Trashing balance sheets and observational equivalence of fundamental and bubble money

Four years ago (and again two years ago) I argued it might be good policy for central banks to (conditionally) trash their own balance sheets. Now this idea is in the news. See Ralph Musgrave for links.

The recent blogosphere debate over whether money is or is not a bubble must have sounded like angels on pins to people who aren't monetary economists. But as JP Koning notes, it's what's at the root of those very policy-relevant questions. Does it matter if central banks trash their balance sheets by buying worthless junk? Might it even be a good policy, in some cases, for central banks to burn the bonds they own?

My views on this question have evolved a bit over the years. From reading other bloggers' posts, from comments here, and from thinking about it.

Here's a parable. Just in case it's not obvious, imagine I am a central bank, issuing currency, and targeting 2% inflation, so my currency pays a real rate of interest of minus 2% on average.

Suppose I could borrow an amount M forever at a negative real interest rate m. Because some people just really really like owning my IOUs, so they pay me m to borrow from them.

I could borrow M, invest the proceeds at a real rate of interest r, consume (r+m)M every year, and keep my stock of debt constant at M forever. Or I could borrow M, consume the whole of M immediately, and then consume an additional mM every year as my lenders pay me interest, and keep my stock of debt constant at M forever.

Would it matter to my lenders which I did? In the first case I have a stock of assets equal to M, which I keep in my basement. My IOUs trade at their fundamental value, because I can redeem them at any time. In the second case there are no assets in my basement. Would my lenders care? Why would any of them ever want to look in my basement? Or are the two cases observationally equivalent, as far as my lenders are concerned?

There are two reasons why it might matter whether I keep a stock of assets in my basement:

1. Maybe the demand to hold my IOUs at a negative real interest rate varies over time. I can borrow M(t) at a negative real interest rate. If there is a risk that M(t) would drop by (say) 30%, would I need to keep 30% of M in my basement to be able to repay my creditors?

No. Because I can always borrow at positive interest rates against my future income stream mM(t). If M(t) drops by 30%, and stays there, the present value of my future income stream will still be 0.7mM/r. So I will only need to keep 0.3M-0.7mM/r in my basement.

If M(t) fluctuates, but on average grows at rate g, the expected present value of my future income stream mM(t) will be mM/(r-g). Even if (r-g) is (say) 1%, if m is (say) 2%, that will be 2M. The expected present value of my future income from being able to borrow at negative real rates will be twice as big as M. That means that I wouldn't need to keep any assets in my basement unless there was a risk that M(t) would drop by two thirds.

2. Maybe people are only willing to own my IOUs at a negative interest rate provided my IOUs are actually worth something. So there's a second equilibrium in which my IOUs are worthless, and so nobody wants to hold any, and so they are worthless. My total IOUs are either worth M, or zero. But by keeping a very small stock of assets in my basement (say 1% of M) I can knock out that second equilibrium. If my creditors all rush to redeem their IOUs at the same time, I just say to them: "OK, I will redeem them all at 1 cent on the dollar", which means they are worth something, which means thay are worth 100 cents on the dollar, because people want to hold M(t) and not 0.01M(t) of my IOUs. For any value above 0 cents and less than 100 cents on the dollar, there will be an excess demand for my IOUs (provided I don't issue more than M(t)), so their value must rise back up to 100 cents on the dollar.

Comments

[123]

There is a third reason. Central banks want to reduce the volatility of AD. The more assets they have, the more they can do to reduce it.

[Nick Rowe]

123: volatility in the amount of M needed to keep AD growing smoothly (or keeping inflation at the 2% target) is isomorphic with the volatility of M(t) in my parable.

[Bill Woolsey]

Suppose libertarians take power and impose a rule that the inflation rate must be zero, or instead -1%, so you can borrow at zero interest or even must pay 1%?

Suppose libertarians take over and recognize the right of private banks to issue redeemable paper currency. The result is that the demand for base money falls by 95%.

If there are assets held in the basement, then the quantity of base money can simply be adjusted to the demand to hold it.

It seems to me that assuming that the demand for base money always grows at a constant rate and that people will put up with being exploited by the monopoly issuer forever is not reasonable.

You entire argument is based upon a perpetual monopoly with a limited 2% rate of exploitation.

[Nick Rowe]

Bill: agreed. Your examples are the same as a risk of M(t) dropping by a big amount, maybe down to zero.

[Phil Koop]

I am reminded that, according to Liaquat Ahamed, during the interwar years when the insane Bank of France was acquiring every particle of gold it could find, the European central banks were storing most of their actual stocks of gold in the vaults of the Bank of England. A gold transfer amounted to a relabeling exercise in the basement of the Old Lady. Yet it seemed to have some sort of real consequences.

Did I make this observation last time you posted on the subject? I can't remember.

[Min]

"Maybe people are only willing to own my IOUs at a negative interest rate provided my IOUs are actually worth something. So there's a second equilibrium in which my IOUs are worthless, and so nobody wants to hold any, and so they are worthless. My total IOUs are either worth M, or zero. But by keeping a very small stock of assets in my basement (say 1% of M) I can knock out that second equilibrium. If my creditors all rush to redeem their IOUs at the same time, I just say to them: "OK, I will redeem them all at 1 cent on the dollar", which means they are worth something, which means thay are worth 100 cents on the dollar, because people want to hold M(t) and not 0.01M(t) of my IOUs. For any value above 0 cents and less than 100 cents on the dollar, there will be an excess demand for my IOUs' (provided I don't issue more than M(t), so their value must rise back up to 100 cents on the dollar."

You lost me, Nick. Isn't that scenario disproven by history? Announcing redemption at some fraction is devaluing the currency, right? And people have accepted the new redemption value, if they accepted anything at all, right? Or are you talking about assets in the basement for which you have not promised to redeem your money? In that case, who is going to care? French assignats were based upon assets in the basement, i. e., land. A lot of good that did.

[Mike Sproul]

Nick:

I'll repeat what I posted over at JP Koning's blog

Consider a landlord who collects rents of 50 oz. of silver per year, so that if R=5%, his land is worth 1000 oz. The landlord then goes around town buying stuff by writing out 1 oz rent certificates (dollars) that he agrees to accept for rent. Once he issues about 700 of these dollars, people will start to worry about their backing, so let's say that he prudently issues just $400 and spends it on candy. No problem. The 400 dollars are more than covered by the 1000 oz of land. His net worth is 600 oz.

Next, he buys another 2000 oz worth of land, paying for it by issuing a 2000 oz. bond. The seller is barely willing to accept this, as long as the landlord has that cushion of 600 oz of net worth. But now the landlord has extended himself as far as he can. Each of his dollars is still worth 1 oz, but any further borrowing or money-issuance will get creditors worried.

Next, the landlord designates his basement as his central bank. From his basement, he issues another $1000 of money, and uses it to buy 1000 oz of the bonds that he previously paid to the land seller. He keeps the bonds in his basement, and the money he issued goes first to the bondholder, then to the rest of the economy. Now he's in Noah's world, and it should be obvious that his net worth is unaffected. Each of his dollars is still worth 1 oz. He could even sell 200 oz worth of his bonds for 200 oz of silver. Now he can tell people that there's a hoard of silver in his basement, and he can even offer silver convertibility of his dollars. The dollar is still worth 1 oz.

At some point the landlord might stop offering silver convertibility. (But he still accepts them for rent.) Then quantity theorists will go crazy and say that his dollars have no backing, that they are fiat money. The folks at mises.org will call him a fraud and a counterfeiter. Nick will say that the value of the dollars is held up by nothing but money demand, network effects, etc., and he'll add that it wouldn't matter if the landlord lost 70% of the assets in his basement.

Finally, the landlord does what Noah suggested and issues another $500 of money from his basement, buys another 500 oz of his own bonds back from the public, and burns the bonds. He just swapped one liability (dollars) for another (bonds) His net worth is still unaffected, the dollars and bonds hold their value, and nothing important happens.

[Alex Godofsky]

The actual problem with the "tear up the bonds" proposal is that the central bank could always just glue them back together.

[123]

Nick: "volatility in the amount of M needed to keep AD growing smoothly (or keeping inflation at the 2% target) is isomorphic with the volatility of M(t) in my parable."

Volatility of M or M(t) is different from the volatility of NGDP.

You can peg the expected NGDP for example by targeting NGDP futures. You can peg the expected NGDP by targeting NGDP options.

Examine the case where M(t) is well behaved and you can successfully peg NGDP futures without having any assets at all. Well, even in this case if you trash your balance sheets NGDP options will get more expensive.

The cost of NGDP options is affected by the assets the central bank holds. Fundamental and bubble money views are not observationally equivalent.

Am I the only market monetarist who cares about the price of NGDP options? If central banks will trash their balance sheets, these options will get more expensive.

[Nick Rowe]

123: Suppose I allow that m may vary over time, so write it as m(t). And suppose I redefine my m(t) and M(t) as "the values for expected inflation and the (real) stock of currency compatible with keeping NGDP futures on target." Wouldn't that work OK?

Alex: or that the government would bail out the central bank if it ran out of assets.

Mike: "Finally, the landlord does what Noah suggested and issues another $500 of money from his basement, buys another 500 oz of his own bonds back from the public, and burns the bonds. He just swapped one liability (dollars) for another (bonds) His net worth is still unaffected, the dollars and bonds hold their value, and nothing important happens."

His net worth goes up. Because the dollars he issues pay negative interest rates. The bonds he issues pay positive interest rates.

Min: "Announcing redemption at some fraction is devaluing the currency, right?"

If you announce redemption at half the original value, and double the stock of paper issued, then you have devalued the currency by half (and have paid real interest on currency of minus 50% for that one period).

Phil: "Did I make this observation last time you posted on the subject? I can't remember."

I don't remember either. But that means it was a good one to make again.

[Mike Sproul]

Nick:

"His net worth goes up. Because the dollars he issues pay negative interest rates. The bonds he issues pay positive interest rates."

If his net worth went up, then rival landlords would issue rival moneys to get a piece of that free lunch, and new rivals would keep popping up until profits from money-issue were driven to zero. For example, his basement (i.e., the central bank) earns 5% on the bonds it holds, while letting its dollars fall in value by 2%/year. The landlord himself is paying that 5% on the bonds, so the bonds leave his net worth unaffected. That leaves the 2% he earns on the dollars he issued. If printing/handling costs amount to .9%/year, then he has a profit of 1.1%/year. Then rival landlords issue notes that only fall by 1.4%/year. Now all money-issuers earn .4% profit. Another landlord is attracted by this profit and finally offers notes that only fall by .9%/year. Now the profit from money issue is burned up by printing/handling costs, and profit from money-issue is zero.

The story wouldn't change if the central bank bought foreign bonds and someone else paid the 5% interest. A guy who earns 5% interest in a world where everyone earns 5% interest is not earning economic profit.

[Too Much Fed]

"I could borrow M, invest the proceeds at a real rate of interest r"

What exactly are you investing in?

Let's say preferences change, and people want to hold no currency and hold 0% demand deposits instead? What happens?

[JP Koning]

Nick, if I understand you correctly, it sounds to me like you are coming up with a way to measure the size of the bank's seignorage, its monopoly "rent", and then proceeding from there, you're subtracting that "rent" from the total number of assets initially received by the bank (M) so as to determine how much of that M the bank can safely eat/consume/destroy. Or something like that.

If so, then I see where Bill W is coming from. One of the assumptions behind the parable is a lack of choice. The lucky IOU producer can probably borrow at negative interest rates only because people are prevented from using the IOUs of producers who offer better terms. Without a monopoly, the great deal on interest rates would end, and the IOU issuer would have to keep a full basement of assets because they no longer owned a monopoly rent they could capitalize.

Of course, now that I look back, you did mention as an assumption: "imagine I am a central bank".

[Max]

The talk of central banks canceling their government bond holdings just seems confused to me. If you don't consider the CB's assets to part of the public debt, then to be consistent, you have to consider the CB's liabilities to be part of the public debt.

The CB can't do anything to reduce the nominal public debt (besides making a profit on its operations); it can only reduce the real value by pursuing an inflationary monetary policy.

Note that by buying government bonds, CBs have been betting *against* recovery (the ECB's bond buying is an exception).

[Patrick]

TMF: Or the Earth could be hit by a meteor, or the Sun could go nova, or ... eventually some pathological case will come to pass, and we're all dead in the long run anyway. Chin up, though. It's a good life if you don't weaken.

[Nick Rowe]

Mike: "If his net worth went up, then rival landlords would issue rival moneys to get a piece of that free lunch, and new rivals would keep popping up until profits from money-issue were driven to zero."

But that hasn't happened. The Bank of Canada keeps on making profits, and people keep on holding its currency, even at a minus 2% real return.

TMF: then the central bank's income mM goes to zero.

JP: "The lucky IOU producer can probably borrow at negative interest rates only because people are prevented from using the IOUs of producers who offer better terms."

How much of it is a legally enforced monopoly on note issue, and how much of it is simply a network effect, is open to debate. But given that it exists, I am exploring the consequences.

Max: I agree that burning the central bank's bonds doesn't reduce the national debt. That's a wash. Since the government owns the central bank, all that happens is that the government stops paying interest to the central bank, and the central bank stops returning that interest to the government. But someone might, more reasonably, argue that burning the bonds makes any increase in the money supply permanent. The central bank has burnt its boats and cannot withdraw that money from circulation again. Which affects expectations of the future price level, which affects aggregate demand today. It's that more reasonable argument I want to question.

[Simon van Norden]

Am I right in thinking that the "money is worthless" equilibrium is ruled out by the fact that taxes are only payable in the form of money? which therefore forces many agents to get at least some money?

[123]

Nick: "Suppose I allow that m may vary over time, so write it as m(t). And suppose I redefine my m(t) and M(t) as "the values for expected inflation and the (real) stock of currency compatible with keeping NGDP futures on target." Wouldn't that work OK?"

No, I am not worried about the ability to peg NGDP futures. I am worried about the case where the that peg is not broken, but the cost of NGDP options gets very high. In such a case, markets expect that for example, two scenarios are equally likely - overshooting NGDP target by 3 percent and undershooting NGDP target by 3 percent. This is possible when the probability of sharp financial crisis is 50%.

If you want to control both NGDP futures and NGDP options, you need to protect the market value of central bank's equity. Cancelling the assets of central bank will not affect the ability of central bank to peg the expectations to the target AD path, but it will increase the ex-post volatility of the economy along that path.

I am also thinking about the September-October 2008, when the Fed's interest rate peg came under attack. The Fed was confident that it is powerful enough to control interest rates, but Bernanke was scared about his balance sheet so he did not suppress the price of the interest rate options enough.

[Ritwik]

'Burning the bonds' or 'cancelling the gilts' is a way to sneak in zero, or money-like rates at long maturities (or whatever maturities the bonds being burnt are of).

It's economically equivalent to fixing the yield curve by fiat.

[Nick Rowe]

Simon: I disagree with those who say, like Wicksteed, that requiring taxes be payable in government money knocks out the "money is worthless" equilibrium. I think it confuses stocks and flows.

123: OK. I am going to have to think about that one.

Ritwik: sorry, but I don't get that.

[Ritwik]

Nick

Say reserves pay 0%. 'Bonds' - 10 year govies - pay 5%. CB buys all bonds. And 'burns' them. I'm saying this is basically the same thing as fixing the yield on 10 year govies as 0%. The effects on money demand, aggregate demand, inflation etc. will be same as that action.

I basically agree with you. 'Assets' don't need to be held to drain money supply or prevent collapses in money demand. Further, I also think that currency, or any other form of seigniorage is not critical to this power. Seigniorage is just the cherry on top.

If a CB fears that M(t) is collapsing, it doesn't need to sell any assets from its basement. It just needs to raise the interest it pays on currency. (I know, I know. Currency doesn't pay interest. But I'm sure you know what I mean.)

[Jacques René Giguère]

We are still talking of assets and liabilities. Can we begin to let sink in that the CB is not a bank but a CB?. As long as we call it a bank, Chamber of Commerce types will be confused and will pollute the debate ( as in the misunderstood "burden of debt").

[JP Koning]

"How much of it is a legally enforced monopoly on note issue, and how much of it is simply a network effect, is open to debate. But given that it exists, I am exploring the consequences."

Yeah, probably some network effects involved in issuing IOUs. A lot of competition, too. Hard to say. Good post though, I follow you on the exploration of the consequences, given that we are assuming a very strict monopoly that prevents movement away from M(t)IOUs to other types of monies and liquidities.

Empirically of course all central banks do keep assets in their basements, even though they have monopolies. Something else seems to be going on.

[Mike Sproul]

"Bank of Canada keeps on making profits"

But that's an illusion caused by the government paying interest to itself.

[Too Much Fed]

Nick's post said: "TMF: then the central bank's income mM goes to zero."

And did the commercial bank(s) income go up?

"I could borrow M, invest the proceeds at a real rate of interest r"

I'm still interested in what asset you are investing in as it may not perform as expected?

[Too Much Fed]

Mike Sproul, isn't some entity paying the interest?

[Max]

Mike,

What determines the price level when the central bank's only assets are loans it makes in its own money? That is, the CB is perfectly hedged so its net worth is always zero no matter what.

(Isn't this the standard "fiat money" scenario?)

[Mike Sproul]

Too much Fed: The government pays the interest on bonds it has issued, and gets that interest back when the central bank turns over its 'profits'.

Max: For example, suppose the central bank has issued $300, against which it holds 100 oz of silver plus bonds, denominated in dollars, and worth $200. Let E=exchange value of the dollar (oz/$). Setting assets=liabilities yields 100+200E=300E, or E=1 oz/$. (Note net worth=0) If the bank were robbed of 30 oz of silver (10% of its assets), the equation becomes 70+200E=300E, or E=.7 oz/$ (30% inflation). Note that holding dollar denominated assets creates a feedback effect, where the loss of assets causes the dollar to fall, which makes the bonds fall, which makes the dollar fall more, etc. If the bank reached the point where all of its assets are dollar-denominated, then the value of the dollar would be indeterminate. Fortunately, governments and central banks always hold some real assets that anchor the value of the currency.

[Min]

JPKoning: "Empirically of course all central banks do keep assets in their basements, even though they have monopolies. Something else seems to be going on."

Old habits die hard.

Didn't Greenspan say that after the world went off the gold standard, central bankers continued to pretend that they were still on it?

[Min]

Jacques René Giguère: "Can we begin to let sink in that the CB is not a bank but a CB?. As long as we call it a bank, Chamber of Commerce types will be confused and will pollute the debate ( as in the misunderstood "burden of debt")."

Excellent point! :)

[Min]

Nick Rowe: "I disagree with those who say, like Wicksteed, that requiring taxes be payable in government money knocks out the "money is worthless" equilibrium. I think it confuses stocks and flows."

Benjamin Franklin was instrumental in the establishment of fiat currency for Pennsylvania. The money was issued via a land bank. It was lent out and eventually paid back. During the Revolution Franklin advised the nascent states to authorize Continental Congress to levy taxes payable in Continental Dollars. It did not. As we know the Continental Dollar eventually collapsed. Do you think that Franklin's advice was unsound?

Thanks. :)

[Max]

Mike,

"If the bank reached the point where all of its assets are dollar-denominated, then the value of the dollar would be indeterminate."

I don't think so. If the value is initially determined (by e.g. convertibility), and the CB has a policy of resisting changes to the value, then the value will be determinate. This only requires the reasonable assumption of some inertia in the economy.

"Fortunately, governments and central banks always hold some real assets that anchor the value of the currency."

Ok, but there has to be an arbitrage between money and the assets. Without convertibility there's no arbitrage. In your paper you mention liquidation value, which I agree could provide an anchor in the case of a private bank, but I don't see how that works for a government bank which will never, ever liquidate.

I really enjoyed your paper, by the way.

[Simon van Norden]

Nick: I don't understand your argument about stocks and flows. You seem to be assuming that flows are small relative to stocks. I think you are confused (or, perhaps, you are just confusing me.)

When I think about comparing a stock to flow, I need to specify a time scale. The time scale allows me to add up the flow over a period of time, giving me a stock, which I can then use to compare to the original stock. Without a (implicit or explicit) time scale, I've stuck with two quite different concepts measured in quite different units. I don't know how to compare them.

How do you do it?

[Simon van Norden]

The stock of money in the US is about $2.5 trillion (give or take) these days.
US Federal Govt Current Receipts are about $2.5 trillion (seasonally adjusted at annual rates.) State governments add about another $0.75 to that total.

Can you please remind me why you say that flows are very, very small relative to stocks when we are talking about the money stock and the need to pay government taxes?

[Nick Rowe]

Simon: in a discrete time model, you can compare flows with stocks. As the modeller's "period" gets shorter and shorter, and you approach a continuous time model, the flows get smaller and smaller relative to the stocks.

There is a flow demand for oxygen in the air to breathe. There is a flow supply of oxygen in the air from plants. But provided the stock of oxygen in the air is always positive, it remains a free good. In a discrete time model, if the period were long enough, it might be the case that the flow demand for oxygen during the period were greater than the stock of oxygen in the air, and the modeller might be confused into thinking that there would be an excess demand for oxygen.

Simply saying there is a flow demand for oxygen to breathe doesn't show that the price of oxygen will be positive.

Simply saying there is a flow demand for money to pay taxes doesn't show that the price of money will be positive.

[Nick Rowe]

Jacques Rene: "Can we begin to let sink in that the CB is not a bank but a CB?."

Scott Sumner did a post about a year ago, with a title like "Central banks are not banks"!

Min. If my local supermarket insisted in only accepting payment in Australian dollars, I might be persuaded to hold a stock of Australian dollars in my wallet so I could shop there. And if other stores know I hold Australian dollars, they too might choose to accept Australian dollars. And it might snowball. Or it might not.

[Mike Sproul]

Max: The central bank might liquidate 200 years from now. Suppose the central bank has issued $100 today, against which it holds assets worth 100 oz. It lends the entire 100 oz at 4%. When it liquidates in 200 years, there will be $100 laying claim to 100(1.04)^200 oz, so each dollar will be worth 1 oz today and will grow in value at 4%/year. If printing/handling costs amount to 4%/year, then the dollar will be worth 1 oz from now til 200 years.

Also, the central bank can maintain the dollar at 1 oz just by using bond convertibility. It doesn't have to stand ready to redeem in actual silver at all times. If the dollar falls a little relative to silver, they sell bonds for dollars, and vice versa.

Even if all the bank's assets are dollar-denominated, it is still possible for the central bank to maintain the dollar at 1 oz, but this is tantamount to holding some real assets.

Simon: About stocks and flows: Think of the landlord who collects rent of 50 oz of silver per year (a flow). If R=5%, his land is worth 1000 oz.(a stock). That landlord can go around town buying stuff by writing out 1 oz rent certificates ('dollars') that he accepts for rent. He can safely issue up to $1000 (a stock) at the most. He can then accept the dollars for rent at the rate of $50 per year (a flow) until they are all redeemed in 20 years. Or he might use the land to buy back all the dollars he issued at once, or he might let them circulate indefinitely.

Min: Franklin was almost a backing theorist, claiming as he did that increased money issuance need not cause inflation as long as it was adequately backed by mortgages.

[Min]

Mike Sproul: "Franklin was almost a backing theorist, claiming as he did that increased money issuance need not cause inflation as long as it was adequately backed by mortgages."

The French assignat experience tells against the backing theory, doesn't it? Yes, they were over-issued, but that was not the only problem. (I do not pretend to understand that whole mess.)

[Jacques René Giguère]

Nick: Indeed Scott posted about that. But we have to hammer the nail till people understand.

[Mike Sproul]

Min:

The assignats confirmed the backing theory. The National assembly started by confiscating all church lands in France, then issuing paper notes backed by that land, spending the notes on soldiers' pay, etc. Then they started to sell off the land in exchange for the assignats they had issued. When the assignats were retired, it created a tight money condition and caused recession, so it's understandable that they decided to re-issue the assignats and spend them on whatever. Every new expense was met by printing new notes, and the land was soon sold off. Thus backing was dropping as liabilities (notes issued) exploded, and the notes lost value just as the backing theory would predict.

People who look at only one side of the central bank's balance sheet (i.e., quantity theorists) always claim the assignat episode in support of the quantity theory (along with John Law's money and continental dollars). In every case, they blithely ignore the assets of the issuer.

[Min]

Thanks, Mike. :)

[Max]

Mike,

"The central bank might liquidate 200 years from now."

I can't conceive of a CB liquidating. Perhaps a failure of imagination on my part.

But come to think of it, it doesn't matter. What you are really saying is that the CB could re-introduce convertibility. Whether it liquidates or not is irrelevant.

In other words, part of a CB's commitment to price stability is a (loose) commitment to offer convertibility in the event that the CB loses control of the price level. It's a loose commitment because exactly what the CB might do is not spelled out in advance.

[Mike Sproul]

Max: Correct. More importantly, convertibility can take many forms. Just as the central bank might have issued some of its dollars by buying bonds, buildings, and furniture, the bank can retire its dollars by selling those same things. So a bank that does not maintain gold convertibility might still be maintaining bond convertibility, building convertibility, and furniture convertibility (or CPI basket convertibility, like Nick said).

[Nick Rowe]

Mike and Max: Yep. I find the concept of "indirect convertibility" useful. The Bank of Canada could make dollars indirectly convertible at a fixed price into haircuts, so that one dollar buys one haircut, even without operating a hairdressers in the basement. Just make the dollar redeemable in something else, and vary the price of that something else in terms of dollars so that a dollar is always worth one haircut.

[Max]

I suppose convertibility can take many forms, but in practice, it's going to take only one form, which is convertibility into a foreign currency (or possibly a basket of foreign currencies).

[Oliver]

Maybe people are only willing to own my IOUs at a negative interest rate provided my IOUs are actually worth something.

You are presupposing that currencies derive value from the assets that 'back' them in order to argue that that is the case. Backing theory ultimately leads to a reductio ad adsurdum. Assuming that banks didn't originally grow out of gold mines or as mould on baskets of rotting CPI goods, the first bank would have had to buy the assets needed to back its initial IOUs. That's circular reasoning and arguing to conclusion all in one. And it always leads to a 'because gold' story.

More plausibly in my opinion, one should begin with the value of the product that was initially financed with the emission of the IOU. The IOU thus promises to pay the bearer in future goods or services equal in value to those rendered in exchange for the initial IOU (+- a fee for the time capsule service). The initial asset of the issuer must thus be the credibility to provide such goods or services. In other words, the relationship between the issuer and the goods provider is of a hierarchical nature, in that the issuer must posess the legal power to extract real goods from the economy to pay its creditors. Bank assets come in later as a tool by which to manipulate relative prices in favour of one one group or another (creditors / debtors). Importantly though, they are not the initial source of credibility.

[Mike Sproul]

Oliver:

Some of the earliest government-issued paper money was issued in 1685, when the payroll was late arriving to a French fort in Quebec. The intendant paid the soldiers with IOU's written on quarter-sections of playing cards, promising to redeem them in silver coins (livres) when the boat arrived. The paper livres were backed by the coins on the boat. Nothing circular about it.

Of course private paper money had been issued much earlier. The first issuer of paper money was the first shopper who ever bought a loaf of bread and wrote out a paper IOU promising to pay 1 oz of silver in 30 days.

[Oliver]

Mike, arguing historically is fine but it will probrbly not produce a logically satisfactory beginning. Where did the silver on the ship derive its value from? Because it's used as jewellery? And the IOU of the skint shopper can hardly be considered currency.

Sergio Rossi (in slight deviation from what I said above about credibility of banks, I admit):

...the money creation process carried out by the bank only provides the economy with the number of money units asked for by the firm (on the assumption that the firm’s creditworthiness satisfies the benchmark set by the banker). To state it clearly, it is the remuneration of labour that gives a purchasing power to money, which, as such, is a mere numerical form of no value whatsoever. Were it not for the monetisation of the production process, banks would be unable to create purchasing power on their own. So, bank deposits are a ‘liquid, multilaterally accepted asset’ (Chick, 2000, p. 131), because they are the organic result (that is, a stock magnitude) of two intimately related actions (or flows): (1) creation, on the monetary side, of the numerical form of payments (money proper) by the banking system, and (2) production, on the real side, of physical output (money’s worth) by the non-bank public, that is, firms and workers taken together.8 So, the flow of money and the flow of production are complementary aspects of the same (income- generating) process. ‘From the beginning, banking and productive systems thus contribute to the determination of a unique macroeconomic structure’ (Cencini, 1997, p. 276).
In sum, from this point of view money as such is a flow, whose result is a stock (of liquid wealth) in the form of bank deposits. Contrary to the ‘cloakroom theory of banking’ à la Cannan (1921),
5
bank deposits are not a financial asset sui generis, originating in some ‘central mystery of modern banking’ (Chick, 2000, p. 131). According to the theory of money emissions, bank deposits are the alter ego of physical output, and come to light as soon as the latter is monetised via the remuneration of wage-earners by firms. The purchasing power of bank deposits has therefore nothing to do with the agents’ trust and confidence in the banking system. In this framework, let us emphasise it, money balances are net worth because they are output – before final consumption of the latter takes place on the goods market.9 Then, when output is sold on the market for produced goods, an equivalent (some would say identical) sum of bank deposits are destroyed, since deposit holders transform a liquid store of wealth into a physical value-in-use, or, to put it in the phraseology of Fama (1980), they exchange a monetary form of wealth for a real form. This exchange, taking place on the product market, destroys a sum of bank deposits equal to the amount of money wages adding up to the production cost of output sold. In fact, the firm recovers on the market for produced goods the income (in the form of deposits) that the bank did lend to it for the payment on the factor market…

[Mike Sproul]

Oliver:

What difference does it make why the silver is valued? The IOU's could just as well promised a quantity of tobacco, salt, cows, etc, and they could have been used as money.

As for the skint (had to look that one up) shopper: The only way his IOU would be accepted is if he is not skint. As long as that's the case his IOU will have limited acceptability in his own neighborhood. Richer and better-known people will find their IOU's accepted all over, and those IOU's can be called money.

[Oliver]

Your definition of money is too loose. The things most commonly known as money are bank deposits, treasury coins and central bank notes. Corporate papers or private IOUs are not usually considered money. Nor will they be accepted as means of payment. I can't buy cigarettes with Apple stock. The question is, what's the distinction? For one, all forms of money are established in a tripartite contract in which the creditor is licenced by fiat to emit new, tradeable monetary assets as its liabilities while taking over the credit risk of what has now become the debtor. Furthermore, the debtor can only repay his debt with monetary assets of the same kind, something that cannot be said of the shopper above. Also, all 3 forms of money trade at par, at least nowadays, which is where the clearing function of central banks and deposit insurance come in. So, it takes a bank license or being a government authority to issue money (it's good to be king), money emission creates a new debt relationship, not merely a transfer of deeds between monetary and other assets or consumption goods, and monies within a currency system trade at par and can be used as means of payment and final settlement of debts.

And why does it matter why silver is valued? Put it this way, I think it's correct to say that silver (in a silver standard) is valued because it is determined by law to act as medium of exchange. It may have use or symbolic value beyond that function, but it is patently different from stating that money has value because it takes on the form of silver coins, as opposed to only being of paper or digits. The last statement is like saying that van Gogh's Flowers are valuable because they are packed by paint. Yes, paint is a useful way of depicting objects on paper, but it isn't what gives paintings their value.

What bothers me most in the metallist depiction is the patent refusal to incorporate legal, sociological or other hierarchical constructs into the analysis. And I don't think this is a minor blind spot of little importance.,It's an autistic, ideologically motivated deformation that runs through many accounts in standard economics on many different levels. Formal and informal power relations matter greatly and, for most of us, overcoming them is not a function of boot-strapping or hard work, but just plain reality.

[Oliver]

That was supposed to read:

The last statement is like saying that van Gogh's Flowers are valuable because they are backed by paint.

[Mike Sproul]

Oliver:

I don't think anyone can define money. It can take too many forms (most of which don't require the issuer to have a license). All we can say is that people trade things of value. Some of those things of value are traded more often than others. We label them money, but our labels are just an attempt to draw lines where nature didn't put any lines.

When we find it inconvenient to trade with a cow, we instead trade with paper claims to a cow. But we shouldn't forget that the paper is only valuable because the cow backing it is valuable.

[Oliver]

You're pretty alone there with you definition of money. According to standard usage you are referring to generic financial asset/liabilities, not money.

From Wikipedia (not known for its heterodox bias):

Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country.

Cow futures do not buy me cigarettes nor can I use them to pay down my mortgage debt. And you're right, finance is not a natural phenomenon, but that's precisely why it's important to define its terms carefully.

[Mike Sproul]

The Romans used cows as money. Cows bought many a cigarette and paid down many a mortgage.

"You're pretty alone there with you definition of money."

Yes, that's been known to happen with one or two other issues involving monetary theory.

[Oliver]

I'm sure you're familiar with the Misky quote: anyone can create money, the problem is getting someone else to accept it.

I think the devil is in the 'accept' part. And I don't think it can be reduced to a simple argument of utility, at least not in the modern context.

To the extent that cattle really were used as money and not only as a stable unit of account, that means Roman peasants bred their own money. That may be conceivably albeit highly unpractical in a simple agrarian economy. But it certainly wouldn't work in a modern surplus economy. There are other forces at work and many economists seem strangely ignorant of them.

[Oliver]

Just stumbled across this: http://socialdemocracy21stcentury.blogspot.ch/2012/11/my-posts-on-origin-of-money.html

Something in it for everyone...

[Jacques René Giguère]

This from Feveryear's The Pound Sterling: A History of english money, chap 11:

"Peel and the Bank Charter Act

WHILE the Bank Charter Bill was still before the House of Commons Sir Robert Peel received a letter from John Horsley Palmer warning him that the proposed strict limitation of the note issue would make it difficult, if not impossible, for the Bank to render that assistance during a crisis which it had rendered in 1825, 1836, and 1839 and which had come to be expected of it. A few days later he received a similar letter from Henry Bosanquet, a director of the London and Westminster Bank, who, without entering into the question of the meaning of 'currency',"...

The quote from

http://www.questia.com/library/1456707/the-pound-sterling-a-history-of-english-money

[Makrointelligenz]

As there seems to be a really sophisticated readership here i thought i might get a good answer to the question here: How much is the Bundesbank worth? There was some discussion here in Germany because of the questionable claims the Bundesbank has to other central banks which might vanish when the Eurosystem should desintegrate (both unlikely imo but ok). I have some thoughts layed out here,
http://makrointelligenzint.blogspot.de/2012/11/how-much-is-central-bank-worth-what.html
but I m sure there is someone smarter than me here that could come up with something interesting.