I did want when I got rid of them. They are a hot potato burning a hole in my pocket or chequing account.

Now, it is possible that if the banks make a better offer for my IOUs, and keep making that same better offer for my IOUs, my desired velocity of circulation of money might fall, now that the interest rate and opportunity cost of holding money has fallen. So it is logically conceivable that my desired average inventory of money might rise by exactly $3,000 on average and stay there. But that's very unlikely. Much more likely is that I borrowed that extra money because I wanted to get rid of it by spending it on something else I wanted more than my IOU. Just like I sold my car to the dealer because I wanted to get rid of that extra money by spending it on something else I wanted more than my  car.

From my point of view there is no difference whatsoever between a bank and a car dealer. One buys and sells IOUs and the other buys and sells cars. But there's a massive difference for the economy as a whole. The bank creates money when it buys IOUs and the car dealer does not create money when it buys cars.

So when the banks offer better deals on IOUs to everyone, and people take them up on the offer, the stock of money expands. But individuals don't plan to keep on holding all that extra money in inventory. By assumption their desired turnover of inventory is the same. They plan to get rid of it. Each individual can get rid of money, by passing it on to another individual, but in aggregate they can't. The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs.

But why would they want to do that?

If I have opals i want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money i want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999? Moreover, wasn't the original shock that got the ball rolling a decision by the banks to offer better deals when buying IOUs? Why would they do that, and at the same time offer better deals when selling IOUs back to us? If the banks raise the prices at which they will both buy and sell IOUs (i.e. lower their lending and borrowing rates of interest) there is no way the excess supply of money will reflux to the banks. Instead we will sell more IOUs to the banks, buy fewer IOUs back from the banks, so more money is created and less is destroyed, so we are holding and trying to get rid of more hot potatoes than we did before.

It can't go on forever, of course. And an inflation targeting central bank will make sure it doesn't go on forever. Because if it does go on forever the inflation rate will rise above target. Yes, in the long run, banks cannot create hot potato money. Because if they did create hot potato money the central bank would tighten monetary policy to stop them creating hot potato money.

In the long run, which means when the central bank is doing its job right, commercial banks can only create money that people want to "hold" (in the same sense that I wanted to "hold" those opals for a month before selling them, and the car dealer wants to "hold" one month's inventory of cars on the lot). The central bank won't let them create more, if it wants to keep inflation (or whatever) on target. And in that same long run, commercial banks can only lend what they can borrow. Because central banks won't let them lend more.

But in the very short run, none of that is true. If a central bank ever does find inflation is heading below target, and wants to get it back up to target, it will take actions to ensure that commercial banks do create more money and do create a bigger monetary hot potato.

[Running through my mind as I wrote this: an old paper by Alchian(?) on specialised traders and costs of ascertaining values of goods and why we use money; a slightly less old related paper by Clower and Howitt; Laidler; Yeager; and Tobin of course too, on the inventory approach.]

Comments

[Min]

"But money is different, money is weird, because nobody wants it, and nobody ever will want it. Unless you understand that, and start from there, you will never understand the demand for money, and why the demand for money is so very different from the demand for all other goods."

Hmmm. People seem to want those big round stones that are at least called money. Now, misers may be few, but they do exist. The Japanese word for "rich" is "kanemochi", having money. Someone who is really rich is yamamochi, having a mountain of money. If people don't want money, why do they say they do? I am not convinced that that aspect of human psychology (desire for money) is captured by economic theory.

[Alex Godofsky]

Min: but very few of those people actually do hold onto huge piles of money. They use the money to buy lots of IOUs.

[Min]

"And the Law of Reflux is always and everywhere wrong. Unless the central bank decides to make it true. (The Law of Reflux says an excess supply of money will always revert to the issuing banks)."

In "A History of American Currency, with Chapters on the English Bank Restriction and Austrian Paper Money, to which is appended “The Bullion Report” [1878]" ( http://oll.libertyfund.org/index.php?option=com_staticxt&staticfile=show.php?title=1653&layout=html ), William Graham Sumner, in reference to the paper money of the American colonies, makes the interesting observation that around five years after the issuance of paper money colonial businessmen wanted more money to be issued, and that pattern repeated after the issuance of more money. Also, IIRC, part of the sad story of the French assignats after the revolution was that the Assembly kept issuing more and more, and did not retire those that were used to purchase gov't land (which was their backing). These demands for more money were not necessarily personal. Do they not indicate that the circulation of money was slowing, and perhaps money was being hoarded? If money is always and everywhere a hot potato, what explains the apparent pattern of the potato cooling down?

[Jacques René Giguère]

Nick: have you seen what Hans-Werner Sinn wrote
as reported by Peter Dorman`s Econospeak HT MArk Thoms`s Economist View

"Germany agreed to relinquish the Deutsche Mark on the condition that the new currency area would not lead to direct or indirect socialization of its members’ debt, thus precluding any financial assistance from EU funds for states facing bankruptcy. Indeed, the new currency was conceived as a unit of account for economic exchange that would not have any wealth implications at all."

Dorman adds: "Take a look at this second sentence, which I’ve bolded for emphasis. It seems to say that, in some magical way, the euro was designed to facilitate exchange without ever serving as an asset. A money that is not an asset.This is coming to you from the most influential “economist” in the German-speaking world. Am I missing some other way to assign a meaning to this sentence that is remotely compatible with elementary economics?"

CohC?

[K]

For the sake of argument, can we assume that money is deposits and deposits earn the policy rate? Lets also imagine that all loans are grossly overcollateralized so there is no credit risk. Therefore banks just have risk free deposits on one side and risk free loans on the other. There's no bank equity or other non-deposit liabilities. Also, deposits and loans are short dated and at the short rate (the loans are lines of credit). Next, lets assume that the quantity of deposits (= quantity of loans) is determined by differences in risk/time/consumption/leisure preferences between old, wealthy people and young, poor people.

When people buy something they just increase their borrowing balance (e.g. write a cheque on their line of credit), and the seller simultaneously increases their deposit balance. No need for the buyer to prepare for the purchase by increasing liquidity. They just buy it, thereby bringing a deposit into existence (or possibly extinguishing one, if they already were a net depositor and the seller an net borrower).

But there is no "hot potato." Money isn't created before buying. The act of buying *is* the act of deposit/loan creation or destruction. And nobody is trying to get rid of the newly created money, since they created or destroyed it *because* a debt modification was a necessary part of achieving the pareto optimal distribution of risk and consumption.

The world that's described here is for relevant intents and purposes identical to the world we live in. There is no meaningful mechanism for an exogenously introduced increase in "money."

[K]

...Which is to say... to the extent that money earns interest, it's not something that people don't want. It's the same as bonds. And almost the entire quantity of money (except for a bit of currency) earns interest. So it's not true that "The best way to understand the demand for money is to start out from the proposition that there is no demand for money." The best approximation is to start with a system of 100% equilibrium-interest-rate earning money, and see how that works. Then add some 0% interest currency (that nobody "wants") and see if it makes any difference (I don't see how it would - but it's worth debating).

[Louis S]

When the bank lowers rates on borrowing/saving, causing an increase in net borrowing and so an increase in the stock of money circulating, I can see why this would put upward pressure on prices. However, assuming that the bank isn't continuously lowering their rates, the increase in the stock of money should be a one time thing. And once prices rise, the real purchasing value of that money stock will have declined, offsetting the hot potato effect by increasing people's desire to hold greater quantities of money.
So why do you say this changes the inflation 'rate' as opposed to being a one-time inflationary event?
Other than expectations, of course, which I don't think were factored in to this post.

[Min]

Alex Godofsky: "Min: but very few of those people actually do hold onto huge piles of money. They use the money to buy lots of IOUs."

I am well aware of that, thanks. :)

[rsj]

I have a full rebuttal, but the size of this textbox is too small for me to present it.

Also, I am in the office.

The concise rebuttal is here:
http://windyanabasis.wordpress.com/2012/08/29/qe/

A fuller treatment is here:

http://windyanabasis.wordpress.com/2011/06/16/pushing-on-a-string-supply-demand-version/

[Mike Sproul]

Nick:

Sorry about the repetition, but what's your reaction to this?

I say that unwanted money will reflux to its issuer (and not do the hot potato), and Nick says it will be spent on goods (and do the hot potato). At first, it seems like there's no way to say for sure which of these two things will happen, and so Nick and I, as usual, reach a stalemate.

I don't think so. Full-bodied coins cannot do the hot potato, because if they did, excessive minting of coins would cause a 1 oz gold coin to lose value, so that the 1 oz coin will buy the same groceries as 0.99 oz. of gold bullion. Every coin holder faces the choice of spending his coin on .99 oz worth of groceries, or melting the coin to get 1 full oz of bullion, which will buy 1 oz of groceries. Everyone will choose to melt (not spend) until the value of the 1 oz coin returns to 1 oz.

I don't see how anyone could argue against the above paragraph, but you would probably say that even if it's true of coins, it's not true of modern paper money. But if you think of the example of a mint, the validity of the Reflux view becomes clearer. Suppose that the mint, rather than stamping 1 oz. of gold into coins, takes the 1 oz. of gold from the customer and puts the 1 oz. in its vault, while giving the customer a 1 oz. paper receipt. Does anything important change? No, it doesn't. If people want more paper money they will bring more gold to the mint. If they have too much paper money then the paper will reflux to the mint as people take out their gold. Reflux works the same as it did for coins.

One last step: The mint starts issuing paper money to anyone who brings miscellaneous stuff worth 1 oz to the mint. The mint keeps the stuff in its vault, just like it did with the gold. There's still no important difference. If people want more paper money they will bring more stuff to the mint. If they have too much paper money they will return their paper money to the mint and get their stuff back. Reflux still works exactly the same.

[M.R.]

Have a look at Gorton on "informationally-insensitive debt," adverse selection, lemons, and money:

"Intuitively, informationally-insensitive debt is debt that no one need devote a lot of resources to investigating. It is exactly designed to avoid that."

http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf

Question for you: Are shares of Apple Inc. stock also a hot potato? Would you say about those shares that "Nobody ever wants the stuff, because it is totally useless"? That it's just pieces of worthless paper, etc.? What about a bond -- a promise to deliver money, money being "totally useless"?

[JKH]

"As a hot potato I didn't want to hold but planned to get rid of, not immediately, but when a favourable opportunity arose, taking into account the costs of finding that opportunity or waiting for a better opportunity."

I assume there's no specific duration limit on the holding period for a "hot potato".

Therefore, is heat really the important characteristic?

[Alex Godofsky]

Mike Sproul:

One last step: The mint starts issuing paper money to anyone who brings miscellaneous stuff worth 1 oz to the mint. The mint keeps the stuff in its vault, just like it did with the gold. There's still no important difference. If people want more paper money they will bring more stuff to the mint. If they have too much paper money they will return their paper money to the mint and get their stuff back. Reflux still works exactly the same.

The mint has no obligation to accept the paper money in return for its hoard of stuff.

In practice, the mint sets a target for the price of its stuff, and so to maintain that target it occasionally has to buy or sell some stuff, which more-or-less amounts to an obligation for the mint to let you buy stuff at a certain price. However, it changes that price every six weeks, so if you sell them some stuff you may have to pay more later to get it back. And if the mint observes lots of people trying to buy their stuff they might raise the price until people stop.

[Nick Rowe]

Min: "These demands for more money were not necessarily personal. Do they not indicate that the circulation of money was slowing, and perhaps money was being hoarded? If money is always and everywhere a hot potato, what explains the apparent pattern of the potato cooling down?"

Dunno. Maybe the US economy was growing? What could cause car dealers to want to hold larger inventories of cars, or have a slower turnover of inventory? Loads of things.

Jacques Rene: I remember Hans Werner Sinn when he was visiting UWO, in 1980, I think.

I don't think that offending sentence is so bad. It's a bit unclear. All he probably meant is that it shouldn't create a transfer of wealth between nations. Which it shouldn't, if Target2 netted out to zero between countries on average. But if Target2 does go bust, and those balances don't get repaid to Germany, then I think HW Sinn is right and Karl Whelan is wrong. This is a debate I've stayed out of, because there's a lot of institutional detail, so anyone who knows that detail (or at least, talk about it in a knowing manner) can always do a snowjob on someone like me.

[K]

Nick,

What if we use a pool of liquid stocks (an ETF) as money. Is that going to be a hot potato? I'd say no. Same goes for t-bills (ie deposits).

[marris]

@Mike Sproul

> Suppose that the mint, rather than stamping 1 oz. of gold into coins, takes the 1 oz. of gold from the customer and puts the 1 oz. in its vault, while giving the customer a 1 oz. paper receipt. Does anything important change? No, it doesn't. If people want more paper money they will bring more gold to the mint. If they have too much paper money then the paper will reflux to the mint as people take out their gold. Reflux works the same as it did for coins.

I agree with your original statement on 1 oz and 0.99 oz, since I think it's basically an arbitrage argument.

I think the paper money / mint example is tricky, since it offers a loophole around Nick's "let's assume fiat money" assumption. If the mint is operating with a full reserve system and hold a 1 oz gold coin in its vault for every receipt it offers, then yes, this example is similar to the non-paper case. And the 1 oz, 0.99 oz arbitrage argument applies. I think the mint's reserve policy is providing implicit "cooling" of the "hot potato paper receipts." Worse-case scenario, a receipt holder can take his receipt to the mint and pick up his gold. Worse-case scenario, he can then can exchange that gold for other goods and services since gold, like cows, has use value.

The example becomes trickier when the mint does not provide face redeemability, but instead posts prices for it's goods. The receipts don't become hot potatoes instantly, but we'll start to see arbitrage of the vault items [similar the opal dealers?]. Further, you can get mint panics when everyone thinks the mint is going to raise prices in the near future.

I think the receipts become complete hot potatoes only when the mint suspends all redeemability. Then, there is no reason to hold the money, except as a medium for future exchange.

[Alex Godofsky]

K:

What if we use a pool of liquid stocks (an ETF) as money. Is that going to be a hot potato? I'd say no. Same goes for t-bills (ie deposits).

Are you talking about using the stocks as the medium of exchange or medium of account?

[Nick Rowe]

K: Lets ask the same question slightly differently: suppose the guy in Australia could have just repo'd his opals?

Louis S: "However, assuming that the bank isn't continuously lowering their rates, the increase in the stock of money should be a one time thing."

Well, it depends on desired saving and investment. Suppose a lower rate of interest means a permanently higher flow of desired investment and desired saving? Yes, the stock of real assets would be growing over time (assuming real output did indeed respond to the hot potato), and the higher stock might or might not cause desired investment to fall (it would in a Solow growth model but not in an AK growth model). But even if that does happen, it would take a very long time to happen. It would only happen in the "very long run". I'm in the very short run.

MR: "Have a look at Gorton on "informationally-insensitive debt," adverse selection, lemons, and money:.."

Yep. That's very much the same idea. In Alchian's very old paper on money, his key insight was that a good for which everyone had low costs of ascertaining its value would tend to become used as money. Used cars would make a very bad money, because we would have to pay for a mechanic's inspection before we sold anything. If I thought I had known as much about the value of his opals as the Australian guy, it would have been a very different story.

On stocks and bonds that pay only dividends in money: yep, if dollars weren't useful as a medium of exchange, they would be useless. But dollars are more useful than opals as a medium of exchange.

JKH: "I assume there's no specific duration limit on the holding period for a "hot potato".

Therefore, is heat really the important characteristic?"

There are degrees of hotness. Celsius? It all depends how big your inventory is relative to the pattern of deals to buy and sell. The bigger your inventory, other things equal, the keener you are to sell some more and the less keen you are to buy some more. Whether we are talking car dealers with cars or anyone with money. "Equilibrium" means only that the aggregate keenness to buy and the aggregate keenness to sell result in inflation staying on target.

Mike. We face a whole spectrum of offers to buy and sell money from our inventories. Somewhere in that spectrum are the banks' offers to buy and sell our money. They aren't the only offers. Do the banks make offers in terms of a pair of interest rates (units 1/time), or in terms of of regular prices (units $ per ton)? If it's interest rates, there is zero equilibrating forces.

Here's how to reconcile your and my view of the world: remember I said that the Law of Reflux is false, unless the central bank acts to make it true. If money starts to hot potato, and prices start to rise above the central bank's target, the central bank will choose to make it true. Now suppose that the Bank of Canada has direct convertibility into the CPI bundle of goods at a 2% crawling peg. It now needs no judgement by the Bank of Canada. All it needs do is keep the crawling peg. We are now in your world.

[K]

Alex: As a medium of exchange. The unit of account can be anything, for example by splitting or reverse splitting the units of the ETF according to whatever formula you want.

Nick,

The guy could have brought his opals to the pawn shop, and got a loan of some amount well under the fair market value of the opals. Then he could have paid you with money, which everyone wants since its a guarantee of future consumption basket.

Are you saying nobody wants to own a risk free real loan? If I give you a loan to buy something from me and you are a perfect credit, then that loan has value (it's a store of value) and since it's risk free, it's perfectly fungible with any other risk-free loan which makes it a good medium of exchange. All we need is a unit of account (no big deal) and we can see why risk free debt makes good money. I can't see why nobody would want it. Guaranteed consumption at some point in the future is an excellent asset that has no properties of hot potatoes. Unlike unbacked intrinsically useless metal tokens.

[Mike Sproul]

Alex:

It's not whether the mint has an *obligation* to accept its paper money in return for its stuff, it's whether the mint does, in fact, pay out its stuff for the money. If the mint behaves in such a way that people believe that the mint will pay out 1 oz/$ (or stuff of equivalent value) this year, 0.98 oz./$ next year, and 0.96 oz./$ the year after that, then that's what dollars will trade for, assuming customers can't find another mint whose money only loses 1%/year in value.

The value of any money is determined by the rate of convertibility maintained by its issuer. That rate, in turn, is governed by whether the issuer has sufficient assets to maintain the chose rate of convertibility.

[Alex Godofsky]

i.e. Nick is right. The law of reflux is only true if the central bank decides to make it true. This is literally the first sentence of his post.

[Mike Sproul]

Marris:
If the mint suspended ALL redeemability, then its paper money would lose all value, so there's no longer any hot potato'ing. But redeemability can mean many things. The mint might offer to redeem its paper money for gold today, or gold 10 years from now. It might tie its paper to gold, and if the paper loses value, it uses its bonds to buy back its paper. I'd call that bond convertibility. Or the mint might announce that in 200 years, it will use whatever assets it has to buy back whatever money it has outstanding. That is enough to give its money value today.

As long as there is convertibility of some kind, there is an open channel of reflux and no hot potato. If there are absolutely no channels of reflux, now or ever, then money loses all value, and again there is no hot potato.

[Mike Sproul]

Nick:

A bank holds 100 oz of gold, plus bonds worth $200 (denominated in dollars, not gold) and it has issued $300 in paper. Letting E=the exchange value of the dollar (oz/$), and setting assets=liabilities, we get 100+200E=300E, or E=1 oz/$. No problem. Next the bank lends $100 new paper dollars at a 2% interest rate, when the true market rate was 5%. This is equivalent to issuing $100 and using it to buy a bond worth $97. Now, setting assets=liabilities yields

100+200E+97E=400E, or E=100/103=.97 oz./$

Sure, you get some inflation by lending cheap, but there is not "zero equilibrating force".

The central bank isn't choosing whether to make the Law of Reflux true. The bank can only choose to buy back its dollars at a certain price, or not to buy them back at all. If it buys back its dollars with stuff worth 1 oz of gold, then its dollars will be worth 1 oz, and if it reduces the buy-back price 2%/year then its dollars will fall at 2% per year (assuming customers can't find a bank that only takes away 1%/year). If the bank does not buy its money back at all, ever, then its money will lose all value.

[Mike Sproul]

Nick and Alex:

I forgot to say that this:

"(The Law of Reflux says an excess supply of money will always revert to the issuing banks)."

is an incorrect statement of the Law of Reflux. Here's a relevant passage from my Law of Reflux paper, cited above by Nick:

"With adequate backing, all the shillings issued by a government or bank can reflux to their issuers in exchange for assets worth 1 oz. of silver. Without adequate backing there will still be a reflux, but that reflux will not preserve the value of the shillings. For example, if the government tries to back 100 shillings with assets worth only 99 oz., and if the government tries to maintain convertibility at the unaffordable rate of 1 oz./shilling, then all 100 shillings will immediately reflux to the government through any reflux channels available. The first 99 shillings will be redeemed for assets worth 1 oz., and the last shilling in the queue will lose all value. In this case the reflux takes the form of a bank run, or more precisely a run on the government’s assets. This type of reflux, rather than preventing inflation, actually causes inflation, as the bank run depletes the bank’s assets."...."The law of reflux is normally, and incorrectly, thought to prevent inflation by assuring that excess money automatically refluxes to the issuing bank. This assumes the correctness of the quantity theory view that the value of money is preserved by limiting its quantity. The backing theory view presented here asserts that the value of money is preserved by maintaining a constant amount of backing per unit of money, regardless of the total quantity of money. The law of reflux still operates, in the sense that unwanted money automatically refluxes to the issuing bank, but the main effect of the law of reflux is only to maintain the quantity of circulating money at a level at which economic activity can be conducted conveniently. "

[Alex Godofsky]

Mike, if the central bank suspended "convertibility" forever (i.e. tore up all the bonds it owns) dollars would still have value at the very least because you have to pay taxes in them.

[Min]

rsj: "I have a full rebuttal, but the size of this textbox is too small for me to present it."

[Min]

Oops! Here is the grin for rsj. ;)

[J.V. Dubois]

Mike: Please could you explain your position in a more clear way? Because from what I read, you actually agree with Nick. At August 29th at 11:55 PM you wrote: "The central bank isn't choosing whether to make the Law of Reflux true" only to write this in the very same paragraph "If the bank does not buy its money back at all, ever, then its money will lose all value"

So if the bank does not let the money reflux back to it (law of reflux) then the money will lose value (hot potato). This is exactly it - it is the bank that decides whether it will uphold the law of reflux or not. But then the "law of reflux" is really a trivial one as it is based on the willingness of the money issuer to absorb excess supply of money. But this in my eyes is no law. It is like talking about "law of acceleration" because we observe that some object tends to accelerate as a result of us applying some force on it - while in reality the true law describing what actually happens is Newton's first law and what we observe is just one possible outcome for this law.

[Scott Sumner]

Nick, Both you and David lost me somewhere. I don't see how there's any controversy here at all:

1. One can imagine changes in banking that lead to more deposits, which as a side effect reduce the real demand for base money. In those cases the new bank money could be viewed as a hot potato.

2. One can imagine changes in banking that lead to more deposits, but do not change the real demand for base money. In that case there is no hot potato effect, the price level is unchanged.

It seems to me that both statments are obviously true, and that you and David would clearly agree with both statements. So what exactly are you disagreeing about?

[marris]

Nick, I'm a bit unsure how to reconcile "money is always and everywhere a hot potato" with "When Old Monetarists were talking about how the monetary hot potato gets passed from person to person, they were talking about the very short run". The latter is from your previous post.

Are you saying the Old Monetarists saw the hotness in the very short run, but not in the short or long run? But you (Nick) can see it even in the short and long run?

Or is *this post* really about the very short run? And you still believe that the hot potato aspect is less important in the short and long run [where things like inflation targets, price targets, etc] come into play?

[Alex Godofsky]

marris, in the long run the prices of goods adjusts so that money is no longer a hot potato.

[JP Koning]

Nick, insofar as I've been following the Rowe/Glasner/Sproul debate for a while, I think that David Glasner would respond to you along these lines.

Nick: "The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs.But why would they want to do that? If I have opals i want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money i want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999?"

Why would people want to return hot potatoes to the bank? David explicitly sets his illustration of reflux in a world characterized by fixed convertibility. Say the central bank promises to convert deposits into x gold ounces and vice versa. If there are too many deposits being created, people spend them away will nilly (which is your point). David's point is that should this happen, the market price of gold rises above the price at which the central bank offers conversion. Professional arbitrageurs will seize on this discrepancy by buying deposits and returning them to the central bank for gold. This arbitrage will close the gap between the two prices, the net effect being that excess deposits will reflux back to the issuing bank.

Your error, at least according to what I've read on Glasner's blog, is universalizing your experience with money as-a-consumer to all money-users. You're right, consumers do often spend their money away on stuff should they have an excess. But not so traders, speculators, and other banks. Says David:

"Arbitrage transaction are facilitated precisely by the commitments of central banks to maintain a fixed conversion rate between their currencies and an ounce of gold. Without such a simultaneous commitment, the scope for profitable arbitrage transactions, carried out by professional traders, not the likes of you and me, is greatly enhanced compared to ordinary monetary exchange much less to barter."

In our modern system, I'd hazard a guess that it is the interbank clearing system that generates the reflux process, and not a discrepancy in the gold price.

Anyways, I'm sure David will respond. It'll be interesting to see how he goes about it.

[JP Koning]

"And the Law of Reflux is always and everywhere wrong. Unless the central bank decides to make it true."

Ok, just re-read this line. I don't think David would disagree. His way of explaining the fiat money mechanism, for instance, is very different from convertible money.

[Mike Sproul]

Alex:

When the government accepts its money for taxes it is maintaining a form of convertibility, and it is backing that money with its assets.

Example: A landlord rents some land for 50 oz of silver per year. The rent is analogous to taxes. The landlord then buys groceries with his own paper IOU's, each of which he promises to accept for 1 oz. of rent. His IOU's can circulate as money. The landlord might not ever pay out actual silver for them, but his acceptance of IOU's for rent is equivalent to making them convertible into silver. Also, the IOU's are backed by his assets, which could broadly be called "rents receivable". In the same way, the modern paper dollar is backed by the government's "taxes receivable".

[Alex Godofsky]

Mike:

To a first approximation, people don't choose whether or not to pay taxes. At the end of a given year, when people are filling out their forms and sending in checks to the government (or getting refunds), you don't see a supply and demand graph with "quantity of jail time served" and "quantity of taxes paid" on the axes (or if you do, it has one of the curves as horizontal or vertical).

But more generally, nothing you are saying actually implies that the central bank can't fix the quantity of money held. You keep objecting that people will (indirectly) reflux the money back to the central bank via the inflation target / price level target / etc. But the original context here is a central bank expanding the quantity of money in order to influence the price level. This central bank doesn't have to let people indirectly reflux money back to it (by selling bonds to keep prices on target) precisely because it desires the prices that emerge from the larger quantity of money.

[Mike Sproul]

JV Dubois:

Sorry about the lack of clarity, but we are all victims here. Victims of a vague economic idea called the Law of Reflux. This vagueness allows Nick to get away with saying things like "the central bank decides to make it true". That's a little like saying that I choose to make the law of gravity true when I jump off a cliff.

An example might help. A bank accepts 100 oz. of silver on deposit and it issues 100 paper receipts (dollars) in exchange. The bank decides, out of the blue, to print 200 new paper dollars and use them to buy 200 oz worth of bonds. A backing theorist (like me) would say that the bank now has 300 oz worth of assets backing $300, so each dollar remains worth 1 oz, even as their quantity triples. A quantity theorist (like Nick) would say that there is now 3 times as much money chasing the same goods, so the value of the dollar must fall. Then the following argument would occur:

NICK: There are 3 times as many dollars. They have to lose value.
MIKE: They have 3 times as much assets backing them. They have to hold their value.
NICK: But there are 3 times as many dollars...
MIKE: There might be, but maybe those new dollars just displaced other moneys, or barter.
NICK: If that's all that happened, then OK, but if that didn't happen, then there are more dollars, without enough offsetting reduction of other moneys, so the dollar must lose value.
MIKE: No, each dollar still has 1 oz of stuff backing it, so it must stay at 1 oz. each. If the dollar ever fell to .99 oz. out on the street, then people would immediately return the dollars to the bank for 1.00 oz. That's reflux.
NICK: But what if the bank refuses to take the dollars back?
MIKE: Then that is tantamount to a default by the bank. Of course the dollars will then lose value, because they have lost backing.
NICK: So the law of reflux only works if the bank wants it to.
MIKE: No, no, no. That's not what the law of reflux says. It's not reflux itself that determines the value of the dollar. Backing does that. It's just that the bank must always keep some channels of reflux open, so that people have channels of access to the assets backing their money.
NICK: Ridiculous! I'm going for a canoe ride.

[Alex Godofsky]

NICK: But what if the bank refuses to take the dollars back?
MIKE: Then that is tantamount to a default by the bank. Of course the dollars will then lose value, because they have lost backing.

Mike, the central bank regularly defaults on its dollars. It freely changes the dollar price of the backing stuff every six weeks.

[Nick Rowe]

Scott: I'm never really 100% sure exactly where I'm disagreeing with anyone. What I thought I would do here was lay out an extreme position, and see what transpires.

But I thought I understood David's view to be that central bank money can be in excess supply or demand (it can hot potato) but that commercial bank money can't. I'm saying the same thing can happen to both inside and outside money.

marris: "Nick, I'm a bit unsure how to reconcile "money is always and everywhere a hot potato" with "When Old Monetarists were talking about how the monetary hot potato gets passed from person to person, they were talking about the very short run". The latter is from your previous post."

Good question. You can't easily reconcile my views in this post with my views in earlier posts. This post is way more extreme. In this post I'm saying that money is *always* a hot potato. In other posts I was saying money is *sometimes* a hot potato, and only in the very short run.

How to reconcile them: assume that hotness comes in degrees. When money is at some medium temperature, people are trying to get rid of it at a medium speed, just as fast as it returns to their hands, so it's just right to keep the economy in short run equilibrium. Goldilocks. If it gets hotter than that everyone is trying to get rid of it more quickly than it returns to their hands. That's what I used to call the "hot potato" in the very short run disequilibrium.

[Min]

So we can have lukewarm potatoes, or even room temperature potatoes? But not cold potatoes?

[David Glasner]

Nick, Thanks for this post, which I have not yet had a chance to read, much less reflect upon. Perhaps over this holiday weekend.

[Nick Rowe]

Thanks David. I'm sorry it's not as clear and short as it should have been. It sort of came out in a rush. Don't feel obliged to respond.

I will be away from the computer for the next few days.

Min: you can have a potato that isn't hot enough, so people are trying to get rid of it too slowly. That's what causes a recession.

[K]

Nick,

"So to keep things simple I'm going to ignore cows and talk about totally useless paper money, which nobody wants and nobody ever will want."

As you know, I'm an advocate of using "cows" (actually a broad pool of liquid securities - same thing) as money. But in our world, instead we use iron clad claims on milk tomorrow as money (actually a govt guarantee of a broad consumption basket). Where have you explained why nobody wants to hold "guaranteed-milk-tomorrow money?" That seems like valuable paper.

[Greg Ransom]

Umm. Not the the government, "Dollars are always a hot potato for everyone."

[J.V. Dubois]

Mike: I think Nick is right here. You are just talking about special case when money issuers claim a specific backing for the currency. But this does not have to be so. I for instance don't see any way of how money comes back to issuer if people use gold coins. Do you want to claim that if there is new money issued into the system (eg. new gold brought from the New World) that it has to reflux back to whom issued it? I don't think so. Reflux is just another way of saying money supply. If one money issuer deems backing of currency as sacrosanct, then how can you even talk about expanding money supply?

Now the situation Nick describes is a little bit more complicated. Modern commercial banks are like little central banks that have to back their currency with government currency (basically cash). I can go to bank and exchange my deposit for government cash 1:1. So as long as commercial banks hold onto this exchange rate, they have limited ability to manage money supply on their own. Actually this is one of the critical positions that MMs (or at least Nick) holds. But the point is that CB that manages the supply of CB money is not held by the same constrains. CB can print whatever money it wants and pour it into the system. So in the end it is really the CB that determines how much expansion of money supply will (as provided by commercial banks) heats up the potatos and how much is it willing to absorb back. There is no law of reflux if you take a comprehensive look on the system as it is represented by commercial banks AND central bank.

[K]

JV Dubois: " CB can print whatever money it wants and pour it into the system"

There's that metaphor (pouring money) that really obscures the critical difference between reversible risk-free lending, and spending of irredeemable coinage. That distinction makes all the difference.

[J.V. Dubois]

K: Not really, unless you wish to steer the debate into a complete different direction. All it takes is a communication strategy. If CB buys reversible risk-free asset such as government bond with freshly printed money and promises to never sell it back, it just poured money into the system.

But in a way reversibility may be at the heart of the debate. If expansion of money supply by CB is viewed as irreversible, then we will end up with a lot of hot potato effect. If everybody expects that CB will reverse this operation, then we will end up with money refluxing back to the CB. However the decision rests upon CB and/or government who instituted it.

[Mike Sproul]

JV Dubois:

1) In the case of gold coins, a new discovery of gold naturally makes gold less valuable, so gold coins fall in step. My point was that if coins fall RELATIVE to gold, then people will melt (reflux) the coins back to bullion. But of course the backing for a 1 oz coin is the 1 oz held in the coin itself. It is the 1 oz. of backing that determines the coin's value, and reflux is only incidental to this.
2) The checking account dollars issued by private banks are backed BOTH by government currency held by the bank as reserves and by the banks' other assets (mortgages, bonds, etc) The checking account dollar is convertible into the government dollar, but only partially backed by it.
3) Given 1:1 convertibility, the private bank has NO ability to control the amount of its money that the public chooses to hold.
4) If the central bank also followed something like the 1:1 rule, it too would have no control over the amount of money people hold.
5) When the central bank pours new money into the system, it normally gets assets of equal value in exchange. Assets rise in step with liabilities, and the money holds its value. As long as new money is only issued to people who bring in assets of equal value, the money supply will only rise when people want that extra money badly enough to hand over their assets for it.
6) If the central bank fails to get adequate new assets is it issues currency, only then will the currency lose value. But the currency falls because of loss of backing, not from the simple increase in its quantity. Here again, reflux is not what determines the money's value. Reflux is only an incidental result of the bank backing its money, and it is backing that determines value.

[Alex Godofsky]

5) When the central bank pours new money into the system, it normally gets assets of equal value in exchange. Assets rise in step with liabilities, and the money holds its value. As long as new money is only issued to people who bring in assets of equal value, the money supply will only rise when people want that extra money badly enough to hand over their assets for it.

When I go to Vanguard to buy ETFs, they are perfectly happy to take my money. If I had (unbeknownst to them) counterfeited that money such that it was indistinguishable from regular currency, they would be just as happy to do so, yet the aggregate money supply would rise. If I were the central bank and had legally printed more money, they would still be happy to do so, and the quantity of money would again rise. i.e. the central bank can freely increase the supply of money.

6) If the central bank fails to get adequate new assets is it issues currency, only then will the currency lose value. But the currency falls because of loss of backing, not from the simple increase in its quantity. Here again, reflux is not what determines the money's value. Reflux is only an incidental result of the bank backing its money, and it is backing that determines value.

What you're missing is that market participants perceive money printing as an implicit loss of backing. Yes, if the central bank actually had a 0% inflation target, and everyone believed that the central bank had a 0% inflation target, then whenever the price level threatened to rise (the value of money threatened to fall) the central bank would immediately sell some of its securities and the law of reflux would be indirectly satisfied. But if the central bank says "we want inflation to be 2%, and to help it hit 2% we're going to print some money and buy some assets with that money" and people believe them, everyone will expect that some of those newly-purchased assets will never be sold.

What you characterize as a default or a loss of backing is actually just the normal day-to-day operation of a modern central bank.

[Min]

Nick Rowe: "Min: you can have a potato that isn't hot enough, so people are trying to get rid of it too slowly. That's what causes a recession."

Don't people (or institutions) differ in how quickly they try to get rid of money? If so, then will they not naturally accumulate money or become bottlenecks in the flow? Does that not play a role in recessions? Thanks. :)

[Mike Sproul]

Alex:

If the Fed has 100 oz worth of stuff backing $100 in paper money, and then you counterfeit $10 of paper money, then we have $110 of paper laying claim to 100 oz of the fed's stuff, and each $ is worth 0.91 oz. But if the Fed issues another $10 in paper, and gets 10 oz more stuff, then we have 110 oz backing $110, so $1=1 oz.

If the fed defaults on 2% of its obligations each year, then the dollar will fall at 2%/year, unless people can find some other currency that only falls at 1%/year.

[Alex Godofsky]

And yet, shockingly, the value of the dollar seems to vary from year to year without particular regard to the ratio of dollars to assets owned by the Fed. Isn't that curious?

[Scott Sumner]

Nick, You said;

"But I thought I understood David's view to be that central bank money can be in excess supply or demand (it can hot potato) but that commercial bank money can't. I'm saying the same thing can happen to both inside and outside money."

In that case I agree with you. A technological improvement in banking might lead to more bank money than people want to hold at the current price level. If the base isn't adjusted, then the price level will rise. Unfortunately I don't seem to be able to comment at David's blog. Perhaps he'll read this and explain.

[Mike Sproul]

Alex:

Finance guys tell me that that, shockingly, the value of corporate stock doesn't correlate very well with the firm's ratio of assets (including expected future profits) to the number of shares issued.

[Alex Godofsky]

How are the finance guys measure the expected future profits?

[Mike Sproul]

The same way that monetary theorists measure the expected future assets and liabilities of the central bank/government.

[Sergei]

"Unless the central bank decides to make it true. "

But central banks have decided to make it true. It is called interest rate policy. What is the whole argument about?

What a waste of time... I am sorry for everybody who read this thread.

[Saturos]

Mike Sproul: what predictions does your theory make that are different from those that Nick would make from his?

[Saturos]

Suppose the world converts to Market Monetarism and the Fed tries NGDPLT, and it successfully stabilizes NGDP for a hundred years. Do you have a rationalization ready to explain that away?

[Saturos]

Nick: did this opal incident by any chance take place at Andamooka? (Lovely post, btw. Sad that it didn't satisfy Mike, though. I suspect you never will satisfy him.)