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Source link: http://archive.mises.org/13734/mo-money-mo-problems/

Mo’ Money, Mo’ Problems

August 31, 2010 by

The US money supply can be increased at the whim of Federal Reserve officials, writes C.J. Maloney, with no compensation at all given to those whose current holdings will be debased by the newly created money. FULL ARTICLE by C.J. Maloney

{ 90 comments }

Kel Kelly August 31, 2010 at 1:03 pm

Great article. I like the example of companies issuing more stocks–that’s exactly right and exactly what the Fed does. Props to Biggie.

Gerry Flaychy September 5, 2010 at 5:41 pm

It seems to me that if the book value of every existing share is 10$, and the company sells some other shares at 10$, then there will be no ‘debasing’ of the existing shares.

What I think, is that we have, firstly, to distinguish between market value and book value, be it a share or a unit of money.

Secondly, owning a share is owning a part of the company, while I don’t think that owning an unit of federal reserve note is owning a part of the Federal Reserve !

Thus, trying to make an analogy between the two doesn’t necessarily brings more clarity in a discussion.

John October 22, 2010 at 1:47 am

Your first statement is false, and you touched on the reason in your third statement. Owning a share is owning part of a company. If you own 50 shares of a company and I own 50 shares of a company, and those are all the shares outstanding, we each own 50% of the company. If we issue 100 new shares and sell them to other people, we don’t each own 50% of the company anymore. It doesn’t matter how much the new shares are sold for. If we create new shares and sell them off without giving ourselves a proportional increase in shares as well, our OWNERSHIP in the company is diluted. (See the film The Social Network and understand what happened to Eduardo Saverin)

It’s the exact same thing with fiat currency. Unless you’re going to put a proportional amount of dollars in the pockets of everyone who holds ANY dollars, any dollars you create dilute the currency in such a way that some gain at the expense of others.

Mike Sproul August 31, 2010 at 1:21 pm

When a company issues more stock, it gets assets of equal value in exchange, so the stock price is unaffected. In the same way, when the Fed issued a new dollar, it gets a dollar’s worth of assets in exchange, so the value of the dollar is unaffected.

BioTube August 31, 2010 at 1:26 pm

If the value of a dollar were unaffected by all this monetary pumping, why have prices increased for almost everything? And even assuming that your claim has been true historically, the latest bout of inflation has been buying assets that are only “a dollar’s worth” on paper and not worth a plug nickel in reality.

Jonathan M. F. Catalán August 31, 2010 at 1:49 pm

What asset did the Federal Reserve get in exchange? As far as I know, the only “asset” it got is the promise of future repayment and interest (and this is not even true in some cases)

Sean September 3, 2010 at 8:55 pm

You’re playing devil’s advocate, right? I mean, is it not obvious that when a company issues stock, it creates a liability in its books in exchange for its new asset? In other words, the company has to exchange something of real value (i.e. a claim on its assets) to acquire something else of equal value. Is this not completely obvious?

George Selgin September 7, 2010 at 4:42 am

If Mike Sproul’s claim about new stock issues is correct, I guess the theory of supply and demand has been a big mistake! Does he really imagine that the “equal” value a company gets for its shares doesn’t decline as it increases the offer size? Goodness, corporate finance just got really easy!

Sorry, Mike: this isn’t the sort of thinking that makes for sound reasoning about monetary economics.

Bill G September 7, 2010 at 12:32 pm

George:

I think Mike is saying that if a firm has 100 shares laying claim to assets worth $500, then each share will be worth $50. If that same firm had 200 shares laying claim to assets worth $1000, then each share would still be worth $50. The theory of supply and demand is meant to apply to actual commodities, not to shares of stock that might only exist as bookkeeping entries.

Bill G September 7, 2010 at 7:08 pm

Whoops! $500/100=$5 per share, not $50.

Mike Sproul September 11, 2010 at 9:43 am

I think I’ll start a corporation. My first act will be to deposit $100 in the corporation’s bank account and issue 100 shares, each giving the right to 1/100 of the bank account. George might disagree, but I think those shares will be worth $1 each. My next act will be to give the corporation a $200 US government bond and have the corporation issue another 200 shares, each of which will then give the right to 1/300 of the corporation’s $300 worth of assets. At this point, George and his fellow quantity theorists will note that the “Supply” of shares just tripled, and their sophisticated models of supply and demand will tell them to expect share prices to fall by about 2/3.

Then I’ll open the floodgates. I’ll agree to issue 100 new shares to anyone who deposits $100 worth of bonds. I’ll do the same for anyone who deposits $100 worth of land, wheat, or anything else. Naturally, George and Company will expect the shares to lose all value. The fact that the shares always seem to stay at $1 each will probably not bother them. In fact, they might even see it as a profit opportunity, and they will sell the shares short, buy puts, write calls, etc., knowing that they will soon cash in on their superior understanding.

I’m afraid their financial wizardry will not go well. But if they don’t understand the backing theory and the real bills doctrine when it’s explained in print, they might understand it once they’ve lost money on it.

Mike Sproul August 31, 2010 at 1:57 pm

Biotube:

If the fed fails to get a dollar’s worth of assets, or if its assets lose value, then the value ofthe dollar will fall. The same is true of stock or any other financial security

Jonathan:

The future repayment, with interest, is an asset. Surely, you see the difference from the case where the fed just prints dollars and drops them from the sky. A sky drop increases the money supply with no corresponding rise in assets. An open market purchase of bonds (or anything else) causes the fed’s assets to rise in step with its liabilities.

J. Murray August 31, 2010 at 3:48 pm

Future payment based on what?

Further, what exactly did the Federal Reserve to to earn that dollar in the first place? What makes them so special to be able to just issue them and get assets without any corresponding production? If that’s the case, I should be able to print and issue dollars as well because I’m getting assets of equal “value” in return.

michael September 1, 2010 at 8:48 am

“If that’s the case, I should be able to print and issue dollars as well because I’m getting assets of equal “value” in return.”

Start your own country and you’ll be able to do just that.

But if you stay in this one, be advised that the USG has given monopoly authority to the Fed for the fiat extension of credit. Them’s the rules of the game.

You are entirely free, of course, to give anyone who wants to give you money promissory notes in exchange for their cash. That’s sort of what a Federal Reserve note is– with the exception that their notes can’t be redeemed at the Fed for anything. They can only be circulated.

Jonathan M. F. Catalán August 31, 2010 at 5:12 pm

Mike,

The future repayment, with interest, is an asset.

So, your entire argument assumes that the creation of money will lead to an increase in the number of physical assets, or capital-goods. It also means that at the time of the extension, there was no real asset “backing” that dollar. That suggests price inflation.

It seems to me as if your argument is therefore irrelevant to our point (I don’t think anybody denies that the Fed is hoping to have its loans repaid).

michael September 1, 2010 at 9:00 am

“So, your entire argument assumes that the creation of money will lead to an increase in the number of physical assets, or capital-goods.”

I’m just stepping in here, Jonathan. No. Mike never said that. Nor did he imply it. He just said that the Fed extended credit to the banks in the form of legal tender. And in exchange it took in their promises to pay.

As a bank, it may be operating on a flawed model. It can’t for instance, call in all its loans at once. That would suck every dime out of America, and still have plenty of debt left over. But that’s much the way all banks work, isn’t it?

So it never calls in its loans other than very cautiously. What causes our fabulous increases in productivity, in capital assets and in the production of material wealth is the way this extension of funds gets ultimately used as payroll. People build things, things that collectively become our wealth, when induced to do so by the promise of pay.

It’s strong backs that built America’s wealth. And each one did it in the hope of gain, in the form of Federal Reserve notes. Call it a shoddy system, but by and large it’s worked very well so far.

So, looking back at your original comment, I guess I’m the one saying it. The issue of Fed banknotes does lead to a tangible increase in wealth, providing those notes are properly deployed among the work force.

Jonathan M. F. Catalán September 1, 2010 at 11:49 am

Michael,

I’m just stepping in here, Jonathan. No. Mike never said that. Nor did he imply it. He just said that the Fed extended credit to the banks in the form of legal tender. And in exchange it took in their promises to pay.

He is trying to argue that money creation by the Federal Reserve is not inflationary, which is pure bollocks. If there is no additional increase in the amount of economic-goods, then the creation of money is generally inflationary (in terms of prices).

As a bank, it may be operating on a flawed model. It can’t for instance, call in all its loans at once. That would suck every dime out of America, and still have plenty of debt left over. But that’s much the way all banks work, isn’t it?

Um, this has nothing to do with what we’re talking about.

It’s strong backs that built America’s wealth.

This is complete nonsense. The fastest period of economic growth in the United States, between 1879 and 1893, was done with only a relatively slight increase in the supply of money (mostly an increase in the supply of metallic money). There was also falling prices, which means an increase in the cost of debt (the interesting thing is that loan contracts were written to take deflation into account).

So, looking back at your original comment, I guess I’m the one saying it. The issue of Fed banknotes does lead to a tangible increase in wealth, providing those notes are properly deployed among the work force.

Nothing you argue in your post leads to this conclusion, sorry.

michael September 1, 2010 at 12:56 pm

“He is trying to argue that money creation by the Federal Reserve is not inflationary, which is pure bollocks.”

If the word ‘inflationary’ is taken to mean any expansion in the money supply, your argument is tautological. But if we’re using the word as most economists and ordinary mortals use it, the word refers to broad increases in prices, especially when accompanied by compensating wage increases.

“If there is no additional increase in the amount of economic-goods, then the creation of money is generally inflationary (in terms of prices).”

If you posit this link between the total sum of money in circulation and the total sum of economic goods, then the opposite is also true. Any time there is an increase in goods, whether capital or consumer goods, there must be a concomitant increase in the money supply. If not, deflation is the dreaded result.

Therefore if we assume there is this link, there’s no impediment to creating the money first… to get the ball rolling. Many millions of idle pairs of hands are lying around; trillions of dollars in idle capital investment are also lying around; just add some money for payroll and the idle hands and plant suddenly become productive, justifying the initial expenditure that made it all happen. The amount of new wealth this combination produces (labor, physical plant and wages) increases to full production capacity, bounded only by consumers’ purses and desires.

Then, with the shelves filled with new goods, all the families who now have fresh paychecks coming in can consume the stuff capital investment plus labor built. They can, for example, afford to buy the backlog of vacant homes out there, once prices reach their natural resting place.

According to the rules you have laid down, this works.

I suspect, though, that there is some flaw in this simple equation. Because if it were true, whenever there was a war, and gazillions of dollars in wealth were destroyed, we would have to destroy a like amount of money to retain balance in the system. And we would have to do so just when we needed money the most, to get the place rebuilt again.

Maybe it’s not all so simple as theory would lead us to believe.

Jonathan M. F. Catalán September 1, 2010 at 1:08 pm

Michael,

But if we’re using the word as most economists and ordinary mortals use it, the word refers to broad increases in prices, especially when accompanied by compensating wage increases.

….

Yes, Michael, I am referring to an increase in prices.

If you posit this link between the total sum of money in circulation and the total sum of economic goods, then the opposite is also true. Any time there is an increase in goods, whether capital or consumer goods, there must be a concomitant increase in the money supply. If not, deflation is the dreaded result.

It’s true that a rise in productivity, without a proportional rise in the supply of money, would bring about price deflation, but the results are not “dreaded”. Like I wrote before (and you ignored), the period of highest growth in the United States was a period of price deflation. Indeed, this empirical evidence led Schwartz and Friedman to review their prior position on price deflation.

The problem is a lack of distinguishing between price deflation and monetary deflation. The former, in and of itself, is not bad. The latter is bad.

Therefore if we assume there is this link, there’s no impediment to creating the money first… to get the ball rolling.

This is a non-sequitur, as I’ve written elsewhere. There is no such link, and this is utter nonsense based on the lack of sound monetary and economic theory.

Many millions of idle pairs of hands are lying around; trillions of dollars in idle capital investment are also lying around; just add some money for payroll and the idle hands and plant suddenly become productive, justifying the initial expenditure that made it all happen.

This is not a problem that stems from the lack of money, per sé. It is a problem that stems from the lack of investment. While monetary deflation may be a cause of this, re-inflation (as I’ve argued elsewhere) is not a solution.

So, you can stop repeating this, because it has already been addressed (maybe you’d like to address the criticism of re-inflation, instead).

According to the rules you have laid down, this works.

Well, only if you allow for your own gaps in your own logic.

Maybe it’s not all so simple as theory would lead us to believe.

Yes, your theory is flawed.

michael September 1, 2010 at 2:30 pm

“Like I wrote before (and you ignored), the period of highest growth in the United States was a period of price deflation.”

Since you’ve had to remind me, let’s take a look at your comment:

“The fastest period of economic growth in the United States, between 1879 and 1893, was done with only a relatively slight increase in the supply of money (mostly an increase in the supply of metallic money). There was also falling prices, which means an increase in the cost of debt (the interesting thing is that loan contracts were written to take deflation into account).”

One of the worst (and longest lived) of our depressions lasted from 1873 to 1879. And if we start from such a low point it’s unsurprising that growth would be fast once the engine started turning. Plus, with no central bank, it’s not surprising that they had to recover without injecting capital. That’s the other way a recovery can be effected: through the long passage of time. (In Europe this was known as the Long Depression.)

Is it preferable? To an idealist, perhaps, someone who believes the economy should propel itself by all-natural means only. But to someone waiting for the chance to feed his family, that person doesn’t have the luxury of waiting. He needs work right now.

With insufficient money on the street, prices are forced downward. Profits disappear and jobs must be cut. So slack demand perpetuates deflation. Most of us understand that to be a bad state to be in, although some Austrians may be overjoyed.

If I understand you, you say that monetary deflation, unlike price deflation, isn’t so bad. But that would be merely academic. In our current downturn there’s apparently been quite a contraction in the money supply. And it’s been bad for us. Less money, whichever way you cut it, means less money. Employers can’t afford to pay you. They don’t have access to borrowed funds and they don’t have a profitable cash flow.

“The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.” etc.
http://www.telegraph.co.uk/finance/economics/7769126/US-money-supply-plunges-at-1930s-pace-as-Obama-eyes-fresh-stimulus.html

This kind of deflation may not trouble you; it troubles me. Without more cash we’re likely to be here for years.

michael September 1, 2010 at 2:39 pm

Here’s what I said: “Therefore if we assume there is this link [between the amount of money in existence and the amount of goods], there’s no impediment to creating the money first… to get the ball rolling.

To which you reply: “This is a non-sequitur, as I’ve written elsewhere. There is no such link, and this is utter nonsense based on the lack of sound monetary and economic theory.”

Here’s what you said, Jonathan:

“If there is no additional increase in the amount of economic-goods, then the creation of money is generally inflationary (in terms of prices).”

This is the same as saying that an increase in the money supply is justifiable when there is an increase in the amount of economic goods. If not you’d have stated it differently, and not used the ‘if… then…’ formulation.

Or are you saying that it’s a one way street? That you can’t increase the money supply without a comparable increase in goods. And you can’t increase the money supply if there IS an increase in goods. You just can’t increase it regardless. Is that what you’re saying?

Beefcake the Mighty August 31, 2010 at 2:46 pm

I’ll repost a comment I made on a different thread that Mike Sproul did not see fit to respond to:

“However, the specific point here is that Mike Sproul’s dog-and-pony show centers around his belief that if banks issue notes “backed” by assets of “equal value,” the effect is non-inflationary. There is first the point that this value, which he expresses in terms of monetary units, obviously cannot be independent of prevailing monetary conditions. However, there is another point, and this concerns the precise nature of our monetary system. The Fed does not “issue” anything; it monetizes Federal Govt debt, which increases the reserves of the banking system as a whole. Now, with these reserves individual banks are able to increase the loans they make to the public. And in turn, the banks can increase demand for loans by lowering the interest rate they charge on these loans. In other words, they can affect the willingness of the public to bring forth the very collateral that Mike Sproul believes “backs” those loans. Demand is not independent of supply here, but like the Monetary Equilibrium theorists who claim to reject the Real Bills Doctrine, Sproul believes these increased isssues by the banks are driven by the demand side, instead of on the supply side.”

http://blog.mises.org/13586/is-our-money-based-on-debt-2/#comments

billwald August 31, 2010 at 3:03 pm

The Fed tells people when they generate new funds. Say a guy made himself a million bucks in undetectable 100 dollar bills and then destroyed the plates. Say he then spent a thousand dollars a week into circulation. If the addition remains undetected, who is harmed.

Say the Fed creates a billion dollars which ends up in Swiss Banks. The money is NEVER spent but is used for collateral to borrow money and purchase bank or other stocks. Has the money supply changed?

Free Radical August 31, 2010 at 3:33 pm

The debate here seems generated mainly by a difference in conceptions of the way money is created. The Friedman “helicpoter drop” is a thought experiment economist have been using for generations but it does fundamentally misrepresent the actual money creation mechanism in our economy (as does the counterfeit example).

Mike Sproul is correct that the Fed (usually) exchanges money for other assets of “equal” value. This fact is of the utmost importance for determing the effects of such a policy and makes it somewhat complicated. I believe he is not correct however in saying that because of this the value of the dollar is not affected by increasing the money supply.

When the money supply increases it does have an inflationary effect in the short run (which Keynesians call the medium run) due to more dollars chasing the same amount of goods (which Keynesians call an increase in aggregate demand). However, Keynesians stop there. In econ 301, we teach IS/LM and AS/AD for short and medium run analysis and then for long run we do the Solow growth model which abstracts entirely from monetary issues. This avoids the question of long run effects entirely.

In the long run, expansionary monetary policy is actually deflationary. There are two ways to think about this. One is a simple interpretation of the Fisher equation which is pointed out by Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis.

http://www.minneapolisfed.org/news_events/pres/speech_display.cfm?id=4525#_ftn1

“Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.”

Another way to think about this is to notice that the debt the Fed takes in exchange for the money must be repaid with interest which means every dollar injected into the economy today means a little bit more than 1 dollar must be sucked out at soem time in the future. For a more nuanced discussion of this process see this post.

http://realfreeradical.wordpress.com/2010/08/26/fiat-money/

This is why we are now paying for the loose monetary policy of the past with deflation and the Fed is having to get creative to solve it since we can’t lower interest rates any more. Sorry for the long comment sometimes I get going and can’t stop.

michael September 1, 2010 at 1:02 pm

“When the money supply increases it does have an inflationary effect in the short run (which Keynesians call the medium run) due to more dollars chasing the same amount of goods…”

But should the newly injected dollars go toward wages, particularly in productive areas like manufacturing, construction and agriculture, production increases as a result. And more dollars chase more goods in the marketplace.

Jonathan M. F. Catalán September 1, 2010 at 1:15 pm

More nonsense. Increasing monetary wages does not lead to greater productivity. Even Keynes agreed with this. Indeed, this was the entire basis of his argument for increasing monetary wages in times of depression (he argued that a rise in monetary wages would cover up the loss in real wages).

Inflating monetary wages only leads to capital consumption, not capital production.

michael September 1, 2010 at 1:22 pm

“Increasing monetary wages does not lead to greater productivity.”

Your comment appears to be designed to mislead, Jonathan. As I’m sure you’re aware, I said nothing about increasing wages from x to y. That may or may not have an effect on productivity.

But when you increase wages from zero to x, by employing someone who otherwise would be sitting on his hands and worrying, that DOES increase productivity. Of course it does. I know you know that.

Jonathan M. F. Catalán September 1, 2010 at 1:23 pm

But when you increase wages from zero to x, by employing someone who otherwise would be sitting on his hands and worrying, that DOES increase productivity.

But, it doesn’t. It increases capital consumption, but that does not necessarily mean that sustainable productivity was increased (i.e. a healthy lengthening of the structure of production).

michael September 1, 2010 at 1:45 pm

“It [an injection of funds as emergency wages into a stalled economy] increases capital consumption, but that does not necessarily mean that sustainable productivity was increased (i.e. a healthy lengthening of the structure of production).”

You seem to be positing that someone hires a person for the express production of goods… but then, inexplicably, he fails to produce those goods. Why, then, would anyone pay him?

IMO you are stretching an argument well beyond its bounds. Hire someone to produce a good and the net effect of the addition of money to the equation idle plant plus idle labor is a direct increase in the amount of goods produced.

BTW productivity is in itself NEVER sustainable without the pull of demand to keep it going. What I’m talking about is kick-starting the economy with a massive injection limited in duration… not carrying it forward for years and years. Once the engine gets started, ongoing consumer demand will take care of the rest.

The missing ingredient, in a downturn characterised by mass layoffs, is wages. With them, productivity returns to normal. Without them it continues to languish, as it did during the first 3-1/2 years of the Great Depression.

Free Radical September 6, 2010 at 6:21 pm

I commented hastily haha so I’m editing it to this: Even this Keynesian argument (which I disagree with) still results in the conclusion of higher prices in both the short and medium runs when you use the IS/LM and AS/AD models….

Free Radical August 31, 2010 at 3:43 pm

P.S. Once you understand this, it really puts these words into context.

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.”

-Thomas Jefferson

Bennet Cecil August 31, 2010 at 6:13 pm

You can exchange your dollars for real estate, businesses, nonperishable items like vodka. You can take refuge in understanding the scam from the Fed-government cartel. Voters who chose politics based on credit and taxing the wealthy will face unemployment and eventual brutal inflation. You will survive and prosper since you understand the con.

Mike Sproul August 31, 2010 at 7:22 pm

J. Murray:Well, suppose the fed issued a new dollar in exchange for a dollar’s worth of farm land. Then the dollar would be backed by the land. In fact, the fed could sell the land for one of its circulating dollars anytime, and retire the dollar from circulation. A bank that helicopter-dropped its dollars could not do that. So if the fed instead issued a new dollar in exchange for a $1 bond that can be traded at any time for a dollar’s worth of land, the dollar is just as backed by the bond as it was by the land.

Jonathan:”creation of money will lead to an increase in the number of physical assets, or capital-goods.”The number of physical assets in existence does not have to increase. It’s just that the fed acquires a dollar’s worth of (possibly pre-existing) assets as it issues a new dollar.

Free Radical: “When the money supply increases it does have an inflationary effect in the short run (which Keynesians call the medium run) due to more dollars chasing the same amount of goods”You have to ask why those dollars were created. If new dollars are issued, and people have no use for them, then the Law of Reflux says those dollars will just reflux to the issuing bank. The more important point is that if a bank has assets worth 100 oz. of silver backing $100, then each dollar will be worth 1 oz. If the next day, that bank has 200 oz. worth of assets backing $200, each dollar will still be worth 1 oz., whether or not there are more dollars chasing the same goods.

Beefcake the Mighty August 31, 2010 at 9:01 pm

Do you lack the ability to read? This is a serious question; I really doubt that you have the slightest idea what others are saying here.

michael September 1, 2010 at 1:07 pm

“.. I really doubt that you have the slightest idea what others are saying here.”

Beefcake: This is not an effective refutation. Sproul appears to understand what people are saying perfectly; he is just saying something else in response.

Why not explain precisely where he’s wrong? His addition certainly seems to be correct.

Jonathan M. F. Catalán September 1, 2010 at 1:14 pm

Beefcake: This is not an effective refutation. Sproul appears to understand what people are saying perfectly; he is just saying something else in response.

He is just ignoring where his theory goes awry.

Jonathan M. F. Catalán August 31, 2010 at 10:23 pm

The number of physical assets in existence does not have to increase. It’s just that the fed acquires a dollar’s worth of (possibly pre-existing) assets as it issues a new dollar.

OK, but if the amount of economic goods remains the same, but the supply of money increases, this represents inflation.

Mike Sproul August 31, 2010 at 10:31 pm

If those new dollars are excessive in quantity, the Law of Reflux says they will reflux to their issuer, while as long as there is a constant amount of backing per dollar, the dollars will hold their value. A simple example of the Law of Reflux is given by metallic coins. If an excessive amount of metal is stamped into coins, then people will melt coins and the coins will reflux to bullion, but the value of coins does not change as long as the backing of each coin (which, in this case, is the metal content of the coin itself) is unchanged.

Jonathan M. F. Catalán August 31, 2010 at 10:46 pm

Are you serious?

The Law of Reflux asserts that competitively issued currency cannot be overissued to such an extent as to cause inflation.

We do not currently have competitively issued currency, whether money or money substitute.

Mike Sproul September 1, 2010 at 9:21 am

Jonathan:

Reflux operates with any money, whether issued competitively or monopolistically. The importance of reflux is not that it prevents over-issue, but that it provides the public with access to the assets backing their money. The US dollar, for example, can reflux to the fed or the government in exchange for bonds, in payment of taxes, in purchasing used furniture from the government, etc. If enough reflux channels were closed to effectively put 10% of previously available assets out of reach of currency holders, then the dollar would lose 10% of its value, just as if the government had lost 10% of the assets that currently back the dollar.

Jonathan M. F. Catalán September 1, 2010 at 11:51 am

The importance of reflux is not that it prevents over-issue, but that it provides the public with access to the assets backing their money.

This is nonsense, which leads to the following nonsense,

The US dollar, for example, can reflux to the fed or the government in exchange for bonds, in payment of taxes, in purchasing used furniture from the government, etc.

It is inflationary because the amount of economic-goods has not increased. The law of reflux suggests that when there is overissue of money, money will leave the system (either fiduciary media will be exchanged for base money, or base money will be smelted, et cetera). In this case, money is not leaving the system, it’s just changing forms. This is inflationary.

Troy September 5, 2010 at 11:21 pm

Mike,
I read your comments and wanted to check your credentials before I replied. Now it makes sense. Only an economics professsor (with notable exceptions like Austrian School economists) can spew this sort of garbage. I’m just out of college but even I’m not buyg what you are selling. The very fact that an entity that can create money ex-nihilo without producing anything first doesn’t strike you as wrong? Imagine a beggar on the street issuing his own money and then buying food from McDonalds. Don’t tell me the Fed Notes are different. The only difference between the vagrant and the Fed is the state’s legal tender laws forcing everyone to accept Fed notes.

This policy of creating money first before producing anything of value, if applied to the entire economy at once, means, metaphorically, that we can eat before we produce the food. I pity your students.

And the other michael – you’re a troll, I’m not going to feed you.

What with this? A gathering for trolls named michael?

james b. longacre August 31, 2010 at 8:54 pm

i suppose free market money can increase at the whim of whomever.

if the new fed money went to a automation process that made the things that people with holdings would likely spend the money on more abundant and cheap would the holding actually lose value??

BioTube August 31, 2010 at 9:18 pm

Since I can’t make heads or tails of your second paragraph, let me offer this: traditionally, the market has chosen commodities as money, which means the money supply increases at most as fast as new commodity can be brought to market; this is kept in check by the fact that the chosen commodities have nonmonetary uses as well(gold, for instance, can also be used for decoration and conduction – in fact, the vast majority of the world’s gold production goes to industrial purposes). In this scenario, hoarded money gains value by virtue of taking itself out of circulation, pushing down prices until it’s reintroduced.

james b. longacre September 1, 2010 at 4:13 pm

Since the beginning of the decade, total investment demand has soared
from only 4% of overall gold demand in 2000 to a record 45% in 2009.
http://www.gold.org/deliver.php?file=/rs_archive/201005_Investors_guide_to_gold_market.pdf

Industrial and dental uses accounted for around 12% of gold demand
or an annual average of 431 tonnes from 2005 to 2009, inclusive…..

james b. longacre September 1, 2010 at 4:18 pm

hayek said that any increase in the money supply was inflation. prices i am not sure about.

or at least a document online attributed that info to him.

Dave August 31, 2010 at 11:14 pm

Free Radical,

I have to say your comment is the best summary of the economic system I have read to date.

Free Radical September 6, 2010 at 6:26 pm

Thank you very much, Dave. (=

Libertarian Jerry September 1, 2010 at 1:05 am

The bottom line is ; in America,today,we have a very corrupt money system and a very corrupt government. In other words,”you can’t have honest government with dishonest money.”

Beefcake the Mighty September 1, 2010 at 6:02 am

It’s worth having a look at what Mises had to say about the Law of Reflux, Fullarton, RBD, etc:

http://mises.org/books/Theory_Money_Credit/Part3_Ch17.aspx#_sec4

This is not directed to Mike Sproul, as he clearly is not interested in entertaining contrary ideas, but to others who might be genuinely interested in the topic.

William P September 1, 2010 at 9:31 am

I liked the Spinal Tap!

Beefcake the Mighty September 1, 2010 at 9:38 am

Anyone who doubts that Mike Sproul is making no effort to comprehend the actual arguments being put forth against his position can inspect his exchange with George Selgin from two years ago:

http://blog.mises.org/8929/in-defense-of-monetarism/comment-page-1/

Jonathan M. F. Catalán September 1, 2010 at 11:54 am

I don’t think you have to read Selgin. Mike’s real bills doctrine just doesn’t make any sense. It’s illogical.

Mike Sproul September 1, 2010 at 12:34 pm

Jonathan:

“This is nonsense, which leads to the following nonsense”
You don’t say much in support of that statement. Let’s start from square 1: Some institution, a bank or government, accepts 100 oz. of silver on deposit, and issues 100 paper receipts (dollars) in exchange. Each dollar is worth 1 oz. The dollars need not be physically convertible into silver. They could just as well be convertible into something else that is worth 1 oz.

Now the bank issues another $200 in exchange for various assets that are collectively worth 200 oz. We now have 300 oz. of assets backing $300, so each dollar is still worth 1 oz. If the extra 200 dollars were wanted in the circulation (maybe because output of goods increased) then the dollars will circulate. If they are not wanted, they will reflux to the issuer in exchange for 200 oz. worth of assets. But of course if the bank refused to reflux the $200, thus denying the public access to the assets backing the money, then the effect would be the same as if the bank had 100 oz. of assets backing $300, and each dollar would be worth 1/3 oz.

Jonathan M. F. Catalán September 1, 2010 at 1:13 pm

Mike,

Now the bank issues another $200 in exchange for various assets that are collectively worth 200 oz.

In the case of the Federal Reserve, the new money issued was not issued in return for an amount of physical assets which would maintain the price level. The money was issued on the promise that it would be repaid later. As such, at the time which the money was issued it represents an inflationary increase in the supply of money.

In other words, when the Federal Reserve issues $200, it doesn’t do it in return for something that is presently worth 200oz. of silver. Instead, it issues it on the promise that at a future date the repayment will be in the form of something worth 200oz. of silver.

This is the point you continue to miss, and you continue to spout your nonsense (nonsense that nobody here really is interested in reading—maybe you should start a blog).

If they are not wanted, they will reflux to the issuer in exchange for 200 oz. worth of assets.

The law of reflux doesn’t work in this way with fiat money, because there are no real assets this money can be exchanged for. You suggest that the money can be exchanged for a bond, but this is just exchanging one form of money for another. It doesn’t represent real wealth.

You keep ignoring this.

james b. longacre September 1, 2010 at 3:48 pm

It doesn’t represent real wealth.

is money supposed to represent real wealth??

Jonathan M. F. Catalán September 1, 2010 at 1:25 pm

Just to specify, I write,

In the case of the Federal Reserve, the new money issued was not issued in return for an amount of physical assets which would maintain the price level. The money was issued on the promise that it would be repaid later.

How does this differentiate from a normal loan? The difference is that the money issued in a normal loan already existed. The Federal Reserve is effectively creating money ex nihilo.

james b. longacre September 1, 2010 at 3:46 pm

if i found some gold and moneyed it and loaned it would that be a normal loan?? with newly created money?
without regard to a price level? with a promise to repay later??

james b. longacre September 1, 2010 at 4:04 pm

accepts 100 oz. of silver on deposit, and issues 100 paper receipts …..They could just as well be convertible into something else that is worth 1 oz………….
bank issues another $200 (receipts) in exchange for various assets that are collectively worth 200 oz……
what is a receipt??

does each receipt correspond to 1oz of silver? how was an asset price calculated with a silver ounce price when each note is corresponds one ounce of silver with silver receipts circulating for which there is no silver at all???

if the silver receipts were cashed in for the silver and the silver was lacking because silver receipts were issued for things worth so-many silver ounces what would be the outcome??

Mike Sproul September 1, 2010 at 3:13 pm

Jonathan:
“nonsense that nobody here really is interested in reading”

Well, for starters, why are you reading it?

“when the Federal Reserve issues $200, it doesn’t do it in return for something that is presently worth 200oz. of silver. Instead, it issues it on the promise that at a future date the repayment will be in the form of something worth 200oz. of silver.”

Yikes! There’s a chapter in some econ books on “present value”. Give it a read sometime.

“The law of reflux doesn’t work in this way with fiat money, because there are no real assets this money can be exchanged for. You suggest that the money can be exchanged for a bond, but this is just exchanging one form of money for another. It doesn’t represent real wealth.”

All government-issued money is backed by the resources of that government–usually the government’s ‘taxes receivable’. I value dollars partly because I can extinguish a tax liability with them, partly because the government accepts them when it sells used furniture, etc. There are real assets backing every kind of money. That’s why it has value.

Beefcake the Mighty September 1, 2010 at 3:50 pm

My God you are dense. Do you really not understand the point he is trying to make? You really don’t read other people’s arguments, do you? Or, maybe since you omitted the “In other words” from the sentence you quote, you are simply dishonest?

Let me repeat JMFC’s point so that even you can (hopefully) follow it:

“In the case of the Federal Reserve, the new money issued was not issued in return for an amount of physical assets which would maintain the price level. The money was issued on the promise that it would be repaid later. As such, at the time which the money was issued it represents an inflationary increase in the supply of money.”

james b. longacre September 1, 2010 at 3:44 pm

“All government-issued money is backed by the resources of that government–usually the government’s ‘taxes receivable’.”

that doesnt sound like backing. that sounds lie a govt scheme to to force various papers with numbers on them on people who may or may not want govt controlled paper for money.

backing seems like a paper that says title to 10 grams of gold…and the ten grams would be in a vault sitting there with you holding title….not in a vault where someone else now owns the amount of gold and is expected to pay it back. that is what i was told earlier gold standards operated like.

now if the money was gold and the govt happened to tax in gold, spend in gold but persons could ‘make’ new money buy mining and minting more gold that doesnt seem like the gold would have backing but only a desire to be used as money.

Mike Sproul September 1, 2010 at 4:44 pm

If a landowner rents out his land for silver, and one day buys his groceries by writing an IOU that says “Acceptable for 1 oz. of rent on my land” then that IOU is backed by “rents receivable”, just like the government’s IOU’s (dollars) are backed by ‘taxes receivable’.

james b. longacre September 1, 2010 at 9:36 pm

If a landowner rents out his land for silver, and one day buys his groceries by writing an IOU….

as for inflation that certainly sounds inflationary. there is more media but the same land.

but the backing claims still seems nebulous to me. a receipt for actual gold or a receipt for a promise of gold. one doesnt seem like backing to me.

Mike Sproul September 1, 2010 at 10:53 pm

What’s so nebulous? One kind of IOU can be redeemed at the bank for 1 oz of silver. Another can be used to rent 1 oz. worth of land. As long as the bank and the landowner are able to cover their obligations, both kinds of IOU are worth 1 oz. And if the landowner increases his issue of IOU’s from 10 to 20, they will still be worth 1 oz each, as long as he has enough assets to buy back all 20 IOU’s for 1 oz. each.

Alex September 2, 2010 at 10:18 am

To Mike Sproul:
At capacity, an economy produces 100 coconuts each year. Thus real income is 100 coconuts. The price level throughout the year is $1/coconut. Total nominal production and income is $100. The government acquires 10 coconuts during the year. The government could employ a 10% income tax rate to acquire these coconuts. The public’s disposable income would then be $90 (or, in real terms, 90 coconuts).

Instead, the government could print up and sell bonds to the central bank, thus acquiring central bank deposits, upon which it writes checks to buy 10 coconuts. But, if the price level remains at $1 per coconut, with the public’s disposable income at $100 (remember, no income taxes in this case), the public would have the purchasing power to acquire 100 coconuts. This means the demand for coconuts is 10 (government demand) plus 100 (consumer demand) = 110. With the supply of coconuts 100, and with demand equal to 110, explain how this disequilibrium situation is eliminated without the price level rising.

Mike Sproul September 2, 2010 at 10:43 am

Alex:
Imagine the government sold those bonds directly to the public for 10 coconuts. Why are people willing to part with 10 coconuts for those bonds? Because the government has the ability to tax 10 coconuts from people to pay back those bonds. So in your first scenario, the public had $90 to spend on coconuts while the government (thru taxation) had $10. In the bond scenario, the public still has $90, since the government must tax them $10 to pay off the bonds, and the government still has $10 to spend.

Now suppose that instead of selling those bonds directly to the public, the bonds are sent to the central bank to be exchanged for 10 green paper dollars printed by the central bank. $10 of bonds goes in to the bank and 10 paper dollars come out. The public still has $90 of disposable income, since they will still be taxed to cover the bonds, and the government still spent $10, just in paper dollars instead of bonds.

What if the government didn’t levy taxes to pay off those bonds? Then the bonds would be worthless; nobody would give coconuts for them, and you’re back to the public having disposable income of $100, while the government has zero.

You didn’t ask, but if the public was already well-stocked with green paper dollars, then the extra $10 would immediately reflux to the central bank for bonds, and it wouldn’t be spent on coconuts.

Alex September 2, 2010 at 2:54 pm

“Imagine the government sold those bonds directly to the public for 10 coconuts. Why are people willing to part with 10 coconuts for those bonds? Because the government has the ability to tax 10 coconuts from people to pay back those bonds. So in your first scenario, the public had $90 to spend on coconuts while the government (thru taxation) had $10. In the bond scenario, the public still has $90, since the government must tax them $10 to pay off the bonds, and the government still has $10 to spend.”

No disagreement on this point!!!

“Now suppose that instead of selling those bonds directly to the public, the bonds are sent to the central bank to be exchanged for 10 green paper dollars printed by the central bank. $10 of bonds goes in to the bank and 10 paper dollars come out. The public still has $90 of disposable income, since they will still be taxed to cover the bonds, and the government still spent $10, just in paper dollars instead of bonds.”

Here is where you err. The interest on the bonds held by the central bank is remitted by the central bank to the government! Hence, there is no tax necessary for these interest payments. Consequently, as I stated in my example, the public has $100 disposable income to be all spent on 90 coconuts. The price of coconuts thus rises. The government taxes the public 10 coconuts in real terms when the government spends its newly created money on coconuts, but this tax is experienced by the public through inflation, that is to say, their $100 of disposable income has 10 coconuts less purchasing power.

Beefcake the Mighty September 2, 2010 at 4:09 pm

I think it’s much simpler than this. The first tax and bond scenarios are identical because in each case, the government takes money from the economy that cannot be spent on coconuts. In the tax case, this money is directly taken from the economy; in fact the govt could simply have levied the taxes *in terms of* cocunuts. In the bond case, people lend the govt money *instead of* buying cocunuts. Taxation (in the future) to repay these bonds is not relevant.

No resources are taken from the economy in the second example (when the central bank monetizes the debt). Both govt *and* citizentry can bid on the cocunuts, as you note. But again, this is because of the ex nihilo money creation, not the expectation of future taxation.

Alex September 2, 2010 at 4:56 pm

In the central bank-financed case, there is no expectation created of future explicit taxation, but this does not mean that there is no taxation. Taxation is the extraction of goods and services by the government from the public. As I said, the taxation occurs at the point in time that the government acquires the coconuts. The precise method of finance does not influence this fact.

The point about the central bank method of government spending finance is that the government still gets its 10 coconuts, leaving 90 coconuts to be acquired by the public for its nominal income of $100. Therefore I’m still interested Mike Sproul’s explanation of how this situation would not imply a market clearing price above $1 per coconut.

Beefcake the Mighty September 2, 2010 at 5:54 pm

Fair enough, but I think it’s helpful to distinguish between formal taxation (fiscal policy) and taxation through inflation (monetary policy). Both are indeed ways govt extracts resources, but it’s a bit of stretch to call them both taxation.

Alex September 2, 2010 at 6:25 pm

It isn’t a stretch at all. We do not have to examine the way government spending is financed to realize taxation has occurred. If you have something and the government acquires some of it, at that very instant you have been taxed. When the government acquires the 10 coconuts from the private sector at that very moment it has extracted a 10 coconut tax.

Mike Sproul September 3, 2010 at 10:34 am

Alex:

“The interest on the bonds held by the central bank is remitted by the central bank to the government! Hence, there is no tax necessary for these interest payments. Consequently, as I stated in my example, the public has $100 disposable income to be all spent on 90 coconuts. The price of coconuts thus rises. The government taxes the public 10 coconuts in real terms when the government spends its newly created money on coconuts, but this tax is experienced by the public through inflation, that is to say, their $100 of disposable income has 10 coconuts less purchasing power.”

Consider a few alternate scenarios:
1. The government buys coconuts directly with the bonds. The public keeps the interest on the bonds, but nothing weird happens. The bonds had a present value of $10 and so did the coconuts.
2. Same as above but the public returns the interest to the government. Again, nothing weird, just a transfer from the public to the government.
3. Those bonds are bought by private banks, who issue 10 of their own dollars in exchange. If those dollars cost nothing to issue, then the private banks would get that $10 free lunch you mentioned. But competition prevents this. If the dollars are issued costlessly, competition requires the banks to pay interest on them. This cancels the interest the banks got on the bonds, so here again the free lunch doesn’t happen.
4. The printing and handling costs of the private dollars use up the interest that the private banks earn on the bonds, so again there’s no free lunch, even though the private banks don’t pay interest on the dollars they issue.

Assuming the public gets the same use out of private money as they do out of government money, you are left with an inexplicable free lunch that the government supposedly gets when the central bank supposedly remits its profits to the government. The right answer is that the free lunch never happens, either because the central bank pays interest on its money, which burns up the bond interest, or the handling costs of the money burn up the interest earned on the bonds.

Alex September 3, 2010 at 2:51 pm

But why would I consider alternatives when, in fact, interest on government bonds held by central banks is remitted to the government (apart from the costs of operating the central bank, of course, but such costs may be considered as part of the 10 coconuts of resources the government acquired from the public)?

Again, here is my example. Please explain how your theory answers the question at the end of the second paragraph below.

At capacity, an economy produces 100 coconuts each year. Thus real income is 100 coconuts. The price level throughout the year is $1/coconut. Total nominal production and income is $100. The government acquires 10 coconuts during the year. The government could employ a 10% income tax rate to acquire these coconuts. The public’s disposable income would then be $90 (or, in real terms, 90 coconuts).
Instead, the government could print up and sell bonds to the central bank, thus acquiring central bank deposits, upon which it writes checks to buy 10 coconuts. But, if the price level remains at $1 per coconut, with the public’s disposable income at $100 (remember, no income taxes in this case), the public would have the purchasing power to acquire 100 coconuts. This means the demand for coconuts is 10 (government demand) plus 100 (consumer demand) = 110. With the supply of coconuts 100, and with demand equal to 110, explain how this disequilibrium situation is eliminated without the price level rising.

Mike Sproul September 3, 2010 at 8:30 pm

Alex:
If the central bank costlessly issues $100, while holding a 5% bond, then its apparent profit is $5, which it sends to the government. But if the inflation rate is 4%, then the real profit was only $1, and mailing $5 to the government makes the bank poorer. The profit was an illusion.

Note-issuing banks have historically not earned profits by issuing notes. They used to issue them mainly as a form of advertising, because the costs of printing and handling more than used up the interest. If this is the case in your scenario, there is no $10 profit to explain.

But to give your logic a chance to work, suppose that the central bank really does earn $10 interest on its $100 bond portfolio. This supposedly happened because the public is willing to hold $100 in cash that bears no interest. Why would the public do that? Because the public got at least 10 coconuts’ worth of liquidity by using the cash. In effect, the public has an extra 10 coconuts. Have you factored those extra 10 coconuts into your thought experiment?

Alex September 4, 2010 at 9:38 am

Mike, please keep checking. I’ll get back to you later today.

Alex September 4, 2010 at 11:18 am

“If the central bank costlessly issues $100, while holding a 5% bond, then its apparent profit is $5, which it sends to the government. But if the inflation rate is 4%, then the real profit was only $1, and mailing $5 to the government makes the bank poorer. The profit was an illusion.”

“Note-issuing banks have historically not earned profits by issuing notes. They used to issue them mainly as a form of advertising, because the costs of printing and handling more than used up the interest. If this is the case in your scenario, there is no $10 profit to explain.”

First of all, you are assuming inflation, even though you are arguing that increases in the money supply don’t cause the price level to rise. However, let’s neglect that for now. Just to simplify, neglect the costs of operating a central bank. The government sends the central bank $5 interest, which the central bank sends back to the government. So the net nominal and real revenue to the central bank regarding the interest is zero. If the inflation rate is 4%, the real value of the central bank’s assets (government bonds) decline by 4% per year but so do the real value of the central bank’s liabilities.

In any case, who cares about the “recorded” profit of a central bank? In my example, I don’t mention central bank profits. Such “profit” figures are totally without economic meaning anyway. In actuality, only the expenses of a central bank are real, reflecting the economic cost of resources used to operate the government’s creation.

“But to give your logic a chance to work, suppose that the central bank really does earn $10 interest on its $100 bond portfolio. This supposedly happened because the public is willing to hold $100 in cash that bears no interest. Why would the public do that? Because the public got at least 10 coconuts’ worth of liquidity by using the cash. In effect, the public has an extra 10 coconuts. Have you factored those extra 10 coconuts into your thought experiment?”

Once more, Mike, I didn’t mention any interest the central bank “earned” on its bond portfolio. As to why, please see my explanation above.

Mike, I would still like you to answer why the price level does not rise when the government issues money in my example. Let me simplify my example further to get to the nitty gritty.

At capacity, an economy of 10 families produces 100 coconuts each year. There is no money. Each family produces for its own coconut consumption.

All of a sudden a very powerful stranger arrives. This stranger is so powerful that he can enforce his will on the public. He calls himself “Government”. Government decides he wants 10 coconuts, but he doesn’t want to work to get them. Instead, he says he has created what he calls a “central bank” and he declares that I.O.U.s of this central bank, which each have $1 written on them, can be used to purchase coconuts. (By the way, he also prints up a zero interest, Government bond for the same $ amount as the I.O.U.s issued, which bonds he declares to be assets of the central bank, “backing” the I.O.U.s the central bank has issued.) Finally, he declares that henceforth these central bank I.O.U.s shall be called “money”.

As you can see, in this simple economy the usefulness of money is zero! But, Government further says that he wants a monetary-market economy. Consequently, he declares that from now on all coconuts will be bought and sold through a “market”. He (Government) will make sure that the price of coconuts will be such that the market will always be in equilibrium (that is to say the price of coconuts will be such that total village demand equals the available supply).

The villagers thus bring their 100 coconut harvest (10 coconuts per family) to the village square (where the market will operate). Government grants each family $10 market purchase credit for their 10 coconuts brought to the market. Government then creates $10 of central bank I.O.U.s (notes) and buys 10 coconuts. The $10 of central bank notes is put in the village square, just to the side of the coconuts.

There are now 90 coconuts left in the market and the villagers have in total $100 credit at the market. In order to have market clearing, Government must put on price tags of $1.11 on each of the 90 coconuts (more accurately $100/90 price tags). The villagers go home with 90 coconuts, using up all their market credit in the process. Remaining in the market is the $100 of paper money, in this example, of no utter use to anyone, but simply a tax receipt for 10 coconuts taken by Government.

It doesn’t matter what the government issued money initially is worth in terms of coconuts, the subsequent market clearing price must be higher.

Mike Sproul September 4, 2010 at 2:44 pm

Alex: First you said, as if it were a key part of your argument:

“The interest on the bonds held by the central bank is remitted by the central bank to the government!”
Which anyone would interpret as a reference to the fact that central banks traditionally hand over their ‘profits’ to the government treasury.

But then you said: “who cares about the “recorded” profit of a central bank? In my example, I don’t mention central bank profits. Such “profit” figures are totally without economic meaning anyway. In actuality, only the expenses of a central bank are real, reflecting the economic cost of resources used to operate the government’s creation.”

I’m with you on the fact that those profits have no economic meaning, but anyone would be left scratching their head over just what you meant.

As for your powerful stranger: Obviously, he arrived and stole 10 coconuts, whether directly or by monetary sleight of hand. So coconuts became more expensive, the end.
Now let me ask you to solve a puzzle: Some town has 100 apples, 100 bananas, and 100 square feet of land, and in a purely barter economy they all trade 1 to 1, except that when people trade land, the thing they physically trade is a paper deed to the land. Those deeds, being easier to carry than apples and bananas, are sometimes used as money by people who otherwise would have bartered apples and bananas directly. This monetary use of land has no effect on land’s value.

Now it should be clear that the value of a deed is the same whether 10 deeds or 100 deeds are circulating. I would even assert, and you might disagree, that people could issue paper IOU’s, backed by apples or bananas, but denominated in land, and those could be added to the money supply without affecting any prices.

Now let the government come along, and let it take 10 deeds by any means–taxation, borrowing, bond issue, money creation, etc. I say that the effect on relative prices will be approximately zero, but more specifically, the effect will be no different, whichever method of ‘taking’ is used.

Sorry, but things are piling up at work. My comments will be a little less prompt than usual.

Alex September 4, 2010 at 4:22 pm

“I’m with you on the fact that those profits have no economic meaning, but anyone would be left scratching their head over just what you meant.”

If I was initially unclear, I apologize. But, now that I have been clear, we agree on this point, so don’t need to discuss it further.

“As for your powerful stranger: Obviously, he arrived and stole 10 coconuts, whether directly or by monetary sleight of hand. So coconuts became more expensive, the end.”

So you do agree that increases in the money supply raise prices. I thought you did not.

“Now it should be clear that the value of a deed is the same whether 10 deeds or 100 deeds are circulating.”

It is absolutely not clear! In fact it would not be the case at all. If there are 10 deeds representing ownership of 100 square feet of land, on average each deed represents ownership in 10 square feet of land. If there are 100 deeds for the same 100 square feet of land, on average each deed represents 1 square foot of land. Therefore, in the two different cases, the average value of a deed in terms of apples or bananas would likewise be different.

“I would even assert, and you might disagree, that people could issue paper IOU’s, backed by apples or bananas, but denominated in land, and those could be added to the money supply without affecting any prices.”

So let’s see. Someone has 1,000 bananas. Suppose 1,000 bananas trade for 1 sq. inch of land or 1,000 apples. So the person issues a paper IOU for 1 sq. inch of land. (Let’s ignore any deterioration in the bananas.) In this instance, assuming full faith in the willingness of the person to redeem the IOU for the bananas (or land actually), there would be no impact on the relative price of apples, bananas and land, and the IOU would trade for 1,000 bananas, 1,000 apples or 1 sq. inch of land. So I agree with your contention.

“Now let the government come along, and let it take 10 deeds by any means–taxation, borrowing, bond issue, money creation, etc. I say that the effect on relative prices will be approximately zero, but more specifically, the effect will be no different, whichever method of ‘taking’ is used.”

Total agreement! Relative prices (of apples, bananas and land) may be unaffected. However, if the government (as in my earlier coconut example) issues bonds, carts them to the central bank, thereby acquiring deposits at the central bank, which it then spends on apples, bananas and land, etc., the average prices of these goods will rise (as shown in my coconut example, which you said you agreed with above). As I say, you now seem to agree with the contention that normal increases in the money supply (backed by government bonds on the asset side of the central bank’s balance sheet) increase the price level. I thought this point was the original bone of contention with you.

Mike Sproul September 4, 2010 at 4:54 pm

Alex:
“So you do agree that increases in the money supply raise prices. I thought you did not.”
I don’t. I agree that if that theft makes coconuts scarcer, their price will rise. But I assert that when some entity issues new liabilities, and acquires assets of equal value in exchange, and stands ready to use those assets to buy back its liabilities, then the value of those liabilities is unaffected.

“It is absolutely not clear! In fact it would not be the case at all. If there are 10 deeds representing ownership of 100 square feet of land, on average each deed represents ownership in 10 square feet of land. If there are 100 deeds for the same 100 square feet of land, on average each deed represents 1 square foot of land.”
That’s not what I meant. There are 100 square feet, and 100 deeds each claiming 1 square foot. Each deed might circulate as money, or it might sit in a drawer. If 10 circulate and 90 sit, or if 100 circulate and none sit, the value of each deed is 1 square foot.

“if the government (as in my earlier coconut example) issues bonds, carts them to the central bank, thereby acquiring deposits at the central bank, which it then spends on apples, bananas and land, etc., the average prices of these goods will rise ”
The bonds would have to be payable in apples, bananas, or land (deeds). I think your example would be clearer if you combined the central bank with the government. The central bank is just the money-issuing branch of the government anyway. So if the government wants to buy 10 apples, it could issue 10 bonds, each worth 1 square foot, and buy them. Since people will be taxed to pay off the bonds, total spending is unaffected. If the government had instead printed 10 bonds which it handed to itself for 10 units of money, which it then used to buy 10 apples, then people will be taxed as before to pay off the money (instead of the bonds), and total spending is still unaffected.

Alex September 4, 2010 at 7:59 pm

“I think your example would be clearer if you combined the central bank with the government. The central bank is just the money-issuing branch of the government anyway.”

Yes, you are right. Let’s do that.

The government issues $10 of new government bonds to its Dept of Central Bank, receiving a $10 deposit at the Dept of Central Bank, which deposit it spends buying 10 coconuts harvested by the village families. At this point there are 90 coconuts left in the market and the consolidated balance sheet of the Government (including the Dept of Central Bank) is as follows:

Consolidated Balance Sheet
Government (including the Dept. of Central Bank)

$10 (10 coconuts) $10 Notes (issued money)

(Since this is a consolidated balance sheet, the bond assets of the Central Bank department cancel the bond liability of the Government)

Now, of course, the 10 coconuts are eaten up by the government – by civil servant pensions, given away to foreigners, etc., leaving only the $10 note liability (which the government has no intention of redeeming for any goods in the future anyway, so the item is irrelevant).

Leaving the Government and Dept. of Central Bank’s balance sheet, we now are still left with 90 coconuts of supply to be matched with $100 of demand. The market clearing price level will be $100/90 per coconut.

Mike Sproul September 4, 2010 at 11:01 pm

“the 10 coconuts are eaten up by the government – by civil servant pensions, given away to foreigners, etc., leaving only the $10 note liability (which the government has no intention of redeeming for any goods in the future anyway, so the item is irrelevant)”

In that case, people would not have voluntarily handed over 10 coconuts for the $10. Now, if the government was going to collect 10 coconuts in taxes already, and if it then issued $10, declaring that those $10 are acceptable for coconut taxes, then people would accept the dollar notes, and that’s been the normal historical method of issuing notes. But of course, this way there’s only $100 being spent on 100 coconuts.

Alex September 5, 2010 at 9:38 am

Shall answer later. Have to go out for rest of the day.

Alex September 5, 2010 at 2:11 pm

“In that case, people would not have voluntarily handed over 10 coconuts for the $10. Now, if the government was going to collect 10 coconuts in taxes already, and if it then issued $10, declaring that those $10 are acceptable for coconut taxes, then people would accept the dollar notes, and that’s been the normal historical method of issuing notes. But of course, this way there’s only $100 being spent on 100 coconuts.”

But, government fiat money never comes into being on a voluntary basis on the part of the public, but rather by government dictum.

For example, suppose, as before, that the village produces 100 coconuts each year, but the villagers do use money in the form of 100 unique unbreakable shells. There are no other such shells that could possibly be found. Hence, the money supply is fixed. Anyway, let us assume there is no economic value to any additional money (no further transactions efficiency could be achieved with any more money in existence). As before, the villagers wish to save for future consumption.

The villagers produce for a co-op that pays the villagers 1 shell per coconut harvested. The villagers then use their wages (in shells) at the end of each year to purchase the coconuts they want to consume during the upcoming year. The price of coconuts at the co-op is 1 shell per coconut. So, each year 100 coconuts are brought to market (the co-op) and villagers use their 100 shell money income to buy 100 coconuts for consumption, the co-op ending up holding all money balances at year-end.

Now, along comes Government (with his Dept. of Central Bank) and dictates that all shells must be turned in to the Dept. of the Central Bank for non-redeemable dollar ($) paper notes in the ratio 1 shell=$1. Henceforth, all prices shall be denominated in $, not shells. At this time, coconut market equilibrium prices would be $1 per coconut.

Consolidated Balance Sheet of Government (including Dept. of Central Bank)
100 shells $100 liability for notes

Government then decides to issue $10 more paper notes (backed by Gov bonds held on the Dept. of Central Bank’s balance sheet) which it spends on coconuts.

The consolidated balance sheet of Government (including Dept. of Central Bank) would then be:

100 shells $110 liability for notes

First, let us assume that the market (the co-op) does not change the price of coconuts when Government makes its purchase. Now, what is the situation in the non-Government sector? If the price of coconuts remains at $1 per coconut, the demand for coconuts on the part of the villagers will be 100 ($100 money in the hands of the villagers/$1 per coconut). But the market’s (co-op’s) remaining supply of coconuts is only 90. To satisfy the $100 villager demand for coconuts, the co-op will have to price the coconuts higher, at about $1.11.

The other possibility is that when the Government prints and spends this other $10 of money, the market (the co-op) realizes that there will now be $110 ($100 of money already in the hands of the villagers plus this additional $10 of Government’s newly created money) demanding (chasing) 100 coconuts. Therefore, unless Government institutes price controls on the co-op, the co-op would complete the sale of coconuts to the Government at the same price the villagers would have to pay, that is $110/100 coconuts=$1.10.

Anyway you slice it, increases in the money supply increase the price level.

Alex September 5, 2010 at 4:59 pm

Mike:

In my prior comment, I meant to say: As before the villagers DO NOT wish to save for future consumption.

Gerry Flaychy September 5, 2010 at 6:05 pm

“According to Mr. Bernanke, money, properly defined, must exhibit three characteristics: it must be a medium of exchange, a unit of account, and a store of value.[2] The US paper dollar certainly meets the first two requirements but it fails miserably on the last.”

According to Ludwig Von Mises, it is very different. See http://mises.org/easier/M.asp#41

Gerry Flaychy September 5, 2010 at 7:29 pm

See also: «3 The “Secondary” Functions of Money» at: http://mises.org/books/Theory_Money_Credit/Part1_Ch1.aspx#_sec3

Extract: “Many investigators imagine that insufficient attention is devoted to the remarkable part played by money in economic life if it is merely credited with the function of being a medium of exchange; they do not think that due regard has been paid to the significance of money until they have enumerated half a dozen further “functions”—as if, in an economic order founded on the exchange of goods, there could be a more important function than that of the common medium of exchange.”

james b. longacre September 5, 2010 at 11:54 pm

do you believe that to be true?

stewart1 April 28, 2011 at 12:34 pm

Ostensibly 97% of all income taxes revenues upcoming from the top 50% of income earners is not sufficiency “sharing”, according to the guy who’s understood money, for decades, off the backs of people who succeed for a experience.
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stewart1

Joe October 5, 2011 at 12:28 pm

Presuming the US gov pays its bills (ie services the debt) then the dollar is a store of value. Gold changes prices the same as the exchange rate does.

The myth of the gold standard really amuses me sometimes. The dead hand of Colbert…

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