Inflation or deflation? Dow 1,000 or wheelbarrow money? FULL ARTICLE by Robert Blumen
Source link: http://archive.mises.org/15848/deflation-confusion-money-is-not-credit/
Deflation Confusion: Money Is Not Credit
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Good article, Mr. Blumen, clearly explaining an important distinction between money and credit. I have a question: What is gold’s status under the present monetary systems? (I intentionally use the plural to include the various nation’s systems.) Is it money, or is it just another commodity?
More and more gold is again–if it ever stopped–being used as money, both as a store of value and a medium of exchange. Gold’s peculiar properties make it exceedingly difficult to impossible for governments and others to counterfeit, as governments routinely do with their paper currencies by printing more of it. One may not yet be able to take a one-ounce bullion coin into Walmart and be able to spend it, but you can certainly do just that in some places throughout the world including places (my friend’s store, for example) in the U.S.
It is my belief that gold will in due course supplant fiat currencies in exchanges and international settlements–not by government decree but by virtue of market forces. Markets like nature abhor a vacuum, which in this case is the need of the market for a monetary unit not subject to government inflation.
I provide my view on what is gold in this article Is Gold Money?.
Thanks for your response. And the article you reference is a beauty too.
Money as a liabilities doesn’t require fractional reserve banking. Let’s assume that an individual deposits $1,000 in gold in a bank, and in exchange that bank gives that individual a note redeemable in $1,000 in gold. Let’s assume that this bank practices full reserve banking. The note (money substitute) is still a liability, while the gold is an asset.
Your example is correct provided that the deposit goes on the bank’s balance sheet. Under most constructions of 100% reserve banking, at least by Austrian writers, the deposit is not an asset of the bank nor is the bank note a liability. The deposit is still the customer’s asset held in custody by the bank. Under FRB the deposit is considered a loan to the bank and the bank note is a liability. Now logically I guess you could set up a 100% reserve bank in which the deposit was a loan but what would be the point of that? If the customer is loaning money to the bank aren’t they going to want interest in return? And why would the bank borrow the deposit if not to loan it out?
Even if the gold weren’t loaned out, the note would still represent a liability. There are many ways a bank can lose gold in its warehouse, including robbery, et cetera. The note still represents a liability the bank may one day have to deal with.
Btw, whether or not the gold is reloaned doesn’t depend solely on the fact that the bank practices fractional reserve banking (at least, under a free frb regime). It actually has little to do with the amount of gold in reserve, and more to do with the volume of returning liabilities at any given point in time (see this “article” of mine: The Theory of Free Banking“).
In accounting terms, the note does represent a liability. Since the customer is not physically placing the gold into a private vault with his own key, the bank or other organization that stores the gold for the customer must keep record of this gold. It takes on temporary custody of this gold and issues a note to represent that it belongs to the customer. This is accounted for in the liabilities side of the equation: A = L + OE. Gold on account is still a bank asset because the customer isn’t getting or using the specific ounces that are deposited originally. 1oz of gold is 1oz of gold, as long as 1oz is returned, the identity of that 1oz is meaningless. If the bank foolishly breaks the 100% reserve requirement, they’re still obligated to return that 1oz of gold back to that individual. It’s a liability because the bank has to take an active role in providing the gold to the depositor.
The only way to get around calling the gold an asset (albeit one that is not permitted to be used for any purpose) and assigning a counterbalancing liability is to rent a safety deposit box and store your gold there. That way, the bank never truly takes posession of your gold and will no longer refer to it as a liability. The bank is passive in the entire process, merely providing rentable space and security, leaving the customer to provide all accounting of the contents of the box and the customer takes full burden of deposits and withdrawls at every step.
To the Mr. Capitalist referenced in Mr. Blumen’s article I post the following question: If “cash … is really just a very very liquid government liability,” then what is the government obligated to pay the holder of cash? Obviously, the answer to this question is that the government is not obligated to pay the holder of cash anything. Compare this to the obligation involved with government debt instruments, e.g., Treasury bills, notes, or bonds: typically, the government is contractually obligated to pay the holder of the debt instrument at certain times interest and principal payments of cash.
In addition, as Mr. Blumen has emphasized, government debt instruments are not cash, i.e., money, because they are not the generally accepted medium of exchange/means of final payment.
Wouldn’t defaulted upon debt be an example in which credit is used as a final form of payment for a ham sandwich? (Someone who uses a credit card with no intention of paying the bill)?
Also, if it is a mistake for Prechter to aggregate money and credit in making his deflation argument, wouldn’t it also be a mistake to aggregate M0, M1, M2, and M3, refering to all of them as “money” in making the inflation argument? What would happen if the general public suddenly decided that they really wanted to keep their money at home rather than in the bank? Since there is only about $930 Billion in US currency in existence (70% of it overseas), what would be the impact on M1, M2 and M3?
@Steve P
I might change my mind about this after more thought but I think you are correct that paying with an IOU is an exchange of credit for a good. I’m not sure though that is what happens with a credit card. I think that with a credit card, the bank advances the money to the merchant and the card holder becomes indebted to the bank.
If you mean that the Ms are not a good measure of money because they contain a lot of things that are credit, not money, I think you are right about that. Mike Pollaro does a great job covering exactly that issue over at his Contrarian Take blog.
If the public withdrew all of their funds, banks would have to shrink their balance sheets which would contract the money supply. Or possibly if people “suddenly decided” to do this, the banks would quickly run out of currency and then cease to allow further withdrawals.
This is a rather convoluted debate, but here goes: In defense of Prechter.
Again, it’s the term “money” that is used by Prechter. As far as I can discern, he means – quite literally – the physical federal reserve notes that you put in your pocket and nothing else. When Austrians say money, we include ‘money substitutes’, Prechter does not. He always says “what I call money isn’t what other people call money”. When he talks about a collapse, he principally refers to a mass retirement/extinguishment of money substitutes (and hence credit). He says that “you won’t be able to get your money out of the bank”. That is the essence of his argument. When he says IOU money: he means ‘money substitutes’. He is also quite prepared for debauched monetary policies to follow his potential scenario; the matter of contention is timing. My guess is that he’ll join the Austrians soon enough; only, he’ll be able to buy us all several times over at that point.
To summarize: he doesn’t really say that Money + Credit ‘counts’ in the way that Austrians think of money and credit. What he’s saying is that Physical Federal Reserve notes + Electronic Demand Deposits ‘count’, and that those demand deposits are going to go up in smoke. Only as a corollary does he think that credit will collapse. Looking at money supply figures it’s clear that money substitutes dwarf physical federal reserve notes…. so if there are no money substitutes left, those remaining physical federal reserve notes are going to rise in value.
I understand that Prechter thinks that there will be a collapse but my read of him is that he counts money+credit together as one kind of thing and that one big thing is what he thinks that will collapse. He is partially correct about this — the credit could and probably will collapse. This would be the subject of a longer article, but monetary deflation and credit collapse are not exactly the same thing. A credit collapse puts pressure on banks to shrink their balance sheets – which is true deflation. But non-bank credit defaults per se does not have any direct impact on he money supply. My problem with Prechtor is that he makes the wrong kind of aggregation.
Understood, I guess sometimes he may be guilty of doing that. The temptation to do so must be pretty high when ‘explaining’ quantitative easing – as that ‘explanation’ nicely corroborates his view.
Nevertheless, I’d still like to emphasize that he says things like; “people who think they have money, are going to find out that they never had any”. He’s speaking from a market psychology point of view: meaning, when people find out the truth – that credit isn’t money (as you lucidly describe) – they’ll be rushing to swap things for real money. When everyone rushes for the exit at the same time, the squeeze on the ‘short physical federal reserve notes’ trade could be enormous. That ‘short physical federal reserve notes’ (and long things) trade is gigantic in its proportions – in time, participation, conviction and size.
i liked steve saville’s take on the hyperinflation/default resolution.
http://www.safehaven.com/article/18601/inflation-and-treasury-bonds
http://www.safehaven.com/article/19070/inflating-the-debt-away
Robert:
“The value of each unit of money rises only when there is less money or more demand for existing money. A change in the volume of credit will affect relative prices but it will not affect the overall value of each money unit in a systematic way.”
You’ve got me wondering which side you’re on. The backing theory says that when private banks issue more credit (i.e., checking account dollars), it will not affect the value of the base money (i.e., paper dollars). I wonder if you’d agree when the backing theory goes on to say that if private banks lose assets, their checking account dollars will lose value, while the paper dollars will be unaffected.
Or what if the paper dollars are only issued for 1 year, at the end of which the government will buy them back with whatever assets it has. The government might have initially issued $100 paper against 100 oz of silver, intending to use the silver to buy back the dollars after 1 year. If the government then issued another $200 in exchange for 200 oz. worth of land, and if the government really will use the land and the silver to buy back the paper dollars after 1 year, would you say that the extra $200 will cause inflation or not?
@Mike
Forgetting about banks for the moment, pure credit transactions by non-banks do not affect the money supply or money demand in any systematic way. A credit transaction is a transfer of existing money in return for a promise to pay the money back. For example, if you loan a friend $100, the money supply has not changed, only who owns some of the existing money has changed. If your friend defaults on the loan then the money supply still has not changed.
When fractional reserve banks get involved things are more complicated because the credit transaction creates new demand deposits which are spendable. A pure non-bank credit transaction shifts around existing money but it does not create new money. That is the difference.
It depends on whether the government did make a good investment and can actually sell the silver + land for $300 on the market. If it can do so and then destroys those paper dollars, it would not cause inflation. If it could turn a profit it even made the economy better off.
Of course that’s not what’s happening in reality, where the Central Bank is buying stuff in order to prop up its prices (government bonds, “troubled assets”, etc.), so it does not have the means (assets) to drain all the excess credit from the system, even if it tried.
iya:
Your answer puts you at odds with Blumen and company, who seem to think that the assets of the central bank are irrelevant to the value of the money it has issued. All that counts, on their view, is how many paper dollars the fed has issued. Whether the Fed has enough assets to buy back those paper dollars seems to count for nothing.
Credit:
1. “a sum of money due to a person; anything valuable standing on the credit side of an account: He has an outstanding credit of $50.”
2. “any deposit or sum of money against which a person may draw.”
Debt:
1. “something that is owed, such as money, goods, or services”
2. “the state of owing something, esp money, or of being under an obligation”
Therefore debt is NOT credit but either debt or credit may be money. If one is changing commonly held definitions one ought to say so and clearly define the usage of the terms.
Unfortunately neither yourself nor Prechter (nor other prominent commentators) actually define exactly what you mean by “money” and “credit”. I believe Prechter has some valid points, but he is let down somewhat by the vague terminology, which also leads him to some errors. Your article also contains a grain of truth, but suffers from similar definitional problems. I believe this plagues Austrian economics generally but could be cleaned up without unduly affecting the theory.
In actual fact, the term “money” cannot be said to have one clear definition, as it is used by so many to mean a variety of different things.
It is possible to describe some of the causes and effects bearing on inflation and deflation without using the term “money” at all, and I believe if commentators took this approach a greater degree of clarity would be achieved.
In terms of commercial bank deposits, these can indeed be created when a bank lends, and so any reduction in total outstanding credit owed to banks (e.g. through paying down of debt) may reduce total commercial bank deposits.
Therefore your statement “The key point is that prices are formed with money because money is the final means of payment for goods, while credit is not”, if rephrased as “The key point is that prices are formed (in part) with commercial bank deposits because commercial bank deposits are the final means of payment for goods, while commercial bank credit is not”, is not very helpful. Actions that reduce outstanding commercial bank credit (e.g. by paying down of debt), may reduce the total amount of commercial bank deposits.
i.e. the causal chain is “Bank debt paid down” may lead to “Reduction in commercial bank deposits” which may lead to “Deflation”. I explain this further below, but first a little on the purchase of Treasuries by the Fed.
Regarding your paraphrasing of Prechter: “To summarize Prechter’s point, when the public’s holding of Treasury debt is replaced by holdings of dollars…, no net inflation has occurred because the volume of money plus credit has not changed.”, this is worth examining in more detail.
The Fed does not purchase Treasury debt directly from consumers, but from large financial institutions. If we examine what actually occurs in such a transaction (assuming the large financial institution is a commercial bank), we go from:
Govt owes Bank $x at y%
To:
Govt owes Fed $x at 0%
Fed owes Bank $x+i+j at z% (where x+i is the previous market price and j is the premium that the Fed pays over the market price).
Commercial bank deposits are not affected in this case, but “High Power Money” is increased by $x+i+j. This High Power Money will only have an inflationary effect if the bank is reserve-constrained, but this is rarely or never the case in today’s environment. There is however the inflationary impetus of the government being able to get away with borrowing more due to the lowered interest burden.
So there is an inflationary effect, but the degree of the effect will depend on circumstances. I would argue that as of today, with the Fed monetizing an amount roughly equal to all new issuance, that the inflationary effect of this is roughly equivalent to a helicopter drop of $x.
i.e. I would agree with you and disagree with Prechter on this point, as things stand today. (Note: I agree with you on the effect, but I think our opinions regarding the actual mechanism would be different).
What we have at the moment is the Fed trying to offset private credit destruction by facilitating public credit creation. In this, the essence of Prechter’s main thesis is correct.
I mentioned above that the paying down of bank debt “may” lead to a reduction in commercial bank deposits. I will elaborate further:
If we examine the case where a consumer pays down debt, the effect can vary depending on how he is able to pay down the debt.
Take a situation as follows:
Consumer A owes Bank $x
Bank owes Consumer B $y (Commercial Bank Deposit)
Consumer A produces goods and sells them to Consumer B for $z, and with the proceeds pays $z off the loan principal. Now the state of play is:
Consumer A owes Bank $x-z
Bank owes Consumer B $y-z
In this case, total commercial bank deposits have been reduced, and there is therefore a deflationary effect.
However if we take the situation where Consumer B uses a credit card to pay for the goods, we go from:
Consumer A owes Bank $x
to:
Consumer A owes Bank $x-z
Consumer B owes Bank $z
In this case there is no effect on total commercial bank deposits, and no deflationary effect.
The difference can be boiled down to the effect of the transaction on “total net credit held by net creditors”.
In the first case, Consumer A starts as a net debtor. The Bank starts as a net creditor to the tune of $x-y. Consumer B starts as a net creditor to the tune of $y. Total net credit held by all net creditors is $x-y+y = $x. After the transaction, the Bank’s net credit is $x-z-(y-z) = $x-y. Consumer B’s net credit is $y-z. Total net credit held by all net creditors is $x-y+y-z = $x-z. Total net credit held by net creditors has been reduced by $z.
In the second case, the bank is the only net creditor before and after the transaction, and its net credit is $x before and after the transaction. Total net credit held by net creditors is not affected.
I believe Prechter’s position makes sense if rephrased as “inflation is an expansion in the total net credit held by all net creditors”, rather than “inflation is an expansion of total money and credit”.
The effect is not limited only to commercial bank deposits. To oversimplify (a lot), if I buy an MBS, and the borrower buys a house previously owned free and clear by a net creditor, the seller’s net credit increases while mine stays the same. Total net credit of net creditors increases, and the effect is inflationary. Again, not all MBS issuance is inflationary, but MBS issuance that increases the total net credit of net creditors is. Here the inflationary effect impacts house prices directly, but also can flow on if the seller consumes goods sold by other net creditors.
I believe if they forget the term “money” and focus on credit, defined as “who owes what to whom”, with a particular focus on “total net credit of net creditors” the antagonists in the “inflation vs. deflation” debate can find a little common ground rather than taking the endless potshots at one another that achieve little.
Interesting analysis. Could you explain what you’re talking about?
Sure, which part do you need clarification on?
The parts where you used signs, symbols and math formulas instead of English.
OK – before I rewrite to remove those, can I just check – are you having trouble understanding because of these, or do you have a philosophical objection to the use of signs, symbols and math? If I replaced the symbols with numeric examples, and the signs and formulae with equivalent English sentences, would that help?
I believe that in our current socio-political ecosystem, “heat” represents a lot more value than gold.
WE my soon get to see who’s right. A lot of people forget or doesn’t know the FED just doesn’t “print money”. They have to write an I.O.U. first. That’s a big differance as to what happened in Zembabwe and other run away hyperinflation countrys. Also Bob postulates that the WHole sytem will collapse BEFORE hyperinflation begins.The True hyperinflation.
Nice article. One small comment: even Credit is not Born Equal. Most of the existing credit is only extended to allow securing of the specific things it was granted for. Then some universal kinds, like the ones that grow on our credit cards can be used to secure end-user goods quite directly.
The extent of “moneyness” of each credit form depends on to what extent the acting humans accept it for the purpose of indirect exchange. The same holds true for banknotes, coins, silver, gold, shells, cigarettes or any other thing people are willing to use under given conditions for this purpose.
The attempts to classify money and credit cleanly, from a SimCity-like perspective, then look a bit futile. Unless one gets to know all the present and future whims of all the acters involved, of course.
I believe the main differnece between the austrian perspective and Prechter’s perspective is that austrians seems to believe that FED is stupid enough to self destruct. If things play out as Austrians predict, (and I’m generalizing here) Bernanke will print boatloads of money to the point the dollar will become essentially worthless and we will all be living through a hyperinflationary holocaust. If that were to happen, as the austrians believe is a possibility, then the FED will have destroyed their monopoly of money creation and their stranglehold over the monetary system will not longer exist. Prechter seems to take a different approach. He believes the Keynesian financial elitists at the Fed are smart enough to avoid self destruction.
As was stated in the article, and I think we all can agree, the credit supply completely dwarfs the money supply. Most purchases in our debt-based monetary system are made with credit. Not money. Similarly, the massive amount of debt-deleveraging that is going on around the world should be apparent to all. Debt-delveraging clearly has deflationary effects. So what the Fed is doing by printing money, is hoping to offset the deflationary pressures created by all this debt deflation. If the Fed were to successfully offset these pressures, they would have to print 10s of Trillions of dollars (or more) which simply is’t politically feasible. We have no doubt witnessing the Fed creating massive sums of money with their bailouts, TARP, QE 1,2 etc. Prechter is just betting that in the end it won’t be enough. Eventually the debt must be repaid or defaulted on. Both of which make the Fed rich, either through default (deflationary situation which money simply disappears) which increases the value of the Feds remaining reserves, or through the collection of interest on those debts which adds to the nominal value of the Feds balance sheet.
I enjoyed your article, but I still think prechter’s view hold more water. Under normal economic conditions, if the Fed embarked on the kind of monetary insanity they have experiences over the past 3 years, we would likely be well on our way toward the inflationary holocaust austrian endgame. However, the fact that the CPI has been extremely low or even negative at times during this period lends credence to Precter’s view concerning the deflationary effects of credit contraction on a massive scale.
Furthermore, the fact that interest rates have remained at zero for so long more accurately reflects the demand of credit drying up than it does the beginning of inflationary dangers or the fed stubbornly manipulating interest rates. Nobody wants to borrow money with record low interest rates. Just think about it. If we had screaming demand for credit with 0% interests rates, then austrian inflation warnings would posess more credibility. But at the moment we have very sparse credit demand, so I think Prechter’s assertion that deflation is a more likely probabily holds.
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