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Source link: http://archive.mises.org/7258/the-rule-of-planned-money/

The Rule of Planned Money

October 4, 2007 by

There is a long history of monetary experience, writes Garet Garrett. It tells us that government is at heart a counterfeiter and therefore cannot be trusted to control money, and that this is true of both autocratic and popular government. The record has been cumulative since the invention of money. Nevertheless it is not believed.

There is also a history of sound money, and if its lessons are likewise disregarded, what shall one conclude but that monetary delusions are, by some strange law of folly, recurring and incurable? There was a century of sound money. During one hundred years preceding World War I, government touched money hardly more than to establish standards of weight and measure, to lay down the laws of liability and to license bankers. In that century the wealth of the world increased more than in all preceding time of economic man. FULL ARTICLE

{ 168 comments }

jean paul October 9, 2007 at 5:01 pm

Person says: “in a growing economy, each dollar (or unit of labor) should purchase more of the same units of what it did previously.”

I think that is wishful thinking more than it is truth.

If the economy consists of my one field of corn which has a constant yield, plus my neighbor who doubles his yield each year, plus some set of consumable goods, my purchasing power for those consumables in terms of corn is going to go down over time, because my neighbor can always outbid me, by an increasing margin.

You could absolutely say that corn is inflationary in this situation, but you cannot lay any kind of attack against my neighbor for any wrongdoing in inflating the corn supply.

Money is just a proxy for goods of real value. Goods of real value are naturally inflationary and deflationary. Money will refelct this.

In a growing economy, you have wealth being created out of thin air. This is wealth inflation. Money is just a proxy for wealth in other forms, and will experience the same inflation.

JIMB October 9, 2007 at 5:07 pm

jp – If money is the proxy for tradeable goods, money can only depreciate (i.e. inflation) if money is in excess supply compared to tradeable goods.

JIMB October 9, 2007 at 5:17 pm

That last post was for Jean Paul …

Jean Paul October 9, 2007 at 5:25 pm

There’s a JP and a Jean Paul and we are not the same :)… in fact we are arguing opposite sides of the point… confusing!

Jean Paul October 9, 2007 at 5:37 pm

“money can only depreciate (i.e. inflation) if money is in excess supply compared to tradeable goods.”

This is precisely the point of the RBD. On a bank-transaction by bank-transaction basis, an RBD-conformant trade is not inflationary IF the pre-trade value of the money issued is not in excess of the pre-trade value of the asset retained. The pre-transaction and post-transaction valuations of any dollar against any asset will remain constant.

If the bank makes a bad trade, that means it gave away excess money for what the backing asset was worth, and the bank’s money depreciates.

If the bank makes a good trade, that means it issued less money than the asset was worth, and the dollar appreciates.

Jean Paul October 9, 2007 at 5:52 pm

I think it’s very intuitive to see that a caveman with 5 carrots is a wealthy man – king for a day among his carrotless peers. The wealth he posesses may bid away almost any other good, labor or otherwise, in the primitive economy.

Whereas today, the same man with the same 5 carrots is relatively impoverished. That’s because value substitutes were created – out of thin air – in everyone’s pockets around him while he clung to his precious carrots. His is no poorer than before, materially – but his economic power has shrunk, because everyone else is relatively less desperate for the marginal value gained from a carrot.

jp October 9, 2007 at 5:52 pm

“If the bank makes a bad trade, that means it gave away excess money for what the backing asset was worth, and the bank’s money depreciates.”

That’s a very mechanical description which I don’t think the RBD merits. Don’t the users of the currency have to percieve that the backing assets are worth less than the money oustanding before they can bid the price of money down? In other words, the bank’s money doesn’t magically depreciate in value – a process of perception, analysis, and communication must ensue in order for depreciation to occur.

If no one notices that a bank mades a bad trade, ie. that it gave away excess money for what the backing asset was worth, than the depreciation wouldn’t occur, no?

Jean Paul October 9, 2007 at 6:21 pm

JP,

Of course there is a latency from the point of action to the point of feeling its effects. This is true of all things. When I pull the trigger on a gun, I set into motion some course of events that will unravel in due course – inevitably, save for the willful interventions of others after the fact (e.g. dodging the bullet or pushing something in its path to intercept it, etc.)

If no one notices (yet) that I pulled the trigger and the bullet is in the air – doesn’t matter. Someone will notice soon. At this point it is inevitable that something is getting hit with that bullet. It’s just a question of what direction it was aimed in.

Same with the banking txn. The trajectory of the economy is either deflected or not when an RBD bank issues money. If it does its job very well, the txn will contribute a deflection toward dollar appreciation, to balance out all the times when the bank gets it wrong.

The problems is really that value is subjective and so no bank can truly have any impact on anything, whether to cause nor to cripple inflation.

JIMB October 9, 2007 at 6:22 pm

Jean Paul – Except, RBD stipulates not only tradeable goods, but issuing money against untraded (or less frequently traded) goods. That is inflationary.

Jean Paul October 9, 2007 at 6:51 pm

JIMB,

RBD stipulates that money should be issued in exact measure, value for value, in exchange for some asset, in order for the transaction to be inflation-neutral.

If more or less value is issued, the transaction will not be inflation neutral.

So the RBD is not undone because some particular trade is inflationary. The RBD states the conditions where inflationary trades occur. If inflation is observed, the RBD simply concludes that the net of millions of transactions has been to issue more money than the retained assets were worth, as valued by the market.

There are two reasons a bank today may claim to be following RBD yet be inflationary:
1. They’re doing it wrong by accident
2. They’re doing it wrong on purpose

The first is totally possible. Aggression introduces noise into market signals, and prevents corrections, in some cases stressing things to a breaking point. In a market befouled by aggression, the best-intentioned bank may find it difficult to invest profitably.

The second is really a consequence of the corruption aggression brings. With a monopoly currency, the values of the consuming public (the money users who desire an appreciating currency) need not be reflected in the bank’s actions. Making valueless, extremely risky, or extremely long term bets is money in the pocket of the casino – the casino in this case being the political elite who set the table rules, and force you to play with their chips.

JIMB October 9, 2007 at 7:32 pm

Jean Paul – The first RBD stipulation is impossible. Increasing the supply of money cannot be neutral, just as increasing the supply of any other good cannot be neutral.

Further, it is not possible to predict how much error is introduced when money supply can grow because goods no longer have to compete for the a pool of money that is stable in size. So one good may “shoot to the moon” (like real estate) and that be regarded as “even better collateral” rather than deserving of even more discounted value.

Jean Paul October 9, 2007 at 8:47 pm

JIMB says: “Increasing the supply of money cannot be neutral, just as increasing the supply of any other good cannot be neutral.”

It is neutral by definition.

If I take a carrot out of the market and put an ‘identical’ carrot in, that is a price-neutral operation. No prices of anything in terms of anything else change. If I take a shoe out of the market and put an ‘identical’ shoe back in, that is also a price-neutral operation.

Where ‘identical’ here means ‘valued identically by the market’, you can see that ‘identical’ substitutions are always price-neutral.

Now if money is by definition identical to the goods that back it, then swapping goods for money is simply an on-paper labelling exercise – and absolutely price neutral for any single marginal single transaction.

If the introduction of money as surrogate for existing goods is price neutral for each discrete transaction, then it is price neutral in the aggregate as well.

Depreciation, where it is observed, is purely due to the depreciation of the backing asset with respect to the bank’s purchase price – this depreciation is inevitable when banks make ‘bad’ trades that don’t cover the bank’s overall loss rate.

That’s what the RBD says and it is correct.

TLWP Sam October 9, 2007 at 9:04 pm

‘in a growing economy, each dollar (or unit of labor) should purchase more of the same units of what it did previously.’

Oops, did Person cack in his own nest then? I certainly believe a better measurement for a potentially wealthier society is the labour time to personal goods ratio. That is to say, how much does working 40 hours a week, say, can convert into purchasing power at the store. So who cares if the dollar value is going down if people get paid more in line with price increases? And even this may presents problems as technology can make that which was hand-made suddenly mass produced or render certain valuable jobs invaluable as those skills aren’t required much any more.

P.S. Yes, I’m pretty much agreeing with what you said Jean Paul with example about the caveman with five carrots.

Michael A. Clem October 9, 2007 at 9:58 pm

This is just getting weird. Carrots and work-hours both miss the point. The value of money is that it can be used for indirect exchange. Yes, if the working man’s salary or wages increase proportionally to price increases, then the same amount of work-hours will buy the same amount of goods. The problem, though, is that inflationary effects don’t take place immediately throughout the economy, but that they take time to propogate through the economy–Those that get the new money first benefit the most, while those that get the new money last end up paying extra or losing the value of their money.
Money has value only for its exchange value for real goods and services. A dollar may purchase a loaf of bread (or five carrots), but it is not equivalent to a loaf of bread. The dollar is of no value unless there are loaves to purchase. Putting new money into circulation by buying and storing assets does two things: it increases the money supply, and it removes an asset from the market. Instead of being an equivalent and neutral exchange, you’ve compounded the inflationary effect.
If the supply of money remains unchanged, then yes, an increased supply of goods and services would tend to be deflationary, and the value of the dollar would increase. One could argue that the money supply of a growing economy needs to be increased to avoid deflationary effects, but it’s difficult to determine the actual quantities of goods or of money, and you’d be using the inflationary effect to counteract the deflationary effect, or at least that’s what you’d be trying to do.
The actual amount of money in circulation isn’t really that big a deal, almost any arbitrary amount would work. The difficulties come from making changes to the money supply and to the ratio of money to goods and services.

Mike Sroul October 9, 2007 at 10:00 pm

Person:

“Even when the Fed’s profits are diverted to the treasury, that implicitly cancels government debt and increases the value of all of the other bonds the Fed holds (by bidding up bond prices).”

When the Fed hands $10 billion or so to the treasury, the effect on government debt (and bond prices) is negligible, while the effect on the Fed’s assets is to reduce them by $10 billion, which is not negligible.

That list of 5 points explains inflation, but don’t underestimate the importance of the last point–that the fed can cause inflation by maintaining (financial) convertibility at a rate below what its assets can support. That one can trump all the others.

Mike Sproul October 9, 2007 at 10:08 pm

JIMB:
“The idea inflation is from issuing currency against overvalued collateral sounds fantastically wrong.”

If a financial security (bonds, stocks, etc) is issued against overvalued assets, it will lose value. Yet when I say that the same thing is true of a particular fianancial security that is used as money, you call it fantastically wrong.

“Everyone borrowing $200K from their homes and spending next month would be massively inflationary, even though the collateral is worth MORE than the money issued.”

I repeat myself: That’s like saying that if farmers grew more food, we’d all be fatter. The food must be eaten to make us fat, just like the money must be spent to act on prices. Furthermore, the farmers won’t grow more food unless people pay them for it, just as the banks won’t issue a new dollar unless people want that dollar bad enough to offer something worth a dollar in exchange for it. As long as every new dollar is backed by a dollar’s worth of assets, there is no tendency to inflation

Mike Sroul October 9, 2007 at 10:16 pm

JP:

Nineteenth century note-issuing banks generally claimed that the issue of paper money was not profitable, since the expenses of printing, handling, etc. used up the interest they earned. The paper money was mostly issued as a form of advertising. If private banks broke even or lost assets from issuing paper money, it’s reasonable to think the same for the Fed. Furthermore, the Fed can always maintain financial convertibility at a rate lower than what its assets can support, so inflation can result even when the fed’s assets are growing.

jp October 9, 2007 at 10:52 pm

M Sproul said:
“If private banks broke even or lost assets from issuing paper money, it’s reasonable to think the same for the Fed.”

For someone who talks so much about monetary economics and the Fed, you are gravely mistaken.

Here is the most recent Fed annual report:
http://www.federalreserve.gov/boarddocs/rptcongress/annual06/pdf/audits.pdf

On page 23 is the income statement.

Revenues – $36 billion
Costs – $2.6 billion
Net income – 34.2 billion

That looks to me like a terribly profitable institution.

Mr Sproul, I’d suggest that in the future you get your basic facts right as such mistakes will cause people to doubt whatever about the RBD.

TLWP Sam October 9, 2007 at 11:33 pm

I beg to differ M. Clem. Doesn’t your reasoning basically must mean you regard gold as the primordial money? Yet isn’t technology the overall cause of the lag effect? Those who get access to a new technology or procedure benefit first and get the profit but eventually the new technology will make it throughout the system and the brief opportunity is past? Likewise, as I just mentioned, new technology can displace old jobs whilst creating new jobs. What if those in the old jobs don’t automatically get one of the new jobs? Perhaps another ho-hum craptacular moment of technology – the rules keeping changing and traditional ways of doing things may be made redundant. Perhaps it’s one of the times where one could look at the past with rose-coloured glasses when the economy was circular and you usually inherited your job and you could keep doing it for the rest of your life.

Jean Paul October 10, 2007 at 12:38 am

M. Clem says: “Putting new money into circulation by buying and storing assets does two things: it increases the money supply, and it removes an asset from the market. Instead of being an equivalent and neutral exchange, you’ve compounded the inflationary effect.”

The asset is not removed from the market (i.e. it is not consumed). The asset, which has value by virtue of being desired by consumers at a certain rate of exchange for dollars (invariant pre- and post-trade if the traders negotiate the price accurately), remains available to be consumed by some later purchaser.

The price of ‘unbanked’ assets do not increase in terms of money post-trade, because if they did, the bank would immediately sell the asset back to the market at the spontaneously inflated price, collecting more money than it had issued in the first place. If this ‘pump’ effect was due simply to the release of ‘MORE’ money, it could be repeated as needed to suck ALL the money out of circulation, while still retaining a large balance of assets.

Obviously arbitrage does not proceed unchecked in a free market, and sooner or later, before the bank could do what is suggested above, things would stabilize to a dynamic equilibrium. In equilibrium the vast majority of trades would be price-neutral at time of trade.

At any time, banked assets could be released back to market to prevent devaluation of the money – for example, if they failed to exceed some minimum rate of appreciation it would be in the bank’s interest to sell the asset back to the market that values it, and retire some money.

Jerry Lee October 10, 2007 at 7:44 am

I think the idea that as the amount of assets (or wealth) increases, the price of everything goes up.

The price of computers, for example, has gone down, even though people are more wealthy than they were 20 years ago. If increased wealth meant increased prices, they’d cost a lot more.

As production becomes more efficient, prices go down. Inflation (an increase in the money supply) may of course cause the price to go up.

TLWP Sam October 10, 2007 at 10:06 am

Bleh. If inflation is the term used to describe more money in the system then deflation has to mean less money in the system. Talking of computers is about technical and production efficiencies and conversely the other end of the straw must technical and production inefficencies. Then there’s low prices for products no one particularly wants versus highly desirable rare products with high prices . . .

Michael A. Clem October 10, 2007 at 10:42 am

Doesn’t your reasoning basically must mean you regard gold as the primordial money? Yet isn’t technology the overall cause of the lag effect?
Weirder and weirder. Any popular commodity could be used for money as long as people accept it and use it for indirect exchange. It’s just that historically, precious metals like gold and silver seemed to work the best as money. I have no particular preference for gold, I’m just trying to explain why gold was used, and what the real advantage of gold-based money was, not the mythical gold-bug version of it.
Yes, changes in technology can and does also cause changes in the economy, but in different ways than a changing money supply does. Changing technology doesn’t seem very relevant to this thread, though. When the bank or government adds to the money supply, they do it at a particular point of entry, as when the Fed buys bonds from other banks, and it takes time for that new money to circulate and have an impact on other parts of the economy. It’s not like the Fed could just add a dollar to everyone’s pocket or bank account at the same time.

Michael A. Clem October 10, 2007 at 10:54 am

The asset is not removed from the market
The price of ‘unbanked’ assets do not increase in terms of money post-trade, because if they did, the bank would immediately sell the asset back to the market at the spontaneously inflated price, collecting more money than it had issued in the first place.

Um, if the bank turns around and sells the asset, it then removes the money from the money supply, and thus counteracting the inflationary effect of buying it in the first place. That’s no way for the bank to make money. Besides, the inflationary effect isn’t immediate

Michael A. Clem October 10, 2007 at 11:01 am

TWLP, “inflation” is usually used to refer to a general rise of all prices in all areas. AFAIK, only Austrians are saying that inflation is specifically an increase in the money supply, although the Chicago people admit that inflation is a monetary phenomenon. Naturally, specific goods and services can change prices due to reasons other than inflationary or deflationary effects.

Mike Sproul October 10, 2007 at 12:33 pm

JP:

34 billion net income on 800 billion in assets not a fantastic level of profit, especially when adjusted for inflation. And the fact that the fed turns the profit over to the treasury only makes inflation worse.

10 billion. 34 billion. Doubtless this will not be the last time I say or do something to besmirch the dignity of the real bills doctrine.

greg October 10, 2007 at 1:14 pm

Mike Sproul: How about providing a year-by-year graph of the amount of government securities/bonds held by the Fed since its inception? Also, notation about any government debt that was retired (by hook or by crook) while in the Feds possession would be good too.

JIMB October 10, 2007 at 1:15 pm

Jean Paul – You’ve not “taken a carrot out of the market” … Banks lend against collateral without removing the collateral from the market. Clearly banks can only issue money for goods that are “ready for immediate purchase” as a lien againt collateral that will maintain it’s value.

Example:

Issuing loans against real estate (houses are infrequently traded) can be highly inflationary … traded goods are bought with this new supply of money, not houses. The currency then depreciates against goods-in-general (traded goods), while the house stays at the same nominal value. It’s only when the income from higher nominal wages cycle back into houses that houses rise.

So then of course there’s “more collateral” in houses to issue more loans against. This effect was the experience for the past 20 years until the recent housing boom in which the dollar depreciated against everything.

JIMB October 10, 2007 at 1:30 pm

Mike Sproul – Money is not a financial security. It is a medium of indirect exchange with immediate spendability (none of your examples have immediate spendability) and zero credit risk (all of your examples have credit risk).

You offer credit transactions and act as if they are “money”. There is NO other asset that meets the function of money, that is why it is money, and it is unique.

Examples:
Deposits – Credit with the bank. There is no “money” although the bank promises redemption at par.

Check – Draft ordering the transfer of money, netted by the bank interbank settlement system.

Refinance – Payoff with new credit cleared with money, netted by the interbank settlement system.

Unless I’ve missed what you are saying, I believe you need to do some thinking on what money is.

“…As long as every new dollar is backed by a dollar’s worth of assets, there is no tendency to inflation.”

Entirely incorrect in my view. Issuing currency against assets of reliable value can still lead to inflation if those assets are not *traded*. Issue 1 Trillion against real estate, even if highly collateralized, will result in massive inflation against ‘goods-in-general’ because real estate isn’t normally traded in the same volume the money is issued.

I’ve got to say that this sounds like it is straight from the John Law book of economics. Have you read http://mises.org/books/inflationinfrance.pdf ?

The arguments John Law made were remarkably like those in support of RBD.

eric lansing October 10, 2007 at 1:54 pm

according to RBD, a bank takes an asset (say an IOU from a farmer backed by his farm and issues money against it. Why should the farmer issue an IOU in exchange for money? Because he wants to borrow.

Now, say I open a bank in RBD world… I need no capital to do so – all I am doing is accepting assets and issuing Lansings which (curiously this has gone much undiscussed) people will presumeably use as payment for goods and services.

What the farmer wants?… he wants purchasing power to secure for himself goods and services, perhaps to expand his farm and hence his future production. If the farmer cannot pay his IOU, the money obviously becomes worthless. (btw Antal Fekete is an RBDer who advocates only 91 day self liquidating bills as proper backing for money.)

What I believe has gone overlooked here is the fact that my lansings represent nothing. I have not saved anything. What the farmer wanted was *savings* to sustain himself while he expands his farm… he wanted bread, shoes, etc.

Assuming (as I don’t) people would accept bank money (Lansings) then Mr Farmer will be engaging in consumption that is not backed by production. Even if prices don’t rise, the capital structure of the economy is being consumed.

jp October 10, 2007 at 3:21 pm

“34 billion net income on 800 billion in assets not a fantastic level of profit, especially when adjusted for inflation. And the fact that the fed turns the profit over to the treasury only makes inflation worse.”

The Fed’s retun on assets is 4.3%, which compares favorably to commercial banks Royal Bank (0.92%), Bank of America (1.54%) and Citigroup (1.27%). Again, you are speaking without an eye to the data.

And by returning profit to the treasury, the Fed still maintains the same amount of backing for each dollar, not less. That’s because existing dollars are already backed by bonds and don’t need the profits from those bonds as additional backing.

You’re theory is interesting, but you seem unable to use it to explain the real world. For instance, you still haven’t explained how the tremendous drop in the purchasing power of the dollar since 1980 has occurred in the face of the tremendous bond bull market over that same time (bonds being what back the dollar).

Here is a better real world question:

I’m sure we can all agree that since 1996, the value of the dollar has fallen. The CPI has risen from 155 to 210. The Dow has risen from 5,000 to 14,000. The Case-Shiller Housing Price index has gone from 50 to 160 or so. Any argument here?

According to your theory, this can only be because the amount of backing for each dollar has declined.

Yet according to the Consolidated Statement of Condition of All Federal Reserve Banks, here are the numbers.

Dec 1996
backing assets: $462 billion
circulating currency: $424.5
each dollar is x% backed: 108.9%

Oct 2007
backing assets: $832
circulating currency: $777
each dollar is x% backed: 107.1%

note: backing assets include gov’t issued and guaranteed securities, foreign currency, gold, SDRs, repos, and discount loans

Yes, the amount of backing has declined slightly, but is it enough to explain why the dollar’s purchasing power has dropped by 30-50% (very approx) since 1996? I don’t think so.

Greg’s suggestion that you provide a year-by-year graph of the amount of government securities/bonds held by the Fed since its inception is a good one. Funny enough, I am in the midst of compiling circulating currency and backing data (including not only gov’t securities but gold, disc loans, repos, etc from 1940 to present) and will make this data available to anyone interested. Will you go out on a limb and predict that the value of the assets backing circulating dollars has declined over that time frame?

jp October 10, 2007 at 4:19 pm

“And the fact that the fed turns the profit over to the treasury only makes inflation worse.”

I just realized that the main problem with this statement is that profits can’t back anything.

The Fed earns a dollar profit from its bond portfolio. On the asset side of its balance sheet you’d see these profits appear. But how can these profits back anything? They are dollars. And dollars cannot back dollars.

So its irrelevant what the Fed does with its profits. Your belief that sending Fed profits to the treasury causes inflation is wrong since profits, or cash, simply cannot back cash.

Jean Paul October 10, 2007 at 5:55 pm

Yes, cash can back cash, provided the backing cash is itself backed, which it has to be because its original issue occured in exchange for genuinely valued backing.

Cash backing cash, of all things, must be seen to be the ultimate uncertainty-free inflation-neutral situation.

Mike Sproul October 11, 2007 at 2:20 pm

Greg and JP:

If you want empirical studies, see

Thomas Cunningham: “Some real evidence on the real bills doctrine vs. the quantity theory”

Bruce D. Smith: Several articles on american colonial currency

Thomas Sargent “The Ends of 4 big inflations”

A little poking around should convince you that since central banks are run by quantity theorists, they collect only data that quantity theorists would be interested in: Tons of data on various measures of the money supply, and almost nothing on the value of the central bank’s assets.

Let me emphasize again that the RBD only sets an upper bound on the value of the dollar. If the fed chooses to maintain financial convertibility at a low level, then the value of the dollar can be much less than the Fed’s assets would lead you to think.

Mike Sproul October 11, 2007 at 2:26 pm

JIMB

It doen’t matter if you call a thing money or not. It’s spent just the same.

In 1710, people denied that paper money was actual money, since every paper pound had ultimately to be paid off in coins

In 1845, people denied that checking account pounds were money, since every checking account pound had ultimately to be paid in paper or coins

Since 1950, people have denied that credit card dollars are money, since every credit card dollar must ultimately be paid with a check, paper note, or coin.

I’m going to predict that by the year 2050, credit card dollars will finally be counted as money, but there will be some newer kind of money that economists will refuse to recognize.

Mike Sproul October 11, 2007 at 2:30 pm

Eric Lansing:

If your lansings are backed by nothing and people know it, then they will have no value. If they are backed, and people know it, they will have value. If enough people know it, they might actually be used in trades, but since you have to hold enough assets to buy them all back, you won’t get the free lunch you might have hoped for.

eric lansing October 11, 2007 at 2:55 pm

Mike,

that wasn’t my point. Even if the Lansings are backed by assets and accepted on the market, the RBD you describe is not borrowing & lending. People borrow *money* (or savings) so they can secure for themselves real goods & services to sustain themselves (say… to improve their capital structure – they must halt production to spend time & resources on this expansion).

In my example, the Lansings are backed by an IOU which is backed by a farm, but I have not facilitated the transfer of savings from saver to borrower, so if my Lansings are used they will be used to consume (steal) capital.

What the farmer wants is food, clothes, services etc. For him to borrow those he must find someone willing to lend those. My RBD bank does not have those. Fractional banking results in consumption that is not backed by production.

Michael A. Clem October 11, 2007 at 4:26 pm

Why do you people keep wanting to make things complicated? The simpler economics can be explained, the easier it will be to explain it to mainstream people.
Essentially, money is simply anything that most people will accept and use for indirect exchange. Cigarettes in jails are essentially money, but in limited circumstances, since most other people not in jail don’t accept cigarettes as a medium of indirect exchange. Credit cards, on the other hand, are not money, because people don’t trade cards, they use cards to manage money transactions without having the money in hand. When I pay with a credit card, I’m not giving the seller a quantity of cards, just a convenient way of handling the transaction. The credit card company gives the seller the money, and then I pay the credit card company in return. Paper currency wasn’t originally considered money because people didn’t trust it, but as its use became more common and more acceptable, it became money, and not merely a money substitute.
Asset-backing doesn’t assure the value of money, that’s determined by good old supply and demand, demand being based on how much money people want for indirect exchange. As I’ve already said, using precious metals like gold or silver for backing money helped reassure people that the supply of money doesn’t go wildly out of whack.
The history of the Fed has given Americans a certain amount of confidence in the dollar, but without something like the gold standard, that trust is more precarious than it needs to be. Bonds for backing provide no real limits on the money supply. Greenspan had a reassuring effect (why do you think people were so darned worried about what Greenspan would say?), but another Volcker as Fed Chair would probably cause increased insecurity. Bernanke doesn’t want to upset the current apple cart, but it’s not clear that he can do as well as Greenspan. And so it goes.
The backing of money is more of a psychological factor rather than any real economic factor in the value of money.

Jean Paul October 11, 2007 at 6:40 pm

Supply and Demand are not about quantity alone. You cannot forget the subjective valuation people place on wants satisfied. This is an aspect which cannot be separated from supply and demand. If quantity goes up, but subjective valuation per unit remains constant, then there is no depreciation due to quantity.

The backing of money represents money’s ability to satisfy wants. To the extent that the backing satisfies wants, the money that stands as proxy for the backing will satisfy wants, and thus it attains approximately equal subjective value as the share of backing assets that it represents (many would value the money more than the concrete backing asset, until point of consumption, due to the portability, longevity, and transaction convenience the money provides prior to an act of consumption).

It has nothing to do with quantity.

What the RBD says is: if you issue money at the appropriate rate of exchange SUCH THAT there is no inflationary effect, and there will be none. It’s somewhat tautological. The key thing is getting the exchange rate correct. If the bank gets it right and the asset-seller gets it wrong, the consequence is neutral or positive appreciation of the money relative to its prior value. If the bank gets it wrong and the asset-seller gets too much money for the stuff he sold, then the money depreciates.

You don’t need to make it a personal mission to track the value of the backing if you don’t want to. You just need to have faith that the other market participants, acting in concert, will provide enough pricing signals to track the value of the backing.

It’s as simple as it can possibly be.

Some examples about IOUs, since they seem a popular gripe:

If IOUs have, and sustain, a certain market value, then the IOU can be used in trade directly on the market. Thus it can EQUIVALENTLY be exchanged for some inflation-neutral quantity of money. I don’t know what that quantity is, but the market does, and if the bank can figure it out, they can safely retain the asset and issue that much money.

If the IOU has zero value in the market, then inlation-neutral exchange rate is zero dollars per IOU, and every issue of a nonzero quantity of money for this IOU will be inflationary at the time of issue (the effects of which will be felt after some elapsed latency).

If the IOU has some nonzero market value on the transaction date, then the issue of money will be non-inflationary on the transaction date. However if the value of the IOU changes as some point, the money will adjust its value sympathetically (with some latency while the innate intelligence of the market discovers what has happened).

The RBD is absolutely sound. Under free banking this would quickly become apparent. The inflationary nature of the current system has two causes: wealth inflation occurs at the rate of wealth production and is refelcted in prices; also an ineptly-managed monopolist currency will significantly underperform a well managed RBD currency in a competitive currency market.

eric lansing October 11, 2007 at 7:53 pm

Jean Pierre, I just can’t take you seriously… it’s like you’re high on cocaine.

Clem, I don’t buy the “reassurance” theory either. Inflation is not bad because it causes prices to rise. It is bad because it causes a boom and then a bust, and the bust commeth…

http://mises.org/article.aspx?Id=1480

Mike Sproul October 11, 2007 at 8:48 pm

Eric Lansing:

Say I’m a farmer with 100 bushels of wheat in my barn, ready to sell. I need to buy lunch, which I can pay for with 1 bushel. But I find it more convenient to pledge 1 bushel to the bank in exchange for 1 checking account dollar lent into my account. This transaction does not increase my net worth, and creates only a negligible increase in my ability to buy goods. There is no more demand than there used to be, and so no effect on prices. Furthermore, the newly created dollar is backed by a bushel of wheat, so the dollars hold their value. If the new dollar wasn’t wanted in the circulation, then someone would bring the dollar back to the bank in exchange for a dollar’s worth of the bank’s assets.

JIMB October 11, 2007 at 9:21 pm

Mike Sproul (and others) – Those historical securities gained their value by being connected to gold, i.e. money. In my view, the analysis really needs to stick with the facts of human action.

Money is defined by its unique economic function.

Today, a U.S. transaction is ultimately settled in actual electronic money (reserves of the banking system through the Fed) or in cash, and direct trades of financial assets are only possible using either as a money-substitute: their value depends on being exchangeable into money, not the reverse.

Said another way: money substitutes always depend on their being convertible into money. If they were unconvertible, those substitutes would have no value. Hence the very real difference between “any financial asset is money” and what the market regards as money.

It doesn’t sound to me like you are making the necessary distinctions to have an informed opinion about the validity of RBD.

Jean Paul October 12, 2007 at 12:21 am

Eric Lansing, thank you for the kind words.

Anyway, it would be nice if we had free banking, then we wouldn’t have to argue about it, we could just see it and shrug.

Michael A. Clem October 12, 2007 at 8:41 am

Clem, I don’t buy the “reassurance” theory either. Inflation is not bad because it causes prices to rise. It is bad because it causes a boom and then a bust, and the bust commeth…
I would agree that the boom/bust is the bigger problem, but it’s the result of the inflation, and higher prices are always a problem for the consumer with lagging wages. I’ll keep thinking about this, but as it stands now, I don’t see how the backing of currency has all that much to do with its actual spending power, except as it reassures the consumer that the money supply won’t vary wildly.
Any commodity that’s acceptable to people could be used as money, and the important thing is how the money supply is controlled. Backing by precious metals has been the historical method of controlling the supply, but other ways are possible.

Michael A. Clem October 12, 2007 at 8:53 am

Supply and Demand are not about quantity alone. You cannot forget the subjective valuation people place on wants satisfied.
Since money is only valued for its ability to be used in indirect exchange, that is for its ability to satisfy wants, then the demand for money is directly related to the subjective valuation people place on wants satisfied. Supply, of course, is done by the bank or government that provides money.
I’m not convinced that the backing of money represents money’s ability to satisfy wants. Money’s ability to satisfy wants depends primarily upon other people accepting the money, and how much they value the money. Backing may reassure people that the money has value, but as a true economic phenomenon, I don’t see how backing actually gives the money any value. You could say, for example, that a dollar represents 1/35 oz. of gold, but its real value is its purchasing power, which is based upon people accepting the dollar and how much people value that dollar. In other words, its real value is based upon subjective valuation, like any other commodity.

Michael A. Clem October 12, 2007 at 8:56 am

Anyway, it would be nice if we had free banking, then we wouldn’t have to argue about it, we could just see it and shrug.
Agreed. I would be satisfied with money derived from a free market process.

eric lansing October 12, 2007 at 10:29 am

Mike,

if the farmer wants to borrow lunch & is willing to go into debt, pay interest and pledge a bushel as collateral, he will surely find a willing lender – someone who, for argument’s sake, has an extra lunch lying around (savings) that they’re looking to lend at interest. Only if everyone in the economy was consuming all they produced & saving nothing would he be unable to borrow.

The RBD bank, however, does not have this lunch to lend. It could only lend the lunch if someone had saved & deposited a dollar with it.

Mike Sproul October 12, 2007 at 10:52 am

JIMB:

Those arbitrary distinctions about what is money and what is not are what lead quantity theorists astray. Are checking account dollars money? Are savings account dollars money? Are gift certificates money? How about overdrafts, certificates of deposit, US bonds, shares of GM stock, foreign currency? I could use any of those things to buy certain items. The fact is that there are degrees of moneyness, but once you recognize that the value of any given financial security–from federal reserve notes to gift certificates–is determined by the assets and liabilities of its issuer, and not by the money substitutes available, all that tortured reasoning about “What is money” can be seen as just a case of people asking the wrong questions.

Mike Sproul October 12, 2007 at 10:59 am

Michael Clem:

If you’re OK with free market money, you should be OK with (say) Disney dollars or Mike dollars. Quantity theorists, however, would say that those “money substitutes” would reduce the demand for “real” money and thereby reduce the value of the dollar. Murray Rothbard once told me that it should be illegal for a bank to issue dollars that are convertible into 1/35 oz of gold, and then, with customer consent, swap their gold for an equal value of silver. Are you a libertartian or a quantity theorist? You can’t be both, unless you’re Rothbard.

Mike Sproul October 12, 2007 at 11:11 am

Eric Lansing:

“The RBD bank, however, does not have this lunch to lend. It could only lend the lunch if someone had saved & deposited a dollar with it.”

A bank gets 10 oz. of silver on deposit and issues 10 paper receipts (“dollars”). The farmer then pledges one bushel of wheat (or a square foot of land, for that matter–anything worth at least 1 ounce of silver) and the banker willingly prints another dollar and lends it to the farmer. The bank does indeed have the dollar to lend, and the dollar is adequately backed by the wheat or the land, so it causes no inflation. Someone “saved” a lunch to offset the farmer’s borrowing, or you could say that the farmer sold his wheat forward to pay for his lunch today, but that is irrelevant to the quantity of dollars issued.

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