Chartalism and stock-flow consistency

[A post for Alex Douglas.]

Here are two closely related questions, about Chartalism and the relation between stocks and flows of money.

1. How can intrinsically worthless bits of paper be a valuable asset that gets used as a medium of exchange?

One answer is that the government forces us to pay taxes with those intrinsically worthless bits of paper, which creates a demand for those intrinsically worthless bits of paper.

There's a problem with that answer. Taxes are a flow; they have the units $/time. Taxes create a flow demand for intrinsically worthless bits of paper. But there is a stock of intrinsically worthless bits of paper; and that stock has the units $. And if that stock of paper is strictly positive and increasing over time, as it usually does, that means the flow supply of new paper created must exceed the flow demand for paper to pay taxes. So if flow supply exceeds flow demand, why doesn't the market price of those intrinsically worthless bits of paper fall to zero?

If intrinsically worthless bits of paper paid interest, or appreciated over time, and so gave the same rate of return as other assets, there would be a stock demand for those intrinsically worthless bits of paper. Matching that stock demand to the stock supply could give us a positive equilibrium price, just like any asset, even if the stock was increasing over time. But paper currency usually does not pay interest, and usually depreciates over time. Indeed the Bank of Canada, which issues the intrinsically worthless bit of paper (OK, plastic) in my pocket, promises it will do its best to ensure they depreciate over time at 2% per year. And sometimes currency is expected to depreciate much more quickly than that, and yet people still want to hold it at some positive price. So why do I have a stock demand for that paper? Why don't I hold my wealth in some other asset instead, then pick up some of those worthless bits of paper off the growing pile littering the streets just before the government stupidly insists I must give it some?

Suppose we did have a theory of the stock demand for money. For example we could say that monetary exchange is more convenient than barter exchange, and that it is very inconvenient to spend money immediately after it enters our pockets, so we want to hold a stock of money temporarily despite it paying no interest and depreciating in value. The convenience yield of a stock of medium of exchange offsets the loss of interest and depreciation. Putting that stock demand for money against a limited stock supply of money there will be an equilibrium in which money has a positive value.  (And yes, there may be a second equilibrium in which it has zero value and so cannot be used as a medium of exchange and so has no stock demand; and we are still waiting to see if Bitcoin for example stays in the first or collapses to the second equilibrium.)

If the government forces us to pay taxes in labour (like a military draft) we won't use labour as a medium of exchange. Labour doesn't work very well for that purpose. But if we have a stock demand for bits of paper to use as a medium of exchange, and if the stock supply were limited, those bits of paper could have positive market value even if we paid all our taxes in labour.

The flow demand for money to pay taxes is neither necessary nor sufficient to explain why a stock of intrinsically worthless bits of paper have positive value. Nor why they are used as medium of exchange.

Now it is true that the government is very influential in deciding what good will be used as money. Because each of us wants to use the same medium of exchange as the people we trade with. If everyone I trade with wants to be paid in those intrinsically worthless bits of paper, I will use that paper to buy food and clothes as well as to pay taxes. There's a strategic complementarity in what we choose to use as money. And governments are big players in the money game. So if the government uses something as money, there's a good chance the rest of us will all follow its lead. Just like when the government switches to Daylight Saving Time most of us just follow along. But it doesn't always work. The Cuban government tried to ban the use of US dollars, but failed.

2. What is the relation between the flow of monetary expenditures and the stock of money?

Purely as a matter of accounting identity, we can define Velocity of circulation as the ratio between the flow of monetary expenditures and the stock of money. Velocity has the units (1/time). Velocity reconciles flows of monetary expenditures ($/time) and stocks of money ($).

But velocity is not just an accounting relationship between flows and stocks. I can choose the velocity of circulation of the money I hold. I can choose to spend it very quickly after I receive it, or I can choose to spend it very slowly. So can every other individual. So any theory which has a stock of money and a flow of monetary expenditures must implicitly also be a theory of individual choice of velocity. Does that implicit theory of individual choice make sense?

Suppose for example you have a theory which says that government expenditure creates money and taxes destroy money. So that a government deficit means that the stock of money is growing over time and a surplus means the stock of money is shrinking over time. Also suppose that same theory says that there is a relationship between the level of government deficit and the level of monetary expenditures. But that means that a government deficit that is constant over time means the stock of money is growing over time relative to the level of the flow of monetary expenditures. And purely as a matter of accounting identity that means velocity must be falling over time, towards zero. And a budget surplus must mean velocity is rising over time, without limit.

Why would individuals choose to have velocity falling over time towards zero or rising over time without limit? Do those choices make sense?

The simple textbook's ISLM model has a clear and simple answer to those questions. It says that velocity is a positive function of the opportunity cost of holding money, so if money always pays 0% interest, a rise in the rate of interest on other assets will cause velocity to increase. You might not agree with that answer, but it is an answer.

Comments

[Alexander Douglas]

Hi Nick,

First of all, thank you for engaging on the question of the theory of money. I find that few economists are willing to engage at this level, and I understand that it's a conceptual question which isn't necessarily that interesting for economists. It is interesting to me, so I appreciate the discussion. I also like the clear terms in which you've posed the problem.

What you've shown very elegantly is that no chartalist theory is complete without a theory of net savings. The demand for money is driven by the need to pay taxes and the desire to net save. So the question is: why do people want to net save in the state-issued currency? That's a good question, and in my book all I said was that there are many competing explanations, and we can't yet claim to fully understand.

Still, we know that the state controls what you call "stock demand" by providing interest-bearing savings accounts (government bonds). How does the state know that it's paying the right level of interest on those bonds to bring stock demand into equilibrium with stock supply? Well, if it isn't, then people will start to dump excess currency, and you'll see its value fall towards zero as you predict. Right now people are willing to hold securities at zero real interest. If they weren't, sustained deficits (with interest on securities fixed at that low rate) would be inflationary - also the bid-to-cover ratio on securities would fall below zero. It's important of course that since the central bank (in countries like yours and mine) acts as a dealer of last resort for government securities the interest rate on them is set by fiat rather than by the market.

Now your explanation for net saving points to the fact that currency is valuable as a medium of exchange, and of course it is. I don't disagree with anything you say here: people are free to use whatever they like as media of exchange, but the currency dominates because it is what the government uses. It is also true that the dominance of currency depends on the size of the state in the economy (not just the domestic economy but the whole currency zone), its ability to maintain and enforce a broad tax base, and other factors like that. Where these are lacking, non-state demand for the currency will be increasingly limited to what is needed for tax payments, and the state will only be able to maintain stock demand by paying higher and higher rates on securities. What gives the state "fiscal space", at a given rate on securities, is the willingness of non-state actors, both at home and abroad, to hold the currency it issues at that rate.

The chartalist point, however, is that nobody would want to hold a fiat currency at all unless the state demanded it for tax payments. Here is the relevance of the point about employment that I made in my post (https://originofspecious.wordpress.com/2016/03/20/mmt-is-political-philosophy-not-economics/). In a barter or private-currency/free-banking economy you could have deprivation but not unemployment, since unemployment is by definition unsatisfied demand for work that pays in the state currency . Thus the state is entirely responsible for unemployment, which is a point of some significance to political philosophy.

The point about velocity is, again, a matter of net savings desires. It's the issue of what Godley called "the stock-flow norm": where flows are constant, stocks do not continue to change at a constant rate forever. I assume that when you write "there is a relationship between the level of government deficit and the level of monetary expenditures" you mean a constant relationship. So if the government continually increases the stock of money, and the volume of transactions does not increase at the same rate, then this must mean that people are building up their stock of net savings in that currency. At some point, we can assume, the thirst for net savings will be fully quenched. V will no longer decrease and (if the level of expenditures stays in a constant proportion to the size of the deficit) then prices will rise.

I know the last thing I said is perfectly consistent with standard macro. Here's something not so consistent with it, I think. The standard story is that the central bank can attain the optimal level of M (stock demand is satisfied but not flooded) by setting interest rates. But interest rates are a tricky instrument because the relative strengths of the income and substitution effects are very uncertain. Higher rates give savers more to spend while discourages spending by borrowers; lower rates have the reverse effect. So, as Warren says (http://www.huffingtonpost.com/warren-mosler/there-is-no-right-time-fo_b_5995896.html), the effect of an interest-rate adjustment depends on whether savers or borrowers have a greater propensity to spend, and that's hard to predict. This is one reason to try to hit the "optimal" quantity through fiscal policy rather than monetary policy. I don't know what you think about that.

Sorry for the long reply, but I thought this post deserved it. Thanks again!

[Alexander Douglas]

"the bid to cover ratio on securities would fall below zero"

I obviously meant below ONE.

[Alexander Douglas]

Also, for "chartalist" (in my reply and also, I think, in your post) read "neo-chartalist". Knapp's theory is a bit different: he thinks that currency starts out as a private means of exchange and is then appropriated by the government.

[Oliver]

I agree. The measure to look at within the Chartalist framework should not be the deficit but (the effect of) government spending. A deficit that results from increased spending is an indicator that policy is having the opposite of the desired effect, namely to increase GDP / expenditure. The so called 'savings desires' and positive effects of government spending on GDP are at odds.

WRT to why the stock of money has positive value, I suppose (Neo-) Chartalists would stress their membership in the Post Keynesian club in which the stock of money has a positive value because it acts as insurance against uncertainty. Holding money is a way to keep all options open, as opposed to spending or investing, which is the act of choosing an option.

So ideally, fiscal policy should have the effect of decreasing uncertainty which means it increases velocity which should, depending on the tax regime, decrease or at least stabilise the deficit. There will be a lag between cause and effect though, I suppose.

[Nick Rowe]

Hi Alex: suppose we have a theory of the demand for the stock of net savings in the form of state-issued currency, Md. Suppose for example our theory says that Md is proportional to the price level P (because you care only about the real value of the stock of paper in your pocket), and is an increasing function of real income Y, and a decreasing function of the rate of interest paid on bonds (because that is the opportunity cost of holding M rather than B, if B pays interest but M does not). So Md=P.L(Y,i). And if the state controls the stock of currency Ms, then in equilibrium Ms=Md=P.L(Y,i). What this means is that, provided L(Y,i) is strictly positive, and provided Ms is finite, there must exist some finite P such that Ms=Md.

In other words, we can explain why intrinsically worthless paper money has value without needing to mention paying taxes in the form of money. Chartalism is not sufficient to explain why paper money has value, and it is not necessary to explain why paper money has value. What is necessary and sufficient is a theory of the desired stock of net savings in the form of that money. (What the rest of us call "the demand for money".)

Now, there is the question of how it all gets started (that's the problem of the two equilibria I mentioned in my post). Because if the bits of paper initially have zero market value, you can't use them as a medium of exchange, so the demand for money would be zero. And there are various theories floating around that try to explain how it all gets started, and what stops us from all suddenly waking up one morning and throwing our money on the ground because we expect it has zero market value and expect everyone else to do the same, so it becomes a self-fulfilling prophecy. But I've set that aside, because people are creatures of habit and don't normally do things like that or expect others to act like that. Once paper money gets started somehow (maybe because it was originally convertible into something intrinsically valuable) it stays up and running.

[Jussi]

"And if that stock of paper is strictly positive and increasing over time, as it usually does, that means the flow supply of new paper created must exceed the flow demand for paper to pay taxes."

I think it is reasonable to assume that taxes are proportional to production (Y). So both quantity of money and level of taxes are proportion of production in the long run (MV = PY and V constant)? Both flows would grow in tandem?

[Nick Rowe]

Alex: " Here's something not so consistent with it, I think. The standard story is that the central bank can attain the optimal level of M (stock demand is satisfied but not flooded) by setting interest rates. But interest rates are a tricky instrument because the relative strengths of the income and substitution effects are very uncertain. Higher rates give savers more to spend while discourages spending by borrowers; lower rates have the reverse effect."

OK. Let's assume (for simplicity and the sake of argument) that income effects and substitution effects on the flow of total spending (Cd+Id+Gd for a closed economy) exactly cancel out. (I disagree with that assumption, but I want to run with it.). What that means is that the IS curve is exactly vertical. The IS curve alone determines the level of real demand Yd. A simple theory would be that Cd=a+b(Y-T), with Id fixed, so Cd+Id+Gd=Y implies Y=[1/(1-b)](a+Id+Gd-bT). And the central bank can buy or sell bonds to control Ms, and thereby control the rate of interest according to Ms=P.L(Y,i), provided the price level is sticky. But changing Ms and thereby changing the rate of interest doesn't do anything to Yd and Y, by assumption. If we want to explain what determines Y, we use the simple Keynesian Cross theory.

But what we now have is British Keynesianism from the 1960's. It's what I was taught for 'A-level' economics in 1972 (alongside the economics editor of the Guardian, IIRC and haven't got muddled). And since Simon Wren-Lewis is a Brit too, and around the same age as me (though maybe a little younger), it's very probably what he meant in his tweet that I "liked". We've been there, we've done that, and it didn't seem to work for policy. And monetary policy, at least until the nominal interest rate went to 0%, so L(Y,i) becomes very elastic, seemed to work fine at controlling aggregate demand and so controlling inflation. MMT, minus the bit about taxes explaining why paper currency has value, which seems wrong, doesn't seem to add anything to the 60's British Keynesian economics we used to get taught but have since moved away from.

[Alexander Douglas]

Nick, thanks for that. I agree that neochartalism isn't necessary to explain the worth of currency. The most popular explanation among economists appears to be what in my book I called the "Friedman-Searle" theory (so named only because Milton Friedman and the philosopher John Searle were famous expounders of it). I think that the Friedman-Searle theory, if it were true, would be a perfectly adequate explanation. So clearly neochartalism isn't necessary. Neochartalism also isn't sufficient in the sense that you need to add a theory of net savings desires before it even makes sense.

Nevertheless. My detailed argument for neochartalism (which I won't go into there) is concerned with the origin story you mention. It is a very serious puzzle, of course, to see how you could coordinate action to get out of the zero-value equilibrium (http://link.springer.com/chapter/10.1007%2F978-1-349-08781-5_2). But out of the "various theories floating around that try to explain how it all gets started", I think neochartalism does best both with respect to the anthropological evidence and with respect to logical consistency. I don't buy the "money started by being redeemable for a real commodity" story at all. I won't repeat my arguments from my book here. But it's an interesting avenue for interdisciplinary research.

[Alexander Douglas]

Wrt to vintage Keynesianism and the MMT policy stuff... in fact I have a soft spot for vintage Keynesianism and I see the parallel with MMT (see the last paragraph of this post: https://originofspecious.wordpress.com/2016/02/24/me-and-mmt/#more-3589).

But I guess the MMT response to what you say would be that in the 1960s Britain was operating a fixed fx system; now it has a fully floating fiat currency, and so the rules are completely different (and IS-LM analysis doesn't apply). This is not my area of expertise, but hopefully Warren will come on here and explain.

[Nick Rowe]

Alex: Yep, Britain was on a fixed exchange rate system. So in the open economy version we would draw an upward-sloping BP curve (we assumed imperfect capital mobility). And so fiscal policy designed to target "full employment" would sometimes (in fact usually) hit the balance of payments constraint, where the BoE would run out of forex reserves. With flexible exchange rates (Canada was the pioneer) you don't have that BP constraint, because the exchange rate depreciates in the central bank holds the interest rate fixed and fiscal policy creates a drop in net exports. But the BP constraint is replaced by a Phillips Curve constraint. In the long run (though not in the short run) those are the same constraint. If you try to increase Y too much that puts upward pressure on P, which makes domestic goods uncompetitive with foreign goods at a fixed exchange rate.

In any open economy it's not that ISLM doesn't apply. It's just it needs supplementing with a BP curve, and which curve shifts when depends on whether you have fixed or flexible exchange rates.

[Nick Rowe]

Both Friedman and Searle are great. But I have never heard of a "Friedman-Searle theory". Never knew Searle wrote anything about money!

[Benoit Essiambre]

>But interest rates are a tricky instrument because the relative strengths of the income and substitution effects are very uncertain. Higher rates give savers more to spend while discourages spending by borrowers; lower rates have the reverse effect. So, as Warren says (http://www.huffingtonpost.com/warren-mosler/there-is-no-right-time-fo_b_5995896.html), the effect of an interest-rate adjustment depends on whether savers or borrowers have a greater propensity to spend, and that's hard to predict. This is one reason to try to hit the "optimal" quantity through fiscal policy rather than monetary policy.

This is the crux of it.

I may be biased by my engineering background which provided a single "engineering economics" class which was all about calculating which set of project was worth doing given interest rates and cost of capital.

I'm not sure if MMTers just ignore that the standard engineering, MBA and business practices are focused on these cost of capital calculations or if they just think people and businesses should not be doing longer term investment planning, that they should only do enough to fulfill short term consumption demand and that the central bank should put enough money in people's account to make them think their future spending needs are covered while giving the government the full responsibility in investing in infrastructure to meet long term needs ( even though, even inside the government it would be difficult to plan investment when there is no good interest rate signal relative to stable inflation and taxes to do proper cost benefit analysis).

To me this seems to be the main issue with MMT. It denies people a way to perform reliable long term bet aggregate investment planning to deal with things like a retirement wave by getting the private economy to only deal with short term immediate "demand pull". (Y) = (C) + (I). MMT greatly under emphasizes the longer maturity (I) especially the part that is supposed to happen in the private sector.

It is especially dangerous in our current society where there that large baby boom is there and about to retire and very low interest rates should be present to spur a build up of net capital investment geared towards allowing consumption to be maintained later with fewer available workers per capita.

Most economists seem to focus more on the consumption than the investment side of income than I do. I'm not sure why. It might be my engineering background or it might be that the boomer demographic wave just doesn't affect the optimal C vs I mix as much as I think. Although real interest rates being so persistently low in the boomer pre-retirement phase kind of supports my theory but then again the fact that they didn't rise in Japan as people started to retire hints more towards low rate being caused by lower growth but on the other other hand there are still lots of Japanese boomers left to retire and the trends might flip later when the retirement wave is more global.

[Nick Rowe]

I have no problem with Chartalism as an origins story. It makes as much logical sense as any. Those origins stories are like car's starter motors -- needed to get the thing up and running from an initial zero value and zero stock, but they just get in the way once the engine has started moving and is running on gas.

[Alex Douglas]

If we stick with is-lm analysis, my suggestion was that the income and substitution effects will rarely cancel out, but they can fail to cancel out in opposite directions. So the 'is curve' often slopes upwards rather than downwards, so that standard monetary policy has perverse effects (the reason for the 'liquidity trap', e.g., is that lower rates *suppress* spending).

[Alex Douglas]

Re Searle, of course - I forgot you studied philosophy! He talks about money in The Construction of Social Reality .

[Alex Douglas]

If neochartalism is just an origins story maybe it's only interesting to historians (I'm in a philosophy dept but identify as a historian).

But the main point is that the currency is a state monopoly, and its distortion causes the market failure of unemployment. Luckily it's a public monopoly, so we can ask it to do something about the unemployment.

What it does right now is leave the central bank to deal with it, by adjusting rates. But central bankers:

(a) Are not democratically elected, and
(b) have the slope of the is curve backwards! Not (or not only) for neo-Fisherian reasons but because the state pays interest on Treasury securities and excess reserves, so that cutting rates is a form of fiscal contraction and raising them is a form of fiscal stimulus.

I'm speaking beyond my knowledge here, but that's one way of expressing what I take to be the MMT position (except the is-lm bit; one reason I'm not High Church MMT is that I don't mind using is-lm sometimes and find it simpler than reams of balance sheets).

[Alex Douglas]

Mistake: if rate adjustments are partly fiscal, maybe the point isn't about the slope of the is curve but rather that it moves with monetary policy. I'm starting to see why MMTers don't like is-lm.

[Majromax]

> But the main point is that the currency is a state monopoly, and its distortion causes the market failure of unemployment.

This is a very bold claim, that the state monopoly of money is the primary cause of unemployment. Do you have any evidence to support this?

What level of monopoly-breaking do we need to cure unemployment? Is the clandestine circulation of US dollars in Cuba or Zimbabwe or Venezuela enough to cure unemployment? How much bigger does Bitcoin need to become to cure unemployment in the US?

Moreover, without a coordinated medium of exchange, it's not at all obvious that barter would not result in unemployment. Price levels become more flexible, yes, but making an exchange with these flexible prices still requires a coincidence of wants.

[Nick Rowe]

Alex: The "T" in the IS curve usually means "taxes net of transfer payments", and those transfer payments include interest paid on government debt, and are included in the standard definition of the budget deficit. So, like any curve, it all depends on what you hold constant when you draw it. But the "elasticity pessimism" view, so common in the UK in the olden days, implied that monetary policy could not be used to bring inflation down. So when in many countries central banks eventually did try to bring inflation down, and then use monetary policy to keep inflation roughly on target (in some cases like Canada despite big exogenous swings in fiscal policy), and the mechanism looked very textbooky, with bigger impact on investment and houses and consumer durables, plus expected inflation eventually coming down, elasticity pessimism was discarded. Monetarism in the stricter old-fashioned sense was also discarded. And we ended up with New Keynesianism. Until the ZLB, when all the old arguments all broke out again.

(Balance sheets usually make my eyes go funny too, and seem often to obscure what's going on, but don't tell anyone I said that.)

[Miami Vice]

Can we please stop with this "intrisically worthless piece of paper" nonsense? My automobile registration is an intrisically worthless piece of paper, contracts are intrisically worthless pieces of paper, your degree is an intrisically worthless piece of paper, books are intrisically worthless collections of paper, the deed to your house is an intrisically worthless piece of paper, a painting is an intrisically worthless piece of paper, all pieces of paper are worthless. So what?

[Nick Rowe]

Miami: I actually have some sympathy for that thought. All financial assets are promises written on bits of paper. (Or sometimes the promise is written in a book or website somewhere). They are worth what those promises are worth. The Bank of Canada promises: "We sorta promise that we will do our best to ensure that this bit of paper (plastic) depreciates at around 2% relative to the CPI basket of goods, and we will adjust the supply as needed to try to make that happen. Unless we really need to change our mind."

Interesting thing is though, there's a demand to hold that stuff, because it circulates as medium of exchange. I could write something like that on a bit of paper and it wouldn't work. I would need to promise it would appreciate, or pay interest, and even then it wouldn't circulate in the shops, and would just be stored in safes.

[Alex Douglas]

I like balance sheets because they're like truth tables. But like truth tables when you try to use them to prove a susubstantial point you only end up arguing over whether you've set them up correctly.

[Nick Rowe]

Alex: I liked Eric Lonergan's post(s) on that.

[Frank Restly]

Nick,

"Indeed the Bank of Canada, which issues the intrinsically worthless bit of paper (OK, plastic) in my pocket, promises it will do its best to ensure they depreciate over time at 2% per year. And sometimes currency is expected to depreciate much more quickly than that, and yet people still want to hold it at some positive price. So why do I have a stock demand for that paper? Why don't I hold my wealth in some other asset instead, then pick up some of those worthless bits of paper off the growing pile littering the streets just before the government stupidly insists I must give it some?"

Are you asking why paper with numbers printed on it is used as currency instead of some other type of asset?
1. It is very portable
2. It is very divisible
3. It can be protected from forgery (for the most part)
4. It is fairly durable
5. It can be manufactured / replaced at a low cost

I mean, before we even get to Chartalism (government expects payment in paper currency for taxes), we need to understand why paper based currencies are appealing in and of themselves. Before centralized banking, there were numerous private banks that offered a variety of paper bank notes. Once governments started charging income taxes, then central banks (with a common currency) became a necessity.

"If intrinsically worthless bits of paper paid interest, or appreciated over time, and so gave the same rate of return as other assets..."

Most other assets depreciate (not appreciate) over time. They eventually decompose, wear out, or just turn to dust. Yes the price of an apple purchased a year from now may be higher than the price of an apple purchased today, but they are likely not the same apple.

[Tom Brown]

Nick, Jason Smith has a short related post on SFC models. He provides a link to your post here, writing:

"Nick Rowe is generally better than me at these things."

Does his post make sense to you, and do you think you're saying pretty much the same thing?

[Miami Vice]

Legal tender laws make something the medium of exchange. Aren't you an advocate for a more flexible price of money (NGDP vs inflation targeting)?

How would cans of soup work as money in an NGDP targeting monetary regime? Would the price of gazpacho fall to zero in the winter? (sorry I know that was terrible)

[Alex Douglas]

Warren sent this analogy:

Why do people save, for example, bus tokens? The bus company always sells more tokens than it collects, and there's no mystery or philosophical discussion as to why that happens and why it doesn't cause the price to fall to 0, etc.etc.etc.etc. And has anyone ever suggested the bus company pay interest on their tokens, payable in more tokens, to support desires to save, or to keep the value of the token from depreciating? Not that I'd ever heard. In fact, seems obvious to all that would be a really stupid thing to do... ;)

[Alex Douglas]

Warren Mosler, I mean.

[Tom Brown]

"Warren Mosler, I mean."

Ah, OK. I was thinking Warren Jeffs.

[Nick Rowe]

Tom: I had a read of Jason's post. I have no idea if we are saying anything similar. It was too hard for me. I think his capacitor is like my pocket, in containing a stock of electrons/money. But I got lost after that.

Alex (and Warren): Bus tickets are a good example. (I once read the autobiography of a Canadian businessman who started out running a bus company, who paid his workers in tickets when he ran out of cash to pay the wages, until the workers complained he was causing inflation, because the price of tickets fell.) Funny how Miami mentions cans of soup, because I was scared you or Warren was going to ask me about the stocks of food in my house.

Why don't people wait until they get on the bus before buying a ticket? AFAIK, they sell tickets at a discount relative to paying the driver, so you earn capital gains on your stock of tickets, or sometimes the driver doesn't sell tickets. But if there is a fixed cost of going to buy tickets, you buy a batch at once and hold an inventory of tickets. Which is very much like the Baumol-Tobin inventory-theoretic model of the demand for money. There's an analogy with a used car dealer holding a stock of cars in inventory, trying to adjust his buying and selling prices to get the desired stock or turnover (i.e. velocity). The difference is that we all hold inventories of money, which we use to buy and sell everything else. And the central bank (plus the commercial banks) produces new cars, and also scraps cars it buys back. And the rest of the government is just another trader. Sure I have to pay money to pay my taxes, but I also have to pay the supermarket money to buy food. If all the supermarkets only accept tokens they issue, I will value those tokens just as much as the tokens the government issues, or the bus company issues. I need to pay taxes, but I also need to buy food, and need to take the bus. But whose tokens will circulate as the medium of exchange? That is less obvious.

In Canada we have something called "Canadian Tire Money", which is like currency but redeemable for merchandise at Canadian Tire stores. Very very occasionally, they get traded for other goods as well (which makes the Bank of Canada very annoyed, because the legality is dubious).

In all these cases: currency which is redeemable for staying out of jail for non-payment of taxes; bus tickets which are redeemable in bus journeys; Canadian Tire money redeemable for goods at Canadian Tire; cans of soup in my larder which are redeemable in satisfying my hunger; the used car dealer's stock of cars; we need some sort of explanation for why velocity is not infinite, why we hold an inventory of stock with flows in and flows out.

But once we have an explanation for that stock demand for money, and a limited stock supply, we no longer need any theory of an ultimate destination like taxes, because if everyone accepts it from everyone else it can keep on spiralling round with a positive value, and velocity will be finite even if it depreciates.

[Jacques René Giguère]

Short observations fron humble IO guy:
BoC undertakes to devaluate your stock of money by 2% a year. Also promise to increase you flow of money by same %.
Canadian Tire is "closing" its system as it move from paper currecy freely transferable by anyone to accounts held on CT computers and usable only at the (increasingly non-)cash register. What effects do you expext on demand, use, etc, of CT money? Am i wrong thinking that CT is moving toward a pure central bank business model?

[Nick Rowe]

Jacques Rene: Personally, I hold a smaller stock of CT money now it's on my card. There's a stash in the glove box that I never remember to spend.

I think you are right, but CT is still not strictly a bank that issues money, because CT "Money" does not circulate (much), and it probably won't circulate at all once it's all on our CT cards. I think it was getting heat from the BoC.

[Andrew_FL]

@Nick Rowe-"I have no problem with Chartalism as an origins story. It makes as much logical sense as any."

No it doesn't. No King or Patriarch or Dictator or Tyrant ever demanded in tribute something he did not himself want. Now ask yourself, in this scenario:

"the government forces us to pay taxes with those intrinsically worthless bits of paper, which creates a demand for those intrinsically worthless bits of paper."

Why does the government want paper? It's worthless, after all.

Government historically demanded tribute either in an already valuable commodity, because they could make use of it themselves, or something which was already a medium of exchange, because they could subsequently make trades using it.

[Tom Brown]

Thanks for taking a look Nick.

[Jacques René Giguère]

Andrew: kings can ask for taxes in paper because they can tax a provinice, give the bit of paper to soldiers or paymasters, move soldiers to another province and then buy chickens. Much easier than collecting and transporting chickens. Kings can create paper money not because it is used but because they will use it.

[Andrew_FL]

@Jacques René Giguère-You didn't answer my objection, you simply asserted that once the paper is collected, it could be used to by chickens. You are not explaining why it is money, you are assuming it is already money.

If you mean to say that they can compel acceptance of paper for chickens at gun point, sure. You can compel men to do many things on penalty of being shot. That's not the same thing as taxation making something money.

[Frank Restly]

Andrew_FL:

"No it doesn't. No King or Patriarch or Dictator or Tyrant ever demanded in tribute something he did not himself want."

This is half in jest.

But Kings, Patriarchs, and Dictators all have a vanity streak. They do like looking at themselves in the mirror, they do like looking at themselves in paintings, and they do like looking at themselves in those pictures on that worthless paper or engraved on those metallic coins.

[Tom Warner]

It's simple and it's complicated.

The simple part is answering the question, "if flow supply exceeds flow demand, why doesn't the market price of those intrinsically worthless bits of paper fall to zero?" The answer is that the bits of paper (and their central bank deposit equivalents) aren't perishable and they're cheap to store.

The complicated part is what determines the value of currency. Too complicated to even start on. But I think the concept of velocity does not help at all, and ultimately it isn't really more than an accounting relationship. There are relationships among some of the components of spending flows and money stocks, like when a government cajoles its central bank into creating money supply to finance an increase in public spending. But there's no inherent relationship generally of the components or at the aggregate level.

[Min]

"I can choose the velocity of circulation of the money I hold. I can choose to spend it very quickly after I receive it, or I can choose to spend it very slowly. So can every other individual. So any theory which has a stock of money and a flow of monetary expenditures must implicitly also be a theory of individual choice of velocity."

Does not follow. In any such theory it is necessary to observe the supply of money and the flow of money in economic transactions. But it may not be necessary to delve into psychology. For instance, it is possible to develop a theory of the motion of billiard balls, including their physical velocity, without delving into the psychology of the players, even though the players make choices about how to play.

[Min]

Andrew_FL: "No King or Patriarch or Dictator or Tyrant ever demanded in tribute something he did not himself want."

Look up English tally sticks.

[Bob]

I've asked the MMT guys this questions and one o them said:

"He forgets that income and outgoings are not matched - which needs a 'working capital' buffer. The more uncertain and irregular your income the bigger the buffer you need. Humphrey Bogart called this his FUF. "FU fund".

Secondly the future is uncertain, but taxes and debt need servicing at a regular interval. Again the more precarious you feel your position is, the bigger "rainy day fund" you require.

And thirdly there is vanity. How big is your wad. You could call this the LoadsaMoney principle.

So essentially time buffer, insurance and vanity are the reasons to hold cash.

The cash you carry around in your wallet is a time buffer. Multiply that by millions of people and you have a lot of 'saving' that is easily explained if you think in terms of human beings rather than mathematical equations.

And most people don't even know what the interest rate is on the majority of their money. Hence why banks have loads of money in crap paying deposit accounts.

Similarly businesses go for convenience rather than income with their cash buffers."

And also N.WIlson at Simon's place:

""The second is that money exists because the state requires taxes to be paid with it."

That's a common misconception.

The actual position is that the ability to impose and enforce taxation by a deadline in a denomination is sufficient, but not necessary, to get that denomination accepted in exchange for real goods and services.

It's in answer to the "why would anybody take your worthless paper" argument by the gold bugs.

But it leads onto the derivative from that which is that the government spends its money into existence and that *causes* an equivalent amount of taxation to occur for any positive tax rate via the multiplier process. The only thing that stops that being an equivalence in any accounting period is if somebody decides not to spend all their income instantly. In other words they save for whatever reason.

In an endogenous system there is no automatic mechanism to equate saving with lending, and so you end up with a government deficit. Or a paradox of thrift induced recession."

[Tom Warner]

In general I think people here are getting too twisted in knots about money supply.

Money is not just about exchange and units of account. It's about financialization of the economy. For central bank money, besides the taxation angle, there's the angle that it's usually backed by sovereign debt held by the central bank, ie base money represents financialization of the government's revenue collecting power, or more indirectly of the future wealth generation of the republic. Broad money represents financialization of all sorts of things, the whole mess of machines and buildings and land and control over private organizations that secure a commercial banks' assets. What matters isn't how quickly the average person and company wants to spend money after receiving it, but how much they all want to spend vs save and in what forms they want to save. What you're really saying when you propose that V has power is that nominal spending is related closely to the extents of particular categories of financialization (the group that make up M2, usually) but not others (eg stocks, bonds), which doesn't make sense and doesn't fit the data.

[Philippe]

Andrew FL,

The point is you have to perform labour or sell resources in order to get the paper notes or metal tokens. So by imposing a tax to be with paper notes or metal tokens, the King can get what he really wants, which is labour and resources.

[Nick Rowe]

Bob: "I've asked the MMT guys this questions and one o them said:

"He forgets that income and outgoings are not matched - which needs a 'working capital' buffer.""

I didn't forget that. That was my point. We need a theory to explain why people have a buffer stock of currency. And if we have such a theory, that is sufficient to explain why currency has positive value. So the taxes theory is ***neither sufficient nor necessary*** to explain why currency has value.

[Andrew_FL]

@Min-"Look up English tally sticks."

Nope. Tally sticks were IOUs for metal coins. They were not money. Nice try, but that's the King demanding payment in something he, you know, actually wants.

[Jacques René Giguère]

Andrew: the King decides that is is not robbery but taxation. The king decides what is taken as taxation. The king decides in what he will pay you. He is the King. Quia nominor leo. (Only She-who-Must-be-Obeyed has more power...)

[JP Koning]

"The flow demand for money to pay taxes is neither necessary nor sufficient to explain why a stock of intrinsically worthless bits of paper have positive value. Nor why they are used as medium of exchange."

What if each bit of paper allows the taxpayer to discharge 1 ounce of gold worth of taxes? Would that be sufficient to explain why currency has positive value?

[Andrew_FL]

@Jacques René Giguère-Power worshipping normative judgments like that have no place in positive economics.

[Philippe]

Andrew_FL

Say the king imposes a tax to be paid in tokens that the king issues. In order to acquire the tokens you have to perform a certain amount of labour or sell resources.

For example, a worker (or soldier) will perform labour for the king, and be paid with tokens. He can then use those tokens to buy resources he needs from someone else, who will then pay those tokens to the king in tax.

As such the issuing and taxing of the tokens is merely a way for the king to obtain the labour or resources he wants. He doesn't want the tokens themselves.

[Nick Rowe]

JP: Yes because that creates a horizontal demand curve, rather than a set quantity demanded. If a stock equal to (say) 10 years' worth of tax obligations were issued (and people knew no more would be issued), that would put a floor on their value equal to the present value of 1 ounce of gold 10 years from now. But it only works if some people still pay taxes in gold, because there aren't enough bits of paper.

[Tom Brown]

Nick, re: gold: aren't those just lumps of intrinsically worthless yellow metal?

[Nick Rowe]

Tom: my dentist disagrees with you.

[Frank Restly]

Nick,

I found this online:
https://core.ac.uk/download/files/153/9311704.pdf

The authors describe a classroom experiment where students are each giving an endowment of various food items and eating utensils and are directed to engage in barter trade to obtain their lunch. Taken a step further, the exercise could be timed with a clock and then repeated with a central market that buys and sells goods for paper money.

It should be apparent that trade will be completed more quickly using paper money as opposed to barter. And so the real value of the paper money used is the amount of time saved during trade in using that currency.

[Jussi]

"what stops us from all suddenly waking up one morning and throwing our money on the ground because we expect it has zero market value and expect everyone else to do the same"

The government gives away pieces of papers. Person A gets four pieces and B gets one. The government announce that it will collect two pieces as taxes in the next period and those failing to pay will be punished. I'm sure paper will have some value. What do I miss?

[Jacques René Giguère]

Andrew: I gave a definition of what is a king. Nothing can be more positive than that. No value judgment. End of story.

[Andrew_FL]

@Philippe-You are asserting that fiat money can be spent into existence, ex nihilo, not taxed into existence. Different claims. why does the person being paid by the King accept tokens in payment? If your answer is "because the King holds a gun to his head" then you have not explained money by appeal to taxation.

@Jacques René Giguère-" I gave a definition of what is a king. Nothing can be more positive than that. No value judgment. End of story."

"the King decides that is is not robbery but taxation."

This is not a positive definition, it is a normative judgment. "When the President does it, it's not illegal."

[Philippe]

Andrew_FL

People accept the tokens in payment because some people need them to pay taxes. So even if I don't have to pay taxes, I'll accept them as I know someone else does, or will have to, so I'll be able to exchange them for goods and services.

"The King holds a gun to their head"

Well, all laws are backed by the threat of force, including private property laws. Taxation is no different in that respect.

[Frank Restly]

Nick,

"We need a theory to explain why people have a buffer stock of currency. And if we have such a theory, that is sufficient to explain why currency has positive value. So the taxes theory is ***neither sufficient nor necessary*** to explain why currency has value."

Perhaps we need a better value theory? Why does an asset "have to" possess a static value? As a for instance, in physics an object lying on the ground will have a coefficient of static friction and a coefficient of kinetic friction. The two values will likely not be the same (though the coefficient of static friction is unlikely to be zero with some positive coefficient of kinetic friction).

[stone]

It makes sense to hold even zero interest money as a short term store of value. Because wages and contracts etc are denominated in money it actually has the best short term stability (in real value terms) of any asset class. Even if someone is managing wealth with a long term outlook, it makes sense to hold a certain percentage of that wealth as money to use it to re-balance against if there is a collapse in stock or bond prices.

[stone]

Warren Buffett's views on cash perhaps explain some of its value as a stock rather than just as a flow: http://www.businessinsider.com/cash-as-a-call-option-2012-9?IR=T

""He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”

It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing.

Suddenly, an investor’s asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it?”

[Mike Freimuth]

Nick, this post and comments really highlight the main thing I've never understood about you. I think there is a bit of circular reasoning deeply rooted in your thinking on this. There are two separate questions here that you seem to be, at times, recognizing but at other times conflating. One is "why does money have value at all" and one is "given that money is used as the medium of exchange (which means it has value), what determines it's value exactly?" I think your position is essentially summarized by this comment:

"We need a theory to explain why people have a buffer stock of currency. And if we have such a theory, that is sufficient to explain why currency has positive value. So the taxes theory is ***neither sufficient nor necessary*** to explain why currency has value."

I agree that taxes are not sufficient to determine an exact value of money under the circumstances, you need some type of liquidity preference. And it's true that if you start by assuming that people have demand for money as a medium of exchange, you can determine its value from that (and it will be positive). But that doesn't answer the question of WHY people are willing to hold it in the first place and use it as a medium of exchange (your original question #1). You can't answer the question "why are people willing to use this for exchange?" with "because it's the medium of exchange."

At times you are acknowledging this question as unresolved but you are relegating it to an "origin story" and say "those origins stories are like car's starter motors -- needed to get the thing up and running from an initial zero value and zero stock, but they just get in the way once the engine has started moving and is running on gas." Now that MIGHT be the case (I don't think so) but it is a matter of faith. It doesn't follow logically that this shouldn't fall apart in the absence of some explanation (in other words that taxes, or something else is not necessary as an explanation). SOME explanation is certainly necessary, otherwise this is the greatest magic trick ever accomplished. Especially since anybody can produce pieces of paper and would love to figure out how to make them into a medium of exchange. But for some reason certain bits of paper are super valuable and others are not.

It seems like you don't find an explanation necessary only because you have accepted another explanation in the form of some collective confusion or force of habit. But that explanation IS necessary. Without it, this whole thing makes no sense. It's just that that explanation sucks. Claiming, sometimes, that you don't need an explanation allows you to ignore the fact that its a sucky explanation but you still have it to throw out there whenever you back yourself into a logical corner that actually DOES require an explanation.

[Nick Rowe]

Mike: I think we certainly do need an explanation for: 1. why people use a medium of exchange (as opposed to say barter); 2. why people demand a strictly positive stock of medium of exchange; 3. why people us this particular good as their medium of exchange (and not something else).

These are very standard questions in monetary economics. And there are answers out there, but this post is not about those answers. And the tax story adds nothing to those answers, with the possible exception of 3, as I mentioned above (about the government being a big player, so others may follow it's lead in a positive feedback game).

Briefly, the standard answers are:
1. Because barter has higher transactions costs (and different theories give different explanations of why).
2. Because it is costly to perfectly synchronise your purchases and sales (again, different explanations for why).
3. Because some goods have lower transactions costs than others (again....), plus positive feedback.

[Mike Freimuth]

Yeah, actually I agree with you about taxes. And I think your point about perpetual deficits regarding that theory is accurate. I sort of glossed over that because I have something else in mind. So just to be clear, this is not an argument for chartalism. Also I completely agree with your answer to those three questions but they are mostly unrelated to the question I am talking about. Of all the goods ("good" implying things with positive value to begin with) the one with the lowest transaction costs becomes the medium of exchange. That's a perfectly reasonable theory. But that's different from saying that we just create something out of thin air which would otherwise have no value whatsoever and decide we will all use it for trade and because of that it becomes valuable. That is a much more questionable claim. Maybe it's true but there are a lot of good reasons to be skeptical about that and if it is true it's an amazing economic phenomenon. I just think it's weird that people are so satisfied with that answer.

[Nick Rowe]

Mike: we are on the same page.

Suppose that intrinsically worthless bit of paper are used as medium of exchange (they have the lowest transactions costs once everyone else is using them, and are valued because there is a demand to hold them, because of the costs of synchronising payments and receipts). But that still leaves open a question that needs answering. There are two different ways to pose what is at root that same question:

1. How did it get started? Did people just pick up worthless bits of paper off the ground, and suddenly start valuing them because they could use them as media of exchange? Was there some sort of initial social contract to use them as money (highly dubious)? (Which is how von Mises posed the problem)

2. There are two equilibria: one in which the paper is used as medium of exchange, so is demanded, so is valuable; and a second in which the paper is worthless so cannot be used as a medium of exchange and so is not demanded and so is worthless. How come we stay in the first equilibrium and don't suddenly all lose faith and jump to the second? (Which is how Hahn posed the problem).

I prefer the von Mises way of thinking about it. And his answer (the "Regression Theory") was that paper money started out as convertible into something valuable, to get the thing off the ground and into the air, but once it gets flying you can withdraw convertibility and it keeps flying. Though Bitcoin is maybe a fascinating counterexample. JP Koning did a good post on it about a year ago. And maybe Chartalism gives and alternative answer.

[Nick Rowe]

It's a bit like asking how languages get started. How can intrinsically meaningless noises come to have common meanings? Eric Lonergan did a good post a couple of weeks back on Hume and language and money.

[Mike Freimuth]

Yeah, I think we just disagree on the explanation, I don't think that is the explanation, I'm just trying to separate this out from the questions you listed initially (in your response to me) and from the issue of liquidity preference. Sometimes it seems like when someone proposes an explanation for why money is valuable (chartalism is also a sucky explanation in my opinion but I've got my own kooky explanation) you say no, there has to be some value related to its use as a medium of exchange, which I agree with and then you jump to: because there is some value from being used as a medium of exchange, no other explanation is necessary. But that last part basically just skips over the question that I think is interesting (which you accurately describe in the second response).

Now I think both of those answers (Mises and Hahn) are mistaken. You were closer to the truth here:

"Miami: I actually have some sympathy for that thought. All financial assets are promises written on bits of paper. (Or sometimes the promise is written in a book or website somewhere). They are worth what those promises are worth. The Bank of Canada promises: "We sorta promise that we will do our best to ensure that this bit of paper (plastic) depreciates at around 2% relative to the CPI basket of goods, and we will adjust the supply as needed to try to make that happen. Unless we really need to change our mind."

However, that is NOT the legal promise which is attached to the bit of paper. Plus that also skips over the question of how it can be valuable by assuming that they creators of the bits have the power to determine their value. But there is a specific legal promise attached to the paper and that is the ability to extinguish $1 of debt. The same debt which is created upon creation of the money. I told myself I wouldn't turn this into a debate about the actual answer though, I just wanted to try to highlight the important question. Maybe later I'll try to push my crazy theory on you again.

[Mike Freimuth]

BTW, I find this kind of ironic but I think you have a situation here where your equilibrium is "unstable" in the way that we both wish we could call "not trembling-hand perfect" but which isn't really what that means. As long as everyone else keeps using this stuff, I might as well keep using it, but if other people stop, it will be a race to the zero-value equilibrium. Doesn't it seem odd at all that that has held up for so long if that's all that is keeping it from falling apart? In other instances, that seems to make you skeptical...

[Nick Rowe]

Mike: I think money is a *locally* but not *globally* stable equilibrium. Like a lot of network things. If 20% of people stop using it I keep using it. If 80% stop using it I stop using it too.

[Bob]

Nick,

This is the problem you get with people who spend too much time with mathematics and not enough time in the real world.

Imposing taxation on somebody is a liability in a denomination with a deadline. You get the denomination by the deadline or you go to jail.

That is enough to get people to give up real goods and services for the denomination and instantly spend it on the taxation - transitively throughout the economy. That is what gives a denomination value in the flow dimension.

People *save* the denomination not because of interest rates, but because of time uncertainty, insurance and vanity. They choose the particular denomination largely due to the denomination of their flow commitments for all the usual minimising risk reasons. That is the value in the stock dimension - why it gets saved to excess.

MMT doesn't say that taxes give value to the currency. Rather it has that taxes are sufficient to create demand for the state's liabilities if the state only accepts its own liabilities in payment.

MMT holds that a currency sovereign has a monopoly over currency issuance, and like other monopolists is able to set the price it is willing to pay in markets that operate using its currency. Specifically, the state can set the own rate of the currency through monetary policy.

[Mike Freimuth]

I wrote the "origin story" using you as a foil sort of. I'd love for you to read it. Even if you don't, I find that you make a very good foil, so I appreciate that. Anyone else who thinks the "Wile E. Coyote" theory is a bit suspect, please click below.

http://realfreeradical.com/2016/04/03/a-fiat-money-origin-story/